Investment metrics

The purchase price and expected rentals are not the only thing that you need to consider when analyzing real estate investments.
There are several investment ratios and calculations that Investors use to assist them in evaluating a potential deal.

An understanding of these metrics is crucial in order to make smart investments. At the end of the day… What’s a good investment? What’s a bad investment? If you don’t crunch the numbers, you’ll never know.

In this article, I am going to cover some of the most important real estate investing metrics that every investor should be aware of when buying real estate.

A quick note before we begin. This article is geared towards buying residential properties.

Investment ratios are relative.

First things first…Before we can use these ratios to evaluate deals. It is very important to understand that these performance measurements are relative.

For example, what might be considered a good CAP rate in one area might be considered poor in another area.
An investment property in a less desirable area would need to be cheaper and therefore have a higher CAP rate, to attract buyers who prefer a higher yield. Conversely, an investment property in a highly desirable neighborhood would be more expensive and have a lower CAP rate to attract buyers who prefer higher-quality assets.

Cash flow:

Put simply, this is the amount of money that you are left with after all of the expenses have been paid.

Rental income – All expenses = cash flow

This is important for understanding the degree of risk in the investment.  If your property has a positive cash flow this can significantly reduce your risk.

In a financial crisis where interest rates may rise and your property might lose value or where you may lose your job. Your property investment will be safe because its income covers all of its expenses.

A second benefit of positive cash flow properties is that it is generating a passive income which can be used to pay down debt quicker, build equity for new investments and help you achieve financial freedom.

Net operating income (NOI):

This is used to measure the properties profitability and its ability to generate revenue before financing costs and tax is paid. Investors use NOI to determine if a  specific investment will generate enough income to cover mortgage payments.

Total income – operating expenses = NOI

Operating expenses include the general running costs of the property, things like management fees, utilities, general repairs and maintenance, rates and taxes and community fees.
It is very important to note that mortgage payments, interest payments and income tax is not included in these expenses.

cYields and rate of returns:

The ROI is a very effective measurement which can be applied to measure the effectiveness of your investment. It can be used to capture the relationship between the total return and invested capital, the net income and invested capital and the properties cash flow and the invested capital.

Gross Return on Investment:

This is a very simple and quick calculation which you can do to compare the value of rental properties in the same area or market area.

(Annual rent  / total cost of property) x 100 = gross ROI

Cost of property includes the purchase price, associated fees, taxes, commissions and renovation costs. It is literally the total cost of the project.

Its simplicity makes it a great back of the napkin number and tool to make a quick calculation. However, is does not take into account things like expenses and debt. Therefore, it needs to be used together with different ratios to provide a more in-depth analysis.

Capitalization rate:

This measures the relationship between the amount of income produced by the property and the total cost of the investment. This is great for completing a quick cash flow analysis of comparable properties, without factoring debt into the equation.

(Annual NOI / total cost of investment) x 100 = CAP Rate.

Because this measurement does not take the details of the financing into account, It gives a pure indication the properties potential return.

 Cash on Cash Return:

This ratio allows investors to calculate the amount of money they get back, for every dollar they personally put in to an investment property.

(Remaining cash after servicing debt / your equity investment) x 100 = COC Return

This shows the relationship of your cash flow with the amount of cash you have personally invested. It is important because unlike the Cap rate, this ratio takes the debt service and mortgage into account.

Debt Service Coverage Ratio (DSCR):

This crucial ratio measures the relationship between the cash generated from the investment and the debt required to pay for that investment.

NOI / debt servicing costs (bond payments, interest and loans) = DSCR

This ratio is especially important to lenders, as they want to ensure that the property being considered for investment purposes will generate enough cash to cover any and all debt obligations.

A ratio of less than 1 means that your property does not make enough income to cover the debt. this means that the property will take money out of our pocket every month.

A ratio of 1 means that your property has exactly enough income to cover your debt.

A ratio of 1.5 means that your net operating income is 51% more than your debt expenses.
            For example, 500(NOI)/330(mortgage payment) = 1.51

A ratio 2 means that your property’s net operating income is twice as much than your debt payments.
            For example, 500(NOI)/250(mortgage payment) = 2

This can be used to determine how much leverage you should be using in accordance with your risk appetite.

In summary:

Using these investment metrics will put you in a better position to make an informed decision when analyzing your rental property deals.
Each ratio tells a different story about your property or potential investment. Therefore, they should be considered in the context of the market, the building, and your investment goals when using them to inform your plans.