Common Metrics Used To Evaluate Real Estate Investments
Popular metrics used to evaluate Real Estate investments are Cap Rate (CR), Internal Rate of Return (IRR), Cash on Cash (CoC), Holding Period(HP) and Equity Multiple(EM). Other metrics that become relevant depending on the property and its financing are Cash Flow, Net Operating Income (NOI), Operating Expense Ratio (OER), Loan To Value ratio (LTV), Gross Rent Multiplier ratio (GRM), Stabilized Rent on Cost, Debt Service Coverage Ratio (DSCR), and Occupancy Rate (as percentage). In this section, we will explain the concept behind each of the metrics, provide formula for computing the metrics, and illustrate with an example.
- Cap Rate (CR)
- Cash on Cash (CoC)
- Cash Flow
- Debt Service Coverage Ratio (DSCR)
- Equity Multiple (EM)
- Gross Rent Multiplier (GRM)
- Holding Period (HP) & Holding Period Return (HPR)
- Internal Rate of Return (IRR)
- Loan To Value ratio (LTV)
- Net Operating Income (NOI)
- Operating Expense Ratio (OER)
- Occupancy Rate (OR)
- Present Value (PV)
- Stabilized Return on Cost
1. Cap Rate (CR)
Concept
Cap Rate (aka Capitalization Rate) is defined as the rate of return on a real estate investment property. It describes what part of your initial investment will be returned to you in a specific year. In the case of rental properties, sponsors typically talk about cap rate at the time of acquisition and at the time of exit.
Formula
The Cap Rate of a real estate investment is calculated by dividing the property's Net Operating Income (NOI) by the Market Value, in a specific year.
Capitalization Rate =
Net Operating Income
Current Market Value
where,
The Net Operating Income is the annual income projected to be generated by the property. NOI is defined elsewhere in this page.
Example
Assume the following parameters for a property investment
Purchase Price = $1,000,000 (value stays steady throughout the year)
Annual Rental revenue = $100,000
Annual Maintenance = $20,000
Given these parameters
Net Operating Income = $100,000 – $20,000 = $80,000
Cap Rate = $80,000 * 100 /$1,000,000 = 8%
2. Cash on Cash (CoC)
Concept
Cash-On-Cash is the rate of return often used in real estate transactions to calculate the cash income earned on the cash invested in a property. Cash-on-cash return measures the annual return the investor made on the property compared to the amount of mortgage paid during the same year. Cash on Cash return is also called Cash Yield.
Formula
Cash on Cash Return % =
Annual Pre-Tax Cash Flow
Total Cash Invested
X 100
Annual Pre-Tax Cash Flow is the Net Cash Flow from an investment which is the difference between Cash Outflows and Inflows, on a pre-tax basis
Example
Assume the purchase and sale of a rental property with the following parameters
Purchase price = $2,000,000
Down Payment = $500,000
Loan Amount = $1,500,000
Closing Costs = $20,000
Property Improvement Costs = $10,000
Total Cash Investment = $500,000 + $20,000 + $10,000 = $530,000
Annual Rental income = $120,000
Annual expenses excluding mortgage and insurance = $12,000
Annual Mortgage payment incl insurance = $60,000
Duration = 1 year
Principal repaid in the first year = $10,000
Net proceeds from Sale of Property at the end of 1 year = $2.25M
Given the above information
Net cash outflow = Down Payment + Closing Costs incl insurance and maintenance + Property Improvement + Mortgage Payments + Other Expenses = $500,000 + $20,000 + $10,000 + $60,000 + $12,000 = $602,000
Net cash inflow = Net proceeds from sale – pre-paid principal – mortgage principal = $2.25M - $10K - $1.5M = $740K
Cash On Cash Return = ($740K – $602K) * 100 / $602K = 22.92%
3. Cash Flow
Concept
Cash Flow refers to the net amount of cash and cash equivalents being transferred in and out of a company. Cash received represents inflows, while money spent represents outflows. A company’s ability to create value for shareholders is fundamentally determined by its ability to generate positive cash flows or, more specifically, to maximize long-term free cash flow (FCF)
Formula
Cash flow = Gross Rental Income - all expenses and cash reserves
Example
Consider a property with the following parameters
Monthly rental income: $1,000
Monthly operating expenses:
Mortgage: $300
Property taxes: $200
Insurance: $50
Property management: $100
Vacancy reserves: $50
Repair reserves: $100
Total monthly expenses: $800
Monthly Cash flow: ($1,000 - $800) = $200
4. Debt Service Coverage Ratio (DSCR)
Concept
Debt Service Coverage Ratio (DSCR) is the ratio between Net Operating Income (NOI) and Total Debt Service. It helps assess if the company can cover its debts using its NOI, and is used to determine the amount that the lender may want to lend to the investor.
Formula
DSCR =
Net Operating Income
Total Debt Service
where:
Net Operating Income = Revenue − COE
COE = Certain operating expenses
Total Debt Service = Current debt obligations
Example
Consider an example where a real estate developer is approaching a lender for a loan for a warehouse. The developer estimates the NOI would be $2M per year, and the lender notes that debt service will be $500,000 per year.
DSCR =
$2,000,000
$500,000
= 4
A DSCR of 4 in this case means that the developer can cover a debt that is 4 times their NOI.
5. Equity Multiple (EM)
Concept
Equity Multiple is defined as the present value of total cash distributions received from an investment, divided by the total equity invested.
Formula
Equity Multiple =
Present Value of the Investment
Amount of Money Invested
Present Value of the Investment = This is the property’s value in present terms.
Example
Assume that a property was bought for $5M, 10 years ago. Also, assume that the Present Value of the property is $10M
Equity Multiple = PV of the Property / Amount Invested = $10M / $5M = 2
The investor has earned an Equity Multiple of 2 in this investment.
6. Gross Rent Multiplier (GRM)
Concept
Gross Rent Multiplier (GRM) is the ratio of the price of a real estate investment to its annual rental income before accounting for expenses such as property taxes, insurance, utilities, etc.,
Conceptually, GRM is the number of years the property would take to pay for itself in gross received rent. A lower GRM represents a better opportunity for the investor.
Formula
Gross Rent Multiplier =
Fair Market Value
Gross Rental Income
Example
Assume that the Fair Market Value (FMV) of a property is $600,000, and the monthly rent is $2,500
Annual Gross Rental Income = 12 * 2,500 = $30,000
GRM = $600,000 / $30,000 = 20
7. Holding Period (HP) & Holding Period Return (HPR)
Concept
The holding period of a commercial property is simply the amount of time for which an investor plans to "hold" the property. It begins on the day the property is purchased and ends on the day the property is sold. In fractional real estate investing, an optimal holding period is about 5 years. Holding Period Return is the total returns (share of income from leases and share of capital gains from sale) as a percentage of the initial investment.
Formula
Holding period return can be represented by the following formula
Holding Period Return % =
(Income + (EOPV−IV)) * 100
IV
where:
EOPV = End of Period Value
IV = Initial Value
Example
Assume John bought shares in a property floated on RealtySlices for $100K. Each year, his share of income distributions was $5K. Assume also that the property was sold at the end of year 4, and the share of net capital distribution was $125K. With these parameters, Holding Period Return can be computed as follows
Net proceeds = ((4 years * $5K per year) + ($125K sale proceeds - $100K initial investment)) = $45K
HPR % = Net Proceeds * 100 / $100K initial investment = $45K * 100 / $100K = 45%
8. Internal Rate of Return (IRR)
Concept
Internal Rate of Return is a way of comparing the future value of an investment as if it were valued in today’s dollar and comparing with the cost of capital to assess whether to make an investment or not.
Formula
IRR is the rate at which the Present Value of the investment will be equal to the amount invested today
0 (NPV) = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3+ . . . +Pn/(1+IRR)n
Where
P0 is the initial investment (cash outflow)
P1, P2, P3..., are the cash flows in periods 1, 2, 3, etc.
IRR is the project's internal rate of return
NPV is the Net Present Value
N is the number of holding periods
Example
Consider a project with the following cash flows
Initial Outlay = $75,000
Year one = $5,000
Year two = $6,000
Year three = $8,000
Year four = $9,000
Year five = $95,000
We can calculate IRR in Microsoft Excel using the following formula:
= IRR(initial investment as negative number, returns each year as positive numbers)
= IRR(A2, F2)
| Initial Outlay | Year one | Year two | Year three | Year four | Year five |
|---|---|---|---|---|---|
| 75,000 | 5,000 | 6,000 | 8,000 | 9,000 | 95,000 |
| = IRR(A2, F2) |
| Initial Outlay | Year one | Year two | Year three | Year four | Year five |
|---|---|---|---|---|---|
| 75,000 | 5,000 | 6,000 | 8,000 | 9,000 | 95,000 |
| 12 % |
IRR = 12.00 %
9. Loan To Value ratio (LTV)
Concept
The Loan-To-Value (LTV) ratio is used by lenders to express the ratio of a loan to the value of the asset purchased. LTV ratio quantifies the lending risk that lenders will look at, before approving a mortgage
Formula
LTV % =
MA
APV
x 100
where:
MA = Mortgage Amount
APV = Appraised Property Value
Example
Assume that an investment property is worth $300,000. After looking at the credit, cash flows, expenses, etc., of the investor, if the bank determines that they would only lend a Mortgage Amount of $225,000, the investor will have to come up with a down payment of $75,000.
In this case, LTV = 225,000 * 100 / 300,000 = 75%
10. Net Operating Income (NOI)
Definition
Net operating income (NOI) is used to analyze the profitability of income-generating real estate investments. NOI equals all revenue from the property, minus all reasonably necessary operating expenses.
NOI is a before-tax figure, appearing on a property’s income and cash flow statement, that excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization.
Formula
Net Operating Income = RR – OE
where:
RR = real estate revenue
OE = operating expenses
Example
Assume that an apartment complex has the following parameters.
Revenue:
Rental income: $25,000
Parking fees: $5,000
Laundry machines: $2,000
Total Revenues = $32,000
Operating Expenses:
Property management fees: $2,000
Property taxes: $5,000
Repair and maintenance: $3,500
Insurance: $1,500
Total Operating Expenses = $12,000
NOI = $32,000 - $12,000 = $20,000.
11. Operating Expense Ratio (OER)
Concept
The Operating Expense Ratio (OER) is a measure of the cost of operating a piece of property compared to the income brought in by the property. It is calculated by dividing a property's operating expense (minus depreciation) by its gross operating income.
Formula
OER % =
Total operating expenses − Depreciation
Gross operating income
x 100
Example
Assume that an investor owns a multi-family apartment building that has a rental income of $100,000. The investor’s monthly operating expenses including his monthly mortgage payments, taxes, utilities, etc., is $70,000. Assume that the annual depreciation of the property is $75,000.
OER =
($70,000×12) − 75,000
(100,000×12)
= 63.75%
12. Occupancy Rate (OR)
Concept
Occupancy Rate is the ratio of used or rented space to the total amount of available space. Analysts use occupancy rates when discussing housing, hospitals, hotels, bed-and-breakfasts, call centers, and rental units, among other categories
Formula
Occupancy Rate% =
Total Units Rented
Total Available Units
X 100
The economic occupancy rate is a metric that analyses potential gross rent collected by the owner.
Economic Occupancy Rate =
Total Gross Rent Collected
Total Gross Potential Rent
Example
An apartment building has 1,000 units out of which 100 are available for rent.
Thus, Occupied Rate % =
Occupied Units
Total Units
x 100
= (1,000 – 100) * 100 / 1,000
= 90%
13. Present Value (PV)
Concept
Present value (PV) measures the current value of an amount of money – or a stream of cash flows – that is expected in the future. Present value is the comparable value today of cash sometime in the future.
Present Value will differ from the cash flows’ nominal value since time affects the value; intuitively, we know that receiving $100 today is more valuable than receiving the same $100 a year from now.
Time represents distance from money, and distance creates risk, which offsets value. In investing, risk is compensated by interest or returns to investors.
Formula
Present Value = FV/ (1+r)n
where:
FV = Future Value
r = Rate of return
n = Number of periods
Example
Assume that you expect to receive $100,000 ten years from now, and that the annual rate of return is 5%.
Using the above formula, PV = $100,000 /(1 + 0.05)10 = $61,391.32
This means that the PV of your investment for which you expect to receive $100,000 ten years from now is $61,391.32
14. Stabilized Return on Cost
Concept
Stabilized Return on Cost is similar to cap rate but is more forward-looking; it looks at the Net Operating Income (NOI) of a property after it has been stabilized. It is expressed as a percentage, like most return metrics.
Formula
Return On Cost is calculated as:
Net cash flow (before debt service)
Sum of acquisition price, closing costs,
and renovations costs
X 100
Example
Net cash flow (before debt service) = $25,000
Acquisition price = $300,000
Closing cost = $7000
Renovations cost = $3000
So,
Stabilized Return on Cost % = ($25,000 * 100) / ($300,000 + $7000 + $3000)