Real Estate Math
By Steve Gillman  2007
Real estate math isn't something you need to learn for calculating
interest rates or amortizing loans. There are computers and calculators
to do that. What you need to know though, is a few simple formulas
so you can say whether a property is a good investment or not.
Real Estate Math You Don't Need
There is one formula you don't need  the gross rent multiplier.
I only bring it up because people are sometimes still using it,
and there are better ways to estimate value now. The gross rent
multiplier is a crude way to put a value on a property. You decide
that you want to buy something that sells for 10 times annual
rent or less, for example. You simply multiply the gross annual
rent a building collects by ten, and that gives you your value.
You can probably see the problems with this formula. It has
to constantly change to reflect interest rates for starters,
because a property might be profitable at 12 times rent when
interest rates are low, but suck you dry at eight times rent
if the financing is expensive. Add to that the fact that there
are just plain different expenses for different properties, especially
when some include utilities in the rent, for example. The gross
rent doesn't say much about the factor that makes a property
valuable: net income.
Real Estate Math You Need
You buy rental properties for the income they produce, so
this is what your real estate valuation should be based on. This
is why your real estate math education needs to start with the
how to use a capitalization rate, or "cap rate" to
determine value. The cap rate is the rate of return expected
by investors in a given area, or the rate of return on a property
at a given price.
An example will hopefully make this clear. You start with
the gross income of a property and subtract all expenses, but
not the loan payments. Suppose the building's gross income is
$76,000 per year, and the expenses are $32,000, leaving you a
net income before debtservice of $44,000. To arrive
at an estimate of value, you simply apply the capitalization
rate to this figure.
Suppose the usual capitalization rate is .10, for example
(ask a real estate professional what is normal in your area),
meaning investors expect to get a 10% return on the value of
their investment. You would divide the net income of $44,000
by .10, and you get $440,000. This gives you the estimated value
of the building. If the common rate is .08, meaning investors
in the area expect only an 8% return, the value would be $550,000.
Simple Real Estate Math
Net income before debtservice divided by cap rate  this
really is simple real estate math, but the tough part is getting
accurate income figures. Make sure the seller is showing you
ALL the normal expenses, and not exaggerating income. Suppose
he stopped repairing things for a year, for example, and is showing
"projected" rents, instead of actual rents collected.
In that case, the income figure could be $15,000 too high. This
would mean you would estimate the value at $187,000 more (.08
cap rate).
In addition to verifying the figures, smart investors sometimes
separate out income from vending machines and laundry machines.
If these sources provide $6,000 of the income, that would add
$75,000to the appraised value (.08 cap rate). First do the appraisal
without this income included, then add back the replacement cost
of the machines (probably much less than $75,000).
Be careful when you use any real estate appraisal method.
No formula is perfect, and all are only as good as the figures
you plug into them. When used carefully, though, real estate
appraisal using capitalization rates is the most accurate method
for rental properties.
For putting a value on a single family home, you need another
approach. Yes this means more real estate math to learn. See
the page Real Estate Appraisal.

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