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ContinueMetrics are how you tell a bad deal from a great deal. We explore 11 key metrics that every real estate investor needs top know.
Written by
Ben Luxon
PUBLISHED ON
7
Jul
2020
Metrics matter. They are how you tell a bad deal from a great deal, they expose the strengths in your portfolio and highlight areas of operational inefficiencies. With the right data and the right metrics, real estate investors are fully equipped to scale their portfolios and achieve financial freedom.
In this article, we take a look at 11 key metrics that landlords need to know about from cap rate to occupancy rates as well as explore some of their weaknesses and strengths.
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Capitalization rates, otherwise known as cap rates, are one of the important starting points for real estate investors. Essentially the cap rate allows real estate investors to estimate the potential returns on a property. You can use the cap rate, for example, to compare similar properties in different markets to get a basic understanding of returns and risks.
To calculate the capitalization rate you divide annual net operating income by the cost or value of the asset.
Capitalization Rate = Net Operating Income / Current Market Value
Since cap rates are based on the projected estimates of the future income, they are subject to high variance. It then becomes important to understand what constitutes a good cap rate for an investment property.
The rate also indicates the duration of time it will take to recover the invested amount in a property. For instance, a property having a cap rate of 10% will take around 10 years for recovering the investment.
Ideally, you want a reasonably high cap rate then. However, a major flaw with this particular metric is that it doesn’t account for the associated risks that come with running a rental property. For example, the age or location of the property, the property type or tenant’s reliability. As such, it can only give you an indication of the properties potential rather than an accurate picture or rate of return or risk.
The gross operating income (GOI) is the overall expected income not including any of the estimated losses which would be associated with expenses and costs such as maintenance or vacancies.
The net operating income (NOI) take the GOI and accounts for the operating expenses. This number then gives you the basis for estimated profit.
NOI includes income from rent, parking, and other monthly fees. Expenses include vacancy and credit losses, property taxes, insurance, management fees (if they apply), utilities, maintenance type expenses, and management type expenses (legal, accounting, etc.). NOI does not include costs that are unique to each investor such as a mortgage.
When this metric is used in other industries, it is referred to as “EBIT”, which stands for “earnings before interest and taxes”.
The internal rate of rate (IRR) estimates the property’s overall profitability. The calculation goes beyond the NOI to estimate long-term yield taking into account initial investment costs, cash flow, and property sale proceeds.
The formula is fairly complex but you can use the IRR function in Excel. Essentially, the higher the IRR value the better.
However, it’s important to understand the metrics’ weaknesses. The main ones being that it assumes a stable rent environment without unexpected repairs.
Cash flow indicates how well your property or business is operating. It is the net cash left at the end of the month after all expenses have been paid. This doesn’t account for taxes.
For example, your rent is $1,500 per month and your monthly expenses are $700 your cashflow would be +$800.
Cash flow = Rental income – Expenses
Cash flow is a simple but important number indicating the success or lack thereof of your business. If you have a property that is regularly negative cashflow for example then you will need to consider taking action to either resolve the issues or selling.
For a great example of why cash flow is just so important listen to our podcast episode with Gabriel Hamel who built his multi-million dollar portfolio using cash flow as his primary metric.
This metric is another important figure for determining an investments performance. To calculate the cash on cash return, sometimes known as the cash yield, calculate the total annual cash flow before tax and divide it by the total amount of cash invested.
Cash on Cash Return = Expected Rental Income Before Tax / Total Cash Invested
For example, a property might cost $200,000 with an estimated cash flow of $30,000. This would equal an estimated cash on cash return of 15%. It’s important to once again understand the weaknesses of the metric. It doesn’t account for future economic changes or unexpected expenses, though you can work them into your calculations to a degree.
For example, you might know that a new school is being built or new transport infrastructure which you belive increase the desirability of the neighbourhood in a years time.
The property experts at Buttonwood explained to us that gross rent multiplier (GRM) is a metric investors use to roughly determine the worth of a building. To calculate this you need to divide the properties purchase price by its gross rental income. To make a projection for your GRM you will want to ask the current property owner to see their rent roll.
Again, this metric doesn’t take into account expenses or vacancies so you wouldn’t use this metric alone to determine if a property is a good investment. It can, however, be a useful number to calculate when comparing like properties.
GRM = Market Value / Annual Gross Income
The loan to value ratio is the ratio of the loan to the value of the asset you are purchasing. Financial institutes and lenders use LTV ratios to assess the risk of the loan. The higher the LTV the riskier you are seen to be by a lending or financial institute.
LTV is calculated by dividing the amount of the loan by the value of the property. For example, if the property is worth $250,000 and you have a deposit of $50,000, the LVR will be 80%.
In general, the required LTV ratio can vary between lenders and by types of loans, generally speaking though, the accepted LTV ratio is between 65-80%.
LTV = Loan Amount / Property Value
This is another metric that lenders pay close attention to. Your debt coverage ratio compares our overall operating income against your overall debt levels. This metric is evidence of your ability to repay your loans.
To calculate your debt service coverage ratio you divide your net operating income by your debt payments on either a monthly, quarterly or annual basis.
DCR = Net Operating Income / Annual Debt Service
Requirements vary by institution, but most banks require a DSCR between 1.20 and 1.40.
A measure of profitability, the OER tells you how well you’re controlling expenses relative to income.
To work out your OER, calculate all the day to day operational expenses but not the mortgage or any capital improvements then divide the total operating expenses by the total expected income.
OER = Operating Expenses / Potential Rental Income
You are looking for the lowest OER ratio which will indicate the most profitable property.
It’s worth noting that if you OER is rising over time, then you could have issues that need to be resolved. Perhaps by annual rent increases to match those annual expenses increases. Calculating OER using specific expenses can help you narrow down the reason for its rise and help you get it back under control.
Unoccupied properties generate no income, yet most of the operating costs will remain the same, and there may even be additional operating costs associated with finding and screening new tenants. Investors tend to track historical occupancy rates and keep an eye on those units which lose income through higher vacancy rates.
For conservative, you should assume a vacancy rate of 5%-10% for all your expense calculations. This ensures that if the property does go unrented you will have the cash flow to cover your expenses during this period.
You can quickly run an occupancy report on Landlord Studio to determine each of your property’s historical occupancy rates and discover any potential discrepancies.
Related: How to Find and Keep the Best Tenants
“Track income and expenses, screen tenants, set automatic reminders, and more with Landlord Studio.”
Having a clear overview and understanding of your portfolio will allow you to gain insights into which properties are and aren’t performing. Using a tool like Landlord Studio you can retain access to data and metrics in real-time.
However, it’s important to note that you can’t determine the efficacy of investment solely from the numbers. These are great indicators and used right will inform an investor to make the right decision. But other factors will affect a rental property’s performance.
These additional factors are where the risks lie with real estate investing. Things like large unexpected maintenance costs, poor tenants, or crises like COVID-19 can upend even the most careful financial plans. So, when regarding an investment property it’s important to factor in the potential for external factors top either negatively or positively affect the investment.
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