4 Rules of thumb for Real Estate Investing

There are number of quick formulas or rules of thumb that are common place in the Real Estate Investment world.  It is important to note that none of these should be relied upon solely for any investment decision.  They are typically used as a quick checks and if positive then further investigation would be warranted.  For a long term look at an investment property a yield capitalization and discounted cash flow approach would be more accurate.  We will outline the 4 rules of thumb below and discuss their applications and limitations.

4 Rules of Thumb

1.  Cash on Cash
2.  Payback Period
3.  Break-Even 
4.  Gross Income Multiplier

 

Cash on Cash

-is the relationship between a single years cash flow before taxes and the equity invested. (also called return on equity of equity dividend rate)

-takes debt service into account when assessing return

-useful comparison of investments assuming no change in value (purchased for annual income not appreciation)

Formula – Cash on Cash

=cashflow before taxes / equity invested

 

Limitations

-no consideration for appreciation- this can dramatically impact return

-no after tax comparison

-no recognition of significant factors that may affect income and expenses (major repairs in the future?)

Payback Period

-is the number of years required for cumulative cashflows before taxes to equal the initial investment (time needed to recoup initial investment)

Formula- Payback Period

=equity invested / cashflow before taxes

Limitations

significant limitations – similar to cash on cash

 

Break Even Ratio

-financial ratio used for property comparison based on gross operating income

-takes into account expenses including debt service but not taxation

Formula- Break Even

=operating expenses + debt service /  gross operating income

Limitations

-does not take  into account return on equity

-no consideration for appreciation of the property

 

Gross Income Multiplier

-is the ratio of sale price to gross operating income

-can be a monthly or yearly ratio (usually yearly)

-typically used as a quick check before a more detailed analysis

Formula- Gross Income Multiplier

=sale price / gross operating income

 

Limitations

-assumes high comparability of properties (most properties differ to some extent)

-does not take expenses into consideration (operating expenses, taxes, debt service etc)

-must use comparable income data for reliable results