There’s more to picking an investment property than how much it costs to buy and how much rent it could bring in. Investors have made a library of ratios and calculations to help them make smart investments that minimize risk and make the most money.
Smart investors know everything there is to know about these real estate investing metrics so they can evaluate a possible investment in minutes and keep an eye on their existing properties.
But why do you need these numbers, you ask? If you want to invest in real estate, you don’t need to know if a property looks nice. Instead, you need to know what the numbers say about it.
Investors have to rely heavily on real estate analysis to find out if a property has the potential to give them a good cash flow, a good rate of return, and long-term profits.
In this article, we’ll be listing down 8 must-have metrics that every real estate investor should know.
1. Net Operating Income (NOI)
Net Operating Income (NOI) is a way to figure out how much money you make from an investment property. It’s a version of a statement of income at a high level. To figure it out, you’ll have to subtract your operating costs from your total income.
NOTE: Never include your mortgage payments in the NOI calculation because they are not operating costs.
Don’t forget to add any money you get from laundry machines, extra parking fees, or service fees to the total amount you make. Fees for a property manager, legal fees, general maintenance, property taxes, and any utilities you pay for are all types of operating costs.
The calculation also exempts capital expenses and taxes. Keep in mind that projected rents could be wrong when using NOI to analyze a possible investment. And, if the facility is poorly handled, cash flow could be inconsistent. You can figure out this metric on your own or ask a professional to do it.
Why Is Net Operating Income Important?
Investors only use NOI to judge a building’s ability to bring in and make money. It lets you know if a certain investment will bring enough money to pay your mortgage.
2. Capitalization Rate (Cap Rate)
Cap rate is the real estate equivalent of the return on investment in the stock market. It is the ratio measured by the amount of income generated by a property to the initial capital invested (or its current value). It indicates the profit percentage as a percentage of the investment’s value.
The cap rate is calculated by dividing your net operating income (NOI) by the asset value. This is the property’s sale price when you’re in the acquisition phase. You can later use your local realtor, broker, or the estimated value on real estate websites such as Zillow.
Why Is Cap Rate Important?
In general, the higher the cap rate, the greater the risk. This is because a high cap rate implies higher returns and, consequently, higher risk. This is why you see higher cap rates in riskier markets and lower cap rates in more stable and larger markets like New York City or San Francisco.
3. Internal Rate Of Return (IRR)
Internal Rate or Return (IRR) is a way to figure out how much interest you’ll earn on each dollar you put into a rental property over the time you own it, which means it’s basically the rate at which a property could grow. The calculation for this metric includes more than just the net operating income and the purchase price.
In calculating the IRR, you will have to set the property’s net present value (NPV) to zero and use projected cash flows for each year you plan to keep the building.
Note: Net present value is the difference between how much money is worth now and how much it will be worth in the future after it has earned compound interest.
Most investors use the IRR function in Excel to figure out the ratio because it is a complicated formula.
Even though investors use IRR to compare properties, you should also know that it has its limits. It assumes that the rental market is stable and that there are no unexpected repairs. The properties you compare should be similar in size, how they are used, and how long they have been owned.
Why Is IRR Important?
Depending on the real estate asset in question, a typical IRR metric can range from 10 to 20%, but it can also be very different. It’s another good way to tell if a property is doing well for you or not.
4. Cash Flow
Cash flow shows how well or badly your business is doing. It’s how much money you have left over at the end of the month after you’ve paid your rent and other bills. If you rent a building for $3,000 a month and all your costs are $1,200, your net cash flow is $1,800.
Why Is Cash Flow Important?
Net cash flow might be a simple metric, but it’s actually very important. If it’s negative, you won’t be capable of paying your bills or earning money. Negative cash flow could also mean that you’re spending too much on the property, in which case you should look at all of its costs. Or, you may have a tenant who isn’t paying rent on time or at all, which hurts your bottom line.
5. Cash On Cash Return
Cash on cash return tells you how much money you made from your investment in real estate. It’s an important metric because, unlike other real estate investing metrics, it includes your mortgage and debt service.
To find the current return on the total amount of cash in a property or your portfolio, divide your net cash flow after paying off debt by the total amount of cash you have in the deal. To figure out the total cash in, add up the price of buying the building or portfolio plus any closing costs. Then, subtract the amount still owed on the mortgage and add any capital expenses.
Why Is Cash On Cash Important?
Cash on cash return can help you figure out how to pay for new investments in the best way. It is used to choose between possible investments and can help you predict returns in years when you plan to spend money on capital.
6. Gross-Rent Multiplier
Gross Rent Multiplier lets investors compare buildings and get a general idea of how much each one is worth. It is worked out by dividing the price of the property by the amount of money it brings in from rent. A “good” GRM will depend on the market in your area and the prices of similar homes.
You can use a gross rental income projection or ask the current owner for a copy of their rent roll. Since it doesn’t consider vacancies or costs, you should never use GRM alone to make an investment decision.
Why Is GRM Important?
The lower the GRM, the better, but most GRMs will be between 4 and 8. This will help you decide if a potential deal is a good investment or if an asset you already own is worth keeping for the long term.
7. Loan To Value Ratio
The Loan to Value Ratio shows how much an asset is being borrowed against. An LTV is important for buyers who want to finance their deals because it tells you how much you’ll need to borrow based on how much the property is worth now.
LTV is also the best way to keep track of how much equity you have in a property, not just for financing but also for figuring out the value of your portfolio and assets when debt is taken into account.
Most lenders won’t lend up to 100% of a property’s value because they want to protect their investment by leaving some equity in it. In a loan-to-value ratio, they say how much of the total price of the house they are willing to finance.
The amount of cash you will have to put into the deal is equal to the difference between the percentage a lender will finance and the total value of the property.
Why Is LTV Important?
If the lender offers loans with an LTV of 80%, you will need a 20% down payment to get the mortgage. In this situation, a property worth $100,000 would need a down payment of $20,000 plus closing costs for an LTV of 80%. If the property is worth $200,000 after 10 years and you’ve paid down your mortgage to $50,000, your LTV is now 25%.
8. Break-Even Ratio
The Break-even ratio (BER) shows how the property’s operating costs and debt service will cut into its gross operating income.
Because it gives so much information, it is often used by lenders to evaluate a property when they are writing commercial mortgages. It shows how likely it is that a borrower will miss a payment if the rental income from the property goes down.
For example, if the investor’s operating costs and debt service add up to $40,000 and the gross operating income is $50,000, the BER would be ($40,000/$50,000) 80%.
This would mean that the investor needs to use 80% of all the money coming in to run the property business.
Key Takeaway
Metrics help people who invest in real estate decide whether to buy or sell a property. They also help keep track of performance so that problems can be found and fixed before they hurt your business. Each ratio tells you something different about your business or real estate. So, when you use them to make plans, you should think about the market, the building, and your investment goals.
