The Real Estate Investor Knowledge Test

Question 1

How is the capitalization rate (cap rate) calculated, and what does it measure?

Accepted Answer

Cap rate = Net Operating Income / Current Market Value (or Purchase Price); it measures the property's unlevered return on value

Answer

Cap rate = (Annual Rent - Mortgage Payment) / Down Payment; it measures leveraged return

Answer

Cap rate = Gross Rental Income / Purchase Price; it measures total revenue relative to cost

Answer

Cap rate = Monthly Rent x 12 / (Purchase Price + Renovation Cost); it measures cash-on-cash return

Question 2

How is cash-on-cash return (CoC) different from cap rate?

Accepted Answer

Cash-on-cash return measures the annual pre-tax cash flow divided by the total cash invested (down payment plus closing costs and renovations), so it accounts for financing and leverage while cap rate does not

Answer

Cash-on-cash return uses gross rent while cap rate uses net operating income

Answer

Cash-on-cash return is the same as cap rate but is used only for commercial properties

Answer

Cash-on-cash return measures five-year cumulative return while cap rate measures only Year 1

Question 3

What is the '1% rule' in rental property investing and what is it primarily used for?

Accepted Answer

A quick screening tool suggesting that a property's monthly gross rent should be at least 1% of the total purchase price for it to be worth analyzing further

Answer

A rule stating that operating expenses should not exceed 1% of the purchase price per year

Answer

A guideline that investors should allocate 1% of the property value annually to a maintenance reserve

Answer

A rule that cap rates should be at least 1% above the 10-year Treasury yield

Question 4

How is the Gross Rent Multiplier (GRM) calculated and what are its limitations?

Accepted Answer

GRM = Purchase Price / Annual Gross Rent; it is a quick valuation tool but ignores operating expenses, vacancy, and financing costs

Answer

GRM = Net Operating Income / Monthly Rent x 12; it is useful for comparing properties across different markets

Answer

GRM = (Purchase Price + Closing Costs) / Monthly Rent; it requires detailed expense data to calculate

Answer

GRM = Annual Gross Rent / Purchase Price; it is precise because it accounts for all expenses

Question 5

What is the Debt Service Coverage Ratio (DSCR) and why do lenders care about it for investment property loans?

Accepted Answer

DSCR = Net Operating Income / Annual Debt Service; a ratio above 1.0 means the property generates enough income to cover its mortgage payments, which lenders require to approve a loan

Answer

DSCR = Total Assets / Total Liabilities; it is used to evaluate the investor's overall financial health

Answer

DSCR = Monthly Cash Flow / Monthly Mortgage Payment; lenders require this to be above 0.5

Answer

DSCR = Loan Amount / Annual Rent; it measures how quickly the rent will pay off the loan

The Real Estate Investor Knowledge Test

What You Will Learn