Selecting an investment property depends on more than just an attractive purchase price. Investing requires thoughtful evaluation to determine whether the deal is right for you. Your team may be experts at driving for dollars or they may understand how to look up the owner of a house, but there are specific metrics every real estate investor should know to direct your team’s efforts toward profitability. Here we’ll go over 8 real estate metrics and why your team needs to understand them.
The net operating income (NOI) is a real estate metric that tells you how much money an investment property makes you. To calculate your net operating income, start with your total income and subtract your operating expenses.
Be sure to include all income streams, including fees for parking spots, income from on-site laundry machines, or other service fees. Also, remember to only subtract actual operating expenses and not expenses like mortgage payments.
Gross Income - Operating Expenses = Net Operating Income
Knowing a property’s net operating income allows real estate investors to calculate the amount of money you would make on an investment property. It differs from the gross operating income because net operating income includes all operating expenses.
This real estate metric is key when evaluating potential new properties or keeping an eye on current properties to ensure they are being managed efficiently. Your team should be able to calculate this to determine what deals are beneficial and what deals to avoid.
Capitalization rates, also called cap rates, are an important metric in real estate investing. This rate is used to estimate the potential returns a real estate investor stands to gain on a property. You use cap rates as a comparison tool for similar properties in different markets.
To calculate the cap rate simply divide the annual net operating income by the cost of the asset or its current value.
Capitalization Rate = Annual Net Operating Income NOI ÷ Current Market Value or Cost
Cap rates are a great indicator of expected returns and are correlated to investment risk. Using this real estate investment formula can be useful in determining which properties offer the right risk profile for your portfolio.
Cap rates are also a helpful tool when comparing potential properties. Typically, a higher cap rate indicates property with a higher prospect of returns but a potentially higher risk level as well. A lower cap rate implies a lower investment risk and lowers potential returns.
The internal rate of return (IRR) is an extremely important real estate metric for real estate investors to know. When you calculate your internal rate of return you are estimating the earned interest on each dollar you invest in the property over the holding period. This rate of growth shows the potential return a property can generate over the long term. To simplify this calculation, you can use a spreadsheet or a financial calculator.
|
IRR = |
t |
|
|
∑ |
Ct |
- C0 |
|
t-1 |
(1 +r)t |
IRR = Internal rate of return
r = Discount rate
Ct = Net cash inflow during period t
C0 = Total initial investment costs
t = Number of time periods
The internal rate of return demonstrates whether a property is performing well or is underperforming. This metric sheds light on the long-term results of holding a property and your team should always consider both short-term as well as long-term financial implications.
The cash-on-cash return takes the total amount of money you have invested in your property and calculates the total return rate you are earning from this investment. This real estate investment formula includes costs such as debt service and your mortgage to accurately calculate your total return.
To calculate the rate of cash return on a property or your entire portfolio, you divide your net cash flow after debt service by the total amount of cash you put in the deal. The total cash you put in is the total of what you spent to acquire the property or portfolio. This includes not only the cost of the property but also any closing costs.
Cash-on-Cash Return = Annual Before Tax Cash Flow / Total Cash Invested
It’s important to note that if you buy a house for $100,000 with a 3% FHA home loan and then rent it out later, your total cash investment is $3,000, not $100,000. That equates to a much better cash-on-cash return.
The cash-on-cash return metric serves multiple roles in real estate investing and is an important measurement tool for your team. Not only can it help you determine the most advantageous way to finance new investments, but it also helps you decide which potential investment to move forward on when you are choosing between investment properties. Additionally, the cash-on-cash return rate can be used as a forecasting tool to estimate returns during years with capital expenditures.
The operating expense ratio provides a measure of profitability and shows whether you are controlling expenses adequately for the income produced. To calculate this important ratio, subtract depreciation from your total operating expenses and divide that total by your operating income.
Operating Expense Ratio = (Total Operating Expenses - Depreciation) / Operating Income
Knowing this real estate investment ratio gives your team a good handle on how the business is doing financially and can clue your company in on areas that require attention and adjustments. If you can maintain a lower OER, it signals that you and your team have done well keeping your expenses down compared to your revenue. If your OER is on the rise or has been increasing for some time, it can signal that you may need to review income and expenses to determine what is causing a higher OER.
The loan-to-value ratio measures the equity you hold in property and allows you to assess the value of your portfolio while accounting for your debt. When buying a property, the loan-to-value ratio expresses how much needs to be financed compared to the property’s current fair market value.
It would be unusual for a lender to finance a full 100% of a property’s value because there would be no protection for the investment. Instead, lenders offer a percentage of the total price and expect the remaining amount to be covered by your cash down payment.
The loan-to-value ratio is a real estate investment ratio your team should know because it provides a clear understanding of the ratio of debt to property value and as it changes over time allows you to see where your equity stands. If you plan to buy a property for $200,000 and the lender offers an 80% LTV, it means your down payment must account for the other 20%, or $40,000.
The debt service coverage ratio measures your company’s ability to pay back all its debt obligations with its operating income. To determine your DSCR, divide your net operating income by debt payments. You can calculate this ratio on a monthly, quarterly, or annual basis.
Debt Service Coverage Ratio = Net Operating Income / Debt Payments
Your debt service coverage ratio communicates your repayment ability which is important to lenders considering whether to approve you for a loan. If your debt service coverage ratio is less than 1, you may not qualify for financing because you may be too leveraged.
Most lenders look for a DSCR between 1.25 -1.5. This range implies you can service your debts and your properties generate at least another 25% of income beyond that debt service. Higher DSCRs may improve your interest rate on the loan because it shows you are capable of repayment.
Cash flow is one of the most important real estate investor metrics because it measures how well your business is doing. Your cash flow is the net cash you have left at the end of the month after all your expenses have been paid, including debt service.
It’s important to educate your team about what cash flow indicates. This real estate performance metric measures the health of your business and indicates profitability and the financial future of a company. When you set out to become a real estate investor it was probably in part to gain financial freedom. Cash flow is what provides that freedom by making passive income possible.
Real estate investing is a dynamic business that requires constant adjusting to improve your bottom line. By looking at these 5 KPIs on a daily basis, you keep your finger on the pulse of your business operations, which is critical if you want to scale.
As you mentor and grow your team, you need tools that allow you to scale efficiently and in a way that increases profits, not just revenue. DealMachine delivers a powerful software stack that allows you to target high-quality leads and simplifies your ability to hold team members accountable. From real estate lead management to free contact data, DealMachine provides the solutions you need to scale your business. Interested in finding out more about the ultimate integrated platform for real estate investors? Sign up for a free trial and set your team up for success!