Any successful real estate investor knows that key performance indicators are the real measure of business performance. These investment metrics are useful when evaluating potential real estate investment, instead of being guided by emotions in your decision-making.
Considering the global commercial real estate industry is worth around $34 trillion, understanding these metrics can protect you from a bad deal and help you maximize your investments. In this guide, we briefly discuss these metrics and how they impact the financial performance of your investment properties.
The metrics below are particular to income-generating properties, such as tenant-occupied residential estate and commercial real estate.
The Net Operating Income (NOI) metric paints a clear picture of how much money you will earn from a given investment property. It measures the total amount of money the property makes, after all, operating expenses – except the mortgage – are paid.
The net operating income includes income from rent, parking spots, laundry machines, and other service fees.
The operating expenses include:
NOI is calculated as follows:
NOI = Gross Operating Income (GOI) – Operating Expenses (OE)
When calculating NOI, remember to exclude major capital expenditures, such as replacing a roof, mortgage payments, or interest.
NOI is used to determine if a property can generate revenue and profit. If the numbers agree, you can tell whether the investment will generate enough income to pay the mortgage. It also helps investors cut down their expenses.
Capitalization rate is one of the most important real estate investment metrics. A property’s cap rate is the ratio between the total income a property produces to the original capital invested. It’s what investors refer to as return on investment (ROI).
Cap rate gives you a percentage of the property’s expected yield over a year. It is an essential metric that allows real estate investors to estimate the potential ROI on a property. For instance, it can be useful when comparing similar properties in different markets to understand the returns and risks.
The capitalization rate is calculated as follows:
Cap Rate = (Net Operating Income (NOI) / Current Market or Property Value) x 100
Cap rate shouldn’t be used on its own because it doesn’t account for the time value for money, mortgage, or your property’s future cash flow. You’ll want to use it in combination with other metrics like Internal Rate of Return (IRR) and cash flow history.
The Gross Operating Income (GOI) is simply the total potential income from your property, excluding any estimated losses, such as vacancy and credit losses and maintenance.
The Gross Operating Income is calculated as follows:
GOI = (Total expected income – estimated losses) + Other sources of income (e.g., coin-operated laundry and parking)
For example, say you have a 4-unit multi-family property. Assuming each unit’s rent is $1,200 per month, the total expected income is $57,600 per year. Assuming a vacancy rate of 10% and a maintenance fee of $1,000, the effective rental income would be $50,840 (i.e., 57,600 x 10% – $1000).
If you have miscellaneous income, say $200 from parking spots and laundry machines each month, your GOI would be $51,040.
Another crucial real estate investment metric every investor should know is the Loan-to-Value Ratio (LTV). It’s the ratio of the loan amount to the value of the property being purchased.
Lenders use this metric to measure your property’s appraised value against how much they are willing to offer you. It tells the lender the level of risk your investment proposal is.
Loan-to-Value Ratio is calculated as follows:
LTV = Loan Amount / Property Value or Price
Generally, the LTV requirements will vary from one lender to another. For an investor, LTV Ratio can help you track the equity you hold in a property for financing, as well as determine the value of your portfolio and assets accounting for debt.
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Return on Equity (ROE) is a measure of the performance of the money you have tied up in the property. Some businesses refer to ROE as return on assets. Equity is the amount of money tied up in your property.
To determine your equity, take your property’s value and subtract any debts you have. For example, a house worth $200,000 with a $50,000 mortgage has $150,000 in equity.
Put another way, equity is the amount of money you can pocket if you sold the property today.
Return on Equity is calculated as follows:
ROE = Return / Equity
The number you get after this calculation is helpful when deciding when to sell or refinance your property.
The Internal Rate of Return (IRR) measures the potential profitability of a property. Also known as annualized return, it estimates the long-term return on investment, considering the initial investment cost, cash flows over the years, sales proceeds, and discounting for the time value of money (TVM).
IRR is expressed as a percentage and can help you evaluate the attractiveness of a project before developing it. Generally, the higher the IRR of a rental property, the more attractive it is to take into consideration, assuming everything else to be equal.
If you want to know how well you are managing expenses relative to income, the OER metric will come in handy. It measures the operating costs of a real estate investment compared to its income potential.
The Operating Expense Ratio is calculated as follows:
OER = (Operating Expenses – Depreciation) / Gross Operating Income
When calculating the total operating expenses, be sure to exclude mortgage payments and capital expenditures.
OER is another real estate investment metric that can prove useful in decision-making as it allows you to compare the operational costs to the rental income. Ideally, the ratio should be between 60% – 80%.
Typically, OER should remain the same or go down over time. If it’s rising over time, you may want to investigate issues affecting your investment. Perhaps you could consider increasing rent to match the increasing costs.
The Debt Service Coverage Ratio is another metric that lenders keep a keen eye on. It shows your ability to pay a mortgage by measuring your cash flow. DSCR compares your overall operating income against your overall debt levels. Your general debts include the principal that you owe for your mortgage/loan, interest on the mortgage/loan, and the tax rate.
The Debt Service Coverage Ratio is calculated as follows:
DSCR = Net Operating Income (NOI) / Debt Payments
Generally, a DSCR greater than one shows that you can afford your mortgage with cash flow left over. Most banks require a DSCR between 1.20 and 1.40. So, if you have a DSCR of 1.40, it means for every dollar spent on the mortgage payment, you (the investor) should have $0.40 left over as cash flow.
If you have a DSCR below 1.20, it will be harder for a lender to lend on a deal, in which case, you may want to consider additional sources of income to cover your mortgage.
Did you know that a vacant unit still costs you money? In fact, most of the operating costs stay the same. In some cases, you may even incur additional operating costs associated with finding and screening new tenants.
Investors usually track two historical occupancy rates and pay close attention to those units that lose income.
Experts recommend building a buffer of 5%-10% vacancy into all your expense calculations. That way, you’ll ensure you have the cash flow to cover your expenses if a unit goes unrented for a certain period.
Understanding these essential real estate investment metrics can help you accurately determine a property’s performance and make the most out of your investment. It’s worth noting that while these numbers are important, you should consider other factors that affect investment properties’ performance. These include crises like political wars, Covid-19, poor tenants, and unexpected maintenance expenses.