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  • Writer's pictureWiehann de Klerk

Investment Formulas

Real estate formulas that the rich use and the poor are not aware of.

Investment Formulas
Formulae and Calculations are an integral part of investing
"Price is what you pay. Value is what you get." Warren Buffet

Ever wondered why some people are able to accumulate more and more properties over time? 99% of the time, it's not because they won the lottery. It's due to their knowledge. Investors understand the importance of calculations. If you don't calculate the deal, you will never know if it is a good deal. Many so-called "investors" believe in the buy and hold philosophy - if I buy the property, surely it will go up over time. Real investors, however, do not think this unless they have done days of research and know that it will go up in value. Most investors buy things that hold value. A property must be valuable, so the question is, what makes a property valuable? Well, this depends on whether you are buying the property to live in it with your family, or as an investment. Assuming that you a buying a property for investment purposes; the property is only valuable if it provides a return. A property is only worth what it brings. This is an investment fact. Let's say you purchased a property for $150,000 and sold it a year later for $200,000. After tax on that return, you're left with $35,000. This makes it a valuable property because it provided a return; it is an asset. Assets are what investors buy - purchases that generate income, not expenses. If, however, you sold the property for $145,000, then the property was not valuable. You lost $5000 - it didn't provide you with any value. When a property provides value, it is an investment. The next question is, how do we calculate the value of a property before making a purchase decision? Easy; we have to calculate the Maximum Allowable Offer (MAO).

If the value of a property is directly related to what it brings, then all we have to do is identify the most that we can pay for that property, based on what the property provides us. First, what do we want the property to provide us with? This is the question that you need to ask. If you want a property with a view of the ocean, two carports and solar panels on the roof, then go and buy a property that provides that - how much you pay in that case doesn't matter because you are making an emotional decision, which is irrational. However, an investor is concerned about one thing, and that is the dollar return of property - being rational about the property. The colour of the walls, the size of the kitchen, the quality of the tiles and whether the bathroom is clean and tidy is entirely irrelevant. An investor does not care if the house is pink, blue, black or yellow. Investors care about the demand in the area and whether a tenant will rent the property. Therefore, MAO is the most that an investor should pay for a property, considering what the property provides.

MAO = YGR x NºYrs ± 10%

This MAO formula is a good starting point. It enables any investor to quickly calculate the value of a property. Here's how it works:

  1. Nº Yrs = This is based upon preference - How long should it take, in years, for Yearly Gross Rent (YGR) to equal the cost of the property? Choose a number between 7 and 10. Do you want to wait 10 years before the rent pays off the cost of the property or you want to wait 7 years?

  2. YGR = Yearly Gross Rent - total dollar amount of rent payable to the landlord on an annual basis.

  3. ± 10% = If the property is of high quality: it doesn't need any rehab, then add 10%. If the property is cosmetically distressed: it needs rehab, then remove 10%. If the property is in good condition: to rent out as it stands, then leave the formula as it is. The ± 10% is optional. I will only recommend adding or subtracting 10% if you have some basic understanding of rehabbing/renovating properties.

Here is how you use the MAO formula:

I was looking at property in Florida recently. The purchase price was $20,999 and the possible rent per month was $750. The property was cosmetically distressed.

YGR = $750 x 12 = $9,000. NºYrs = 7 years. We are subtracting 10% because the property needs rehab. Therefore, MAO = ($9,000 x 7) - 10%. $9,000 x 7 = $63,000 - 10% = $56,700. This formula makes it clear whether more calculations should be made or whether we should ignore the deal. MAO = $56,700 is greater than the purchase price. In other words, the maximum we are allowed to pay for the property is greater than the purchase price of the property. It looks like a great deal. The next step is to complete more calculations and double check.

The next formula that many investors use is Cash-On-Cash Return, which calculates the cash income earned on the cash that was invested. For example, let's say that Sarah, our smart investor, put down 20% as a downpayment for a mortgage, the cash-on-cash return will measure the annual percentage return Sarah will make. A down payment (DP) is the cash an investor puts in the deal. Cash-on-cash return is calculated as the annual dollar income divided by the total dollars invested. The annual dollar income is the Yearly Gross Rent (YGR) of the property and the total dollars invested is the cash that the investor puts in the deal (DP). Let's assume that Sarah wants to buy a $100,000 property. Her DP, in this case, will be 20% of $100,000 = $20,000 if she was to put down a standard 20% deposit to avoid mortgage insurance. If the YGR of the property is $10,000, then the Cash-on-cash return will be $10,000 divided by $20,000 = 50%. This is an example of a great deal. Investors look for a cash-on-cash return of at least 30%. The reason you want at least 30% is because this formula doesn't include the costs associated with the investment such as maintenance costs, insurance and council rates, rental management fees and other expenses.

Cash-On-Cash Return = YGR / DP

An important element of this investment is leverage; Sarah is leveraging the deal by using the money of the bank = $80,000 to finance the rest of the cost of the property. This is known as Other People's Money (OPM). OPM should only be used to leverage the return on investment, not just to leave your money out of it. For example, if Sarah used only $50,000 from the bank as OPM, her cash-on-cash return will only be $10,000 divided by the new DP of $50,000 = 20%. The cash-on-cash return will be lower (20% in comparison to 50%) if Sarah uses more of her own money rather than other people's money. Clearly, in this instance, you are better off using $80,000 OPM rather than $50,000 OPM.

Return on Investment (ROI) = Cashflow / Capital Invested

ROI includes the costs associated with the investment such as maintenance costs, insurance and council rates, rental management fees and other expenses, in contrast to cash-on-cash return. The reason cash-on-return is popular is that it's a fast and efficient calculation, similar to MAO. However, ROI is a popular metric because of its versatility. In its essence, ROI gauges an investment's profitability and encompasses more facets of the investment. Despite this, the calculation remains relatively straightforward and can be applied to a range of investment alternatives, not just real estate. Here is my life rule - never buy an investment with a negative return, and that's why I love ROI; a negative ROI signals to investors that other opportunities with higher ROI are available (somewhere in the world), enabling investors to eliminate the bad options and make better investment decisions. An investor that doesn't know what ROI is is not an investor. ROI measures performance. Earlier in this blog, I mentioned that a property must perform; its only worth what it brings. ROI does precisely that - it measures the performance of a property by looking at what it provides the investor. The return of an investment is measured, relative to the cost of the investment - something that every single one of us does every day. Think about it - when you go out to buy a burger, the return is hunger satisfaction, the cost is the $5.99 you paid to acquire the burger. A person that purchases a burger, calculate the ROI in their head very fast - will the return of this burger (hunger satisfaction) be greater than the cost of acquiring it? If it will, not you say YES and you make the purchase decisions. Property, alongside other investment markets, tends to attract irrational and emotional behaviour. People buy because they like the colour of the house, the area, the fact that its close to the beach etc. All of these are worthless considerations. When you buy a burger from McDonalds, you don't care about which McDonalds it is, what colour the walls inside are, or what the weather is. You want a burger, you're hungry and you are going to buy it. So, why do you look at the irrelevant things around the investment, instead of focusing deeply on the investment and the performance of it? Emotion! We are emotional beings! However, when it comes to investments, we need to set aside our emotional thoughts. Otherwise, we take the irrational road. Investors are not irrational; they are rational.

The cashflow section of this formula is the gain of the investment minus the cost of acquiring the investment. If we think of the burger example, and you believe that the burger is worth $7,99, then your burger cashflow is the gain from the investment = $7,99 minus the cost of the investment = $5,99 totalling $2. Okay, I think I'm getting hungry now. Back to real estate - let's look at Sarah' $100,000 investment property. Her DP was 20% of $100,000 = $20,000. The YGR of the property was $10,000. Her yearly mortgage repayment on a 30-year principle and interest loan at 5% = $5,149. The Yearly Operating Expenses (YOE) such as maintenance costs, insurance and council rates tends to equal 15% of YGR, on average. Therefore YOE = $10,000 x 15% = $1,500. The rental management fees (RMF) of a property is between 7% and 12% of YGR, depending on the company you select to manage rental agreements and tenants. On average, it tends to be 10%. Therefore RMF = $10,000 x 10% = $1,000. You can also add vacancy costs (costs of tenants leaving and the waiting time to get new tenants) at 5% of YGR = $500. If you have the monthly cost of these expenses readily available, then you do not need to use average % figures. The gain from the investment is YGR, and the cost of the investment is mortgage repayments, YOE, rental management fees, vacancy costs and other expenses. The gain in Sarah' case is YGR = $10,000, the annual cost of investment is $5,149 (Mortgage) + $1,500 (YOE) + $1,000 (RMF) + $500 (Vacancy) = $8149, and the capital invested was $20,000.

ROI = ($10,000 - $8,149) / $20,000

ROI = 9.26%

Highly intellectual investors use ROI to calculate the return of an investment and look for a return of at least 10% to 15%. Nothing less! No exceptions! None! Investors with some knowledge will be okay with a return above 0% allowing them to at least cover their expenses on a monthly basis. Still not a great idea because what if the value of the property falls? The rent would fall too, and the mortgage repayments will remain the same. When this happens, the 0% return will result in a -4% return. In Sarah's case, she passed the cash-on-cash return, but she failed the ROI calculation. Yes, her return is substantial when compared to the interest rate the bank provides you, but my question is, do you want to be an average investor or a smart investor? An average investor will be happy with 0%, and a dumb investor will be happy with a -6% negatively geared, negative cash flowing property. Here is the cool thing about doing all three of these formulas, instead of being selective: The MAO formula immediately tells you whether the property is a good deal or too expensive. For example, if Sarah completed the MAO formula, she would have identified that the property is worth no more than $77,000, assuming it was in great condition (MAO = $10,000 x 7 + 10%). The cash-on-cash return would have been 64.9% (instead of 50%), and the ROI would have been 19.7% (instead of 9.26%). 19.7% is better than the minimum return of 10% to 15%. Again, the value is what matters, not price - a property can't have a positive value if it doesn't provide a positive return.

Stay tuned, there are many formulas where that came from.

Disclaimer: This blog provides you with general advice, not personal advice. That means that I did not take into account your personal objectives, financial situations or needs, even if they are known. Accordingly, this information may not be appropriate for you. I may provide general advice regarding the economy, federal reserve policy and risk management techniques, but this is only general advice. You should obtain professional advice and ensure you read and consider the appropriate offer and disclosure document before acting upon any general advice provided.

If you have any questions about these formulas, ask below.

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