There are numerous ratios and formulas you can use in determining whether or not a property is a viable investment. Some of the ratios that gauge profit and help determine the level of risk are the Cap Rate, Gross Rent Multiplier, Cash on Cash Return, Net Operating Income Internal Rate of Return; Debt Service Coverage Ratio; Loan to Value Ratio and many other terms and formulas.
One of the most common terms you are likely to hear is the Capitalization Rate, commonly referred to as the “Cap Rate.” The Cap Rate is a reliable ratio used to compare properties in different price ranges, and it also can be used to place a value on a property based on the income it produces. The higher the Cap Rate, the better. The formula is Net Operating Income (NOI) ÷ Sales Price or Fair Market Value (FMV).
Example: I want to sell my triplex in Old Torrance, and need to come up with a marketable price. My property produces a net operating income (NOI) of $27,000 annually; if I know the Cap Rate in that area is 6%, then the fair market value (FMV) for that property is about $450,000 ($27,000 ÷ 6%).
Example: I sold a property and need to do a tax exchange. I have identified two properties. I can buy only one of the properties, and want to make a smart investment. The first property has a NOI of $20,000 with an asking price of $500,000. Property number two has a NOI of only $15,000, but an asking price of $250,000. Is property number one or property number two a better investment? You decide:
Property number one has a Cap Rate of 4% ($20,000 ÷ $500,000); property number two which has a Cap Rate of 6% ($15,000 ÷ $250,000). Since property number two has the higher Cap Rate (6%), it is the better of the two investments when judging based solely on Cap Rate.
You can use Cap Rates to quickly compare various properties, prices and areas. All you need is accurate Cap Rate information, which you should be able to obtain either from your real estate agent or your lender.
The formula for Net Operating Income (NOI) is Gross Revenue – (Operating Expenses + Vacancy). The gross revenue is income from rent and other income, such as laundry income or late fees. The operating expenses and vacancy is any revenue lost to cover expenses and vacancies. NOI is your net income before mortgage payments and taxes.
For example, the NOI for my Old Torrance triplex:
| Gross Rental Income |
$43560.00 |
| (-) Vacancy & Expenses |
($3546.00) |
| ( =) Net Operating Income |
$40014.00 |
| Annual Income & Expenses |
| Gross Rent |
$43200.00 |
| Other Income (laundry) |
$360.00 |
Total |
$43560.00 |
Expenses:
| Vacancy Loss 3% |
$1296.00 |
| Credit Loss |
$ - |
| Insurance |
$600.00 |
| Management |
$ - |
| Advertisement |
$ - |
| Business License |
$50.00 |
| Telephone |
$ - |
| Other Expenses |
$ - |
| Supplies |
$ - |
Utilities:
| Water |
$600.00 |
| Trash |
$ - |
| Electricity |
$ - |
| Gas |
$ - |
Maintenance:
| Paint |
$ - |
| Appliances |
$ - |
| Plumbing |
$ - |
| Electrical |
$ - |
| General |
$1000.00 |
Total |
($3546.00) |
The Gross Rent Multiplier (GRM) is another tool to help you quickly compare properties; it provides you with a value based on gross rent. The formula is Sales Price ÷ Gross Scheduled Income. Since you only need the price and the gross rent, this is an easy way to evaluate several similar properties in an area. For the triplex I used in the example above, if I decided to ask $650,000 it would be a GRM of 15: ($650,000 ÷ $43,200) = 15. The price is 15 times the gross rent.
However, it does not account for vacancies and other expenses. If you need a more accurate estimate of value, or if the property has a high vacancy factor, perhaps due to disrepair, you can use the Effective Gross Income rather than the Gross Scheduled Income. Effective Gross Income is simply (Gross Scheduled Income – Vacancy Amount).
When evaluating an investment, I often use the Cash on Cash Return, also referred to as the Yield. It is (Cash Flow ÷ Down Payment) or (Cash Flow ÷ Net Investment), expressed as a percentage. It shows the relationship between the total dollars you invest and the income you receive. One of the limitations is it does not take appreciation into account, so if you are evaluating more than one property to buy, and one may have higher cash on cash return monthly or annually, it may not appreciate as well.
For example, I purchased a triplex for approximately $450,000 a few years ago with an annual net cash flow of only $2,100, and the cash I invested in the property was over $90,000. My cash on cash return was only 2%. At that rate, I’d have been better off placing the money in a savings account. However, I knew the property was in an area that was prime for appreciation. I sold the property one year later for $705,000. When you calculated the cash on cash return one year later, it was approximately 286%.
A couple of years ago, I purchased a new construction property that I intended to “flip” as soon as construction was complete. Flipping refers to the practice of buying an asset and quickly reselling ("flipping") it for profit. Usually the term is applied to the practice of buying a property below market value, making improvements to the property then and reselling for a profit (usually market value). The term also was used when investors would take advantage of the market conditions, as in the real estate market we experienced at the beginning of this decade. No improvements are made; the buyer simply takes advantage of market fluctuations, or the knowledge that prices will soon increase, to make a profit.
I “speculated” that once completed, the value would have increased on these new construction homes. Luckily for me, I was correct. I gave the builder $2,500 in September 2004 as a deposit. The property was completed in February 2005. I found a buyer for the house two days before I closed escrow. To close the escrow I needed to bring in the rest of my money, which was 10% of the sale price plus closing costs. Our net investment totaled approximately $15,500 (including the initial $2,500 deposit). Once I closed escrow, I immediately opened up the new escrow and closed 30 days later with the new buyer. After paying all fees and closing costs, I netted approximately $27,400. Our Cash on Cash Return was 177% ($15,500 ÷ $27,400). Not bad for a property that I basically just sat on while the builder completed it for me. Not all deals are this lucrative; however, the way I look at an investment is that as long as I am earning more than I could by leaving the money in the bank, I consider it a wise investment.
With the example I just used, I was so excited and confident that the market would appreciate and I would make money that I told all of my friends and family. Of everyone I know only my plumber, Rudy, jumped at the chance. One other friend (a REALTOR®) went into escrow, but canceled one week into the deal because she did not feel comfortable in an area she did not know.
Once I told Rudy about it he drove to Tucson from Los Angeles to check out the property, and he too was convinced. He opened escrow and made more money on his re-sale than I did, because his completion was delayed and by the time he sold, two months after I did, prices had jumped again.
All of our other friends, family and clients had a “wait and see” attitude. Once they saw that I did in fact make some money, they too wanted to jump on board; but it was too late. By the time we resold our unit, the builder restricted the sales to owner-occupants only. They would no longer allow investors to buy their units. This is a great example of why you need to learn to make a move and just go for it. It certainly was not a guarantee that I was going to make money in that transaction, and I don’t make that much on every deal; but I know that the only way to be successful is to keep trying and keep moving forward.
We, along with many friends, clients and collogues continued to invest in Tucson through 2005, but eventually the market became saturated with investors, making it difficult to buy property at a reasonable price or to resell property for a profit; renting even became difficult because there was so much competition. We did not give up on investing; we simply changed our strategy and looked for more lucrative markets in which to invest. To be successful in any business, you need to be able to change with your market.
Since I invest in Southern California, one of the most expensive markets in the country, it can be difficult to find properties with a great cash flow - so, I will evaluate the cash on cash return of the property. If the cash on cash return is better than I will receive if I simply placed the money in a savings account, I might be inspired to buy a property - especially if it’s in an area I like, or if it’s the type of property in which I like to invest.
In the following example, the before-tax cash flow is ($9,914.30 ÷ $67,500) = 14.6%. My cash on cash return is a little over 14%, which is better than the bank will give me for my savings account; although I will make very little money each month, I would likely move forward with this purchase. Also, I know I can probably resell for a profit within a couple of years. I would improve the property and raise rents. Once I resell in a year or two, my cash on cash return will jump up tremendously.
Cost per Unit is simply the cost of the building divided by the number of units. I use this a lot as a quick evaluation tool when comparing buildings with a similar number of units. For example, if I’m looking at several 10- to 12-unit buildings, this is a great tool to use. It would not work when comparing a duplex or triplex to a 10-unit building.
Annual Debt Service is the total amount of all interest and principal paid for all loans on your property.
Leverage is using borrowed funds (loans) to purchase a property. Leverage is the main reason I prefer to invest in real estate rather than the stock market. To buy $100,000 in stocks, I would need $100,000; to buy a $100,000 piece of real estate, I would need only $5,000 - $20,000. Sometimes the bank will even lend me 100% of the value of the property, depending on its condition and most importantly, my credit. As an investor one of my most important assets is my credit ,so I work diligently to make sure I keep up my credit score.
Loan-To-Value (LTV) Ratio. The LTV ratio is the amount of leverage you are using or can use to determine your equity. For example, if you buy a $100,000 property and put 20% down ($20,000), your LTV is 80% (an $80,000 loan). If you bought the property several years ago, and using the same example paid $100,000 and put down $20,000, but now your loan amount is $70,000 and the property has appreciated to a FMV of $140,000, then your LTV would be 50% and your equity would be $70,000. Equity is the Fair Market Value or the sales price of your property minus the loan amount, (FMV – Loan Amount).
You will see banks and other lenders asking for the Debt Service Coverage Ratio (DSCR) with larger apartment buildings and commercial properties. The debt coverage ratio shows the property’s ability to pay the monthly mortgage payments from the income it produces. The formula for DSCR is (NOI ÷ Annual Debt Service). For example, I want to purchase a 10-unit apartment building; the NOI is $132,000 and the Annual Debt Service is approximately $99,000. The DSCR is 1.33: (132,000 ÷ $99,000) = 1.33. This means that the property generates 33% in income over and above the monthly loan payments. I will probably get a bank to give me a loan on this property.
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