Real Estate Investing Metrics

It is critical that any valuation calculations for investment real estate include complete and accurate income and expenses of the property. It is the responsibility of the buyer to ask for and receive certified income and expense figures that become the basis for making an informed purchasing decision.

Personal property is not included in any calculations. A vigorous property inspection prior to an offer being made is critical.

There are many more real estate ratios that an investor can use to evaluate an income producing property these are the most often used and the ones most looked at by banks.

Operating Ratio: Compares the annual income necessary to cover all operating expenses plus debt service. An Operating Ratio of 100 indicates that the property is making zero profit. A number higher than 100 means the property is loosing money.

Operating Ratio = Annual Debt Service + Annual Operating Expenses X 100

Annual Effective Gross Income

OR =  $22,000 + $35,000  x 100 = $75,000 or 76%

What this means to an investor is that they are making 24% gross profit before income taxes on their property.

Capitalization Rate: An estimate of the value of an income producing property. The CAP Rate is a risk and reward calculation. The higher the CAP Rate the more risk in the property but the higher the profit potential which is better for the investor.

The CAP Rate calculation is a snapshot of how the property will perform the first year. It does not calculate the out-years of the investment.

The major problem when calculating the CAP Rate is not including all expenses of the property and not having accurate expense figures. Without compete numbers the CAP Rate will not be accurate.

It is rare that income and expenses for comparable properties will be available to establish a CAP Rate for a specific property type. The danger of using an arbitrary CAP Rate is that the investor could over pay for the property.

Establishing an appropriate CAP rate is best done by a real estate professional. A mere 1% difference in the suggested CAP rate could make a 12 ½% difference in the value estimate.

The CAP rate measures risk involved in an investment, thus, the higher the risk, the higher the CAP rate: the lower the risk, the lower the CAP rate.

Debt Coverage Ratio: This ratio is used by lender and investors to evaluate the property’s ability to pay its operating expenses and mortgage payments. From a bank’s view point the larger the DCR the better. Break-even is 1.0 which means that there is no additional money to pay the operating expenses. Banks look to have a DRC of 1.25 or higher.

To get an accurate DRC all income and all expense figures must be included and verified.

Net Operating Income  = $150,000 X  DCR  1.25 = Debt Service $120,000

Loan-to-Value (LTV): Lenders use this ratio to determine the amount of equity (initial down payment) that a borrower would need to bring into the purchase of the real estate.

When the property owner wants to refinance (remove cash out of) the property the LTV is re-calculated.

Banks consider that the lower the LTV the greater the owner’s equity in the property and less of a chance that the owner will default on the loan.

The LTV is calculated by dividing the loan balance of a property by the market value.

LTV = Balance of loan(s) x 100

Market Value of Property (estimate of sales price)

Operating Expense Ratio: The comparison of the operating expenses to the effective gross income.

Costs associated with the operation and maintenance of the income property.

Total gross income is revenue from all possible sources; rents, vending, parking, etc.

The Operating Ratio (OE) is an indication of how well a property is being managed. The higher the percentage the better the property is being managed making sure that there are no deferred expenses which will devalue the property.

OE Ratio  =  Operating Expenses $25,000 = .33

Total Gross Income $75,000

What this means to an investor is that their expenses are 33% of income. This does not include mortgage payments.

Income Approach: When offering an opinion of value an appraiser will look at the property from three different views; income, sales comparison and replacement cost.

The income approach is accepted as the best way to value income producing property.

Information needed:

  • Total gross income less vacancy allowance
  • Total operating expenses

Appraisers will compare similar properties for sales price and net operating income and establish a CAP Rate for each property and then average the comparables.

** The problem is that it is very difficult to get access to net operating income from comparable properties and infrequent sales of similar properties raises the risk of inflating the property’s value.

Gross Rent Multiplier (GRM): A ratio to estimate the value of an income property. The GRM provides a very rough estimate and is not the most precise metric when evaluating income property. It is the least reliable metric to establish value.

Information needed:

  • Total gross rents possible
  • Sales price

Deficiencies of GRM

  • Does not account for vacancies
  • Does not account for operating expenses
  • Different areas yield different GRM Ratios

GRM  = Sales Price

Monthly Potential Gross Income

Estimated Market Value   = GRM x Potential Gross Income

Sales price $500,000 (sales price) ÷ $8,000 (gross income) = 62.5

62.5 x $8,000 = $500,000 (Estimated Market Value)

Cash on Cash Return: A percentage which measures the return on cash invested at the time of purchase. It is before tax calculation and doesn’t take into consideration the buyer’s tax bracket.

Cash on Cash Return  =  Annual Cash Flow x 100

Cash Invested

Cash Invested: down payment, closing costs, bank loan points, appraisal costs

Net Operating Income (NOI): The difference between gross income and operating expenses.

Gross Income: rental income, parking, vending, and laundry plus any other.

Operating Expenses: insurance, maintenance, management fees, utilities, depreciation, income taxes, loan points, supplies, property taxes, contract services, etc.

This ratio is dependant upon knowing the market CAP Rate for the specific type of property: multi-family, retail, office, industrial, etc. This requires a great deal of information about the area and the property type.

Estimated Property Value   = Net Operating Income $150,000 = $1,500,000

Cap Rate .10

The KEY is to know the CAP Rate by getting complete income and expense figures.

Establishing an appropriate CAP rate is best done by a real estate professional. A mere 1% difference in the suggested CAP rate could make a 12 ½% difference in the value estimate.

The CAP rate measures risk involved in an investment, thus, the higher the risk, the higher the CAP rate: the lower the risk, the lower the CAP rate.

As in all investments there is a risk vs. reward component. The higher the risk the higher potential return; the lower the risk the lower the potential return.