Real estate investing isn’t about knowing if a property looks nice but almost all about what do the numbers tell about it. Investors must rely heavily on real estate analysis to get the facts and figures about a property’s potential to provide a good cash flow, sufficient rate of return and sustained profitability. All these would help the investors to decide whether or not to invest in the property.
Because of this, there are many real estate analyses that have become the staple formulas that investors and brokers use. The results of their computations and analysis help them in the decision-making aspect of the investment activity.
Why Using Ratios?
In Math, a ratio indicates proportion or the relationship in quantity, amount or size of two or more things. In real estate, they provide the relationship between two important variables regarding a property. Mathematicians and analysts make themselves experts in this manner of computation and analysis. For a real estate investor like you, using the ratios to analyze your investment is essential to evaluate the potential of a property.
Unless, of course, you decide only based on a bandwagon mentality. You should use these ratios against generally-accepted standards to determine whether a property is worth getting into or not.
Where You Can Find The Data
It doesn’t help to know the formulas if you don’t know where to get the input data. This is where you should look:
1. Property Details
Although the seller could provide this information, it would be better to get more comprehensive and detailed information about the property. Your local County Records Office would have sufficient information that would be of good use for you.
2. Purchase Information
The seller would normally quote a price that would, most likely, be the starting point for your price negotiation. As an interested buyer who aims to use the property for a money-making venture, you should be more particular on whether it can meet your income expectations.
To achieve that, you might need to do some immediate repairs or improvement after you buy it. If you are not an expert, it would be good to bring in a professional building inspector to properly assess if there are no hidden defects or issues about the property. You might spend a bit more, but the potential savings and peace of mind will be worth it.
3. Financing Conditions
You should discuss with your lender or mortgage broker about the terms and conditions of your financing deal.
You need to see their computations about the exact cost of the loan, the down payment, and your monthly payment so you can see whether the income from the property would cover them.You can always use mortgage payoff calculators and make part of the calculations by yourself.
4. Income Potential
The seller would be able to give you an idea of how much the property can bring in but that may be a little exaggerated. Try to validate the figures and don’t rely on unverified data for your final analysis.
You can talk to the property management company who runs the place (if there is one) or to other businesses in the area to get information.
5. Property Expenses
Much like the income, sellers would tell you details about expenses but again, you should not always take that as pure truth. The property management company might be able to help you with this.
If you have employed the services of a professional, he could point out to you about any major repairs that the property may need soon such as new roof, new tiles, new heating or air conditioning, etc.
Basic Ratios and their definitions
This is the total overall income that the property generates and may include rent from tenants, income from facilities such as parking fee, laundry facilities, etc. It would also include other income that the property will produce on a regular basis.
If you want to be a successful investor in rental properties, you must know how to analyze an investment by doing the figures on your real estate deals. As you make an analysis, one of the most important tasks is estimating as close as you can, how much would be your operating expenses.
Here are some of them:
- Property tax
- Property management fees (around 7-10% of the rent, when applicable)
- HOA fees (if applicable)
- Maintenance (around 4-8% of rent)
- Vacancies (4-8% of rent)
- Utilities (if the owner is the one who pays)
Gross Rental Yield
The formula for this is: Annual rent collected divided by the total property cost multiplied by 100. The resulting percentage would be your gross rental yield. The total property cost includes the purchase price, renovation cost, and all closing costs.
Formula: Gross Rental Yield = [Annual Rent / Total Property Cost] x 100
Net Operating Income (NOI)
This is simply Gross Income of the property minus Expenses and gives you the income for a property but excludes the acquisition cost.
Sure, NOI shows only a pinch of information and does not show you the whole picture, it is the key for calculating the most important metrics in your analysis. In the following section, we’ll look into those key metrics.
Property Investment: The Most Important Ratios for Beginners
1. Cash Flow Ratio
You might ask why we do not include debt service in the computation of NOI. The reason for this is that an NOI will show what level of income the property will generate regardless of the owner’s specific financing option. The monthly or annual debt service amount would depend on the owner’s financing plan and takes consideration of the down payment amount, interest rate (including future changes impact) and length of the loan. Debt servicing, when included in the NOI, would only be applicable when we are computing ratios in relation to the specific financing plan. But since buyers will favor different financing plans, the ratio should accurately display an income metric that is specific to the property and not to the buyer.
This is the reason why we need to compute the cash flow. Cash flow is the counterpart of an NOI that you’ve adjusted to reflect the debt service expense. More accurately, cash flow is the NOI minus the debt service payments.
So, if you look closely, you’ll see that the cash flow is the total profit that you will realize at the end of the year from the property. Obviously, if you have a large loan, high-interest rate or shorter loan term, the bigger will be your debt servicing expense. And the bigger your debt servicing expense is, the smaller your cash flow would be. Supposing you’ve paid for the property in cash and did not get any financing, your NOI will be equal to your cash flow which is theoretically, the highest cash flow of any property.
2. Rent Ratio
When you compute for the rent ratio, make sure that the total cost of the property includes the purchase price, financing costs, and any rehabilitation costs that you spent to acquire it.
Here’s a sample computation: If your total acquisition cost for the property is $100,000 and you receive a monthly rent of $2,000 from it, your formula would be $2,000/$100,000. This will give you a Rent Ratio of 2%.
Generally, a ratio of at least 1% would be good enough. However, there are investors who will not be happy unless they could get at least 2%. You can tell that the higher rent ratio you have, the better it is for you, provided that all things are equal. In reality, for a single-family home in some areas such as in central Ohio, getting a 2% rent ratio is not easy at all.
Take note that this ratio does not include the expenses in the computation. This is very important in your analysis. We usually don’t buy properties with HOA (homeowner’s association) fees and by doing so, we can finance properties at competitive rates. Having said that, this ratio is very acceptable as an initial assessment tool for a property.
3. Return On Investment
You may consider ROI as the amount of cash flow you will be getting from the amount of money you have invested in the property.
You can compute for your total ROI by adding up your remaining cash after you have paid the equivalent amount to amortize the principal and dividing the sum by how much you’ve paid for your property.
The total ROI is a must in any investment analysis. It is one ratio that considers the cash and non-cash portions of your investment. The non-cash portion is that part that goes into your home equity and you realize that amount when you sell the property or take up a loan against your equity in the future.
As a general guideline, you can expect the ROI to be higher if one or both the following conditions are present:
- The Cash Flow is higher
- The Investment Basis is lower
The premise is just simple practical logic: if you can generate a lot of income from a small capital investment, that would be very ideal in any kind of business.
4. Capitalization Rate or Cap Rate
Do you still remember what we said about NOI that it is completely independent of the details of the financing? Well, there’s also a key ROI ratio that is also independent of the buyer and the details of the financing. This is what we call the Capitalization Rate or Cap Rate for short. As you can see in the formula above, the Cap Rate measures the NOI in relation to the Property Price. One could say that this is the single most important ratio you will need when performing a financial analysis of a rental property. Since the Cap Rate sets aside any reference to the buyer or the financing, it gives a pure indication of the return a property can potentially give its owner.
The Cap Rate assumes that the investment amount is the total maximum or full price of the property. The same principle we learned in ROI still applies in Cap Rate: the higher the investment amount goes up, the lower the value of the Cap Rate goes down.
So what Cap Rate are we looking for? It would actually depend on where in the country your property is – but most areas record a maximum Cap Rate anywhere from 8-12%. Here’s the thing about using ratios for real estate: you need an appropriate standard to base your comparison with. So, for a single family house, you should check the general ratios of similar single-family houses within the area. The same thing applies to large investment properties. If the average Cap Rate in your area is 10%, then your investment property should be generating also at least 10% provided that there no other complicated and extraordinary situations and considerations.
5. Cash on Cash Return Ratio
This final ratio is the cash on cash return and as you can see from the formula, it shows the relationship of your cash flow with the amount of cash you have invested in the property.
You can get your pre-tax cash flow by getting the total of your annual rent and deducting all the cash outflows which include the principal and interest of the mortgage payment.
Many investors would be happy to get anything between 15% to 25%. But let me tell you this: for us, the actual ratio doesn’t matter. Look closely at the formula and you can see that the more leveraged an investor is, the higher the ratio he gets. Would this mean that the investment is a reasonable one? It does not. We would rather look at the actual cash flow that the property might be able to generate because, for any business, a positive cash flow means life. Knowing the ratio of cash on a cash return ratio doesn’t help too much.
Note: If you’re using other metrics as your evaluation tools for real estate investment analysis, you can share them with everybody in the comments box below.
6. Loan to Value Ratio or LTV
The LTV is quite simple as it shows the relationship between the investor’s loan against the property’s worth. Banks must use a strictly accurate valuation for the collateral property before they lend money but in most cases, the third party appraisers who determine the value side of the formula. For example, the property seller might be asking for $200,000 for a property but an independent appraiser may only peg it at $175,000.
7. Break-even Ratio or BER
The Break-even ratio (BER) shows how the property’s operating expenses and debt service will cut into the gross operating income. Lenders often use it to analyze a property when underwriting commercial mortgages because of the information that it provides. It shows how prone a borrower will be to miss his payments in case his rental income of the property diminishes.
For example, if the investor has a combined total of $40,000 for operating expenses and debt servicing and a gross operating income of $50,000, the BER would be ($40,000/$50,000) 80%. What this would mean is that the investor needs to use all 80% of all the money that comes in to run the property business.
Now that you have all the ratios and what they mean, you can do a more accurate analysis of the income viability of the property. However, keep in mind that it is only good for the first year of ownership of the property. In the coming years, the accrued equity will naturally increase, inflation will cause the expenses to rise, the market will move the rental prices to go up or down, taxes may change, and a whole lot of other things might affect the property’s income. Of course, this would affect the return on investment either to improve or to deteriorate.
In property investing, it’s impossible to accurately make future projections but this should not stop you from extending your analysis to a few more years out. You can use trend data or demographic data to see which direction the market is heading or whether inflation will go up or remain as it is, and some other important relevant information.
Watch out for the second article in the series where we will provide the important real estate ratios for advanced investors.