Real estate math are necessary in order to analyze the viability and profitability of real estate investments.
Real estate investments differ from other investments in many respects and specialized mathematical formulas are needed in order to calculate several measures of performance that can help the investor evaluate whether a property investment is worthy and whether it fits his/her return and risk objectives.
The formulas needed to evaluate properly property investments include simple formulas such as those for calculating, the income and appreciation returns, net income multiplier, gross income multiplier, return on capital, etc. and more complex ones such as the internal rate of return (IRR), modified internal of return (MIRR) and present value.
Furthermore, real estate math provide all the formulas needed for calculating property cash flows, including gross rental income, net operating income, before tax cash flow (BTCF) and after tax cash flow (ATCF), which are needed for calculating the most commonly used measure for calculating the internal rate of return. The internal rate of return measures the compounded periodic (annual, quarterly, monthly, etc.) rate of return of a real estate investment over a given holding period.
Math for Calculating the Effects of Borrowing
Real estate math should also provide the formulas needed for assessing the effect of borrowing on real estate investment performance. Real estate investments are very capital intensive and therefore borrowing is very common in property acquisitions. Formulas that are commonly needed when analyzing real estate investments that involve borrowing include the mortgage constant, loan payment, interest payment, and remaining balance. Furthermore, in calculating the
leveraged IRR, the analyst needs to use the appropriate formulas that take into account the effect of borrowing on the property’s cash flows.
Property Portfolio Mathematics
Real estate math include also formulas for analyzing property portfolios. Property portfolio calculations may include calculating aggregate total portfolio return, portfolio income return, portfolio appreciation return, portfolio cash flows, and portfolio internal rate of return. The formulas for these calculations are the same at the portfolio level but the analyst need to use portfolio cash flows in the formula. These portfolio cash flows can be simply derived by summing up the cash flows for the individual properties included in the portfolio. For example, the portfolio net operating income is the sum of the net operating incomes of each of the property included in the portfolio.
Another field of property portfolio investment analysis is the application of modern portfolio which uses the formulas embedded in the Markowitz model. These formulas are used for the calculation of portfolio return and portfolio variance of return (or risk). The model can also be used for the construction of optimal portfolios from a universe of investment opportunities. The formulas of portfolio return and variance are used by an optimization algorithm that calculates the maximum attainable return for a given level of risk and the minimum risk portfolio that can achieve a given level of return. The model requires as inputs return, risk and correlation measures for the properties/assets included in the investment universe.
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