Real Estate Investing - 3 Formulas Investment Newbies Should Learn

Successful real estate investing is the result of hard work, good research, and a stringent analysis of each and every investment opportunity. There is no other ("secret") way to achieve real estate investing success.



Yes, a proficient real estate professional can help you find, research, and even analyze the profitability of specific investment opportunities. But that does not mean that you should not be prepared. It is good for you to have some knowledge of the rates of return real estate investors generally use during the analysis process before you make that all-important decision to purchase a rental property, regardless.



Since you are new to real estate investing, it seems like a good idea to discuss three of the most commonly used measures and returns. None of these would provide enough data to sway a decision by themselves, so you cannot make a decision solely on the results of these returns. But they are popular, you will hear them referred to, and it certainly will better prepare you to achieve your investment goal by becoming familiar with them.



1) Cash on Cash Return - Cash on cash return (C-o-C) measures the initial profitability of a rental property. That is, it indicates the return you can expect to receive in the first year on the money you invest to purchase the property (i.e., the initial cash required to cover your down payment and closing costs). There are no hard fast rules regarding what cash on cash return makes a good investment, but it should be obvious that the higher the cash on cash return is the better.



Formula: Cash on Cash = Before Tax Cash Flow / Cash Equity (Initial Investment)



Test your understanding: Given the opportunity to invest $50,000 for a cash-on-cash return of 6.5% or an investment of $75,000 for a 10.2% return, which appears to be the better investment? Though it would require more cash outlay, the higher return, at least on the surface, seems to be the better investment. Why, because a first-year yield of 10.2% on your cash investment is better than a first-year yield of 6.5%.



2) Gross Rent Multiplier - Gross rent multiplier (GRM) measures the ratio between annual gross rental income and sale price. Gross rent multiplier is not efficient as a stand-alone number and is probably the least informative because it does not indicate profitability, nor does it consider operating expenses or debt service. Nonetheless, gross rent multiplier can be helpful for simple comparisons between rental properties. It is an easy calculation you can make in your head, and can be used when you simply want to get some idea how the price for one rental property compares to similar properties recently sold or currently for sale in the market. In this case, a higher GRM indicates a higher property value.



Formula: Gross Rent Multiplier = Purchase Price / Gross Rent



Test your understanding. What does it say about a rental property selling at a gross rent multiplier of 7.2 given that two similar duplexes in the area recently sold at gross rent multipliers of 8.5 and 9.0? Namely, that the duplex for sale appears to be offered at a better price than the comparable duplexes.



3) Capitalization Rate - Capitalization rate (or cap rate) is essentially an indicator of how much debt an income property can carry; the higher the cap rate, the more debt a property can support, and vice versa. The idea is straightforward. A property's cap rate indicates the percentage rate of sale price attributable to net operating income (income less operating expenses). That is, it shows how much cash flow is generated to make the mortgage payment as a percent of sale price. In this case, a higher cap rate indicates that more money would be available to pay the loan, and explains why lenders use it in their appraisals.



Formula: Capitalization Rate = Net Operating Income / Purchase Price or Value



Test your understanding. Would you consider a small office building selling at a cap rate of 9.7% to be better priced than a building with a capitalization rate of 7.2%. Well, you should, because by all appearances it seems to generate a higher net operating income.



You get the idea. Pure luck is improbable to succeed at real estate investing. So seek out a real estate agent who can help you with the research, and a good real estate investment software solution to run the numbers for you. Because the more prepared you are for real estate investing, the better your chances are to make money at it.



Here's to your real estate investing success.

James Kobzeff is the developer of ProAPOD - leading real estate agent software solutions since 2000. Create rental property cash flow analysis and marketing presentations in minutes! Easy and affordable. Go to => www.proapod.com