Key Real Estate Finance Formulas

Why This Matters

Real estate finance formulas aren't just math problems—they're the language investors, lenders, and analysts use to communicate about property value, risk, and return. On your exam, you're being tested on your ability to select the right formula for the right situation, interpret what the results mean, and understand how these metrics connect to financing decisions, investment analysis, and risk assessment.

These formulas fall into distinct categories based on what question they answer: Is this property profitable? Can it support debt? What's my return? How risky is this investment? Don't just memorize the calculations—know which formula answers which question and how they relate to each other. A strong grasp of these relationships will help you tackle any scenario-based question thrown your way.

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Income and Profitability Metrics

These formulas measure how much money a property actually generates and how efficiently it operates—the foundation for every other calculation.

Effective Gross Income (EGI)

• Potential gross income minus vacancy and credit losses—this is the realistic income figure you'll actually work with
• Formula: $EGI = \text{Potential Gross Income} - \text{Vacancy Loss} - \text{Credit Loss}$—accounts for the fact that not every unit stays rented and not every tenant pays
• Foundation for NOI calculation—you can't assess true profitability without first adjusting for real-world income losses

Net Operating Income (NOI)

• $NOI = EGI - \text{Operating Expenses}$—the single most important number in commercial real estate analysis
• Excludes debt service, capital expenditures, and income taxes—this isolates the property's operating performance from financing decisions
• Used as the numerator in cap rate, DSCR, and debt yield calculations—master NOI and you've unlocked half the formulas on this list

Operating Expense Ratio (OER)

• $OER = \frac{\text{Operating Expenses}}{EGI}$—measures management efficiency as a percentage
• Lower OER indicates better cost control—typical ratios range from 35-50% depending on property type
• Useful for comparing similar properties—a high OER might signal deferred maintenance or management problems

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Valuation and Quick Analysis Tools

These formulas help investors quickly assess property value and compare investment opportunities without complex cash flow modeling.

Capitalization Rate (Cap Rate)

• $\text{Cap Rate} = \frac{NOI}{\text{Property Value}}$—expresses the relationship between income and value as a percentage
• Higher cap rates suggest higher risk and/or higher potential returns—a 4% cap rate property is priced very differently than an 8% cap rate property
• Market-derived metric—cap rates vary by property type, location, and market conditions, making them essential for comparisons

Gross Rent Multiplier (GRM)

• $GRM = \frac{\text{Property Price}}{\text{Annual Gross Rental Income}}$—a quick-and-dirty valuation shortcut
• Lower GRM generally indicates better value—you're paying fewer "years of rent" to acquire the property
• Does not account for expenses or vacancy—useful for initial screening but too crude for serious analysis

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Debt Analysis Metrics

Lenders use these formulas to assess whether a property can support financing—and at what terms. These directly impact your ability to secure loans.

Loan-to-Value Ratio (LTV)

• $LTV = \frac{\text{Loan Amount}}{\text{Property Value}} \times 100$—measures leverage as a percentage
• Higher LTV means more leverage and more lender risk—typical commercial loans max out at 65-80% LTV
• Directly affects interest rates and loan approval—push LTV too high and you'll pay more or get denied

Debt Service Coverage Ratio (DSCR)

• $DSCR = \frac{NOI}{\text{Annual Debt Service}}$—shows how many times over the property can cover its loan payments
• DSCR > 1.0 means positive cash flow after debt—most lenders require 1.20-1.25 minimum
• The lender's favorite metric—this tells them whether they'll get paid even if things go slightly wrong

Debt Yield Ratio

• $\text{Debt Yield} = \frac{NOI}{\text{Loan Amount}} \times 100$—measures income relative to loan size, independent of property value
• Preferred by conservative lenders—unlike LTV, it doesn't rely on potentially inflated appraisals
• Typical minimum requirements: 8-10%—provides a margin of safety if property values decline

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Return on Investment Metrics

These formulas help investors compare different opportunities and evaluate whether an investment meets their financial goals.

Cash-on-Cash Return

• $\text{Cash-on-Cash} = \frac{\text{Annual Pre-Tax Cash Flow}}{\text{Total Cash Invested}} \times 100$—measures the cash yield on your actual out-of-pocket investment
• Accounts for leverage—unlike cap rate, this reflects what you earn on your money after debt service
• Simple annual metric—great for comparing current-year returns but ignores appreciation and future cash flows

Return on Investment (ROI)

• $ROI = \frac{\text{Gain from Investment} - \text{Cost of Investment}}{\text{Cost of Investment}} \times 100$—the classic profitability measure
• Can include both cash flow and appreciation—more comprehensive than cash-on-cash but less standardized
• Flexible but sometimes ambiguous—always clarify what's included when someone quotes an ROI figure

Equity Multiple

• $\text{Equity Multiple} = \frac{\text{Total Cash Distributions}}{\text{Total Equity Invested}}$—shows total return as a multiple of invested capital
• An equity multiple of 2.0x means you doubled your money—includes all distributions over the entire holding period
• Doesn't account for timing—a 2.0x return in 3 years is very different from 2.0x in 10 years

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Time Value of Money Metrics

These sophisticated formulas account for when cash flows occur—critical for comparing investments with different timing profiles.

Net Present Value (NPV)

• $NPV = \sum \frac{\text{Cash Flow}_t}{(1 + r)^t} - \text{Initial Investment}$—discounts all future cash flows to today's dollars
• Positive NPV = investment exceeds required return—if NPV > 0 at your target discount rate, the deal works
• Requires choosing a discount rate—this rate reflects your opportunity cost and risk tolerance

Internal Rate of Return (IRR)

• The discount rate that makes NPV equal zero—represents the investment's actual annualized return
• Allows apples-to-apples comparison across investments—normalizes returns regardless of investment size or timing
• Sensitive to cash flow timing—earlier returns boost IRR more than later returns of the same amount

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Risk and Stability Metrics

These formulas help assess how vulnerable a property is to market downturns or operational challenges.

Vacancy Rate

• $\text{Vacancy Rate} = \frac{\text{Vacant Units}}{\text{Total Units}} \times 100$—measures the percentage of unoccupied space
• Directly impacts EGI and all downstream calculations—a 5% vs. 15% vacancy assumption dramatically changes your analysis
• Market indicator and property-specific metric—compare individual property vacancy to market averages to spot problems or opportunities

Break-Even Ratio

• $\text{Break-Even Ratio} = \frac{\text{Operating Expenses} + \text{Debt Service}}{EGI}$—shows what occupancy level covers all obligations
• Lower break-even ratio = more financial cushion—a 75% break-even means you can survive 25% vacancy
• Combines operating and financing risk—useful for stress-testing an investment's resilience

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Quick Reference Table

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Self-Check Questions

1. Which two formulas both use NOI in the numerator but measure fundamentally different things? Explain what each one tells you.

2. A lender is evaluating a loan application and wants to know if the property can cover its debt payments. Which formula should they prioritize, and what minimum value would they typically require?

3. Compare and contrast cash-on-cash return and cap rate. Why might an investor prefer one over the other when evaluating a leveraged investment?

4. You're comparing two investments: one returns 1.8x equity multiple over 4 years, the other returns 2.2x over 8 years. Which additional metric would help you make a fair comparison, and why?

5. An FRQ presents a property with declining occupancy and asks you to assess financial risk. Which three formulas would you calculate, and what would each reveal about the property's vulnerability?