The first step when analyzing any property you are considering purchasing is to write down all the numbers. Calculate the gross annual income of the property, as well as the cost of the potential mortgage and taxes. These are the basic numbers which you will need in order to make a basic analysis of the potential economic return on the property.
Gross Annual Income/Sale Price
Yield is the most basic analyzing tool for any real estate investment. It is also the least useful in informing you of the economic value of the property. However it is a quick and easy way to give you a basic idea of where the property is going.
To calculate the yield, simply total up the income you will receive from the property in a given year, then divide this by the sale price. You will receive the yield in a form of a percentage.
For example, let’s say that you are looking at a duplex that costs $100,000. One half of the duplex earns $500 a month, the other $600 for a total of $1100 a month. That gives us $12,100 a year. $12,100 divided by $100,000 gives us a yield of 12.1%. This is not the greatest yield ever, but it is not necessarily bad either However, this basic analysis does not take all of the many factors which must be taken into account: the price of your mortgage, property taxes, other expenses, depreciation values of the house or equity in the long term.
Sale Pirce/Gross Annual Rent
The Gross Rent Multiplier is almost exactly the same as calculating the yield. The numbers are the same, but now we are looking at those numbers in reverse. Using the GRM we can find how many years it will take the property to earn the sale price of the property. The lower the number, the better.
Using our example from above, we know that we are earning $12,100 on our $100,000 duplex. When we do the math we learn that it will take about 8 years and three months for our property to earn us the sale price. 8.25 is well within the normal range for a GRM. With older housing that might not be selling for full value we can sometimes see a GRM as low as 5, for newer housing it can often be as high as 12.
This gives us a slightly different view than we had just looking at the yield, but it still does not give us a complete picture. We do know now, though, that our property will pay itself back in 8 years and three months.
Debt Coverage Ratio (DCR)
Net Operating Income/Annual Mortgage Payments
Debt Coverage Ratio is a tool used more commonly by lenders than by purchases, but it can give you a good idea of the ability your property has in covering its expenses.
In essence we are trying to find the amount of money that you have coming in net over the price of the mortgage in a year. Still looking at our duplex, let us say that costs of maintaining the property in its current condition is about $3,000 a year. This will come off the total of our operating income. $12,100 minus $3,000 gives us a total of $9,100.
To calculate the DCR, we then divide $9,100 by our total annual mortgage of $6300. $9,100 divided by $6,300 gives us a DCR of about 1.44. This is an excellent DCR. Lenders often like to see a minimum DCR of 1.25, and this is well over that amount. We are looking good on our Debt-Coverage Ratio.
Cash-on-Cash Return (COC)
Cash Flow Before Taxes/Investment
This is a very useful tool in analyzing real estate investments. It gives us a basic look at how much cash we are receiving in any given year verses the amount of cash we initially invest in the building.
First we will have to calculate our cash flow before taxes. This is the gross annual income of the property less the mortgage payments that are made over the course of the year.
Let us look once more at our $100,000 duplex. Say that we made a $25,000 down payment on the building, and thus have to pay a mortgage on $75,000. At 7% interest our mortgage is about $525 a month. Over the course of the year, then, we are paying $6300 off on the mortgage. Subtract that from our $12,100 income and we get a net cash flow before taxes of $5,800.
To calculate our cash-on-cash return, then, we simply divide our net cash flow before taxes by our initial investment in this case $25,000. $5,800 divided by $25,000 gives us a COC return of 23.2%. Almost twice as high a percentage as our yield! Thus, although according the yield we are only earning 12.1% on the property, based on our initial investment verses our net income we are actually getting a return of 23.2%
This gives us a much clearer idea of the return on our investment than does the yield, but it still ignores such things as tax benefits, equity in the property, etc.
The methods described here are very basic analysis tools that can give us insight on several basic economic indicators on a property that we choose to invest in. They ignore, however, some of the more complicated aspects of real estate investments: such as calculating tax benefits, estimating equity and so on. These are much more advanced questions that take a lot more time to look at.
Using these tools can give you a good basic idea of the quality of a real estate investment, however. Look at each of the numbers individually as well as as a total. Also remember that these numbers cannot always tell you everything. Every property is different, and must be looked at on its own merits.