Analyzing Short Sale Rental Properties

In their rush to get in on the boom in real estate—the boom that preceded the bust–many new real estate investors made (in retrospect) a rather fatal error. Many small investors just didn’t look hard at the profitability and financial leverage numbers with any real degree of sophistication.

That’s too bad, really, because three simple formulas would have given them huge insights into the investments they made and may have even given them an early warning when the real estate investment market become dangerous.

Income Capitalization Rate Formulas

The first tool that far too many investors ignored at their great peril was the income capitalization rate formula.

A property’s income capitalization rate is a simple percentage calculated by taking the net income generated by a property and then dividing this value by the property value.

Suppose some investor is considering a $100,000 rental property that generates (say) $10,000 of rent and which requires $5,000 of a year of operating expenses for taxes, insurance and maintenance.

In this example, the net income for the property equals $5,000 because $10,000 of rent minus $5,000 of expenses equals $5,000

Further, the capitalization rate equals five percent because $5,000 divided by $100,000 equals.05.

By the way, a capitalization rate, also known as a cap rate, is interesting in and of itself. The cap rate, for example, lets you know how much income and cash flow a real estate investment generates. And that information is useful for verifying that you’ll be able to cover the mortgage payments.

Capitalization rates, however, also become useful if you want to make more sophisticated calculations of the property’s financial profitability as is possible with the next two formulas I discuss.

Property Rate of Return Formulas

Once you have a property’s cap rate, you can estimate the property’s overall rate of return. Sometimes this is also called a project rate of return.

To calculate a particular property’s rate of return, you add the capitalization rate to the inflation rate you expect for the property’s value. For example, if the cap rate equals five percent and the inflation rate equals two percent, the property’s overall rate of return equals seven percent.

Note: If you buy a property without a mortgage, the property rate of return is the annual return you’ll earn on the investment. Cash buyers, in other words, earn the property rate of return on their investment.

Knowing the property rate of return measure lets you compare multiple real estate investment options. And knowing the property rate of return also lets you compare categories: looking at direct real estate investments versus stock mutual funds versus corporate bonds, and so on.

Financial Leverage Effect Formulas

One other key formula is important for real estate investors: the financial leverage formula.

Here’s the deal: If you compare a property’s overall rate of return to the mortgage interest rate paid on the money used to fund an investment, you will learn whether you’re making extra money by borrowing.

If the property rate of return minus the mortgage interest rate is a positive number, you’re making money by borrowing, by using financial leverage. If the number is negative, you lose by borrowing money.

Example: If a property generates an overall rate of return equal to 7% and you borrow mortgage money for 4%, you calculate the financial leverage effect as equal to 3% because 7% minus 4% equals 3%. Because 3% is a positive number, you know you make money by borrowing. Earning 7% on a $100,000 investment funded entirely with borrowed money costing 4%, for example, means you make 3%, or $3,000.

Tax professor and author Steve Nelson is the author of more than one books about using computers. Nelson also publishes How to Buy a Short Sale Property website where he talks in more detail about how to analyze rental property investments.