6 Key Ratios For Property Investors

Real estate investors use certain analytical tools to get the relevant facts and figures about a rental property. They must know the property’s cash flows, rates of return, and profitability so they can make intelligent investment decisions regarding the property.
Because of this, a good real estate analysis would include numerous rates of return that become very relevant for investors and brokers. They would learn all the formulas so they can learn how to interpret them and put them to good use.
So, this article will orient you with the important key ratios so you can learn what they mean. However, let us warn you that it is not easy for beginners to understand these formulas. We hope that all readers will be able to use them for their own real estate analysis.

Ratios are useful because they show the relationship between different variables. They are the staple of every mathematician, engineer, and analyst – especially financial analysts. Using the ratios to analyze your prospective and current investments are extremely important in understanding property in the context of profitability and return on investments.
Unless of course, you’re just joining a bandwagon and copying what majority of buyers are doing. With these analyses, you should also learn to compare them to generally accepted standards or benchmarks the majority of professionals use to determine whether a property is a potential hit or an impending flop.

Cap rate is short for capitalization rate which allows you to evaluate and compare properties without considering financing. As you can see above, the formula simply looks at how big of a percentage your income will generate concerning your cost of acquiring the property.
You can get your Net Operating Income or NOI from annual numbers and is equal to gross rents less all expenses but without the principal and interest portion of a mortgage payment. The expenses would include taxes, insurance, repairs, and vacancy.
Take note that it is important to get a good estimate of the cost of repairs and vacancies. You can check out the estimates that we used for these costs as an example.
As a quick guide, you want to have a cap rate of at least 6% or higher – that is a must if you want to earn from your venture. While some investors don’t focus much on the cap rate since the rent ratio is already a good indicator, it is common to find some properties that give a cap rate from 8% to 10%.
If you’ve noticed, the cap rate does not account for the cost of financing.

This ratio provides the investor with a measure of the property’s value and is a good indicator of the real market value of the property. The economic value determines how much the property is worth from its net operating income (NOI) vis-à-vis a capitalization rate that would be attractive to investors.

For instance, if a particular property can generate an NOI of $24,000 and the investor is looking at a capitalization rate of 10% for him to make the investment, the economic value of the property to the investor is $240,000. Simply put, he should invest not more than $240,000 so he can reach his target cap rate.

How this differs from the 2nd ratio is that market value would really depend on the current market. Or, you can get the market value of the subject property by looking at the capitalization rate that typical investors have accepted when they invested in relatively identical properties.

For example, if there are similar properties in the area that have been selling at an average cap rate of 5% and we want to see the market value of a property that will generate an NOI of $10,000, we would arrive at $200,000. What it means is that if we consider market-driven cap rates in the neighborhood for similar properties, this asset may have a market value of $200,000.

This ratio as the name net income multiplier (NIM) suggests, tells the investor how much he has to pay to generate every $1 of net operating income (NOI) that the asset will provide.

As an example, if you have a property with a market value of $200,000 and gives an NOI of $10,000, the resulting NIM would be $20. This would translate to the investor having to pay $20.00 for every $1 of net operating income from the property if he would purchase it at the property’s market-driven worth.

If you want to see how the annual NOI can cover your annual debt service, this is the ratio to use. If the debt coverage ratio (DCR) is over 1.0, it means that there should be some net income remaining after servicing the mortgage. If less than 1.0 remains, then the income is not sufficient to pay the mortgage.

For example, if the subject property needs $12,000 for its annual debt service and an NOI of $20,000, we will get a DCR of 1.67 (rounded). In this case, the income is 167% bigger than the mortgage payment so, it can cover the mortgage comfortably while leaving a little bit of money to the investor.

Lenders just love this next ratio. This is because from this, they can assess whether a prospective borrower will be able to repay his mortgage without much effort. It will tell you how much of the operating income will go to service the mortgage. That is why this equation makes a lot of sense.

Each bank will have a different ceiling on the amount they would be willing to lend to a borrower. If you’re the borrower, that’s something beyond your control so don’t worry about it. What you should concern yourself with is whether your property’s cash flow will be able to meet the mortgage so that it pays for itself. If the cash you will generate will significantly fall short in servicing your mortgage debt, it’s but practical to retreat and look somewhere else.

There are a lot of things to consider if you’re really bent on acquiring a property. You could ask the lender to extend the loan term so you can have lower monthly payments. However, this will increase your accumulated interest over the years. As a reaction, you could raise the rental immediately. The downside is, you might drive tenants away from your property which will mean you’d lose the rent that’s supposed to give you a higher income. You might want to put down a higher down payment which will bring down the loan quantum. However, this will negatively impact your ROI and decrease the viability of the investment. In this case, what should you do?

Now, you have all the key ratios to make a good assessment of the viability of the property but remember that these formulas only compute the first year of ownership of the property. In the following years, several changes would and could happen. Your annual equity will grow, your expenses may rise due to inflation, rent may go up or down following the market, your tax bracket or situation may move and a myriad of other factors may contribute to the increase or decrease of your return on investment.