There’s more to choosing an investment property than its purchase price and potential rents. To help them invest wisely, investors have developed a library of ratios and calculations to minimize risk and maximize profit. Savvy investors learn these real estate investing metrics inside and out so that they can both evaluate a potential investment in minutes and monitor their existing properties.
Whether you’re a new investor or one with twenty years of experience who needs a refresher, these are the top ten real estate investing metrics you should know.
1. Cap Rate
Cap rate, short for capitalization rate, is the real estate equivalent of the stock market’s return on investment. It’s the ratio between the amount of income produced by a property to the original capital invested (or its current value). It tells you the percentage of the investment’s value that’s profit.
Cap Rate divides your net operating income (NOI) by the asset value. When you’re in the acquisition phase, this will be the property’s sale price. Later on, you can use your local realtor, broker, or the estimated value on real estate websites like Zillow.
Generally speaking, the higher the cap rate, the higher the risk. That is because a high cap rate indicates higher returns, and ultimately higher risk. This why you generally see higher cap rates in riskier markets, versus lower cap rates in stable and larger markets like New York City or San Francisco for example.
2. Cash flow
Cash flow is a sign of how well your business is – or isn’t – doing. It’s your net cash left at the end of the month after you’ve received your rents and paid your expenses. If you rent a building for $2,000 a month, and all costs are $1,200, your net cash flow is $800.
Net cash flow is a simple but important number. If it’s negative, you won’t be able to pay your bills or make a profit. Negative cash flow could also indicate that you’re spending too much on the property, and you should examine its associated expenses. Or, you may have a delinquent tenant whose late or partial payments are impacting your bottom line.
3. Cash on Cash Return
Cash on cash return tells you the total return on the money you have in your real estate investment. Simply put, it’s how much money you’re earning off your cash invested. It’s an important metric because, unlike other real estate investing metrics, it includes debt service and your mortgage.
To get the current return on the total amount of cash in either a property or your portfolio, take your net cash flow after debt service and divide it by your total cash in the deal. To calculate total cash in, sum the acquisition price of the building or portfolio plus closing costs, subtract the outstanding mortgage balance, and add in any capital expenditures.
Playing around with cash on cash return can help you determine the best way to finance a new investment. It’s used when choosing between potential investments, and can help you forecast returns during years you anticipate capital expenditures.
Internal Rate of Return or IRR estimates the interest you’ll earn on each dollar invested in a rental property over its holding period. It’s the rate of growth that a property has the potential to generate. The calculation goes beyond net operating income and purchase price to estimate long-term yield.
When you calculate IRR, set the net present value (NPV) of the property to zero and use projected cash flows for each year you plan on holding the building. Net present value represents the value of money now, versus in the future once the money has accrued compound interest. It’s a complicated formula, so most investors use the IRR function in Excel to calculate the ratio.
While investors use IRR to compare properties, you should know its limitations. It assumes a stable rental environment and no unexpected repairs. The properties you compare should be similar in size, use, and holding period.
Example: Depending on the specific real estate asset, a typical IRR metric ranges from 10-20%, but can vary widely.
Net operating income or NOI tells you how much money you make from a given investment property. It’s a version of a high-level income statement. To calculate it, take your total income and subtract operating expenses. Never include your mortgage payments in the NOI calculation, those are not considered operating expenses.
Don’t forget to include income from laundry machines, extra fees for parking spots, or any service fees in your total income. Operating expenses include property manager fees, legal fees, general maintenance, property taxes, and any utilities that you pay.
The calculation excludes capital expenditures, taxes, mortgage payments, or interest. Investors use NOI solely to judge a building’s ability to generate revenue and profit. It tells you if a specific investment will generate enough income to make mortgage payments.
When using NOI to evaluate a potential investment, remember that projected rents could prove inaccurate. And, if the building is improperly managed, income could be inconsistent.
6. Gross rent multiplier (GRM)
Gross rent multiplier or GRM helps investors compare buildings and roughly determine a building’s worth. It’s calculated by dividing the property’s price by its gross rental income. A “good” GRM will depend on your local market and comparable properties.
You can use a projection of gross rental income, or you could ask the current owner for a copy of their rent roll. Since it doesn’t take into account vacancies or expenses, you wouldn’t make an investment decision solely on GRM.
Example: The lower the GRM the better, but you can generally expect a GRM to range between 4-8.
7. LTV ratio
Loan-to-value (LTV) measures the amount of leverage on a particular asset. An LTV matters to buyers who finance their deals as it measures the amount you’ll need to finance against the property’s current fair market value. But, LTV is also the best way to track the equity you hold in a property (not just for financing) but for the value of your portfolio and assets accounting for debt.
For financing, most lenders will not finance up to 100% of a property’s value; they want to leave equity in it to protect their investment. They express how much of the total purchase price they’re willing to finance in a loan-to-value ratio.
The difference between the percent a lender will finance and the property’s total value is the amount of cash that you will have to put into the deal.
Example: If the lender will do 80% LTV deals, you need a 20% down payment to secure the mortgage. In this scenario, a $100,000 property would require $20,000 as a down payment plus closing costs, and would represent an 80% LTV. After 10 years, if the value of the property is now $200,000 and you’ve paid down your mortgage to $50,000, your LTV would now be 25%.
8. Debt service coverage ratio
Lenders also pay close attention to your debt service coverage ratio or DSCR. It compares the operating income you have available to service debt to your overall debt levels. Divide your net operating income by debt payments, on either a monthly, quarterly, or annual basis, to get your DSCR.
If you’re applying for a new mortgage, lenders look at your DSCR to gauge your repayment ability. A high ratio indicates that you might be too leveraged, and will make it harder to qualify for financing.
Example: Typical A and B lenders require a DSCR in the 1.25–1.5 range. This means that your rental property produces 25% more of additional income after debt service.
9. Operating Expense Ratio (OER)
A measure of profitability, the operating expense ratio tells you how well you’re controlling expenses relative to income. Take all operating expenses, less depreciation, and divide them by operating income to get your OER. It’s one of the few ratios used by investors which includes depreciation, which makes it more inclusive of the property costs.
A lower OER reflects that you’ve minimized expenses relative to revenue. If your OER has been rising over time, it could indicate many issues. Perhaps annual rent increases haven’t matched expense increases. Or, your management company isn’t keeping up on routine maintenance, leading to more serious problems down the road. Calculating OER using specific expenses can help you narrow down the reason for its rise and help you get it back under control.
10. Occupancy Rates
An unoccupied unit generates no income but still costs you money. Many operating costs remain unchanged even if you have no tenants. Most investors track two historical occupancy rates to keep an eye on open units and lost income.
Physical Vacancy Rate
This rate gives you the percent of your units vacant when compared to the total units available. It’s easy to calculate, take the number of vacant units, multiply by 100, and divided by the total number of units. This metric can be useful on a property by property basis, or across your entire portfolio.
Economic Vacancy Rate
The economic vacancy rate looks at the amount of income you’re missing out on when a unit is vacant. Add up rents lost during the vacancy period and divided by the total rent that would have been collected in a year to get what the vacancy cost you.
It’s also a good idea to keep an eye on your overall market’s occupancy rate. To be conservative, build that rate into potential income calculations before buying a new building. You’ll want to build a buffer of 5-10% vacancy into all your expense calculations, which ensures you can cover all expenses when units go unrented.
The final word on real estate investing metrics
Real estate investing metrics guide investors when deciding to buy or sell potential properties. They also help track performance to identify problems before they damage your business. Each ratio tells a different story about your business or property. Thus, consider them in the context of the market, the building, and your investment goals when using them to inform your plans.