# 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)