How to Model Your First Real Estate Investment

Fellow Real Estate Investors welcome back to another helping of real estate investing knowledge. The goal of my posts are to help you become better income investors by providing tips, tricks and step by step instructions that I have complied based on my experience of investing into multimillion dollars of investments across Northern New Jersey.  Last week, we defined a framework of indicators for you to utilize in helping determine your growth and risk assumptions that will fit in your real estate investment model.  If you missed this post then feel free to read the post by clicking this link. This week we will begin introducing you to key real estate ratios that I feel that you should know and understand so that you can analyze and understand your investment better. By now you should feel fairly comfortable in your skills of reviewing the income and expense side of a property’s operating statement. You will need those skills to extract the key data to plug into these ratios. Remember that a ratio or model is as good as its inputs so garbage in = garbage out. 

 

There are two broad categories of ratios that I want you to know and understand and I will explain the importance of each category as we go through this blog post.  So lets dig into this exciting real estate finance journey it may not be the most exciting for you but I am a numbers guys so this is always a fun topic for me to cover.

 

Profitability Ratio: these ratios advise you as the profitability metrics that you can expect from your potential investment. 

Ratios

Ratio Definition

Formula

Capitalization Rate aka Cap Rate

A capitalization rate is the overall or non-financed return on a real estate investment, akin to the return on total assets in accounting terms.

 

Net Operating Income

Total Equity Investment*

 

*Purchase Price + Construction Costs + Closing Costs

Return on Equity aka Cash on Cash Return

A rate of return often used in real estate transactions. The calculation determines the cash income on the cash invested.

 

 

Cash Flow x. Debt Pmts

Total Cash Invested

Internal Rate of Return aka IRR

The internal rate of return is a rate of return used to measure and compare the profitability between investments.

 

IRR Calculation:

Use IRR function in excel to make this calculation easier for you.

Net Present Value aka NPV

NPV can be described as the “difference amount” between the sums of discounted: cash inflows and cash outflows. It compares the present value of money today to the present value of money in future, taking inflation and returns into account

 

NPV Calculation:

Use the NPV function in excel to make this calculation easier for you.

 

 

Debt Ratios: real estate is typically not bought all cash and debt is typically utilized. So it is important to understand debt related ratios. These ratios help you determine the type of leverage you can utilize and the potential interest rate risk.

Ratios

Ratio Definition

Formula

Financial Leverage

Financial leverage refers to the use of debt to acquire additional assets. Financial leverage may decrease or increase return on equity in different conditions.

 

 

         Total Debt

     Total Capital*

 

*Equity + Debt + Preferred Equity

Debt Service Coverage aka DSCR

DSCR ratio of cash available for debt servicing to interest, principal and lease payments. It is a popular benchmark used in the measurement of an entity's (person or corporation) ability to produce enough cash to cover its debt (including lease) payments. 

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Net Operating Income (NOI)

Annual Debt Service

Break Even Ratio (BER)

Break-even ratio (sometimes called default ratio) is used to ascertain how vulnerable a property might be to defaulting on its debt in the event rental income derived from the real estate income property should decline.

 

  Debt Service + Operating Expense

-----------------------

Gross Operating Income

 

Utilize these ratios to help you ascertain the degree of profitability and risk associated with your potential investments. Also, utilize the NPV and IRR calculation to help you compare between different investment choices. Remember that money is finite so choose the investment that gives you the highest positive NPV (I prefer NPV over IRR as a comparison measurement tool) while making sure that the risk ratios are comparable between the investments. 

 

Enjoy crunching these numbers as trust me if you analyze these ratios then you will have a better understanding of the risks and the rewards associated with your next investment choice.

 

Until next week fellow income investors, happy investing!

 

Ankit

Confused? Then twee me @Ankit_RER

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