Some definitions you need to know-

Gross Rent Multiplier (GRM)

Perhaps the simplest form of real estate investment analysis is the Gross Rent Multiplier which just measures the price to rent ratio.

GRM = Purchase Price / Annual Gross Scheduled Rent

Let’s say you purchased a property for $125,000 and it rented for $1,300/month, which would be an annual gross scheduled rent of $15,600 (just multiply your monthly rent by 12 to get this). So, in this example:

GRM = 125,000 / 15,600

GRM = 8

Analytical Note: A GRM is like a golf score: the lower the better.

Net Operating Income (NOI)

While a price to rent ratio is simple and easy to calculate, it does not take into account your operating expenses. Some markets have much higher property taxes than others for example so to get a more accurate analysis of how much money will go into your pocket, you need to move on to more comprehensive calculations.

Your Net Operating Income (NOI) is your total gross scheduled rent minus all your expenses—property taxes, insurance, HOA fees if any, property management fees, "vacancy" and "maintenance" estimates.

NOI = Gross Scheduled Rent – Operating Expenses - Maintenance and Vacancy Estimates

Important Note on "Vacancy" and "Maintenance": Smart investors always make sure to factor in "vacancy" and "maintenance" estimates when analyzing properties, even new or fully renovated turn-key properties that have tenants in place at closing. This is because if you hold a property over the long term there will eventually be tenant turnover, vacancy and maintenance, all of which cost you money and affect your cash flow. Maybe your property will have no vacancy for 3 years, but then the tenant leaves and your property is vacant with no income for 60 days until a new tenant moves in. Or maybe you have no repairs for a couple years, but then you have an expensive one. Well, if you account for all that up front and amortize your estimated vacancy and maintenance across every month (we usually suggest estimating at least 5% of the monthly rent for maintenance and 7% of the monthly rent for vacancy), then you are not caught off guard when it occurs, because you factored it in from the beginning.

So let’s use our example above again with the $125,000 property with $1,300/mo rent and include some sample expenses:

Gross Monthly Rent : $1,300 Property Taxes : $120 Insurance : $60 HOA : $30 Property Management : $130 Vacancy Estimate : $91 Maintenance Estimate : $65 Net Operating Income : $804/mo

Capitalization Rate (Cap Rate)

A Capitalization Rate (Usually called a "Cap Rate" for short) is simply your annual net operating income divided by your purchase price.

Cap Rate = Annual NOI / Purchase Price

So, sticking with our example above, you would multiply your $804 monthly NOI by 12 to get your annual NOI of $9,648.

So, in this example:

Cap Rate = $9,648 / $125,000

So

Cap Rate = 7.7%

Analytical Note: The higher the Cap Rate, the better

Important Note on Running Your Own Numbers: While a cap rate is one of the most common formulas used to for real estate investment analysis, ALWAYS be sure to check the calculation and make sure the person presenting it to you has calculated it properly. For example, MANY sellers quietly omit the maintenance and vacancy assumptions (which in the example above would change the Cap Rate from a 7.7% to 9.2%, which is a huge difference!). If you were to just compare "cap rates" without confirming how they have been calculated, you would be seriously mis-analyzing the properties. This is why it is crucial for you to understand how these formulas work so that you can apply them yourself when doing your own real estate investment analysis.

Now, even when calculated properly, a cap rate does not take into account any financing you may have used to leverage your purchase. So, the final formula we will discuss here goes one additional step.

Cash-on-Cash Return

If you got financing on the property that means that you put less money down out of your pocket and it also means that you have an additional monthly expenses for your mortgage payment (often called "debt service"). You need to be able to analyze the results of this "leverage" and assess how profitable it is for you. The cash-on- cash return formula calculates the return on the total cash invested (which is your down payment plus closing costs plus any other initial expenses) and takes into account the additional "debt service" expense you now have.

Cash on Cash Return = Net Annual Cash Flow / Total Cash Invested 

So, in our example, let’s say instead of paying cash you purchased this property for 20% down and received an 80% loan at 5% interest with fixed principle and interest payments for 30 years, and let’s say you had a total of $5,000 in closing costs (including lender fees, title fees, etc). On our $125,000 property that means your down payment is $25,000 plus your $5,000 in closing costs so your total cash invested is $30,000. Then if you got an 80% mortgage for $100,000 at 5% interest fixed for 30 years, your P&I monthly payment would be $537/mo (use a mortgage calculator to determine this, or ask your lender), which you then just multiply by 12 to get annual debt service of $6,444. So, in our example:

So let’s use our example above again with the $125,000 property with $1,300/mo rent and include some sample expenses:

Purchase Price : $125,000 20% Down Payment : $25,000 Closing Costs : $5,000 Total Cash Out of Pocket : $30,000 Gross Monthly Rent : $1,300 Operating Expenses : $496 Net Operating Income : $804 Debt Service $537 Net Monthly Cash Flow : $267/mo

To calculate "Net Annual Cash Flow", just take our net monthly cash flow of $267 and multiply by 12.   
So, Net Annual Cash Flow = $3,204 

Cash on Cash Return = $3,204 (Net Annual Cash Flow) / $30,000 (Total Cash Invested)

So

Cash on Cash Return = 10.7%

Feel free to reach out ANYTIme with any questions you may have in regards to real estate investments.

The numbers shown are an example and you should make certain you verify your deal with a professional real estate analyst.