Real estate investors typically rely upon a real estate analysis to provide them with the facts and figures about a rental property’s cash flows, rates of return, and profitability in order for them to make prudent real estate investment decisions regarding the property.
As a result, a real estate analysis includes numerous rates of return that real estate investors and brokers engaged in real estate investing routinely learn the formulas for so they properly understand how to interpret them.
In this article we want to acquaint you novices with seven of those returns and ratios so you, too, can learn what they mean and see how to formulate them for your own real estate analysis.
This is a measure of the property’s value to the investor and could be more or less than the market value of the property. Economic value measures the value of an investment from the standpoint of its net operating income (NOI) and a capitalization rate that would attract that specific investor’s capital to the project.
Economic Value = Net Operating Income (specific property) / Capitalization Rate (individual investor)
For example, if a specific investment property generates a NOI of $30,000 and the investor desires a capitalization rate of 8.0% to make the investment, then the economic value of the property to the investor is $375,000. In other words, no more than $375,000 should be invested for the buyer to achieve the desired cap rate.
This varies from economic value in that market value is driven by the market. That is, the market value of the subject property is derived by the capitalization rate typical investors have accepted when investing in similar properties.
Market Value = Net Operating Income (specific property) / Capitalization Rate (market)
For example, if we assume that similar rental properties have been selling at an average cap rate of 6.25% and we want to determine what may be the market value for the subject property based on its NOI of $30,000 then the result would be $480,000. In other words, based upon the market-driven cap rates in the area for similar properties it’s likely that this asset may have a market value of $480,000.
Operating Expense Ratio
This provides an indication of what percentage of the annual gross operating income (GOI) is being consumed by annual operating expenses.
Operating Expense Ratio = Total Operating Expenses (annual) / Gross Operating Income (annual)
For example, if our subject rental property generates a GOI (annual rental income less vacancies) of $57,000 along with operating expenses of $25,500 then the operating expense ratio is 44.74%. In other words, the annual expenses required to keep the property in service is 44.74% of all income generated.
Gross Rent Multiplier
This tells real estate investors the amount that would have to be paid for each $1 of annual gross scheduled income (GSI) generated by the property. Despite its shortcomings, the gross rent multiplier (GRM) is easy to calculate and can be used to quickly make comparisons between similar properties.
Gross Rent Multiplier = Market Value / Gross Scheduled Income (Annual)
For example, if our subject property produces a GSI of $60,000 coupled with a market value of $480,000 the result is an 8.0 GRM. In other words, the investor would have to pay $8.00 for each $1 of GSI generated if the asset is purchased at its market-driven value.
Net Income Multiplier
Net income multiplier (NIM) tells the investor the amount that would have to be paid for each $1 of annual net operating income (NOI) produced by the asset.
Net Income Multiplier = Market Value / Net Operating Income
For example, if our subject property has a market value of $480,000 as well as a NOI of $30,000 the result is a 16.00 NIM. In other words, we would pay $16.00 for every $1 of net operating income if we made a purchase at the property’s market-driven value.
The break-even ratio (BER) provides investors with the percentage that operating expenses and debt service will consume gross operating income. This is also typically used by lenders when underwriting commercial mortgages to measure how vulnerable a property is to defaulting on its debt in the event that rental income declines.
Break-even Ratio = [Operating Expenses + Debt Service] / Gross Operating Income
For example, if our subject has a combined total of $47,145 for operating expenses and debt service along with a GOI of $57,000 the BER is 82.71%. In other words, money going out to run the property consumes 82.71% of the money coming in.
Debt Coverage Ratio
This provides real estate investors information on the extent to which the annual NOI covers annual debt service. A debt coverage ratio (DCR) in excess of 1.0 indicates that there should be net income remaining after servicing the mortgage, whereas less than 1.0 means that there is not enough income generated to pay the mortgage.
Debt Coverage Ratio = Net Operating Income / Debt Service
For example, if our subject property has an annual debt service of $21,645 along with an NOI of $31,500 the result is a DCR of 1.46 (rounded). In other words, the income is 146% greater than the mortgage payment and therefore will cover the debt with money left over.
So You Know
ProAPOD provides real estate analysis software solutions that automatically calculate and post these returns into the appropriate reports.