I didn’t need the whole world to tell me that we were headed into recession in late 2008 to know that it was probably time to get the heck out of the stock market. Wild swings up and down may be fun for some people, but I like my investment returns to be a little more steady and a little less risky.
That makes real estate one of the most perfect solutions that I could ever hope to find. If you are like me and have had it with the wild swings of the stock market and are looking for something a little more dependable, then real estate may be right for you too.
But with real estate investing you have a whole new set of things to learn before you can even think about getting started. So today I thought I would write a short article and discuss several ways to analyze real estate investment in order to determine whether or not you should invest in it. Many of these analysis methods are mathematical in nature but you don’t have to have an advanced degree in mathematics in order to put them to use yourself.
First I want to talk about the gross rent multiplier. This is the sales price divided by the gross annual rents and it will tell you the number of years of rent that you will have to get in order to equal the sale price of the property. In this case you want a gross rent multiplier as low as possible.
Next calculate the debt conversion ratio. This is just basically the net operating income divided by the annual mortgage principal plus interest payments. Just to make that clear what you do is add your interest payments to the annual mortgage principal and then take that number and use it to divide into the net operating income. So it looks like this: Net Operating Income / (Annual Mortgage Principal + Interest Payments).
The DCR will show you the ability of a project to service its debt obligation. A lender will usually want you to have a DCR that is at least 1.25 which means that the net operating income will be a least 25% larger than the principal and interest payments.
Next you should calculate the overall return on capital. This is simply the net operating income divided by the total investment. It will measure the productivity of your investment and is generally more reliable than the gross rent multiplier in most cases.
Finally you should calculate the cash on cash return which is just cash flow before taxes divided by your initial investment. A lot of investors will use the cash on cash return ratio as an indicator of how productive the equity will be in a given project. If you’re going to be primarily concerned with the cash flow that your project throws off then this is a good number for you to take a look at.
Hopefully this list has been helpful to you but you should realize this is far from a complete list and there are many other things you should calculate before investing in real estate. Hopefully this list will get you off on the right foot though.
Written By Jason Markum