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Real Estate Math

By - 2007

Real estate math isn't something you need to learn for calculating interest rates or amortizing loans. There are computers and calculators to do that. What you need to know though, is a few simple formulas so you can say whether a property is a good investment or not.

Real Estate Math You Don't Need

There is one formula you don't need - the gross rent multiplier. I only bring it up because people are sometimes still using it, and there are better ways to estimate value now. The gross rent multiplier is a crude way to put a value on a property. You decide that you want to buy something that sells for 10 times annual rent or less, for example. You simply multiply the gross annual rent a building collects by ten, and that gives you your value.

You can probably see the problems with this formula. It has to constantly change to reflect interest rates for starters, because a property might be profitable at 12 times rent when interest rates are low, but suck you dry at eight times rent if the financing is expensive. Add to that the fact that there are just plain different expenses for different properties, especially when some include utilities in the rent, for example. The gross rent doesn't say much about the factor that makes a property valuable: net income.

Real Estate Math You Need

You buy rental properties for the income they produce, so this is what your real estate valuation should be based on. This is why your real estate math education needs to start with the how to use a capitalization rate, or "cap rate" to determine value. The cap rate is the rate of return expected by investors in a given area, or the rate of return on a property at a given price.

An example will hopefully make this clear. You start with the gross income of a property and subtract all expenses, but not the loan payments. Suppose the building's gross income is $76,000 per year, and the expenses are $32,000, leaving you a net income before debt-service of $44,000. To arrive at an estimate of value, you simply apply the capitalization rate to this figure.

Suppose the usual capitalization rate is .10, for example (ask a real estate professional what is normal in your area), meaning investors expect to get a 10% return on the value of their investment. You would divide the net income of $44,000 by .10, and you get $440,000. This gives you the estimated value of the building. If the common rate is .08, meaning investors in the area expect only an 8% return, the value would be $550,000.

Simple Real Estate Math

Net income before debt-service divided by cap rate - this really is simple real estate math, but the tough part is getting accurate income figures. Make sure the seller is showing you ALL the normal expenses, and not exaggerating income. Suppose he stopped repairing things for a year, for example, and is showing "projected" rents, instead of actual rents collected. In that case, the income figure could be $15,000 too high. This would mean you would estimate the value at $187,000 more (.08 cap rate).

In addition to verifying the figures, smart investors sometimes separate out income from vending machines and laundry machines. If these sources provide $6,000 of the income, that would add $75,000to the appraised value (.08 cap rate). First do the appraisal without this income included, then add back the replacement cost of the machines (probably much less than $75,000).

Be careful when you use any real estate appraisal method. No formula is perfect, and all are only as good as the figures you plug into them. When used carefully, though, real estate appraisal using capitalization rates is the most accurate method for rental properties.

For putting a value on a single family home, you need another approach. Yes this means more real estate math to learn. See the page Real Estate Appraisal.

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Houses Under Fifty Thousand | Real Estate Math