How important are ratios?
If you are a serious real estate investor, you must understand that you need real estate analysis in order to make intelligent investment decisions. You have to know how facts and figures paint a picture of a real property’s viability by interpreting their cash flows, rates of return, profitability, etc. Doing so will keep you from making wrong decisions and make better choices on properties that can give you better income for your money.
An honest-to-goodness real estate analysis would include plentiful rates of return that investors and agents must learn to compute. Of course, they must also know how to properly interpret them and relate to other factors along the way to making a wise decision.
This article is for the real estate novices who want to arm themselves with the primary (but initially difficult to understand) ratios so they can learn what the number means and how to use them for their own analysis.
Why Should You Use Ratios?
Ratios are important in financial analysis because they help provide trends, rates, and comparisons of significant data. A ratio is a number that shows the relationship between different variables.
It is imperative for any mathematician or analyst to be adept in reading and interpreting ratios. Using ratios to help analyze your investment is therefore crucial because you want to see the potential of your property. You don’t buy in an area just because it’s a new project and everyone else is buying.
Aside from the analysis, there are generally accepted standards that professionals also use to determine whether an investment could turn out to be a good one.
Understanding Real Estate Advanced Ratios
1. Cap Rate
Cap rate or capitalization rate helps you to evaluate and compare properties based on their income and without considering the financing aspect. The simple formula places the Net Operating Income against the property’s Total Cost.
When you compute for the Net Operating Income or NOI, you must use annualized numbers and gross rents minus all the expenses. You should not include the principal and interest portions of your mortgage payment. Most of the time, you will need to include taxes, insurance, repairs, maintenance and anticipated periods of vacancy.
It is important that you reasonably estimate the cost of repairs and vacancy. You can see from the example the estimates we used for both of the expenses.
So, what do you look for? A cap rate of at least 6% or better is good enough. We don’t usually use the cap rate for our investments because for us, the rent ratio is enough. Just the same, our properties normally register an 8% to 10% ratio.
As we’ve mentioned, the cap rate does not factor in the cost to finance the property. If you want a ratio that would also account for that, our fifth and last ratios effectively do.
2. Economic Value
This ratio measures the property’s value to the investor in terms of the income it provides and more or less what maximum amount an outsider would be willing to pay to buy it. The ration measures the value of an investment by looking at its net operating income (NOI) and a capitalization rate that reasonably draws an investor’s capital to the project.
That may sound a little confusing so let me give you an example. If a specific property normally generates a NOI of $20,000 and the investor wants a capitalization rate of 10% to convince him to invest in it, then following the formula, we will get $200,000. This means that a buyer should pay or invest no more than $200,000 on the property so that he can reach the desired cap rate.
3. Market Value
Don’t confuse this with a preceding ratio. This is usually what investors use when the property is in an area where the market primarily drives the market value. This simply means that the market value of the property gets its estimated worth by the capitalization rate that typical investors accept if they were to invest in similar properties.
To illustrate: Let’s assume that a bunch of rental properties in an area has been selling at an average cap rate of 5% and we want to check what the market value would be of property therein. If we were to base it on an NOI of $25,000 then the result would be $500,000. To put it in simple terms, when you look at the market-driven cap rates in the area for similar properties, this particular piece of real estate would have a market value of $500,000.
4. Net Income Multiplier
The Net Income Multiplier (NIM) helps investors see how effective property is in generating income relative to its market value. It tells the investor the amount he should invest for every dollar of annual Net Operating Income (NOI) the property produces.
So, if your subject property has a market value of $500,000 and an NOI of $25,000, you will get $20 using the formula. What it means is that the investor has to shell out $20 for every $1 of net operating net income if he purchases the property at its market-driven value.
5. Debt Coverage Ratio (DCR)
Investors use this ratio to determine the extent to which the annual NOI goes for servicing debt related to the property. As a benchmark, a DCR over 1.0 is healthy because it means that after servicing the mortgage, the investor will still have some funds left as a return for his investment. If the DCR turns out less than 1.0, the investor should watch out because it indicates that the property is not generating enough income to pay the mortgage.
As an example, a property that has a yearly annual debt service requirement of $20,000 and a NOI of $30,000 will have a DCR of 1.5. To simplify, this means that the property’s income is 150% bigger than the mortgage payment for the entire year so there will be money left over after the mortgage has been paid for the year.
6. Operating Expense Ratio
This formula is simple and straightforward. Just divide the total operating expenses by the total effective gross income (EGI). If you want to see how much or what percentage of your income actually goes to your operating expenses, this is what you should use.
This ratio is very helpful if you want to make a comparative analysis of your business from year-to-year. It can show you important trends pertaining to your operating expenses, gross income and of course, net income.
7. Debt Servicing Ratio (DSR)
This ratio is very popular in the sense that lenders widely use it to evaluate whether a borrower will be able to easily repay his loan. This ratio pits the debt against the potential income of the property to see how much of the operating income will go to mortgage payments.
Banks have different lending limits as well as different tolerance ceilings for debt ratios. That is something that is beyond the control of a borrower. What is important is that you know whether the property can sustain itself through the cash flow it will generate. If the cash is not enough to service the mortgage debt, taking the property would be tantamount to financial suicide. Common sense dictates that you back off and have nothing to do with such a property.
There are things to think about if you are insistent on getting the property. You could stretch the loan tenor and decrease monthly payments. This will increase your accumulated interest expense over time. You could increase rental immediately. This can scare off your tenants which will defeat the purpose of increasing rent collections. You could also put down a higher down payment to decrease the loan quantum. This will affect your ROI negatively, decreasing the attractiveness of the investment. So what are you going to do?
Nevertheless, if you are really interested in acquiring the property there are still things you can do. You can negotiate to lengthen the tenor of the loan and therefore decrease your monthly payment. The downside is that it will increase your total accumulated interest expense over time. One way to counter that is by raising rental as soon as you can.
However, you risk losing your tenants, defeating the purpose of trying to generate higher rent collections. If you have extra funds, you can increase the amount of down payment and lessen the loan portion. However, this will affect your ROI in a negative way and lessen the attractiveness of the property. You should think about this thoroughly.
8. Gross Rent Multiplier (GRM)
You can use this ratio to see whether potentially, the expected income from the property will be more or less commensurate to the price you will pay for it. Your expected income means the amount of rent you will collect as provided for in the tenancy agreement.
You may notice that the higher your expected income goes, the lower the GRM goes with it. You would want the GRM to be as low as possible because inversely, that translates to a higher ROI.
Rules on The Ratios
Remember these rules to guide you in your investment:
- For capitalization – higher is better
- For ROI – higher is better
- For Cash ROI – higher is better
- For DSR – lower is better
- For GRM – lower is better.
Your resulting ratios will only be relevant if you have a target number to achieve or a market figure to benchmark with. These benchmarks are important because it will give you a standard to base your decision on whether a property is worth investing in.
By definition, taxable income is that portion of your revenue from rental properties on which you have to pay Federal income tax. After an accountant determines the net amount, the state uses your marginal tax rate (i.e., combined state and federal rates) to compute for your tax liability.
To compute for the taxable income, here is the formula:
Net Operating Income minus the total of Mortgage Interest, Depreciation, Real Property Depreciation, Capital Additions, Amortization, Points and Closing Costs, then add all Interest Earned (e.g., property bank or mortgage escrow accounts) = Taxable Income
To compute for the tax:
Annual Depreciation Allowance
The Annual Depreciation Allowance is the amount of tax deduction that the tax code allows for property owners may avail of each year until the entire value of the depreciable asset becomes nominal.
To calculate, you must identify the depreciable assets by computing the portion of the property’s value that pertains to improvements since land does not depreciate. Then, divide that amount over the asset’s useful life as provided for in the tax code which is 27.5 years for a residential property and 39 years for non-residential properties. Follow these formulas:
You may have all the information to compute all these ratios and assess the value and potential of your property but remember that they are only for the first year of ownership of the asset.
The following years will usher in an increase in the accrued annual equity, inflation may increase your expenses, rental rates may rise or fall depending on market conditions, your tax situation may shift and so many other things that could happen. All these things could affect your investment and may cause your return on investment to increase or decrease.
You may not be able to predict the future but you should extend your analysis for a couple of years more using other data. You can look at trend data or demographic statistics that can show the direction of the market, inflation, etc.