Who wants to be millionaire? Well, everybody! (Obviously!) Becoming one doesn’t require rocket science, either. It’s pretty freakin’ simple.
Notice I didn’t say easy, but simple.
As most of this awesome community knows, one of the fastest ways to building a million-dollar net worth is through income-producing real estate. The beauty of income-producing real estate is that it’s an asset class where you can basically print money.
If you are able to either increase income or lower expenses, boom, the value of your asset goes up in accordance with how much you increase profitability.
The beauty of income-producing real estate — cash flow, value appreciation, capital events — have been repeated ad nauseam on these pages, so no need to get into that too much right now.
(SIDE NOTE: It is actually for that very reason that I don’t like stocks — too many variables outside my control. Because of the blood in the streets on Wall Street, I bought into some tech stocks (AI/VR, Snap, Twitter, Square, BlackBerry and a few others), figuring I’d made money on the buy (I did; on literally all of them) — and I absolutely hated it. I’m working on a piece about that horrific, very profitable experience. Watch out for that.)
However, like in anything in life, you won’t make it far unless you know your basic numbers. And real estate is no different. And it’s not just about the numbers themselves, but the meaning behind the number.
So, I’ve written in the past about how you can — in theory — turn $500 into a $1 million asset in less than two years with basic math. It’s totally doable. But in order to do so, you’ve gotta know your numbers — and the metrics.
Here are 5 Vital Metrics You Must Master to Succeed in Real Estate
1. Cap Rate (with context)
The basic definition of a cap rate is the hypothetical yield on a property, assuming it was bought cash. (Read this BP piece for more detail.)
Here’s the equation:
Obviously, nothing is ever really set in stone. Shit happens (this is why you account for vacancy, for instance) so this figure invariably varies.
However, it is a crucial starting point for any investor to determine whether an investment is feasible.
“Philip, what’s a good cap rate?”
I get asked this all the time, and there’s no straightforward answer. It depends on asset class, the state of the building, market, etc. #Context.
But in short jargonese, the lower the number, the lower your yield. (Obviously you want a higher number; if not, what’s the point? Throw your money in a municipal bond instead, sit on your ass, and collect the tax-free yield.)
The higher the number, the higher the yield. Pretty simple.
But here’s the trick with that. Big-city markets typically have lower cap rates because they’re deemed safer investments, and value traditionally curves upwards. Smaller markets typically deliver higher yields because they’re considered higher risk investments.
Anyway, we can discuss cap rates ’til the cows come home. However, this is often the first question you ask your broker when he sends you a deal. “What’s the cap rate?”
And you go from there. So understand this figure: Your net income divided by the price in a percentage.
Read this one carefully because this one may be the most important to master. In boxing they say everything comes from the jab; it’s not the knockout punch, but it sets everything up for the big win.
Net operating income (NOI)—real estate’s equivalent to corporate finance’s EBIT — is defined as your gross income minus expenses.
In layman’s terms, this metric is your money maker, your profits, your extra cheddar. So forget all the noise. If you’re already in a deal and investing for both extra cash and net-worth boosts, this is the metric that matters.
The cool thing about real estate is that — beyond rent, which should obviously account for 95+ percent of your asset’s income —there are only so many ways you can generate revenue, none of which should distract you from the main source…which is rent!
And here’s the kicker: the value of your asset is derived directly from the income it produces. Not supply and demand, not the S&P, not the economy, but from how much money you can manage to squeeze from it.
In other words, if you can figure out how to increase your NOI, you’re well on your way to building your fortune.
Whether you’re an owner or potential buyer, a property’s operating expenses (OPEX) is a basic but extremely important metric to monitor — and very often the hack for value-add investors to unlock crazy profits.
As the name suggests, OPEX is essentially what it costs you to run the property, which includes trash removal, taxes, management fees, maintenance, and so on.
As an owner, the metric is vital for no other reason than if you’re mismanaging your expenses, you’re eating into your profits and thus the value of your asset. As a potential buyer, mismanagement could mean big money for you.
In last week’s article (Newbie Landlords: This Might Be The Most Important Metric To Know), I told the hypothetical story about Uncle Bill and his 25-unit apartment building that was bleeding money due to delinquent tenants and unfavorable tenant laws. In the piece, I illustrated how you can force the appreciation by running the numbers.
As illustrated in the story, you raise some money, buy out Uncle Bill — he’s cashed out with a million dollars, sipping Margaritas on a beach somewhere. And you’re sitting pretty on a $2+million asset. Here are the basic assumptions for how that comes to be:
- 55 percent current OPEX
- 9 percent cap rate for the market
- You buy it for $1.4 million at an 8 percent cap rate
- You cut OPEX to 35 percent
- Raise rents 15 percent
Even though you overpaid for it, by getting OPEX (and NOI) under control, you’re sitting pretty on a $2+million building:
$287,500 NOI minus 35% OPEX divided by 9% cap rate = $2,07,388.89
How about it, eh?
4. DSCR: Can You Pay The Bills?
The DSCR metric sounds offensive for no real reason: “Debt service coverage ratio.”
That aside, it’s actually pretty sensical once you get to know it — and super important to know. In regular English, DSCR’s a metric used for banks and lenders to determine if you can afford to pay off your loans.
This metric matters mainly because nine times out of 10, when you’re buying real estate, you’re going to use debt to complete the buy anyway. Gotta know how to leverage.
Anyway, here’s the formula: NOI/annual debt (“total debt service”).
And here’s a somewhat-informative video breaking it down in jargon, but the visuals are pretty cool.
A ratio of one puts you at breakeven — meaning there’s just enough to cover your interest payments. Banks won’t go for that; they want you to have a cushion just in case shit happens. (Fannie Mae and Freddie Mac want you at 1.2x for multifamily loans.)
Even more importantly, what’s left over after debt service is your free cash flow — your pocket money after the bank’s gotten its piece. If you’re a cash flow investor, this is a serious one to monitor.
NOTE: While the calculation itself is relatively straightforward, getting an accurate figure can be tricky. Lenders might fiddle with your NOI assumptions—which could lower the DSCR even more — before granting the loan. So make sure your spreadsheets account for the different variables. (Shoot me a DM if you’re just starting out and want one.)
Return on investment. Internal rate of return. Return on equity. Cash-on-cash returns. There are many ways to measure the profitability of a real estate investment.
For the sake of this point, I’ll simply use the generic umbrella return on investment here since the actual metric may vary based on your strategy.
Jargon and technicality aside, at the end of the day, before you go into any deal, you always want to know what your returns are going to be. Here’s a pretty informative discussion from the BP forum.
For most, however, the simplest and quickest way to calculate your returns — especially when starting out — is to look at the return on capital invested; money-in, money-out. Which is the cash-on-cash ROI metric.
Here’s the formula: cash flow divided by cash invested.
It’s quick and dirty, fairly accurate, and allows you to contrast and compare to other investment vehicles like stocks, bonds, and so on.
Say you have a $1.5 million apartment building with $50,000 in annual cash flow that you bought at a 80 percent LTV (meaning 20 percent down). That’s $300,000 down invested in the down payment:
$50,000/$300,000 = 16.67%.
Again, this is just one of several relevant return metrics and obviously doesn’t apply to value appreciation, a core strategy for many investors. But if you’re looking to compound wealth and generate passive income, this is a great one to start.
Any other metrics new investors should know?
Let us know in comments below!