I’m going to share my four favorite formulas when it comes to analyzing real estate investments.
After sharing each formula, I’m going to explain how to calculate it and why I like it. Then I’ll finish with a real-life example of how I use that formula in my portfolio.
Rent-to-Value (RTV) Ratio
Whenever a new deal hits my desk, the first thing I like to do is calculate the Rent to Value Ratio.
The formula for Rent to Value Ratio is.
Every market is different and every investor has different criteria, but in my markets of Northeast and Southwest NJ, I’m personally looking for an RTV of 1% or better. That means for every $100,000 of purchase price, I need to see monthly rents of $1,000 or more.
Before really diving into the numbers on a property, I like to calculate the rent to value ratio in 2 separate scenarios.
First, I find the RTV in the property’s current condition.
So I’m dividing what the property is currently renting for by how much I have to pay to acquire it.
Second, I calculate the Rent To Value ratio in the property’s stabilized condition.
What will the rents be after I renovate the property and how much will it cost in renovations to get me there?
Let’s walk through an example using my very first BRRRR property, which was a 4-family home in Camden County, NJ.
Before I bought the property, the rents were $900 per unit or $3,600 per month.
We negotiated the purchase price down to $240,000.
Based on those numbers, we had a Rent To Value Ratio of 1.5%.
In my pro-forma, I predicted the rents would be $1,250 per unit or $5,000 per month and it would cost roughly $160,000 in renovations and holding costs to get there. Based on those numbers, my stabilized Rent To Value Ratio was 1.25%.
Thankfully, we beat those rent numbers. The total rent-roll at this property is closer to $5,250 per month. And luckily we came in right on budget. The total cost behind purchasing and renovating this property was exactly $400,000.
If you’re wondering how to predict rents, I use the following 5 tools: Rent-o-meter, HUDuser Fair Market Rent Tool, Zillow, Craigslist, and the MLS.
Since the Rent to Value Ratios in both scenarios hit my benchmark, I knew the deal was worth looking into further.
Max Allowable Offer (MAO)
Let’s move on to my second favorite formula, which is commonly referred to as MAO or Max Allowable Offer.
I use the Profit First method to determine my max allowable offer.
If you’re unfamiliar with Profit First, it’s a highly recommended business book by Mike Michalowicz.
Here’s the TLDR;
Instead of thinking about business as Revenue – Expense = Profits, The Profit First Method challenges you to think about business as Revenue – Profit = Expense.
It’s a subtle, but meaningful difference. Instead of having your profits dwindle down to keeping what’s left after all expenses, you first determine how much you want to make in profit and then you’re able to spend what is left.
So here’s my Profit First inspired Max Allowable Offer in action.
Revenue = After Repair Value, or ARV for short.
For Profit, I shoot for 30% of ARV on rental properties or at least $100K on a fix and flip.
Expenses = All Costs Incurred From Acquisition to Stabilization (Purchase Price, Closing Costs, & Carrying Costs, Renovation Costs)
For a rental property, my formula Looks like this: MAO = ARV * 70% – Expense. The reason I target a 30% margin is because I intend to refinance all of my money out when I go for a refinance at 70-75% LTV.
For a fix and flip, my formula looks like this: MAO = ARV – $100K – Expense. The reason I target a $100K gross profit on a fix and flip is because I believe that’s the minimum profit required to come out even in a worst case scenario.
Now let’s take a look at how put my MAO in action.
We recently bought an off-market duplex in Morris County, NJ. We thought the property was worth $585K as-is without doing any work to it. We made an offer of $485K and the seller accepted.
We bought the property in late June and listed it for sale in early August.
We spent zero dollars on improvements.
We are currently under contract at $565K and are looking forward to closing in the next 30 days.
It’s not the $100K spread we were looking for, but $80K gross margin isn’t too bad for a few months of holding a property.
When it’s all said and done, after paying realtors and closing costs and factoring in a few months of holding costs, we should be able to net north of $40K on this deal.
The trick to this formula is nailing the ARV. To determine ARV, you need to know how to run comps.
The best place to run comps is the MLS, but if you don’t have access, Zillow can be a good substitute.
The main question you’re trying to answer when running comps is “What have similar properties in the immediate area sold for in the past 6-9 months?”
The 5 most important details when determining comparable based value are property type, bedroom count, bathroom count, square footage, and condition.
It can be really hard to find an identical recently sold comp so you have to finagle your way into a valuation, but here are some traps you want to avoid!
Don’t compare apples and oranges. If you’re buying a small multifamily property, don’t compare it to a single-family home.
Don’t believe value is linear. If you’re buying a condo with 2 beds and 2 baths, don’t just double the value of a 1 bed, 1 bath.
Don’t forget about condition and finish. If you’re buying a dated property, don’t compare it to a new construction home unless you plan on doing a full gut renovation with similar finishes.
Unlevered Yield On Cost (UYOC)
Ok, let’s move on to the most recent addition to my favorite formula list: Unlevered Yield on Cost.
I first heard this term from someone named Moses Kagan. Moses is the founder of Adaptive Realty and is kind of a huge deal in the REtwit community on Twitter.
Unlevered yield on cost is kind of like Cap Rate, but it tells a better story.
Before I explain UYOC, let me first summarize the better known formula, Cap Rate.
Cap Rate, as you probably already know, is net operating income divided by the purchase price. Cap Rate is the de facto format in which commercial properties are evaluated.
A good way to think about Cap Rate is the income you can expect if you buy the property without debt. If a property is valued at $1,000,000 using a 5% cap rate, you can expect to make $50,000 in net operating income per year.
Cap rate is a simple valuation metric and EVERYONE uses it. It’s a great metric for sellers, because it’s a reliable way to determine the value of your property. But cap rate falls short for buyers because it doesn’t include the ancillary costs of purchasing, financing, or improving the property.
Closing costs on a million-dollar commercial property can easily add up to tens of thousands of dollars. Title insurance will probably cost $15,000. Legal fees will probably cost another $5,000. Getting the property appraised and inspected can cost another $10,000.
This doesn’t even begin to consider all of the costs associated with improving the property after you buy it. Then you have to bring the property up to par. There’s almost always deferred maintenance and capital improvements that need to be made.
So what started as a 5% cap rate, ends up being a 3 or 4% unlevered yield on cost.
When we bought our 4-unit mixed use building in March 2021, we paid $315,000 for it. Prior to the sale, the seller provided his profit and loss statement. His rental income was $51,144 per year. His expenses added up to $20,884 per year. That left the seller with an annualized net operating income of $30,260 per year.
The seller originally asked for $359,000, which computed a Cap Rate of 8.5%.
However, we paid $315,000, which computed a cap rate of 9.6%.
We’re still making improvements to this property. When it’s all said and done, I think we’ll be into it for $375,000, which means we spent roughly $60,000 of additional money above and beyond the purchase price.
Today, our gross rental income at this property is $69,000 per year and our fixed and variable expenses are $38,000 per year after budgeting for vacancy, capex, repairs, and maintenance. That puts our Net Operating Income at $31,000 per year.
Our Unlevered Yield on Cost is $31,000 / $375,000 = 8.2%. That’s more than a full point lower than the cap rate when we purchased the building.
I’m going to quickly mention a bonus metric here I recently learned about called the Loan Constant.
A loan constant is a percentage that shows the annual debt service on a loan compared to its total principal value.
When we go to refinance this property, we’re expecting to get a new loan for $400,000 at roughly 4% over 30 years.
The monthly principal and interest payment will be $1,910.
That means our Loan Constant is $1,910 x 12 / $400,000, or 5.7%
Why am I mentioning this?
Because when you deploy capital, you want to make sure your cap rate, or in my case, Unlevered Yield on Cost, exceeds your Loan Constant. Otherwise you will LOSE money.
Thankfully, this project meets that criteria as my Unlevered Yield on Cost is 8.2% and my loan constant will be 5.7% once I refinance into long term fixed rate debt.
Return on Equity (ROE)
My final favorite formula is Return on Equity.
I typically don’t calculate Return on Equity until the property is stabilized because that helps me determine if I want to keep it or not.
To calculate equity, you have to know a few things:
First, you have to know what your property will sell for.
Second, you need to know the costs associated with the sale.
Last, you need to know your outstanding debts.
The best way to determine what a property will sell for is to get an appraisal. I recently had a 3-family investment property appraised for $320,000. We would pay a realtor a 5% commission to sell the property and will probably pay another 2.5% in closing costs.
Finally, we currently have a loan of $215,000 on this property.
So $320,000 minus $16,000 for realtor fees, 8,000 for closing costs, and $215,000 for a loan payoff leaves us with $81,000 in net equity.
After you calculate the equity you’d actually walk away with, you have to calculate your net return on the property.
Right now, we charge $3,750 per month in rent. We spend $150 per month on property management, $225 per month on insurance, $635 per month on property taxes, $100 per month on water and sewer, $100 per month on the landline, and then another $100 per month on common area utilities. Then we budget 4% of gross collected rents for vacancy and 8% of gross collected rents for repairs, maintenance, and capex. That leaves us with $1,990 in net operating income.
Our principal and interest mortgage payment here is $1,220 per month, which leaves us with a free cash flow of $770 per month, or $9,240 per year.
Now that we have our cash flow and net equity figures, we can calculate our Return on Equity.
Our return on equity is $9,240 divided by $81,000, or 11.4%.
I like to keep anything above an 8% return on equity.
I feel stupid saying that because I actually made a video about selling this property 2 weeks ago.
If you want to watch that video, click this link. I had a lot of good reasons to sell the property, but after talking to my mentor, I changed my mind. I’m going to keep it. Hopefully it jumps in value again next year and my ROE dips below 8%, at which point, I’ll consider selling it again.
Before we leave, I do want to mention one last thing.
Good real estate investments are like good books. There are far too many of them out there to acquire or read them all.
So after you reach a certain point or do a couple deals, you have to look at more than just the numbers to decide which ones you’re going to spend your time going after.
Here are five important qualitative questions I ask myself before jumping into my next investment.
- How much of my time will this take?
- How much risk am I taking on?
- Does this transaction fit within my broader strategy?
- Am I the best person to execute this transaction? In other words, What’s my edge?
- If I end up losing or not making any money on this deal, what lessons or relationship can I walk away with to make this a net positive?
With that said, I’m going to drop the mic here and leave you to think on those questions