16 Jun 2020
It is very often confusing for new real estate investors when they need to evaluate an investment opportunity. Fortunately, there are dozens of simple metrics that can help property investors to make the right decisions. For some investors, depending on their goals and the property type, some metrics are more important than others. However, if you want to become a real estate professional or investor, the following simple metrics are essential.
Net Operating Income is a calculation used to analyse the profitability of income-producing real estate investments and it is the annual income generated after all of the operating expenses have been paid.
When estimating our rental income, we assume that some vacancy is going to happen. In addition, anything that is not part of the rent roll but is still income to the property such as parking structures and laundry facilities, is considered as other income and must be taken into account. Therefore, if we add the other income while we first deducted the vacancy losses, we get the Gross Operating Income. GOI is basically our net revenue number. Then, all operating expenses must be deducted from GOI in order to get the Net Operating Income. Operating expenses include the costs of running and maintaining the building. Such costs are insurance premiums, legal fees, utilities, property taxes and repair costs.
Real estate investors usually use the net operating income to calculate the capitalization rate, which in turn helps them determine a property’s value, thus allowing them to compare different properties they may be considering buying or selling.
The capitalisation rate is one of the main measures in the world of real estate. It is usually used to indicate the rate of return that is expected to be generated on a property. However investors should never base a purchase on the CAP rate of a property alone as it doesn’t take into account time value of money and leverage, among other factors. CAP rate is expressed as a percentage and it is used to estimate the investor’s potential return.
Capitalisation Rate = Net Operating Income / Current Market Value
Loan to Value ratio is the proportion of a loan to the Value of the asset purchased and is commonly used by lenders and banks to assess risk. The higher the LTV the more risk involved with the loan. In addition, a higher LTV can increase the cost of the investment because of the interest rates and also due to the probable requirements of additional insurance. On the other hand, a higher proportion of loan financing in an investment will probably increase the cash on cash return for the investors.
Loan to Value Ratio (LTV) = Loan Amount/Property Value
Cash on Cash return or Cash yield is a rate of return commonly used in real estate transactions and refers to the annual pre-tax cash flow divided by the total cash invested. Cash on Cash return is a metric that is used to assess the investment’s performance and measures the annual return the investor made in relation to the total cash invested. Furthermore, Cash on Cash return is a good measure to comparing the performance of separate investments.
Cash on Cash Return = Annual Pre-Tax Cash Flow / Total cash Invested
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