When you buy a stock, you hope for the best. When you buy real estate, you control the investment from start to finish, and you can forecast all expenses with laser accuracy. It makesreal estate a relatively safe investment, especially coupled with its greater price stability.
But that’s only if you know what numbers to look at and how to accurately assess them.
Whether you want to flip houses or invest in income properties, here are the numbers you need to know as a real estate investor to ensure every deal you buy is a good one.
Pro tip: If you decide to purchase turnkey investment properties through Roofstock, some of these important numbers will be included within each listing. This will allow you to easily assess the profitability of available properties.
Goals and strategies differ dramatically between flippers and income investors, so many of the numbers and calculations involved also vary. But some numbers are universal in real estate investing.
No matter your strategy, make sure you know how to accurately forecast these figures.
1. Closing Costs
If you’ve ever bought a home, you know how expensive closing costs can be. Brace yourself, because closing costs for investors are even higher.
You can almost certainly expect your lender to charge points, more formally known as an “origination fee.” It’s based on a percentage of the total loan amount, with each point equal to 1%. Thus, a $200,000 loan charging 3 points means a $6,000 origination fee.
Beyond points, many lenders still charge junk fees, which they basically invent to earn more money on loans. These are flat fees with names like “Processing Fee,” “Underwriting Fee,” and “Wire Transfer Fee.”
There are also title fees, appraisal fees, transfer taxes, recordation stamps, and all the other fees buyers incur.
Your goal as an investor is twofold: Get accurate breakdowns of all closing costs while comparison shopping for lenders, and then negotiating them down as low as possible.
2. Loan-to-Value Ratio (LT) & Down Payment
Loan-to-value ratio, or LTV, is the percentage of the purchase price the lender will finance.
For example, if you buy a property for $200,000 and the lender offers you 80% LTV, they fund $160,000 of the purchase and require you to come up with the other 20% ($40,000) as the down payment. An easy concept, but one you still need to understand as a real estate investor.
LTV varies based on many factors. One is your credibility as a borrower. The better your credit score and the more stable and documentable your income, the higher the LTV lenders feel comfortable offering you. Lenders operate based on risk, and the higher the perceived risk, the more they charge and the less they lend.
Some portfolio lenders andhard money lenders also offer better rates and higher LTV to investors with more experience. When you apply, these investor-oriented lenders ask how many properties you own and how many deals you’ve done in the last year.
Finally, expect a lower LTV on investment loans than homeowner loans. Once again, it comes down to risk. When in financial trouble, investors always default on their investment property loans before their primary residence mortgage.
3. Cash-on-Cash Return
At the heart of real estate investing lies cash-on-cash return. This is the return on investment (ROI) you can expect to see on your own cash investment in the deal. It depends not only on the deal itself, but also how you finance it.
The formula for ROI is simple: your profit divided by the amount you invested. Say you buy a property in cash for $100,000, then spend $30,000 on repairs and another $15,000 on carrying costs and closing costs. Then you sell it for $175,000 as a flip.
Your total cash investment was $145,000, and your revenue was $175,000, for a profit of $30,000. So, your profit of $30,000 divided by your cash investment of $145,000 equals a cash-on-cash return of 20.7%.
Now, say you finance the deal with 75% financing of the purchase price and 100% financing of the repair costs (common numbers for a hard money loan). It greatly reduces your cash investment, but it also adds to your expenses, as lenders charge both upfront fees and interest for each month’s payment. Let’s say it adds an extra $10,000 to your carrying and closing costs.
In this case, you come up with $25,000 as a down payment and spend another $25,000 on carrying costs and closing costs. That puts you at $50,000 out of pocket with a narrower profit of $20,000.
But your cash-on-cash return skyrockets. Your $20,000 profit divided by your $50,000 cash investment comes to an impressive 40.0% cash-on-cash return — nearly double the cash-on-cash return of buying the same property in cash.
While none of these concepts are complicated, the nuances lie in accurate forecasting. Here’s what you need to know about the math behind flipping houses and what to watch out for as you run the numbers.
4. After-Repair Value (ARV)
To flip a home with any hope of earning money, you need to know the after-repair value, or ARV. Your profit depends on getting this number right because it’s your one and only revenue number.
In the first flipped home example above, the ARV was $175,000. But when you go into a flip, you have to estimate the final sales price based on comparable properties in the market. It’s an art, not a science, leaving you with a probable range of prices.
Be conservative in your estimate. Determine the range of prices you can expect to sell for after renovating the property, and then use the bottom of that range as your ARV.
Hopefully, you end up selling the house for a higher sales price. But hope has no place in real estate investing, so use conservative numbers to avoid losing your shirt on the deal.
5. Renovation Costs
Renovation costs fall into a few simple categories: material costs, labor costs, and legal and administrative costs.
Labor costs are negotiable. As you build relationships with contractors and get better at managing them, you also get better atnegotiating with contractors for better rates.
While material costs are less negotiable, many contractors overcharge for them and earn a hidden margin. It’s a commoncontractor scam, and you can avoid it by paying for materials yourself. As a bonus, you could put the material expenses on atravel rewards credit card or cash-back credit card to earn some rewards from your flip. (Just make sure to pay off the balance in full so interest charges don’t eat up your earnings.)
Finally, flippers incur some legal and administrative costs, such as the costs of pulling permits. Permits are another way some contractors rip off property owners, by charging far more than the permit offices actually charge.
Word to the wise: If you want to flip houses, get comfortable with the process of pulling permits yourself. It’s part of the job description.
As with ARV, be conservative with your renovation costs estimates. Always add a buffer for unexpected expenses. Consider at least $5,000 or 15% to 20% of the estimated repair costs, whichever is greater. Just don’t let your contractor know about the buffer, or they’ll find an excuse to spend it.
6. Carrying Costs
It costs money to own a property, even if only for a few months. If you took out a loan, you have a mortgage payment to pay. Even if you didn’t, you still owe property taxes, water bills, gas and electric bills, property insurance, and all the other expenses that come with owning a property.
Every month that goes by when you own the property, you lose more money. It’s why flippers need to renovate and sell quickly: Time is money in a literal sense for them.
Use a conservative estimate for how long it will take to renovate, market, and sell the property. As with every other number, plan for the worst-case scenario.
Numbers for Income Investing
Landlords and income property investors have a different set of goals and, therefore, a different set of numbers to measure results. That said, they do sometimes share expenses with flippers, such as renovation and carrying costs when theybuy a fixer-upper to renovate and keep as a rental.
Below are the numbers income investors need to understand to profitably earn ongoing cash flow.
7. Gross Rent Multiplier (GRM)
Like many numbers in real estate, gross rent multiplier (GRM) sounds complicated but is actually quite simple. It’s so simple, in fact, that many rental investors disregard it. But it has its uses as an instant comparison of a property’s price to its rent.
GRM is a ratio of the property’s price to its annual gross rental income. You calculate GRM by dividing the cost of the property by its annual rental income. For example, a property that costs $100,000 and rents for $1,500 per month has a gross annual rental income of $18,000, so the GRM is 5.56:
You can think of GRM as the number of years it would take the gross rental income to pay you back for the purchase price. The lower the GRM, the quicker you’ll recoup your investment.
Some investors approach GRM differently and take the monthly rent as a percentage of the purchase price. In the example above, the property rents for 1.5% of the purchase price. It’s still a comparison of the same numbers: price versus annual rent.
GRM tells you nothing of the property’s expenses, which vary wildly, and it doesn’t take financing into account. But it offers a ballpark calculation you can do instantly to compare a property’s price to its income potential, which is a useful starting place when evaluating properties at a glance.
8. Cap Rate
Capitalization rate, or cap rate, goes one layer deeper than GRM by including expenses. You calculate cap rates by dividing a property’s annual net operating income (NOI) by its purchase price. In formula format, it looks like this:
NOI / Purchase Price = Cap Rate
Note that cap rate uses net operating income, rather than the gross annual income GRM uses. To calculate NOI, take the gross annual income and subtract all operating expenses. Those expenses include:
Property management fees
Repairs and maintenance
Accounting, travel, and administrative fees
Any other expenses incurred in managing and owning the property
Financing costs and closing costs are not included in NOI. Cap rates don’t account for financing. Instead, they’re meant to compare two or more properties based on their inherent characteristics, not your personal returns.
Sample Cap Rate Calculation
For a quick example of how cap rates look in real life, here are the approximate numbers for one of my properties:
Property Taxes: $800
Property Management Fees: $1,200
Repairs and Maintenance:$1,200
Accounting, Travel, and Administrative Fees:$400
Total Annual Expenses:$4,700
Gross Annual Income: $9,600 ($800/month)
I bought the property for $50,000, so the cap rate is 9.8 (4,900 / 50,000 = 0.098, then multiplied by 100 to get a percentage).
Cap rate is sometimes expressed with a “%” behind it, as it calculates as a percentage. I don’t like to do this, however, because it creates the illusion that cap rates represent your return on investment. But they fail to account for nuances like crime, rent defaults and damage caused bybad tenants, property management labor, and overalllandlord headaches. That’s why cap rates for low-end properties are inevitably higher than those for luxury properties, yet investors buy luxury properties anyway.
9. Monthly Cash Flow
Going another level deeper in analyzing income properties, investors can calculate a property’s monthly cash flow. It’s most commonly used for residential (one- to four-unit) rental properties, but it can be useful for larger properties as well.
Unlike cap rates, your monthly cash flow accounts for financing costs and your mortgage payment. It’s a measure specific to you as an investor, based on your financing terms.
You calculate cash flow by subtracting all expenses from the monthly rent. Don’t make the common rookie mistake of ignoring or underestimating infrequent expenses that impact your returns and cash flow. You can’t simply subtract the mortgage payment from the rent and call that the cash flow.
As with cap rates, you need to take the long-term average of expenses like vacancy rate, repairs, maintenance, and other infrequent-but-real expenses. Using the same example property as above, here’s how the monthly cash flow looks:
Property Taxes: $66.67
Property Management Fees:$100
Repairs and Maintenance:$100
Accounting, Travel, and Administrative Fees:$33.33
Total Monthly Expenses:$696.67
Monthly Cash Flow:$103.33
Most months, I don’t have to pay for any repairs or suffer a vacancy. Other months, I face a $1,500 repair bill. The key to calculating monthly cash flow is accurately forecasting the long-term average of your expenses.
For example, if a given neighborhood has a vacancy rate of 4%, you should account for a vacancy rate costing you 4% of each month’s rent, despite your property being rented most months. A 4% vacancy rate comes out to around one month’s vacancy every two years as one tenant moves out and you make repairs and advertise it for a new tenant.
This is the least useful number on this list because you can’t accurately forecast it. Your property might appreciate, or it might not. It also could go down in value. For example, your local government may decide to build a freeway next to it.
Still, home values do tend to rise faster than inflation, albeit not by much. From 2000 to 2019, home prices grew at an average rate of 2.37%, compared to an overall inflation average of 2.08%, according to the Bureau of Labor Statistics (BLS).
The mammoth gains in home values in the 1970s, ’80s, and ’90s were a historical aberration, largely due to women joining the workforce. With two earners, families could afford to make higher offers on homes, which drove up prices. It was a one-time cultural shift causing a one-time economic phenomenon.
In other words, don’t count on massive future appreciation.
There are ways to boost the odds of strong appreciation. You can review a property’s history of appreciation, which is the percent it rose in value each year. That said, as every investment pamphlet is quick to point out, past performance does not indicate future results.
For any real insight into future market movements, you have to run numbers on the market level, not the property level.
Housing Market Fundamentals
What causes property values to rise or fall?
In a word: demand. But that answer merely raises more questions about how you measure (and predict) housing demand.
The following numbers aren’t foolproof, and they aren’t a crystal ball. However, you can increase your odds of real estate appreciation by investing in markets with sound fundamentals.
11. Population Growth
First and foremost, housing demand can be measured by population growth. You don’t need a degree in economics to understand that cities with fast-growing populations will see home prices and rents leap.
Consider Midland, Texas. From 2010 to 2018, it saw the second-highest population growth of any city in the U.S. at 25.8%, according to the BLS. From April 2018 to April 2019, home values skyrocketed by a dizzying 19.5%, according to Zillow.
Unfortunately, population growth is a lagging indicator. It shows what happened in the past, but it can’t predict the future. Even the numbers themselves come with a delay. After years of growth, people could be fleeing Midland today in droves. We don’t know for sure because the government doesn’t provide up-to-the-minute (or even up-to-the-month) data.
So while population trends offer useful insights, they don’t tell the whole story.
12. Job Growth & Unemployment Rate
People move where the jobs are. Job growth drives population growth, which in turn boosts demand for housing. As a result, job growth is closer to a leading indicator (predictor of future trends) of housing demand and home appreciation.
Areas with slow job growth and high unemployment rates aren’t likely to see population growth any time soon. They’re likely to see population drain and falling home values.
Keep an eye on markets’ job growth rates and unemployment rates, and only invest in markets with strong fundamentals.
13. Price-to-Income Ratio
Housing affordability is relative. A city could have home prices 20% higher than the nationwide average, but if its median income is 30% higher than the national average, it still has better housing affordability than average.
So, beyond simply looking at the median home price for an area, investors should look at the price-to-income ratio. This is the ratio of the city’s or neighborhood’s home prices to its incomes.
The ratio is measured in years — specifically, how many years it would take to pay off the home if you put every dollar you earned toward it. For example, imagine a city where the median home price is $200,000 and the median household income is $50,000. That city has a price-to-income ratio of 4 years (200,000 / 50,000).
This number because the further the ratio stretches from the national average, the less room there is for additional stretching. People can only afford to spend so much of their income on housing. Mortgage lenders allow the mortgage payment to take up only a certain percentage of a borrower’s income — for instance, 28% for conventional mortgage loans.
Besides, high price-to-income ratios usually mean poor price-to-rent ratios, too.
14. Price-to-Rent Ratio (aka GRM)
Remember the gross rent multiplier from the house-flipping numbers? The same principle applies on a neighborhood- and city-wide level. Some cities offer better price-to-rent ratios than others, which makes them more attractive to income investors looking for a bargain.
Be careful to look at the economic health of the city before fixating too much on price-to-rent ratio. Economically stagnating cities tend to have price-to-rent ratios that look good on paper because relatively fewer people are scrambling to buy homes there.
If all these numbers and acronyms sound like alphabet soup, remember: You don’t need to use every single ratio or metric. Focus on the ones most relevant to your investing goals.
Most of all, remember that your calculations are only as good as the numbers you plug into them. Do your homework and get accurate figures for expenses like repair costs or vacancy rates and revenue figures like ARV or market rent.
When evaluating a potential investment, your job is to get a well-rounded sense of its returns. Don’t stop at simplistic numbers like GRM; go deeper to calculate monthly cash flow and cash-on-cash return.
Do it right, and you’ll never make a bad investment again.
What do you consider the most important numbers in real estate investing? Why?
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