Investing In Real Estate When You’re Young – 3 Formulas To Know
Investing in real estate is a fun and exciting adventure but it also takes a little bit of know-how and some math. Don’t worry though, I’m not talking about complicated calculus equations or anything like that. What I want to do is take you through three formulas that can lead you in the right direction when evaluating a real estate deal.
These formulas are:
- Capitalization Rate (Cap Rate)
- Cash-on-Cash Return
- Monthly Rent Ratio
Before we get into these formulas I want to make sure you understand that these are not set rules of evaluating properties. There are many aspects that go into any real estate deal and if a deal checks off on one of the ratios below that doesn’t mean it’s a good deal. Each ratio will vary widely based on:
- Location of the property
- The type of property
- Condition of the property
- The state of the real estate market/economy
- Your plans for the property
- Your personal money situation
What these equations will allow you to do is evaluate any deal in under 20 minutes from a math standpoint. Numbers don’t lie and numbers don’t take into account emotion. That is why I rely on numbers over everything else as we close on our first duplex purchase.
Capitalization Rate (Cap Rate)
If you have been around anyone that has ever invested in real estate and gotten into the numbers then you have heard the term cap rate or capitalization rate for you fancy people. If you haven’t ever heard this term from someone who has done any sort of real estate investing then I would highly suggest you turn around and walk away slowly.
The cap rate is essentially the return that you should expect a property to give you. In simple terms, it is your return on investment. To calculate a cap rate of a property you need to follow this formula:
The cap rate makes an assumption that you are purchasing the property in cash. I realize most people, including myself, won’t be doing this but it does give a great gauge of a real estate deals value.
One part of the cap rate formula is the net operating income (NOI) of a property. To calculate NOI you need to do a couple of things. First, figure out what your yearly gross rent total is. For example, a property that rents for $1,000 a month has a yearly gross rent of $12,000.
Next, you need to total all of your expenses excluding your mortgage payment on a property. Property taxes, insurance, maintenance, management, and a vacancy cost should all be totaled up. Finally, subtract that number from your yearly gross rent to get your NOI.
Take this number divided by the current market value of your property and you get your cap rate.
Personally, I shoot for my cap rate to be better than my next best alternative. The thought process here is why would I invest in real estate if it offers a lower return than say the stock market. Because of this, I use 7.5% as my cutoff. Another way of doing this is by comparing multiple pieces of real estate. The one with the highest cap rate may be your best option.
We all want a return on our cash that we invest in a real estate deal and that is what the cash-on-cash return formula tells you. Buying any property is going to take a large chunk of capital. Most of this will go towards the downpayment while the rest will cover things like closing costs.
In those closing costs will be things like your inspection, escrow balance, filing fee, and a bunch of other small fees. I can’t stand fees but that’s a part of the game we play. It doesn’t matter how you feel about it though, the point is you still want to get a return on your initial cash invested.
Here is how to calculate it:
This formula may seem a little more complicated but I assure you it isn’t. Most people freak out when they see the term “Annual Before-Tax Cash Flow” and think only an accountant can get that number. I assure you, you don’t need to call them to figure this out. Annual before-tax cash flow or BTCF is calculated by taking your net operating income (which we just calculated) and subtracting your mortgage payment (principal and interest).
This number will give you the income that your property would give you at the end of the year just before you pay taxes and deduct depreciation.
Then we simply take this number and divide it by the total cash invested. Obviously, you want this number to be as high as possible. Personally, when I’m looking at a residential rental property, in my area, I’m aiming for greater than 15%. Again, it will matter on all the aspects I described in the introduction.
Monthly Rent Ratio
Of the three formulas, the monthly rent ratio is by far the easiest and quickest of them all. If you are buying a property to turn into a rental or to house hack as we do then you need to make sure it passes or comes close to passing, the monthly rent ratio. The formula for this is simple:
Take your monthly gross rent, that’s total rent without any expenses taken out, and divide it by the market value of your property. If you are house hacking then add in your area as if you were renting it to a full-time tenant. If you are living in a duplex then pretend that the whole side is rented to someone else. Your rent ratio goal should be 1% or greater.
For example, if you own a $150,000 single-family home and rent it for $1,550 a month that would make your rent ratio 1.03%. Or passing the rent ratio test. For the duplex we are buying it currently has a rent ratio of .96%. This is under the 1% rule but not so much that it’s a red flag. I believe in a couple of years we can get it well over that benchmark.
Is Real Estate Right For You?
Before I end this article I want to give you a warning. Real estate can be a great investment but all too often I see it made out to be an easy investment that will put money in your pocket every single month.
Nothing about investing in real estate is easy. It takes a ton of time, money, and sweat equity. Just getting the paperwork ready for our duplex deal took me 10-12 hours. In the scheme of things that may not seem like a lot but at the time I promise you’ll be second-guessing yourself.
That is just the start. When you actually do buy a property you need to understand that you are responsible for it. You have to find renters, you have to clean, you have to fix things, and the list goes on and on. Can you pay for a management company? Sure, but when you are just starting out you may not have the capital to do that.
This section isn’t meant to scare you off from investing in real estate when you’re young but I want to be 100% honest with you and make sure you know what you are getting yourself into. This all ties into the point I made at the beginning of this article, investing in real estate goes past just the numbers.
The Bottom Line
If you look at any piece of real estate and run it through these three formulas I’m confident you will have a greater idea of what kind of prospect you are looking at. No matter how much due diligence you do on a property things are going to go wrong and you will miss something. That is just the name of the game.
All I can say is learn to roll with the punches and learn from every step. In the end, it has been a rewarding experience and I would suggest anyone that has an interest in taking a chance on.
If you want to learn more financial formulas that you can use to evaluate real estate then I would recommend checking out Bigger Pocket’s article. Lastly, if you want to follow along on our journey of purchasing a duplex as a real estate investment then make sure you subscribe to the Young, Dumb, and NOT Broke?! YouTube Channel.
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