Real estate investment has some guidelines every investor needs to follow in order to be successful. There are several math formulas that investors use to identify the best rental property investment opportunities and property management.
Here are some common real estate math formulas every beginner investor should know.
The 1% Rule
This real estate rule of thumb states that your monthly rental income should be equal to or greater than one per cent of the purchase price of an investment property. To find out if a property meets the one per cent rule, you’ll need to apply the following formula:
(Rent ÷ Purchase Price) x 100
For example: Take an investment property that costs Ksh. 5M, and rents for 40,000 per month:
(40,000 ÷ 5,000,000) x 100 =0.8%
This property comes under the one percent rule, and therefore an investor using this as a hardline guide to assess real estate investment deals, would systematically reject this deal.
The 1% rule is a useful tool to quickly estimate how property will generate cash flow. It can also serve as a guide to set rental rates if the property is unoccupied. However, note that this rule doesn’t account for property expenses such as mortgage, repairs and maintenance, insurance, taxes etc.
Learn more: How to Profit With Real Estate Regardless of The Economy
The 2% Rule
A more extreme variant of the 1% rule mentioned above.
The 2% rule is used to assess whether a real estate investment deal is good or not. This rule is applied by multiplying the price by 2% to determine the gross monthly rent the property needs to generate in order to remain profitable.
i.e. Purchase Price x 2% = Monthly gross rent needed to satisfy this rule.
For example, the purchase price of a certain property you intend to acquire is Ksh. 5M, then you’ll need to generate at least 100,000 in gross monthly rent to satisfy the rule.
The aim of an investor utilizing this rule is to only consider extremely cash positive properties that will generate enough cash to cover expenses and provide a cash cushion for vacancies and unexpected maintenance.
However, this rule isn’t without its own limitations. It can be quite difficult to find properties that meet this criteria, unless you are buying a property from a distressed seller or the real estate market is extremely weak.
The 50% Rule
The 50% rule stipulates that you should estimate an expenses ratio of 50%. That is to say that your operating expenses should be 50% of your gross rental income.
Therefore, if your property makes Ksh. 1.2M per year in gross rents, you should assume that Ksh. 600,000 will go towards expenses. This does not include mortgage payments.
Property expenses include, insurance, taxes, maintenance/repairs, utilities, property management fees and reserve funds.
This rule is important for investors as it allows investors to make quick ballpark estimates when analysing deals before making the decisions to do a full-fledged analysis.
The 70% Rule
The 70% rule is typically used in house flipping when determining the maximum price you ought to consider paying for a property. This rule dictates that you should pay no more than 70% of the after repair value (ARV), minus repair costs.
The after repair value of the property is essentially, the esimated value of the property after all the work is done to completion. The value at which you’d sell the property for after doing all the repairs.
Let’s use some simple math.
If a property’s ARV is Ksh. 5M, and needs Ksh 1.25M in repairs, then the 70% rule suggests that the most you should pay for it is Ksh. 2.25M
i.e. [Ksh 5M (ARV) x 70%] – Ksh 1.25M (repair costs) = Ksh. 2.25M
The main idea here is that removing that 30% from its value, will leave room for profits and other miscellaneous expenses.
Note, this is a very loose guideline meant to offer a quick reference when evaluating potential deals. The reality of things can, and may very well be entirely different.
Learn more: How to Make Money in Real Estate
Gross Rent Multiplier
The Gross Rent Multiplier (GRM) is an easy method to estimate the value of any income-generating real estate. It can be used to quickly assess whether a rental property will be profitable or not as, market conditions change.
Here is how its calculated:
Gross Rent Multiplier = Property Price ÷ Gross Rental Income
For example, suppose we have a property priced at Ksh. 5M, and an estimated gross annual income of Ksh. 0.48M, the Gross Rent Multiplier will be as follows:
Ksh. 5M ÷ Ksh. 0.48M = 10.4 GRM
Since the GRM compares a property’s asking price against its gross rental income, its a good way to assess how quickly the property will be paid off from its gross rent. In this example, it will take a little over 10 years.
However, note that this figure doesn’t includes expenses such as repairs, taxes, insurance and more. Therefore, it may actually take longer.
Occupancy Rate
The occupancy rate reflects how much rental space is occupied or the number of days the property is occupied by a tenant (in the case of short-term rentals). This is one of the most important indicators in real estate for success, as low occupancy rates can let you know that you need to do something.
Occupancy Rate = (Total Number of Occupied Units ÷ Total Available Units) x 100
For short-term rental, you can use:
Occupancy Rate = (Number of Days Occupied ÷ Number of Days in a Year) x 100
Debt Service Coverage Ratio
The Debt Service Coverage Ratio (DSCR) is used to measure the ability of a rental property to use its cash flow to pay its debt obligations. It shows you whether you have enough income to pay your debts.
The ratio is computed as follows:
DSCR = Net Operating Income ÷ Debt Obligation
For instance, take a property with net operating income of Ksh. 0.6M per year and an annual debt obligation of Ksh. 0.45M. The DSCR in this case will be:
0.6M ÷ 0.45m = 1.3x
A property with a DSCR of more than 1 is considered profitable, while as one with a DSCR of less than one is losing money. Essentially, if your property has a low DSCR, it will be difficult to pay back the loan on time or even get additional funding.
Learn more: Things You Need to Know About Investing in Real Estate In Kenya
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There are many more real estate math formulas used. As you take the time to study more about the industry, you’ll come across them. Here, we only took a look at some of the ones we think are important and maybe helpful as you start your journey.
For any real estate investment you make, ensure that you do not substitute any of these formulas for in-depth analysis. Before, you make an offer, ensure that you do your homework – take additional time and effort to analyze any deal to great detail.
Happy Building!