How can an investor look at a property and quickly know if the asking price allows him to make money? In this article we propose to reveal the formula of how to evaluate a real estate investment in 5 minutes, which will allow you to quickly know if it is profitable or not.
Surely, you must have noticed or heard of people who look at a house in very bad condition and can immediately understand whether or not it is a good investment. They are often said to have a “business eye” or “tremendous intuition.” It seems they have a magic wand not accessible to ordinary mortals. It has been many years of practice, it is said…
Now, of course, this is not quite the case, and what we propose today is to unveil the formula for how to value a real estate investment in 5 minutes. And, let’s use very simple math, which any elementary school child can do! Of course, putting together a complete investment plan covering all the associated costs is quite complex, but what we are going to do in this exercise is to reduce everything to a very simple set of rules. Come on.
The basic concepts
To start, let’s discuss 2 basic concepts that are important to understand: capital and income (or yield). Capital is the appreciation of the price of the property, and rent is the percentage (gross) return that is obtained in a year (of rents) against the price of the property.
Let’s apply a simple example to illustrate the concepts:
- Capital appreciation: a 2BR apartment in Avenidas Novas in 2014 was worth €250,000, and in 2015 it will be worth €300,000. It is said that there has been a capital appreciation of 20%;
- Income (Yield): this same apartment was rented in 2014 for €1,100. It is said to have a yield of 4.4% (1,100*12/250,000).
The values of the yields considered are gross, that is, we are not including taxes and/or financing costs (with leverage effect) that differ from case to case.
Then, it is important to define two investor profiles:
- Leasing: the time horizon of the investment is long-term, and the yield is of particular interest;
- Renewal for Resale (in the US also known as flip): the time horizon of the investment is the short-medium term (1 to 2 years), capital appreciation matters;
- Mixed – Renovation and Lease: Sometimes the investor who buys to rent, before putting the house on the rental market, renews, so it is a mixed situation.
In the last 10 years the average total return was more than 10% per year
Before diving into the accounts, let’s quickly review the return on real estate investment in Lisbon over the last 10 years, to show you why at Nomera Capital, we believe real estate investment is one of the most attractive. And if you are already thinking that “yes, the problem is that I need to have a high amount of capital available to invest”, believe that this belief is wrong and limiting. In a next article we will talk more about the subject of financing. So don’t give up without hearing the full story!
In Lisbon, since 2011, the average appreciation (capital+rents) was 11.6% (or 11.2% discounting the Euribor-12), or an accumulated 116%, a period that includes the negative years of 2011 and 2012. investments that provide double-digit returns, with similar risk.
Can you give examples of many investments with these appreciation rates? Yes, you can argue that Lisbon has lived in recent years, in particular since 2015, a period of real estate “boom”. Yes, this effect on capital gains is certain and noticeable, but we would like to draw attention to the stability of the income return, which is always very constant and close to 5%. In other words, even excluding the “capital” effect, typically more volatile and conjunctural, the return only on yields, given a situation of historically low interest rates, close to 0% or even negative (as currently), we would say… not bad!
And now the formulas!
We will present you with 2 formulas:
- The Lease Calculation formula, based on the price of the property and vice versa: the investor buys a house to put it on the rental market (traditional lease), and wants to know the amount of rent that gives you a return of x%;
- Renovation for Resale formula, based on renovation cost and purchase price: the investor buys a house, renovates it, and then sells it for his profit margin, and wants to know whether the purchase price is attractive enough to allow for renewal and earn a y% margin on the sale (including all associated costs).
For the Lease calculation formula, set the number 240
Imagine that you are looking for an apartment to invest in renting, that is, you want to buy and then rent. For simplicity’s sake, before we include the cost of renovations, let’s assume that the apartment is renovated or in good condition, that is, ready to move in.
Find a 2BR apartment in the Arroios area whose asking price is €300,000. He went to visit the apartment, and found that it was in good condition. Will the asking amount allow you to obtain a return of 5%? It’s easy, just divide the price by 240. That is, 300,000/240=1,250€. Therefore, if the apartment is rented for €1,250, then the asking price is in line with your profitability objective.
You can also use the formula in reverse: if you want to sell an apartment that you have rented for €1,250, you already know that the asking price is €300,000.
And why 240? 240=12/0.05, that is, it is the factor to obtain 5% profitability. Doing the math differently, in one year you get €15,000 (1,250×12), so €15,000/€300,000=0.05.
If your goal is 6%, then the factor is 200. And for 4.5% it’s about 270.
Objective Profitability |
4.5% |
5% |
6% |
Factor |
267 |
240 |
200 |
Note that the average yield in Lisbon is currently around 4.5%.
Note: when buying, you should aim for a higher target return (ideally close to 6%) and when selling, it can be slightly below 5% (close to 4%-4.5%).
This calculation is behind the property valuation method known as the income method.
For the Renewal for Resale calculation formula, set the number 1.35
Now imagine that the apartment you are going to buy needs work. The first thing you will need to develop sensitivity to is estimating the degree of intervention needed. To simplify, we will share a table with indicative costs of the price/sqm of the refurbishment. This table will cover most situations.
Degree of Intervention |
SMALL RENOVATION (remodel kitchen, bathroom, without changing structure) |
INTERMEDIA New kitchen and WCs (+ than 1), flooring, some structural adjustments) |
HIGH (significant structure changes) |
TOTAL (structure/amplifications) |
Renewal price/sqm (€) |
400-600 |
600-850 |
1000-1200 |
1650-1850 |
Note: prices include 6% VAT.
Here are examples of Intervention Degrees to help develop your intuition:
- Small Remodeling: usually it is a small 1BR apartment of 50sqm, in which we will replace the kitchen, renovate the bathroom, general painting, smooth the floor, replace the window frames. Overall, it’s a small low cost remodel, with entry-level materials;
- Intermediate: renovation of a larger apartment, 3BR or 4BR, with 120sqm, usually with 2 or 3 WCs, replacement of the kitchen, keeping the floor, general painting, it may involve enlarging the room, knocking down a wall, maintains location of wet areas (kitchen and WCs). Mid-range materials are chosen;
- High: renovation of a larger apartment, in the house of 150sqm, which was a 5BR and we want to convert it into a 3BR. It is a more complex work, which involves knocking down several walls and changing the layout significantly, reinforcing the structure, changing the location of the kitchen and WCs, the floor may have to be changed or repaired. High quality materials are chosen;
- Total: this is the case where it is a building and if you want to expand one or two more floors, it will have to involve significant structural reinforcements, and a work in which almost only the facade is used (often it’s cheaper that way).
Suppose now that you are facing a 100sqm 3BR apartment, which you think is interesting to renovate, and that the asking price is €350,000, or €3,500/sqm. He visited the apartment and came to the conclusion that the rooms are small, so the ideal would be to convert it into a 2BR and make a bigger room. As he is thinking of carrying out a contained renovation, and it is just a matter of knocking down the wall between a bedroom and the living room to expand the latter, he concludes that the degree of intervention will be intermediate, and estimates the price at €700/sqm.
How can you assess whether it is a good investment or not?
Will use the calculation factor table for the margin target:
Margin Objective |
15% |
20% |
25% |
30% |
Factor |
1.35 |
1.45 |
1.55 |
1.70 |
NOTE: Factors include taxes (VAT+IMT), project costs (architecture, specialties, licensing), construction cost and work monitoring/supervision (in the most complex), marketing costs (5% commission+VAT charged by the real estate agency).
Add the acquisition price/sqm to the renovation price/sqm and multiply by the Factor in the table above to obtain the target margin for your investment. That is, assuming you want to resell the apartment after renovation and earn 15% (on the sale price), then the sale price/sqm will have to be (3,500+700)*1.35=5,670€, that is, the price resale of the apartment after renovation will have to be €5,670*100=€567,000.
Therefore, the question you now have to answer is: will the apartment, after being renovated, sell for €567,000? If so, your margin will be 15%*€567,000=~€85,000.
NOTE: the margin usually requested by promoters is 15% to 20%.
If your objective is to renovate to rent, then just add the price/sqm of the purchase and the renewal and multiply by 1.1 to have a good indicator of the final price/sqm (including related costs), and it will be to this value that you should apply the lease factors discussed earlier.
Taking the example we have been working with, the final price/sqm will be (3,500+700)*1.1 = 4,620, that is, the price of the house after renovation will be €462,000. Dividing this amount by 240, we get a target income of €1,925.
To finish…
We hope you have realized the added value of having a set of simple formulas that allow you to pre-analyze your investment project. Our objective here is, above all, to illustrate the key variables and derive a set of factors that allow us to quickly filter whether or not it is worth proceeding with a more detailed analysis, in the 5 minutes we promised.
These calculations do not replace a more detailed analysis that incorporates not only estimates, but values closer to the real ones (namely through requests for quotations). It is not an exact science because costs can vary greatly, particularly construction costs. Don’t forget that often the numbers they give you are much more optimistic than reality, so it’s worth keeping some “pillows”.
Finally, we advise you to derive and optimize your factors based on your own experience.
We hope this article has been helpful. Give us feedback so we can produce content that is more relevant to you. Just reply by email.
And if you need any advice on buying, selling or renting, you know, it will be a pleasure to serve you! Contact us.