Formulas And Rules You Should Know Before Investing In Real Estate (Part 1)

Endless numbers, calculations, strategizing and re-strategizing can be a deterrent for some people when it comes to real estate investing. “I don’t know anything about finance or investing, how could I possibly do this,” is (unfortunately) a common phrase most beginners experience. But when you were younger you didn’t know how to walk and look at you now! There was always the fear of falling, but you got back up and kept trying. Same thing goes for real estate investing, the more you try and learn, the better you will become at the skill. It’s the fear of the unknown that stops people from trying in the first place, so, learn – simple as that. Learn concepts, formulas, and strategies so that the unknown becomes known.

Before we get too philosophical here, let’s get nerdy together and explore the different numbers and analytics involved in real estate investing – hopefully, I can make it easy to understand along the way!

1% Rule

The 1% rule in rental property investing is used to determine if the gross monthly rental income is equal to 1% of the property’s purchase price. Typically, investors want to aim for equal to or greater than 1%. This sounds like an ideal and easy calculation; however, it is not the most accurate calculation for smaller cities where average market rates are lower. It may be more accurate for larger metropolitan centres where market rates are typically higher because of demand and location. Best bet, do your research on the local market and rental rates before purchasing a property.

Tip: Contact a Property Manager before purchasing a rental property. They can give you an accurate rental analysis and provide an estimated market-competitive monthly rental rate. Knowing this before purchasing the property could save you (1) time, (2) money, and (3) allow you to maximize your investment and return on investment (ROI).

Example: You are looking to purchase a stunning two-bedroom condo for $250,000. Using the 1% rule, you calculate that the estimated gross rental monthly income should be $2500 per month ($250,000 * 1%). Meaning, the $2500 is take home/profit at the end of the month (after expenses profit).

2% Rule

Like the 1% rule, the 2% rule suggests that (ideally) a rental property should rent for 2% of the original purchase price. But you just said it should rent for 1%? Confusing, I know. The 2% rule considers maintenance and expenses, whereas the 1% rule focuses on the gross take home monthly pay for the investor. It basically says that the monthly property mortgage should be no more than 2% of the purchase price. Note, this rule is pretty much extinct but it’s a “nice to know” rule to keep in the back of your mind before purchasing a property.

Example: You are looking to purchase a stunning two-bedroom condo for $250,000. Using the 2% rule, you calculate that the monthly mortgage should be no more than $5000 ($250,000 * 2%). The 1% rule suggests the gross monthly profit should be $2500, leaving room for $2500 in additional maintenance and expense costs.

5% Rule

The 5% rule explores the value of debt and equity in a property. To put it simply, debt is money that is owed. Equity is essentially the profit or cash amount invested in the property (money that is not or no longer owed). Analysts conservatively suggest that properties earn 3% equity return per year and costs, such as maintenance, expenses, and property taxes, account for 2% per year. So, take the purchase price and multiply it by 5% then divide that amount by 12. The total amount is the minimum rate that should be charged for rent per month to avoid further debt. Unlike the 1% and 2% rules, the 5% rule is a more realistic and attainable calculation.

Example: You are looking to purchase a stunning two-bedroom condo for $250,000. Using the 5% rule, you calculate that your expected 3% equity return on the property is $7500 and your 2% expense costs are $5000, totalling $12,500. Meaning, your annual mortgage (excluding interest rates) should be around this total amount. Divide the total amount by 12, and you end up with $1041.67 per month. To profit on the rental property, the rent you charge should (ideally) be greater than $1041.67 per month; anything less and the rental property will cost you money out of your own pocket.

50% Rule

Okay, this one is easier understand. The 50% rule says that the investor should anticipate operating expenses to be (roughly) 50% of the monthly rental rate. This does not include mortgage payments, but includes property taxes, repairs, maintenance, property management fees, insurance, etc. – to put it simply, the 50% rule anticipates unrecoverable costs.

Example: You are looking to purchase a stunning two-bedroom condo for $250,000. Using the 1% rule, you calculate that the estimated gross rental monthly income should be $2500 per month ($250,000 * 1%). Using the 50% rule, you calculate operating expenses to be $1250 per month ($2500 * 50%).

Cash-on-Cash Return

A cash-on-cash return calculates the rate of return percent an investor receives for the current period; typically, one year. You may also hear this referred to as a cash yield. Unlike the standard return on investment (ROI), cash-on-cash return calculates the return an investor receives by only measuring the actual cash invested and the income the property generates in the current period. Essentially, it provides a more accurate analysis of the investment property’s performance throughout the period. Investors should try to aim for a 10% minimum cash-on-cash return to maximize their asset and generate cash flow.

Cash-on-Cash Return = (Total Pre-Tax Cash Flow) / (Total Cash Invested)

Example: You purchase a stunning two-bedroom condo for $250,000 and invested $100,000 cash into the property. At the end of the year, the property generates $10,000 (pre-tax) income in the current period. Your cash-on-cash return would be: 10% ($10,000 / $100,000). This is an optimal cash-on-cash return. If the property generated less than $10,000 (pre-tax) income, the cash yield would not be optimal; more than $10,000 is great!

Gross Rent Multiplier Ratio

Wondering how long it will take you to pay back your mortgage on a rental property? Use the gross rent multiplier (GRM) calculation. The GRM is a ratio that calculates the expected monthly rent (pre-expenses) relative to the purchase price of the property to determine how long it will take to pay for the property. Properties with a lower gross rent multiplier are the better investment because they can pay for themselves quicker. The ratio does not account for vacancies, turnovers, expenses, interest rates, etc. – Basically, it’s an approximate calculation that will help the investor determine an investment strategy before purchasing the property.

Gross Rent Multiplier = Property Purchase Price / Gross Rental Income

Example: You are looking to purchase a stunning two-bedroom condo for $250,000. Using the 1% rule, you calculate that the estimated gross rental monthly income should be $2500 per month ($250,000 * 1%). Using the gross rent multiplier, you determine it will take you a (minimum) of 100 months ($250,000 / $2500), or 8.33 years (100 / 12), to pay back the mortgage (not including interest on the mortgage).

Loan to Value Ratio

Reading definitions online, this one can be hard to comprehend but it is quite simple. The loan to value ratio determines how much of the property you truly own through equity and how much you still own on the loan (mortgage) you took out on the property – think debt-to-equity ratio. The loan to value ratio is used for both the purchase of the property and any refinancing that may occur. Typically, the more equity you have in the property, the more financing options will be available to you. The amount of equity you are willing to put down during the purchase of the property will also help the lender when deciding to approve or deny your application.

Example: You are looking to purchase a stunning two-bedroom condo for $250,000. You have decided on a 30% down payment for $75,000 and will need to finance the remaining 70% for $175,000 (pre-interest). To the lender, this means that you are borrowing 70% of your rental property’s value, so your loan to value ratio is 70%. As you continue to pay down the loan (mortgage), the loan to value ratio will decrease and home equity will increase.

Operating Expense Ratio

Like the gross rent multiplier ratio, the operating expense ratio determines what percentage, or portion, of income is required to cover the property’s operating expenses. This does not include the mortgage principals and loan interest. Lower percentages are ideal as they indicate that operating expense do not consume a large portion of the property’s revenue and that you are doing a great job at controlling the expenses – meaning, the property can be more profitable.

Operating Expense Ratio (OER) = (Total Operating Expenses – Depreciation) / Gross Revenue

Example: You are looking to purchase a stunning two-bedroom condo for $250,000. Using the 1% rule, you calculate that the estimated gross rental monthly income should be $2500 per month ($250,000 * 1%), or $30,000 per year. Assume the property depreciates $5000 per year and operating expenses are $1000 per month, or $12000 per year. What is your operating expense ratio for the year?

OER = ($12,000 – $5000) / $30,000 = 23.33%

Conclusion

Whew, this was a long one. There are so many variations to calculate the similar concepts. Dependent on the property type, your geographic location, and target customer (tenant) base, some calculations and strategies will be preferential over the other. However, knowing all these concepts will be your secret weapon when browsing potential rental properties online.

Stay tuned though, we still have a bunch more formulas and rules to go through!