Do you ever get confused by all the investment jargon people use when talking about real estate? In this article, some common investment buzz words and simple math used in rental real estate will be explained. ROI (Return on Investment) is one basic concept that should be understood.
First let’s relate this ROI concept to the management of your household finances. Your salary plus any money earned in side gigs is your income. You add together what you spend – such as rent or mortgage payment, utilities, home repairs, insurance, set savings amount, food, etc. – to determine your expenses. It is always recommended to always be looking for ways to reduce expenses. Then, you take your income and subtract these expenses to see your net income. Finally, to manage your personal finances, you choose which discretionary expenses such as concerts, restaurants, and travel make sense. In this way, you can ensure your lifestyle and a savings cushion for the future.
You would follow a similar process for analyzing rental property. First, you want to see the income the property brings in rent. Then check expenses – check those regular, expected expenses plus add a margin for any unforeseen occurrences. Then, the same as in your personal finances, you must check to see that the income covers the expenses safely and budget for extra improvements to the property.
Several additional factors must be considered in the ROI calculation. One is the amount you actually pay to buy the property. Another is the mortgage amount borrowed on the property.
Here are some basic terms:
Annual Rent = Monthly Rent charged by Landlord to the Tenant multiplied by 12.
Vacancy Rate = Amount allowed for lost time between Tenants – perhaps standard in your area is 5% per year.
Gross Operating Income = Annual Rent minus Annual Vacancy amount.
Operating Expenses = Total of Annual Expenses, such as utilities, real estate tax, repairs, or insurance. Sophisticated investors look closely here. They ask about how much does it really costs to run the building. Just like in your personal finances, an investor can look to reduce expenses.
Net Operating Income = Gross Operating Income minus Operating Expenses.
Purchase Cost = Price you pay for your rental property. Again, this is where sophisticated Investors look to save money. You will hear about various negotiating techniques, how to buy low and sell high, and how to buy under market. All the games may or may not be necessary. Just like looking at good stocks to buy, there are good, strong real estate investments to consider, with good, strong fundamentals, like condition, neighborhood, and existing rental market.
Mortgage = Amount you actually borrow for your Purchase Cost.
Monthly Debt Service = Monthly payment calculated to pay off the mortgage.
Annual Debt Service = Monthly Debt Service multiplied by 12.
Down Payment = Amount you pay in cash. ( Purchase Cost minus Mortgage = Downpayment.)
Closing Costs = Charges collected at closing , such as title insurance, taxes and fees. Sophisticated investors will look to save money here, also.
Cash Invested = Down Payment plus Closing Costs. This is the total you pay in cash. This is why investors consider rental real estate to be valuable. Some consider the tenant as actually paying for the building, since the rental income is used to pay the expenses and pay off the mortgage over time.
So the basic ROI calculation is as follows (taking the Italic Items from above):
Net Operating Income minus Annual Debt Service = Cash Flow before Tax
Cash Flow before Tax/ Cash Invested = ROI
Thus, the ROI is the % amount that is left over or “the return” after all expenses are paid. Investors will look to get the highest return available compared to other investments they could make. Investors also look to increase their Return on Investment by negotiating to reduce the initial sales price, or reducing expenses, or increasing rent.
There you have it. This is the basic calculation used to compare various real estate with other investment options. ROI is refined further by calculations of principal reduction, income tax savings, and appreciation.
Please contact us at me with any of your questions on specific investment properties. I will be happy to help with calculations, choices, and finalizing your future real estate investments.
This blog written by Marie Scarpulla at eXp Realty.
