Common real estate formulas you should know

Property still seems to be the best long-term investment one can make into one’s retirement.

We all struggle to save. Property, specifically a property you can rent out, is a forced retirement plan. Buying a property is a significant commitment that you are required to commit to and maintain.

Property is probably also the single biggest investment an individual will make. The asset, its return and the viability of operating, leasing or growing your capital relies heavily on the type of decisions made in the investment process. The real estate market involves a lot of math, and understanding real estate finance includes knowing a lot of formulas and ratios. Sometimes it’s easy to forget or confuse them.

Here are three basic formulas to help you along your way.

Net operating income (NOI)

The starting blocks of the investment marathon is the operating cost and possible net operating income (NOI). NOI measures
the ability of a property to produce an income stream from operations. Understanding the NOI is essential when it comes to investing in real estate. Without a firm grasp of NOI, it’s impossible to fully understand your investment.

NOI is simply the annual income generated by an income-producing property after taking into account all income collected from operations, and deducting all expenses incurred from operations. The net operating income formula is as follows:

Calculating NOI is relatively straightforward once you break out each of the individual components. The components of NOI consist of potential rental income, vacancy and credit losses, other income, and operating expenses.

It’s also important to note that there are some expenses that are typically excluded from the net operating income figure, being:

• Debt service
• Depreciation
• Taxes
• Tenant improvements
• Leasing commissions
• Reserves for replacement
• Capital expenditures

While many of the above items are almost always excluded from NOI, it’s important to remember that some are open to interpretation depending on the context. Keep this in mind when evaluating NOI calculations performed by others.

Capitalisation rate

The capitalisation rate, also just called the cap rate, is used by many investors to quickly determine what a property is worth, or to measure the performance of a property already owned. In other words, the cap rate gauges profitability.

Basically, this formula expresses the ratio between a rental property’s value and its net operating income (NOI). So, for example, if a property is valued at R1,000,000 and has an NOI of R100 000, then the cap rate would be R100,000/R1,000,000, or 10%. The advantage of the cap rate is that it considers vacancy, credit losses, other income, and operating expenses. It also doesn’t require complicated cashflows.

What does the cap rate tell you?  One way to think about the cap rate is that it represents the return an investor would receive on an all cash purchase. For example, it can and often is used to quickly size up a possible investment relative to other potential investment properties. Another way cap rates can be helpful is when they form a trend.  If you’re looking at cap rate trends over the past few years in a market, the trend can give you an indication of where that market is headed. 

It’s important to note here that the NOI did not include debt financing, hence the cap rate is best used when looking at cash purchases. You can however factor in debt financing, remembering to do this for all properties being compared and the likelihood that you are restricted to the first year of operating data for accuracy.

Gross rent multiplier (GRM)

The gross rent multiplier (GRM) is the ratio of sales price, over potential annual rental income (PRI). This is a simple measure that can give you an indication of value relative to the market trends.

You would first calculate the GRM using the market value at which other properties in the market sold, and then apply that GRM to determine the market value for the target investment.

Conclusion

Calculating NOI is an important step in evaluating and valuing a property. Once you have an NOI figure, you can begin looking at various measures such as the cap rate, Cash on Cash Return, Debt Service Coverage Ratio and the Net Present Value amongst others. Then you can also move on to a more detailed analysis that includes a bottom line cash flow figure and a full discounted cashflow analysis.

In our country, there is still a significant shortfall of good developments to house a generation of financially secure individuals not satisfied with low cost housing and struggling residential areas. This shortfall further drives the investment growth opportunity in organised residential estates.

Real estate is one of the few investment vehicles where using the bank’s money couldn’t be easier. The ability to make a down payment, leverage your capital, and thus increase your overall return on investment is still a solid investment. Product scarcity and financing access to the ordinary individual ensures it remains a great investment, if you inform yourself of the risks and make a calculated decision.