When getting into real estate, most people are drawn towards looking at the annual cash flow after debt. That’s the amount of money that is actually flowing into your hands after paying back all of your obligations. This is a perfectly valid and logical instinct for investors to have and should always be one of the first things you consider about a property.
Buying more complicated and expensive deals with investors involved requires your analysis to be a little more in-depth. You need to be able to pitch deals to savvy investors that want to understand the opportunity from several different perspectives.
In this article we will outline five analysis metrics that are either very important to investors or may be overlooked or misunderstood. These are specifically pieces of information that deal with the property and do not include things like population growth, which we have discussed separately in our Demand Generators for Real Estate Explained article. I also hope to explain it in simple English, as these sorts of things seem easy to understand with experience, but I remember starting out how confusing it could be.
1. Net Operating Income:
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To find your NOI, you first need your gross income for the property. This is all your rental income as well as any additional income the property produces (laundry, paid parking spaces). Then, subtract from that all of your operating expenses related to the property, other than capital expenditures and your debt service.
Capital expenditures are those costs made for long-term improvements to the property, like a new roof or furnace. You do not need to subtract these out when calculating your NOI, only the “regular” operating expenditures necessary to run the property.
You also do not subtract the amount of money you pay every year towards your lender, assuming you have one. Your NOI is used to calculate several other metrics on this list.
2. Capitalization Rate:
This is perhaps the most discussed and important valuation metric for commercial real estate. A property’s cap rate is calculated by dividing the net operating income by the price.
Different markets will have “typical” cap rates for different asset classes.
For example, in very expensive, densely populated coastal cities, you’ll see lower cap rates than in working class, lesser known satellite communities. You or your broker will know the going cap rate when evaluating a property by comparing to comparable sales in the area.
Typically speaking, areas viewed as riskier in the long term tend to have higher cap rates. Cap rates are very important when trying to project what increased value your property can gain with increases in your NOI.
Say you increased your NOI from $100,000 in year 1 to $125,000 by year 5. Assuming the cap rate remains stable at 7%, your property was worth $1,428,571 in year 1 and had risen in value to $1,785,714 by year 5! You can figure this out simply by reversing the equation and dividing your NOI by .07 (7%).
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3. Cash on Cash Return:
This is another important piece of data, especially for investors looking to live off of the cash flow their real estate portfolio produces. This specifically looks at the amount of cash you invested into the deal, which includes your initial equity contribution as well as any closing costs or other costs associated with the purchase.
You first need your annual pre-tax cash flow, which is simply your gross income with all expenses subtracted, including your debt service, but not including taxes or capital expenditures for the year.
You then divide that number by the total amount of cash you invested when purchasing the property. If your annual cash flow was $25,000 and your total cash into the deal was $100,000, your cash on cash return would be 25%. This would be a great cash on cash return – implying you would earn all your money back after only four years into the deal.
4. Annual Principal Reduction:
This is simply the amount of your debt service (mortgage) payments that go towards your principal balance and not towards interest.
When you own a cash flowing property, your return is not generated simply by the cash flow you receive, but also the amount of equity you are building. Say you are syndicating the purchase of a multi-family property with a 5 year term. In year 5, when you go to either sell or refinance the property, you will gain back this equity and it is important to keep this in mind and included in your projections as it is a significant piece of the return on your investment.
5. Expense Ratio:
This is the ratio of the total operating expenses (not including capital expenditures) as compared to the gross income for the property.
To calculate, simply divide your annual operating expenses by your annual gross income.
This number will be your expense ratio.
It’s important to know what a typical expense ratio is for your market and asset class. Remember that, in more expensive markets with higher rent rates, the expense ratio is usually a bit lower.
A “national average” safe bet should be around 50%, but we usually invest in areas where 30-40% or below expense ratios are the norm.
6. Return on Cost:
This is best understood as your “future” cap rate. It’s used when trying to project how a building will perform after you have spent large amounts of money on it.
We most typically see it as an important item for lenders when evaluating large new construction multi-family development projects. They want to get an idea of what the cap rate will shake out to once the project is complete and the building is rented out, including all the costs incurred along the way. This is also used in larger and more complicated value-add or repositioning deals that require additional funds invested beyond just the purchase price.
The return on cost for a property is calculated by adding your purchase price to any renovation or construction costs. Then, you take that added sum and divide it by your projected NOI based on when construction/renovation/stabilization is complete. Of course, in order to do this you will have to have a projected NOI based on rental comparables and an accurate expense ratio for your market.
7. Loan to Value Ratio:
This is the ratio of the loan amount as compared to the property value. Lenders will only provide a certain percentage of the actual property’s cost and you will have to finance the rest through your own capital or through your investors.
A popular method used by many first time investors is to leverage FHA loans where they can occupy one unit and put 5% or less down. These loans have very high LTVs (95%+) and are not typical for most real estate investments.
Expect 75% LTVs for smaller multi-family purchases with 80% as a possibility if you are an experienced borrower with the lending institution. For different asset classes and larger and more complicated deals, the LTV can be much lower, as low as 50%.
8. Debt Service Coverage Ratio:
This is important to both lenders and investors alike. It is a ratio that shows how safe a bet it is that the property is able to cover the debt payments from the lender.
In order to calculate the DSCR, sometimes also just called the DCR, you simply divide your property’s annual NOI by your annual debt payments. For example, if your NOI was $130,000 and your annual debt payments were $100,000, your DSCR would be 1.3. There is no rule of thumb, but for stabilized assets lenders typically like to see a DSCR of 1.2 at a minimum.
9. Vacancy Rate:
This is simply the percent of your annual income that is lost due to vacancy. Assume that, if there was no period of time with vacancies in your building(s), your annual income should be $100,000, but in reality it was $95,000.
This means that your building had a 5% vacancy rate that year. Vacancy rates can vary from market to market and you need to have an accurate grasp of a realistic rate for your market or your projections will be completely inaccurate.
10. Internal Rate of Return:
This is used to project the profitability of potential investments. The discount rate is used in order to value future cash flows in today’s dollars. As a result of opportunity cost and the time value of money, cash flows of equivalent dollar value are more valuable today than they are in the future.
Net present value, another important underwriting metric, discounts those future cash flows to their present value using a percentage discount rate, which can vary depending on the risk profile of the asset.
The IRR is simply the discount rate that would bring the NPV to zero. In other words, it is the discount rate at which the investment would break even. The larger the spread between your IRR and the actual discount rate for the asset, the more secure the value of your future cash flows.
With longer investment time frames that have variable returns per year, IRR becomes very useful. It allows you to take a project that might have no cash flow for the first three years and a large influx in year four and compare it apples-to-apples with a different property that has steady income all four years.
This is a more accurate way of calculating the interest an investor earns when viewing the investment as a whole because it tracks the percent return over each period of time invested to calculate a blended rate.