In the article below, we’ll dive into the top 10 metrics that all multifamily investors should understand before investing a single dollar in an investment deal. These are the metrics that we believe, once understood, best inform an investor’s decision to pull the trigger or not.
1. Net Operating Income (NOI)
NOI is a measure of the profitability of real estate investments that generate income. It is calculated as revenue minus all operating expenses that are necessary to keep the property running. NOI is a before-tax figure that appears on a property’s income and cash flow statement and excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization.
The formula to calculate the NOI is as follows:
(Gross operating income + other income) – operating expenses = Net operating income
An investor can use this metric to measure an asset’s profitability without taking into account how one finances it. When you analyze the NOI that sellers report in their brochures (i.e., offering memorandums), it must be verified to ensure it is accurate. If a seller overreports or fabricates income, their NOI will be artificially inflated. If certain expenses are deferred or ignored, the NOI will be inflated as well. An inflated NOI can lead a buyer to overpay for an asset. You can calculate this metric yourself, or let Impex Capital do it for you.
2. Capitalization Rate (Cap Rate)
The Cap rate is a property’s Net Operating Income divided by the price at which you purchased it. There are various methods to estimate the return on a real estate investment, but the cap rate is the metric most investors use to forecast return on investment (ROI). The capitalization rate of a property can also help to find the risk and the quality of the investment by comparing a property’s cap rate against similar real estate investments.
In general, the higher the cap rate, the higher the risk. A higher cap rate indicates higher returns and thus higher risk. You can see higher cap rates in riskier markets like rural parts of TN versus lower cap rates in stable and large markets like New York.
3. Internal Rate of Return (IRR)
The elephant in the room. In simple words, IRR is a summary statistic of cash flows. A property’s long-term yield is determined by calculating the IRR. It estimates the interest rate on each dollar invested over the holding period. The IRR is the rate at which the money you invested grows on a compounded basis. Since IRR uses compounding, it is used to find the time value of money.
IRR is one of the most widely advertised statistics in real estate investing. You will notice, investors boasting about their 18% IRR rate but you can’t be sure about these returns. That’s the catch, there are tens of assumptions used to find IRR. Due to this reason, you should not compare just the IRR of two different properties as they could be using entirely different assumptions. It is difficult to calculate IRR. Usually, a financial calculator is required to calculate IRR or let Impex Capital do it for you.
4. Loan-to-Value Ratio (LTV)
Lenders and other financial institutions use the loan-to-value ratio, or LTV, to determine the risk associated with issuing a mortgage loan. The LTV ratio is not restricted to real estate investor loans, but is a critical factor in determining the amount of financing required for such purchases. Lenders typically think of a higher LTV ratio as a higher risk, as the investor owns less equity in the property, increasing the risk of default. As a consequence, a loan with a high LTV might result in paying a higher interest rate, having to purchase extra mortgage insurance, or being denied.
The LTV is calculated by dividing the mortgage amount by the appraised property value, then expressing the result as a percentage. For example, if an investor borrows $280,000 to purchase a house whose appraised value is $350,000, the LTV ratio would be 80%, i.e., 280,000/350,000.
5. Gross Rent Multiplier (GRM)
The gross rent multiplier, or GRM, is a formula used to compare and evaluate commercial real estate investments. It’s used to measure a property’s performance by calculating the proportion of gross rent to the property’s purchase price. It can also be used to screen out undesirable properties by estimating the rental income they might earn.
The gross rent multiple is calculated as the property’s purchase price divided by the potential monthly rental income. The GRM is calculated as the property’s purchase price divided by the cumulative monthly rent over a twelve-month period. For example, if a property’s purchase price is $300,000 and the potential monthly rental income is $2,500, the GRM would be 10, e.g., 300,000/30,000. Other properties with comparable GRM are then assessed to determine which will perform the best. A low GRM is preferable, but a GRM between 4 and 8 is typical. You can use this information to determine whether a prospective investment is a good deal or whether a current asset is worth keeping for the long term.
6. Debt Coverage Ratio (DCR)
A real estate investor should be concerned about the debt coverage ratio because it indicates whether the net cash flow from an investment property is sufficient to pay the mortgage. In other words, this ratio determines whether an investment property will produce enough income for the investor to pay the mortgage.
Lenders and real estate investors both use the debt service coverage ratio to evaluate rental property opportunities. Lenders rely heavily on this metric to determine the maximum loan amount for a property. Investors, on the other hand, use this metric to determine what their offer should be on a property or whether the property is worth investing in at all. The higher this figure is, the more protected the lender feels and the more cash flow available to equity investors. Conventional bank and agency lenders typically require 1.20-1.25x DCR to finance the deal, while bridge lenders may require substantially less. DCR generally increases over the life of the asset as the difference between your income and expenses increases.
To calculate the debt service coverage ratio, divide the net operating income by the debt service on the property. You can calculate it yourself or our experts can do it for you.
7. Occupancy Rates
The occupancy rate of a property is the ratio of rented or used space compared to the total available space. Generally, the higher the occupancy rate, the better the investment opportunity. Most investors use two types of occupancy rates to keep an eye on open units and lost income.
Physical Vacancy Rate: It tells us the percentage of units which are actually physically unoccupied. To calculate divide the total number of rented units by the number of available units on a property. For eg. If a property has 500 units total but only 450 are rented then the physical vacancy rate of the property would be 90%.
Economic Vacancy Rate: it tells us the amount of income you’re missing out on when a unit is vacant. You can calculate how much it cost you by adding up the rents lost during the vacancy period and then dividing by the total amount of rent you would have collected in a year.
Generally speaking, if the asset is managed properly then a 4%-6% vacancy rate is expected.
8. CASH on CASH Return
Cash on cash return is the amount of money that you make on your investment over and above the amount of money you put into the investment. Put simply, the cash-on-cash return is the return earned by an investor on a property compared to the percentage of the mortgage paid during the same time frame.
With the help of cash on cash return, you can determine the best way to finance a new investment. It’s used when choosing between potential investments and can help you forecast returns during years when you expect capital expenditures.
9. Operating Expense Ratio (OER)
Operating expense ratios, known as OERs, compare the costs of operating property to the income generated by it. Investors compare operating expenses across different opportunities using the OER. The OER can also be used to identify red flags such as higher-than-average maintenance expenses or costly utilities. A range of 60% to 80% is the ideal OER. The lower the OER the better. A lower OER indicates that you’ve reduced expenses relative to revenue. A higher OER might signal a variety of problems. It might suggest that annual rent hikes haven’t kept pace with expense increases, or that your property management company isn’t performing routine maintenance as frequently as it should. Using specific expenses to determine OER can help you identify why it has grown and assist you in lowering it.
To calculate take all operating expenses, minus depreciation, and divide them by operating income to get your Operating Expense Ratio. You can calculate it yourself or let Impex Capital do it for you.
10. CASH FLOW
Cash flow refers to the difference between the money flowing into and out of the real estate investment over a certain period of time. It indicates how much cash is left over after a transaction is complete. Ideally, net cash flow should be positive each month for investments.
It is a simple but important number. If it’s negative, you won’t be able to pay your bills or make a profit. A negative cash flow indicates that you will not be able to pay your bills or make a profit, which implies that you are spending too much on the property and its associated costs.
Final WORDS
There are many metrics that are important in monitoring the performance of a real estate investment property but no one metric tells the whole story. Each ratio tells a different story about the investment. One should always compare multiple metrics before investing.