Real estate investment can be an extremely lucrative pursuit. But any wise investor knows that it isn’t a guessing game. Maybe word on the street is that a certain market will likely blow up in a couple of years. You totally want in, right? Well, you can trust the rumor mill, or you run the numbers to know for sure. This is where real estate ratios come into play.
Before you take on the landlord title, you want to make sure you have a strong understanding of the finances that come along with it. And there’s a lot more to that than the purchase price and the potential rents. Savvy investors will dive into the metrics that can be the difference between a successful endeavor and a regretful one.
Here are seven of the most important financial ratios when evaluating your investment.
Net Operating Income (NOI)
Net operating income is a calculation used to analyze the profitability of real estate investments that generate income. It's a simple, direct way to understand the property’s cash flow. To quantify NOI, you take all revenue from the property minus all reasonably necessary operating expenses.
Or another way to think about NOI is:
NOI = [Potential rental income - Vacancy and credit losses] + [Other income - Operating expenses]
NOI tells the owner if renting the property is worth the expense of owning and maintaining it, and it’s also a key metric used in several of the other important ratios for investors.
Keep in mind, NOI does not include capital expenditures.
Capitalization Rate (Cap Rate or Net Rental Yield)
You can use a property’s cap rate to help determine what you can expect on its return. To calculate cap rate, you’ll need two basic numbers: the value of the property (or a similar property in the same market) and your net operating income (NOI). Dividing the cost of the property by your NOI will give you your cap rate. If the average cap rate in your area is 9%, then your property should be generating at least 9%, assuming there are no other complicated situations or considerations involved. The average cap rate will differ depending on a property’s location, so make sure you compare your figure to a similar property in a local market.
In essence, the cap rate can be and should be compared to your properties local cap rate to make sure it's a good deal. The cap rate provides this comparison by removing any financing to potentially be used.
Also take note, higher cap rates tend to be riskier assets in less established areas, while lower cap rates are likely to be found in established neighborhoods or lower risk properties.
Your cash flow is the monthly debt to net ratio. Basically, if you’re netting money after expenses, you have a positive cash flow. If your monthly net income from a rental property is negative, you should probably take inventory of your expenses and see if anything is unnecessary (see ROI below). To calculate your cash flow on a property, take your NOI minus the cost of your debt servicing.
The reason for this is that when debt servicing is included in an NOI, it would only be applicable when the ratios you are computing are based on a specific financing plan. But since different buyers will favor different financing plans, you want an income metric that’s specific to the property itself, not the buyer. If you have a large loan, high interest rate, or shorter term, the bigger your debt serving expense will be, and the smaller your cash flow as a result.
A good rule of thumb is The 1% Rule — a formula that rental property investors use to size up a property’s cash flow quickly. The rule stipulates that the property’s total rental income should be 1% of the purchase price at a minimum. Rental properties with a higher income relative to the purchase price will earn you more cash flow.
But remember, The 1% Rule is only a general guideline.
Return on Investment (ROI)
Most folks are familiar with the concept of a return on investment . In most cases, if your ROI isn’t positive, you can chalk it up to a bad investment. Find this ratio by dividing the sum of both your cash flow and principal payment by your investment cost.
An ROI ratio can help you with certain decisions like which upgrades are going to pay off, and which ones may be unnecessary. But also, be sure to note that ROI can easily be manipulated so pay attention to how ROI is calculated when you are using or comparing homes.
Cash on Cash (CoC)
Your cash on cash return reflects the relationship between your cash flow and the amount you’ve invested in the property. It tells you the percentage you can expect to recoup annually on your initial investment. To find this number, divide your total cash investment (including all operational costs) by the amount you make on rent before taxes.
Break Even Ratio (BER)
The break even ratio is an equation that helps lenders determine how likely you are to default on your payments — which is obviously helpful for you to know too before moving forward with a purchase. To find the BER of a rental property, add up the property’s total operating expenses and loan expenses (interest, principal, and any potential late payments you may incur) then subtract any financial reserves. When you have that number, divide your gross operating income by it to arrive at your BER.
Loan to Value Ratio (LTV)
Your loan to value ratio is the value of the investment property divided by the loan amount that a bank or credit union is willing to finance on that purchase.
So if your LTV is 60%, then you would need to come up with a downpayment of 40%. Keep in mind that if your LTV is above 80%, the loaning entity may ask that you also get private mortgage insurance to cover themselves against potential losses if you can’t repay the loan on time.
Rent ratio will give both you and a lender an idea of how soon the cost of the property can be offset by rental payments. To calculate this, divide the property cost by the monthly rent you plan to charge.
Similarly, your rent ratio is also a helpful ratio for determining that monthly charge. Average rent ratios will vary depending on location and market, but of course, the ideal scenario is to have that percentage be as high as possible.
Investing in real estate is a big step that can yield major returns. If you would like to ensure that you’re approaching it with your ratios and finances in place, give us a call at K Wealth Advisors today. We’ll be more than happy to schedule a GoodFit meeting to discuss your goals and options. #KWA