Financial Ratios Every Real Estate Investor Needs to Know
Think about writing a letter to your younger self. If you are like me and those I have asked, you would likely tell yourself things that help ease the burden of everyday life.
You may tell yourself to work more or less. You may remind yourself to take life less seriously, go for that promotion, start that business, ask him or her out, whatever it might be!
This blog in a way, would be one dedicated to my younger self, pre Real Estate investing to help better navigate this tricky environment not only allowing me to talk the talk but better walk the walk.
Financial Ratios Every Real Estate Investor Needs to Know
There are a number of great metrics to track property valuations, make determinations on good vs bad deals and help you acquire financing but today we will focus on the three that I have found most helpful throughout the last decade in Real Estate.
Capitalization “CAP” Rate
Cash on Cash Return
Gross Rent Multiplier
Capitalization “CAP” Rate
Before we get to CAP Rate, we must understand how to calculate a property's Net Operating Income or more commonly referred to as NOI.
NOI is calculated as follows -
Total Revenue - Operating Expenses = NOI
It is important to point out that Operating Expenses do NOT include a mortgage at this point as not all investors need to obtain financing to purchase a deal making it easier to evaluate buildings on a broader basis.
Operating Expenses do include things like Taxes, Insurance, Utilities and General Ongoing Maintenance. Okay, now that we have NOI down, let's look at the three main components to using CAP Rate effectively -
Net Operating Income
CAP Rate
Valuation
The beauty of math is that we can arrange this equation to be immensely helpful in three different ways.
Solving for Valuation - When you want to know what to offer on a property or if your current deal under agreement is worth it, ask the seller for a copy of current revenues and expenses and solve for NOI. From there, divide NOI by the CAP Rate that you’re comfortable with after careful consideration and boom, you have a number to evaluate.
Net Operating Income / CAP Rate = Valuation
Solving for CAP Rate - If you know a Sellers NOI and what they want for a Valuation, you can work backwards to solve for the CAP Rate.
Net Operating Income / Valuation = CAP Rate
***Typically a Higher CAP Rate, the more potential profit a building will produce for the price but this is less important than comparing the number you get to the averages of your area.
Solving for NOI - If you have a stubborn Seller that’s NOI does not seem up to standard. Work backward to see what a proper NOI could be or should be which could ultimately help you at the negotiation table.
Valuation * CAP Rate = Net Operating Income
I would only use this as a last ditch effort to keep a deal alive but it is worth knowing.
It is also important to know that Cap Rate Ranges are typically determined by asking local brokers, looking at recent sales data and asking the Pros. Companies like PWC and RealtyRates can do much of the leg work for you for a fee. Here is an example of CAP Rate Ranges from a recent appraisal -
Broker’s Opinions 7.0% to 9.50%
Sales Extraction 8.50%
Band of Investments 9.58%
Investment Survey (PWC) 8.61%
Investment Survey (RealtyRates) 8.56%
For new investors, understanding the relationship between Net Operating Income, CAP Rate and Valuation should be your sole focus for now. When you have a solid understanding, you can start down the rabbit hole of financial ratios to consider.
Cash on Cash Return
Why invest in Real Estate if a CD at the bank can pay you more? I promise, buying a CD and waiting to make any decisions at all until it expires is a million times easier than being a landlord or seeing an investment through from purchase to sale.
If you are going to take on this massive risk, you better know what your investments are truly earning you today and into the future. Let’s dive in a bit deeper.
Remember NOI, well Net Cash Flow or NCF is just NOI with our Mortgage payment added back in. This gives us the true cash flow of the property we are evaluating.
Calculating Cash on Cash Return -
Net Cash Flow / Total Cash in the Deal = Yearly Cash on Cash Return
Let’s look at three real life examples of Cash on Cash Return from our portfolio -
Property #1 - $22,300 / $40,000 = 55.75% Cash on Cash Return
Property #2 - $27,400 / $21,000 = 130.47% Cash on Cash Return
Property #3 - $19,100 / $141,000 = 1.35% Cash on Cash Return
Ex. Portfolio Total - $68,800 / $202,000 = 34% Yearly Cash on Cash Return
This for me, makes investing worth it. All the Bull Shit, all the hours, all the tenant drama is worth it to achieve a return on cash that is otherwise (for me) unobtainable out there on the public markets.
Gross Rent Multiplier
This is the quick and dirty back of the napkin calculation to be done on the fly. It can be useful in conversation and quickly evaluating property deals as they come up in conversation without a lot of leg work.
Calculating Gross Rent Multiplier -
Property Price / Total Gross Revenue = Gross Rent Multiplier
A lower GRM is certainly better as this means you are making more money per dollar you invest into the property. I have heard ranges from 4 - 8 are generally good but take this with a grain of salt. This will vary widely from rural areas to cities.
My personal GRM range is as follows for investing in New Hampshire -
Great Acquisition: 1 - 3
Good Acquisition: 4 - 6
Poor Acquisition: 7+
Great Sale: 10+
Good Sale: 7 - 19
Poor Sale: 1 - 6
Please remember to never take any of these as absolutes. They should be guidelines that, if used enough as an investor, will start to give you confidence in your decisions and ability to act quickly if and when a deal presents itself.
If an investment passes these three tests for me, I would 100% feel confident putting the property under agreement with the proper due diligence language to allow for an out ONLY if needed.
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