The best real estate investors always run the numbers. Mastering the most important real estate investment formulas is key to success in investing in real estate. Whether you are a fix and flipper, a buy and hold investor or do the BRRRR Method; the numbers matter! The key real estate investment formulas can be straightforward but super important to success! Here is a helpful guide to the most important real estate investment formulas to know when pursuing financial freedom!
LTV: Loan-To-Value Ratio
LTV is a key formula for real estate investors using rental loans to finance their investment properties. It measures the ratio of the Loan Amount to the Value of the property. When buying rental properties, many real estate investors seek the highest loan-to-value ratios. This is because the higher the LTV ratio, the lower the down payment. In fact, your down payment on a investment property purchase is the difference between the LTV and 100%. Thus, if your LTV is 80%, then your down payment is 20% (100% – 80% = 20%). While higher LTVs are often preferred due to the lower down payments, it also represents more risk!
LTV Formula
Loan / Value = LTV
Down Payment Formula
Value (Purchase Price) – Loan Amount = Down Payment
Example:
Loan Amount = $400,000
Property Value (Purchase Price) = $500,000
LTV = 80% ($400,000/$500,000)
Down Payment = $500,000 – $400,000 = $100,000 or (100% – 80% = 20%)
DSCR: Debt-Service-Coverage Ratio
DSCR Is a key formula for measuring the cash flow for rental properties. While this is a key metric for the popular DSCR Loan product, it can be used by any real estate investor. Many real estate investors invest for monthly cash flow – building financial freedom through rental income. One of the key reasons that DSCR Loans are so popular with real estate investors is that they are typically 30-year fixed rate loans. That means the debt service cost (typically the biggest expense on a rental property) is fixed for 30 years. Thus, as rents increase over time, cash flow tends to increase!
For DSCR Loans, the DSCR Ratio is calculated as Rents divided by PITIA. PITIA refers to “Principal plus Interest + Taxes + Insurance + HOA dues.” These represent the typical expenses associated with a financed rental property. A DSCR of 1.00x represents “breaking even” or rents equaling expenses. A DSCR above 1.00x represents a “cash-flowing” property, or when the invest is earning profits every month. However, a DSCR below 1.00x represents “negative cash flow” or losing money every month (at least in terms of this formula). There are however instances where it makes sense for real estate investors to invest in real estate when the DSCR real estate investment formula is below 1!
DSCR Formula
Rents / PITIA = DSCR
Example:
Rents = $50,000
Principal + Interest = $33,000
Taxes = $3,000
Insurance = $1,000
HOA dues = $3,000
DSCR = 1.25x ($50,000 / ($33,000 + $3,000 +1,000 + $3,000)
CoC: Cash-On-Cash Return
Cash-on-Cash Return is a real estate investment formula growing in popularity with investors. It measures the annual cash flow earned from a property divided by total cash invested in said property. Basically, real estate investors want to maximize the cash flow they earn from their investment properties. And they want to minimize the cash (capital) they invest in the property. Increasing cash-on-cash returns is another key reason that DSCR Loans are so common for investors looking to scale. By using leverage and maximizing LTV, investors can typically increase their cash-on-cash return.
Cash-On-Cash Return Formula
Cash Flow / Cash Invested
Example (no debt)
Purchase Price= $500,000
Mortgage Loan = $0 (purchased all cash)
Cash Invested = $500,000 ($500,000 – $0)
Rental Income = $50,000
Expenses (PITIA) = $5,000 (only taxes and insurance)
Cash Flow = $45,000 ($50,000 – $5,000)
Cash-On-Cash Return = 9% ($45,000 / $500,000)
Example (using a Rental Property Loan)
Purchase Price= $500,000
Mortgage Loan = $400,000
Cash Invested = $100,000 ($500,000 – $400,000)
Rental Income = $50,000
Expenses (PITIA) = $35,000 (principal, interest, taxes and insurance)
Cash Flow = $15,000 ($50,000 – $35,000)
Cash-On-Cash Return = 15% ($15,000 / $100,000)
The above examples present an interesting comparison and the value of using Cash-on-Cash Return. At first glance, using no debt appears better. And it is from a cash flow standpoint ($45,000 in cash flow vs. $15,000).
However, the 15% Cash-on-Cash Return (versus only 9% with no debt) tells a different story. Many investors prefer this because of the ability to buy more properties with the same amount of cash. Since only $100,000 of the investor’s $500,000 is used in example 2 – they can buy four more properties with the same initial cash! If they can find four similar ones, that’s actually more cash flow using debt. The math: $15,000 x 5 = $75,000, which is much greater than $45,000!
An additional benefit – real estate investors earn 100% of appreciation in the property even when using debt. Bottom line? Cash-On-Cash Return can tell you a lot more about an investment property’s potential than just simple cash flow. An important formula to know!
ROE: Return on Equity
Return on Equity is a real estate investing formula similar to cash-on-cash return. Note: Cash-On-Cash Return is essentially the same formula as “Return on Investment” also known as ROI. There is a key difference however between Return on Equity and Return on Investment. While ROI (or Cash-on-Cash) measures the return on the initial investment, Return on Equity (ROE) measures return on equity – which can change (sometimes largely) over time.
ROE thus works the same as Cash-On-Cash at first, as the value of the property changes, it becomes a better measure for investors. Especially real estate investors that build a portfolio of rental properties over the long-term. For long-term investors, what might be a great for a property at first, can become quite poor over time. Especially in investments that are most successful!
Huh? How does that work. It works because when real estate appreciates, all of the appreciation goes to the equity holder (owner). Even if the property has debt on it. Therefore, as the property appreciates and the loan is paid down, the equity amount continues to increase.
Lets look at the same example as above, but with ROE.
Example:
Purchase Price= $500,000
Mortgage Loan = $400,000
Equity = $100,000 ($500,000 – $400,000)
Rental Income (Year 1) = $50,000
Expenses (PITIA) (Year 1) = $35,000 (principal, interest, taxes and insurance)
Year 1 Cash Flow = $15,000 ($50,000 – $35,000)
Cash-On-Cash Return = 15% ($15,000 / $100,000)
Return on Equity = 15% ($15,000 / $100,000)
However, lets look at this same property after five years, where the property appreciates to $750,000 and the cash flow increases to $20,000. Additionally, $20,000 of the mortgage loan was paid down.
Example (After 5 Years)
Property Value = $750,000
Mortgage Loan = $380,000
Equity = $270,000
Cash Invested = $120,000 (purchase cash + loan paydown)
Year 6 Cash Flow = $20,000
Cash-On-Cash Return = 16.7% ($20,000/$120,000)
Return on Equity = 7.4% ($20,000/$270,000)
So in our example, in year 6, the cash-on-cash return improved slightly to 16.7%. Great returns right? Well, the ROE has plummeted down to 7.4%, which is down quite a bit, and not terrific in terms of real estate investing.
This happens because as equity grows, real estate investors are deleveraging, where less of the property is financed, and the capital is “trapped” in the property.
However, there is good news. There is a popular solution many investors use in this situation called cash-out refinances. What is a Cash-Out Refinance? It is when a real estate investor refinances debt on a property that typically, like in our example, has experienced significant equity appreciation. Cash-Out Refinances allow you to payoff existing debt and then take out a loan based on the new, higher value of the property! In addition, these proceeds (generally difference between the prior loan and new loan) are not taxed, since its not income!
Many investors looking to maximize their ROI and real estate returns turn to DSCR Loans for cash-out refinances. These loans are popular for cash-out refinancing rental properties because they are generally easy to qualify for (no income verification or tax returns) and typically have a smoother process than working with a bank or conventional lender.
Rent-To-Income Ratio
For our final real estate investing formula to know, Rent-To-Income Ratio is a key metric for choosing a market. While the previous formulas focused on individual property metrics, this one is different. While analyzing individual properties are important, picking the right market is arguable just as important to real estate investing success.
A key concern for rental property investors is ensuring cash flow. Cash-on-Cash Return and Return on Equity is zero if there is no rent coming in! Thus, ensuring cash flow is dependent on ensuring rent. TO make sure there is rental income coming in, investors need tenants that can both occupy the property and reliably make rent every month.
What is Rent-To-Income Ratio? The Rent-To-Income Ratio measures the average market rent divided by the same markets median household income. The lower the Rent-To-Income ratio, the more affordable the market is for renters (i.e. potential tenants). Real Estate investors use Rent-To-Income ratio to find markets where there are plenty of potential tenants to lease the property. More potential tenants, means lesser vacancy, higher potential for rent growth and less overall risk!
Generally, economic experts say that Rent-To-Income Ratios over 30% is unaffordable, so real estate investors looking to invest in markets with highest pool of qualified renters should look to markets with Rent-To-Price Ratios under 30%. Nerdwallet has a monthly report highlighting the US markets with lowest Rent-To-Price Ratios and can be a useful tool for investors.
Example:
Average Market Rent = $15,000
Median Household Income = $50,000
Rent-To-Price Ratio = 30% ($15,000/$50,000)
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