When considering buying a home, building one, or investing in other real estate assets, understanding how to run your numbers is critical. Whether you're making a personal purchase or stepping into the investment world, the process outlined here ensures you make informed decisions and minimize financial risks.
Step 1: Start with the Purchase Price
The first step in running the numbers is determining the cost of the property you’re buying. Let’s say you’re purchasing a house for $200,000. Plug this figure into your calculations. If you’re offering a different amount, adjust the number accordingly.
Step 2: Calculate Closing Costs
Closing costs can vary but are typically between 3% and 6% of the purchase price. For example:
If you’re paying cash, closing costs might be closer to 3% due to the absence of bank-related fees.
With a bank loan, you’ll likely incur origination fees, prepaid interest, escrow deposits, and more, pushing the costs closer to 6%.
Be sure to include all potential fees, such as attorney charges, underwriting, recording, and inspections. Always verify with your lender or real estate agent to avoid surprises.
Step 3: Factor in Renovations and Repairs
Consider any necessary improvements to the property. For instance, in this scenario, you plan to invest $48,000 for upgrades like a new roof and kitchen. Adding this to the purchase price brings your total investment to $254,000.
Step 4: Estimate Rental Income
If you’re renting the property, project the income. For this example, let’s assume $2,500 monthly rent, totaling $30,000 annually. But rental income isn’t guaranteed.
Step 5: Account for a Vacancy Factor
No property remains rented year-round forever. To prepare, introduce a vacancy factor. A 7% vacancy rate accounts for one vacant month every 14 months. Adjusting for this, your annual rental income drops to $27,900. This conservative approach helps you prepare for income gaps.
Step 6: Include Property Management and Ongoing Expenses
Even if you manage the property yourself, account for management fees—typically 8% of rental income—to ensure you’re valuing your time. Other expenses to consider include:
Insurance: Estimate $1,500 annually.
Property Taxes: Taxes may increase based on your purchase price. Verify the updated assessment value to avoid surprises.
Maintenance: Budget at least $500 annually for routine repairs and unexpected issues.
Legal and Accounting Fees: Set aside approximately $400 annually to cover professional services.
Adding these, your total annual expenses reach $8,500.
Step 7: Calculate Net Operating Income (NOI)
To find your NOI, subtract total expenses from annual revenue. Here, $27,900 (adjusted revenue) minus $8,500 (expenses) leaves $9,350 in annual net income.
Step 8: Determine Return on Investment (ROI)
To calculate ROI, divide your NOI by your total investment. In this example:
NOI: $9,350
Total Investment: $254,000
ROI: $9,350 ÷ $254,000 = 7.6%
Why Running the Numbers Matters
Always test your numbers against worst-case scenarios. If your investment doesn’t work under challenging conditions, it’s better to walk away. A 7.6% return is respectable in today’s market, but this process ensures you won’t face financial surprises later.
By following these steps, you can confidently evaluate potential real estate investments, maximizing returns while minimizing risks. Pay attention to the details, verify your assumptions, and make data-driven decisions.
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