Real estate investing is not small feat - there are many factors to consider, and so much jargon and numbers thrown around all the time! Understanding basic metrics is a great way to begin your investment journey. These ratios and calculations are ways to quickly gauge risk and profit potential to help you evaluate a property and whether or not you should invest.
NOI provides a good estimate on how much you will make from an investment property. It will tell you if an investment will generate enough income to make mortgage payments. It is the total income subtract operating expenses (property manager fees, legal fees, general maintenance, property taxes, utilities and other miscellaneous fees like laundry machines and parking spots).
The calculation excludes capital expenditures, taxes, mortgage payments, or interest (these are not considered operating expenses).
Cap rate tells you the percentage of the investment's value that is profit. To calculate cap rate, divide your NOI by the property value (original capital invested or current value). A rough estimate of the property value before you have put in capital would be its sale price, but you can also use estimates values from real estate platforms and Zillow.
Generally, higher cap rates mean higher risk, but also higher returns.
IRR estimates the interest you’ll earn on each dollar invested in the property over its holding period. IRR can be used to compare properties that are similar in size, use, and holding period. It is a useful metric to seeing how well a property is expected to perform and how much future returns your investment will provide.
Cash flow is quite literally the amount of cash flowing - it is the amount of cash left after you have received your monthly rent income and have paid off all your expenses. Cash flow is super important as this metric shows you how much money are you expected to earn and spend each month. If the number is negative, you can easily see that you will not be making a profit and suggest that you are overspending on the property.
Cash on cash return is essentially the amount of money you are earning off the cash invested. It will include debt service and the mortgage. It is calculated by taking the net cash flow (after debt service) and dividing by the total cash in the deal (this is the sum of the acquisition price of the property including closing costs and any capital expenditures and subtract the outstanding mortgage balance). This metric provides insight on the best way to finance an investment by playing around with mortgage levels and debt services.
GRM is calculated by dividing the property’s price by its gross rental income (this can be projected for determined from the rent roll of the current owner). A lower GRM is better, but will depend on the local market and similar properties. You can expect GRMs to range between 4 to 8.
The LTV Ratio measures the amount of leverage on an investment - the amount you need to finance against the property's current market value. The LTV is great way to measure the equity you hold in a property to account for debt.
For financing, most lenders will not finance up to 100% of a property's value since they want to leave equity in to protect their investment. Lenders will express how much of the total purchase price they are willing to finance in a LTV ratio. The difference between the percent a lender will finance and the property’s total value is the amount of cash that you will have to put into the deal.
For example, if the lender will do 80% LTV deals, you need a 20% down payment to secure the mortgage. In this scenario, a $100,000 property would require $20,000 as a down payment plus closing costs, and would represent an 80% LTV. After 10 years, if the value of the property is now $200,000 and you’ve paid down your mortgage to $50,000, your LTV would now be 25%.
DSCR compares the operating income available to service debt to overall debt levels. To calculate, divide your net operating income by debt payments, on either a monthly, quarterly, or annual basis. Lenders will look at your DSCR to determine your repayment ability. A high ratio suggests you are too leveraged, which may make it harder to qualify for financing.
Typical lenders require a DSCR in the 1.25–1.5 range. This means that your rental property produces 25% more of additional income after debt service. A DSCR of 1.5-1.75 is even more desirable, and could help lower your interest rate.
The OER is a measure of profitability and shows you how well you are controlling expenses relative to income. To calculate, take all operating expenses, less depreciation, and divide them by operating income.
A lower OER reflects that you’ve minimized expenses relative to revenue. If your OER has been rising over time, it could indicate many issues. Perhaps annual rent increases haven’t matched expense increases. Or, your management company isn’t keeping up on routine maintenance, leading to more serious problems down the road.
It’s always a good idea to keep an eye on your personal vacancy rates, as well as your overall market’s occupancy rate. An unoccupied unit generates no income but still costs you money. Most investors track two historical occupancy rates to keep an eye on open units and lost income.
This rate gives you the percent of your units vacant when compared to the total units available. It’s easy to calculate, take the number of vacant units, multiply by 100, and divided by the total number of units. This metric can be useful on a property by property basis, or across your entire portfolio.
The economic vacancy rate looks at the amount of income you’re missing out on when a unit is vacant. Add up rents lost during the vacancy period and divided by the total rent that would have been collected in a year to get what the vacancy cost you.