The art of successful real estate investing is not rocket science. The investor locates a property, crunches the numbers, and makes an investment decision based upon whether those numbers indicate a positive return that meets or exceeds the investor’s investment strategy.
Nonetheless it can be illusive and confusing for novice real estate investors who have little or no experience to crunch the numbers. For them, trying to discern whether or not a rental income property might be a good and profitable investment, or even warrant a second look based upon the numbers can be daunting.
This is not the fault of the novice real estate investor.
Investment property analysis reports typically yield a host of returns, measures, and ratios that are not listed in order of importance. A real estate analysis could easily place debt coverage ratio (which is not necessarily a profitability indicator), for instance, ahead of the cash-on-cash return (which is more significant to profitability).
It seems like a good idea, therefore, to assign some of the more popular real estate investing returns and measures to the category where they commonly associate. The list is by no means exhaustive, and certainly is not scientific, but it should help you and other real estate investor get a better idea of what to look for about the profitability of income-producing property.
For our purpose, we’ll keep it simple and create just three categories.
- Mortgage related
- Value related
- Cash flow related
Getting a favorable mortgage is certainly important to an investor because the loan will have a direct impact upon a property’s financial performance. But the numbers associated with mortgages themselves, although major benchmarks for lenders, don’t reveal much about the health of an investment.
- Loan to Value (LTV) – This is the ratio between the property’s mortgage financing and its value. It is used by lenders to control the amount of your investment equity.
- Debt Coverage Ratio (DCR) – This is the ratio between annual net operating income and annual debt service. It is used by lenders to measure the relationship between the income generated and the loan payment.
- Break-even Ratio (BER) – This reveals the proportion between income and expenses. Its purpose is essentially to estimate how vulnerable a property is to defaulting on its debt should rental income decline.
The desire of any real estate investor is being able to purchase rental income property at or below the market value, and absolutely never to pay more than its worth. This requires a good understanding of what the local market value is for rental income properties and then to make a comparison.
Several indicators are commonly used to accomplish this but these are market-driven (i.e., the results in one region are inconsequential to properties outside the region) so by themselves they say little about the subject investment potential. They merely help you to assess fair market value. Just bear in mind that you must always apply these measures to similar-type properties (i.e., apartments to apartments, etc.).
- Gross Rent Multiplier (GRM) – This is a ratio between gross scheduled income and property value. It is not the best valuation technique but does provide a quick and easy first glance.
- Cap Rate – This expresses the relationship between a property’s value and its net operating income. This is the technique most commonly used by appraisers and property tax assessors for valuation purposes.
- Cost per Unit – This takes the property’s price and divides it by the number of rental units. This can provide a quick overview of apartment complexes because they tend to be more uniform in their ability to generate income. Commercial properties are more apt to look at cost per square foot. Either way it should be used as a secondary valuation technique at best.
Okay, this where the rubber meets the road. Cash flow is what real estate investors are purchasing and ultimately what determines the profitability of income property. It may be a positive monthly or annually cash flow (depending on the investor’s personal financial needs) or maybe even a negative cash flow (depending on the investor’s personal income tax needs).
Nonetheless, at the end of the day, the profitability of any real estate investment boils down to cash flows—generated both during ownership and upon re-sale. Here are some of the returns you want to look for to measure profitability, but bear in mind that no one approach to investment decision-making will provide all the answers.
- Cash on Cash (CoC) – This is the ratio between a property’s cash flow and the amount of the initial capital investment. It is not particularly powerful but can be used as an easy comparison to other types of investment.
- Internal Rate of Return (IRR) – This is the rate of return your actual cash investment will yield based upon forecasted future cash flows. It is probably the most widely used measurement by real estate investors.
- Net Present Value (NPV) – This is the difference between the present value of all future cash flows and the amount of cash invested to purchase those cash flows. The result is a dollar amount that in essence tells you whether the yield you desire on your cash investment is achieved by those future cash flows.
- Profitability Index – This is similar to net present value as a method of measuring return except it results in a ratio between the present value of all future cash flows and the amount of cash invested. It is typically used by investors to compare two investment opportunities that require different initial investments.
- Cash Flow After Tax (CFAT) – This is the actual amount of cash you can pocket after satisfying your income tax liability from the operation of the property. You can also pocket cash flows before taxes (CFBT) but remember that it is subject to taxation so you may have to part with some of it at tax time.
- Sale Proceeds – This is what you hope to get when you sell your property but is subject to taxation. Sale proceeds after taxes are what you hope to keep after settling up with Uncle Sam. The easiest way to determine both proceeds is with a real estate investment software solution that creates a proforma income statement. This will allow you to make projections out over (say) ten years and reveal the sale proceeds in both cases.
So You Know
ProAPOD does provide a real estate investor software solution that automatically calculates these returns for inclusion in the appropriate reports.