By James Kobzeff,
the developer of ProAPOD,
Salem, OR, U.S.A.

jamesrk at proapod com
http://www.proapod.com/

Real estate investing success depends on an understanding of several key financial measures and formulas. Otherwise, investment real estate cannot be evaluated concisely, which in turn, can cause investors to lose money.

So to help you better understand real estate investing, I've assembled a list of twenty-one measures and formulas used by investors. Some formulas are omitted because they require a financial calculator or investment real estate software to compute.

1. Gross Scheduled Income (GSI) - This represents the property's total annual income, as if all the space was occupied and all the rent collected. It includes the rent actually generated by occupied units, as well as a potential rent for non-occupied units.

Example: $46,800

2. Vacancy & Credit Loss - This is potential rental income lost due to unoccupied units or nonpayment of rent by tenants.

Example: $46,800 x .05 = $2,340

3. Gross Operating Income (GOI) - This is the gross operating income, less vacancy and credit loss, plus income derived from other sources such as coin-operated laundry facilities.

Example: $46,800 - 2,340 + 720 = $45,180

4. Operating Expenses - These are the costs associated with keeping a property in service and revenue flowing. This includes property taxes, insurance, utilities, and routine maintenance but does not include debt service, income taxes, or depreciation.

Example: $18,525

5. Net Operating Income (NOI) - Net operating income is one of the most important measures because it represents a return on the purchase price of the property and, in short, expresses an objective measure of a property's income stream. It is the gross operating income, less the operating expenses.

Example: $45,180 - 18,525 = $26,655

6. Cash Flow before Taxes (CFBT) - Cash flow before taxes is net operating income, less debt service and capital expenditures, plus earned interest. It represents the annual cash available before consideration of income taxes.

Example: $26,655 - 19,114 = $7,541

7. Taxable Income or Loss - This is the net operating income, less mortgage interest, real property and capital additions depreciation, amortized loan points and closing costs, plus interest earned on property bank accounts or mortgage escrow accounts. Taxable income may be negative as well as positive. If negative, it can shelter your other earnings and actually result in a negative tax liability.

Example: $1,492

8. Tax Liability (Savings) - This is what you must pay (or save) in taxes. It's calculated by multiplying the taxable income or loss by the investor's tax bracket.

Example: $1,492 x .28 = $418

9. Cash Flow after Taxes (CFAT) - This is the amount of spendable cash generated from the property after consideration for taxes. In brief, it's the bottom line, and is calculated by subtracting the tax liability from cash flow before taxes.

Example: $7,541 - 418 = $7,123

10. Gross Rent Multiplier (GRM) - This enables you to quickly estimate the market value of any rental property.

Formula: Price / Gross Scheduled Income = GRM

Example: $360,000 / 46,800 = 7.69

11. Capitalization Rate - Cap rate (as it's more commonly called) is the rate at which you discount future income to determine its present value.

Formula: Net Operating Income / Value = Cap Rate

Example: $26,655 / 360,000 = 7.40%

12. Cash on Cash Return - This represents the ratio between the property's annual cash flow (usually the first year before taxes) and the amount of the initial capital investment (down payment, loan fees, acquisition costs).

Formula: Cash Flow before Taxes / Cash Invested = Cash on Cash

Example: $7,541 / 110,520 = 6.82%

13. Time Value of Money - This is the underlying assumption that money, over time, will change value. For this reason, investment real estate must be studied from a time value of money standpoint because the timing of receipts might be more important than the amount received.

14. Present Value (PV) - This shows what a cash flow or series of cash flows available in the future is worth in purchasing power today. It's calculated by "discounting" future cash flows back in time using a given rate of return (i.e., discount rate).

15. Future Value (FV) - This shows what a cash flow or series of cash flows will be worth at a specified time in the future. It's calculated by "compounding" the original principal sum forward at a given compound rate.

16. Net Present Value (NPV) - This discounts all future cash flows by a desired rate of return to arrive at a present value (PV) of those cash flows, and then deducts it from the investor's initial capital investment. The resulting dollar amount is either negative (return not met), zero (return perfectly met), or positive (return met with room to spare).

17. Internal Rate of Return (IRR) - This model creates a single discount rate whereby all future cash flows can be discounted until they equal the investor's initial investment.

18. Operating Expense Ratio - This provides the ratio of the property's total operating expenses to its gross operating income (GOI).

Formula: Operating Expenses / Gross Operating Income = Operating Expense Ratio

Example: $18,525 / 45,180 = 41.00%

19. Debt Coverage Ratio (DCR) - This is the ratio between the property's net operating income and annual debt service for the year. Lenders typically require a DCR of 1.2 or more.

Formula: Net Operating Income / Annual Debt Service = Debt Coverage Ratio

Example: $26,655 / 19,114 = 1.39

20. Break-Even Ratio (BER) - This measures the portion of money going out against money coming in, and tells the investor what part of gross operating income will be consumed by all estimated expenses. The result should be less than 100% to be viable (the lower the better). Lenders typically require a BER of 85% or less.

Formula: (Operating Expense + Debt Service) / Gross Operating Income = BER

Example: ($18,525 + 19,114) / 45,180 = 83.31%

21. Loan to Value (LTV) - This measures what percent of the property's appraised value or selling price (whichever is less) is attributable to financing. A higher LTV means greater leverage (higher financial risk), whereas a lower LTV means less leverage (lower financial risk).

Formula: Loan Amount / Lesser of Appraised Value or Selling Price = LTV

Example: $252,000 / 360,000 = 69.22%

Published - May 2011