Choosing an investment in property is not only about its purchase price and the potential rental return but there’s much more to it. To help investors stake their money wisely, certain calculations and ratios have been devised that help maximize profit and minimize risk. Wise investors learn, understand, and keep these real estate investment metrics in mind in order to evaluate the potential of their investment in minutes and monitor the profitability of their existing properties as well.
Likewise, certain KPIs also act as real estate performance metrics and help track the potential returns on existing and future investments. Confidence in the investment strategy backed by empirical evidence, especially in times of economic volatility can make investors as well as realtors better, smarter, and eventually a successful businessman.
It all starts with these key real estate valuation metrics:
Internal Rate of Return (IRR)
IRR is a percentage estimate of the amount you’ll on each unit of money invested in a rental property throughout its holding period. It is essentially the numerical rate of a property’s growth potential. This calculation goes beyond net operating income and purchase price for the purpose of estimating long-term yield.
How to calculate IRR
To calculate IRR, the net present value (NPV) of the property should be set to zero. Now use the projected cash flows for each year that you have planned on for holding the property. NPV represents the value of money in the present date, versus in the future once the money has accrued the increased value. Calculating the internal rate of return is a complicated formula, therefore most investors utilize the IRR function in Microsoft Excel to calculate the accurate figures.
While investors use IRR to compare properties, it is important to know that it comes with limitations. It must be noted that the IRR formula does not take into account any unexpected repairs and assumes the property to remain in a stable environment. The properties you equate should be identically comparable in size, use, and holding period.
Net Operating Income (NOI)
NOI reveals the potential amount of money that you can make from a given investment property. It’s a version of an advanced income statement.
How to calculate NOI
To calculate the net operating income of your investment property, take the figure of your operating expenses, and subtract it from your total income. Keep in mind that mortgage payments are not considered operating expenses, therefore they should not be considered in this calculation process. Moreover, do not forget to incorporate income from laundry machines, extra fees for parking spots, or any service fees in your total income sum.
Operating expenses comprise legal fees, general maintenance, any utilities that you are required to pay, and all applicable property taxes. The calculation of NOI excludes income taxes, capital expenditures, mortgage payments, or periodic appreciations.
Capitalization (Cap) Rate
The Cap rate can be regarded as the real estate equivalent of the stock market’s return on investment (ROI). Capitalization rate is the ratio between the amount of income produced by a property against either the original capital invested or the current value of capital invested initially. The Cap rate evaluation process provides you with the percentage of your investment’s value that’s profit.
This formula divides your net operating income (NOI) by the asset’s actual value. If you are in the acquisition phase, this will be the property’s sale price. Afterward, you can take assistance from any local realtor, broker for the present value of the property, or you can also find the estimated value on real estate websites or any reliable online real estate marketplace.
Operating Expense Ratio (OER)
Being a tentative measure of profitability, the OER tells you how adequately you’re adjusting expenses relative to the income. To calculate the value of OER, take into account all operating expenses, deduct the depreciation, and divide them by operating income. It is one of the few ratios used by investors which considers the value of depreciation. This makes it relatively more inclusive of the property costs.
Translating OER figures
A lower value of OER identifies that you’ve minimized expenses in contrast to revenue. However, if, with the passage of time your OER has been rising, it could ring the danger bell. For instance, your annual rent increment hasn’t matched expense increases. Calculating OER with the help of specific expenses can help you constrict the reason for its rise and guide you in getting it back under control.
Occupancy Rates (ORs)
A vacant or unoccupied unit of property generates no income but still costs you money. Many operating expenses remain unaffected even if you have no tenants. To keep a check on these invisible costs, the open units, and lost income, most investors track two historical occupancy rates.
Physical Vacancy Rate (PVR)
This rate gives an investor the percent of property units vacant as compared to the total units available. Calculating PVR is not complicated at all. You only need to take the number of vacant units, multiply them by 100, and divide their resultant value by the total number of units in possession. This metric is useful for both, on a property-by-property basis, or across your entire portfolio.
Economic Vacancy Rate (EVR)
The EVR metric looks at the amount of income you’re missing out on when a unit is left unoccupied. To find this, add up the rents lost during the vacancy period and divide their sum by the total rent that would have been collected in a year. The resultant value will be the economic vacancy rate.
Significance of EVR
As an investor, it’s always a wise practice to keep a keen eye on your personal vacancy rates, as well as your overall market occupancy rate. To be cautious, build the EVR rate into potential income calculations before buying a new property. It is ideal to keep a tentative buffer of 5-10% vacancy into all your expense calculations. This will ensure that you can cover all expenses when units go unrented.
Gross Rent Multiplier (GRM)
GRM helps you, as an investor, compare real estate properties and roughly determine their worth. The gross rent multiplier is calculated by dividing the property’s price by its gross rental income. A “reasonable” GRM value will depend on the compared properties and the local real estate market.
Cash Flow
Cash flow indicates how well your business is doing. It is the net cash left with you at the end of the month after you’ve received the rental income of your rental properties and paid the liable expenses. For instance, if you rent a building for $2,500 a month, and the associated costs are $1,500, your net cash flow is $1,000.
Operating Expense Ratio (OER)
The Final Word
Real estate investment metrics serve as great assistance for investors during their decision-making process regarding the sale and purchase of properties. These KPIs in real estate also help track performance to identify problems timely before they damage your business. Each KPI in real estate tells the story about your business or property from a different angle and a whole new perspective. It enables you, as an investor to have a 360-degree round-up of your investment decisions. Therefore, it is always essential to make use of these real estate metrics for making informed and calculated decisions about your real estate investments.
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