Welcome to the second of a series of articles to help demystify the many terms and numbers used in real estate investing. The goal of this series is not only to help define terms, but also identify how to properly use the concepts to evaluate and close deals.
Check my first article in the series for a quick overview of what a Sophisticated Investor is and why it’s important.
So What are the 6 Metrics you Need to Know?
Billionaire Andrew Carnegie famously said that 90% of millionaires got their wealth by investing in real estate.
While this is true historically, we’ve seemed to have reached a level of interest and participation in real estate investing that we’ve never seen before.
The result is an overabundance of new investors forging ahead without following proper due diligence.
You can’t turn on the TV without finding a half-dozen shows on house flipping, rehabs and income properties. You can’t go down many blocks in any city without seeing cranes and construction everywhere.
A big part of the demand is a strong economy and the persistently low mortgage interest rates that have been in place for 10 years now.
Access to investment options is also at an all-time high, so you may have already jumped in or be close to it.
But before doing so, I’m going to break down the 6 metrics you need to know and evaluate to differentiate a risky or OK deal with a GREAT one.
Our main investing strategy is of the buy and hold variety, so that’s what I am going to focus on.
A Word of Caution
Let’s talk about specifics on what to look at when evaluating return projections. First, I never recommend doing what I call paper-napkin analysis or creating a spreadsheet on your own.
While this can work for a sniff test on a property to see if it can be profitable, it will not give you information you need to truly understand the short and long term potential and risk.
We use tools to analyze deals, which in many cases are spreadsheet based, but with very complicated formulas that evaluate a deal against each and every metric we are about to dive into.
A good one to start with is the BiggerPockets Rental Property Calculator. I use some others which are more geared to our syndication offerings. I’d be happy to share these, so let me know if you’re interested.
Before jumping in, know that some metrics can be taken alone to pre-screen a property, but should be evaluated in combination during your analysis. This process is called underwriting.
Again, USE TOOLS!
The Case Study
We will base the examples we use on the following property:
5-unit apartment building being acquired for $600,000
Capital invested (25%) = $150,000
Rents: $1,250 per unit = $6,250 / mo or $75,000 / yr
Taxes: $5,000 / yr
Insurance: $2,500 / yr
All other expenses (utilities, vacancy loss, management, maintenance, etc): $1,625 / mo
Mortgage (Debt Service): $2,500 / mo
Total Gross Rents = $75,000
Total Expenses = $27,000
Net Operating Income = $48,000
Debt Service = $30,000
Cash Flow = $18,000
OK, let’s jump into the 6 metrics you need to know to find great deals!
1 – Cash Flow
Cash Flow = Net Operating Income – Capital Expenses – Debt Service
Example: $48,000 – $5,000 – $30,000 = $13,000 / yr or $1,083 /mo
Cash flow is the difference between the gross rental income and rental property expenses, including capital expenses (big ticket improvements) and debt service (mortgage).
In the example above we had a $5,000 improvement during the year. This could have been a roof, HVAC, etc.
The cash flow projection of a real estate investment is called pro forma cash flow. This projection allows real estate investors to evaluate the overall cash flow of a property for a defined period in the future.
Cash flow is probably the easiest concept to grasp, but can be one of the most difficult to determine.
The reason is that cash flow includes many variables that can and will change depending on who owns or manages the property, not to mention market changes in rents.
For example, if the current owner/manager does little in the way of preventative maintenance – like regularly servicing HVAC systems – then they could have positive cash flow in one year and then nothing the following year when the system breaks down and needs to be replaced.
Financing terms and mortgage amount is another big one, which will most certainly be different from one owner to the next.
I often hear investors target a cash flow amount that is way too low to be supported long-term. For example, if you have a property that cash-flows $100 a month under normal conditions, a broken water heater can wipe out 10 months of rent overnight!
Our example property has a stable cash flow of $1,500 a month or $300 per unit.
Tip: Target minimum cash flow of $250 a month per unit.
2 – Cap Rate
Capitalization Rate = Net Operating Income / Current Market Value
Example: $48,000 / $600,000 = .08 or 8%
The capitalization rate (also known as cap rate) is used to indicate the rate of return that is expected to be generated on a real estate investment property.
Although you should use it regardless of the size of a property, know that it is less indicative of the value of a property in buildings with 4 or less units.
The reason for this is that lenders consider such properties residential – as opposed to commercial – and base value primarily on sale comparables.
The cap rate is calculated by dividing a property’s net operating income by the current market value.
This ratio, expressed as a percentage, is an estimation for the potential return on an investment, but is only useful to compare to the market and similar properties.
You always want to buy at a higher cap rate and hope to sell at a lower cap rate.
Refer to Sophisticated Investor 101: What is a Cap Rate and Why Most Get it Wrong to learn more and determine what an appropriate cap rate should be for any given deal.
Using our example, the property was bought at an 8 Cap. If 3 years from now nothing changes except for the market cap rate which drops to 7% because of demand, then our property is now worth $48,000 / .07 = $685,714!
Tip: Buy at target cap rates of 7+ and target sell at 6.5-
3 – Cash on Cash (COC) Return
Cash on Cash Return = NOI / Total Cash Investment, or
Cash Flow / Total Cash Investment (When debt payments are included)
Example: $18,000 / $150,000 = .12 or 12%
Cash-on-cash return is the ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage.
Cash on cash return is one of the most popular real estate metrics. Because we are financing the property, you might also see it referred to as levered COC return. The mortgage is the leverage.
Cash on cash return is an indication of whether or not financing a cash investment is a good idea.
In other words, cash on cash return computes the rate of return on an investment property on the basis of the cash invested in it.
Tip: Buy at target COC rate of 8%+
4 – Total Return
ROI = Total Income (over time) – Total Expenses + Equity / Amount Invested
Example: $144,000 – $90,000 + $54,000 / $150,000 = .72 or 72% (24% / yr)
Assumptions: 3 year hold, appreciation rate of $18k per year
Total return is the actual rate of return of an investment or a pool of investments over a given evaluation period which includes income and appreciation.
First, calculate the total annual rental income, then subtract the expenses and debt service from the annual rental income. Add equity appreciation to the cash flow. This is the net income.
Divide the net income by the total investment to get the total return on investment.
Tip: Buy at target ROI of 20%+
5 – Internal Rate of Return (IRR)
IRR = Use a Calculator!
Example: Year 1 outlays – $150,000
Year 1 NOI = $13,000 ($5k for the HVAC)
Year 2 = NOI – $18,000
Year 3 (Sold for $654,000 – $430,000 Loan) = $242,000 ($18,000 + $224,000 profit)
Combined with a sound cap rate analysis, IRR is a key metric used by investment firms to project the return of an investment.
The equation to calculate IRR is best left to a calculator. Know that it is used to evaluate the profitability of an investment over its lifetime and is represented as the average annual return percentage.
Internal Rate of Return uses the time value of money (TVM) to determine an investment’s performance. TVM says that a dollar today is worth more than the same dollar in the future due to its earning capacity.
When evaluating the projected IRR of an investment, focus on the discount rate being used. It should represent the projected cap rate at the time of sale.
Suppose an investment is being marketed with a projected stabilized IRR of 20% using a 6% discount rate. If the market discount rate is 7%, then the projected IRR is going to be artificially inflated based on that single percentage difference.
IRR will change year over year with normal fluctuations of income and revenue. Since IRR is a calculation of TVM, it will peak and then gradually decrease the longer a project is held.
Once a property and the associated returns have been maximized, then your investment dollars would grow at a higher rate by reinvesting the capital in another project with more upside.
This is the primary reason that hold periods on many real estate syndication deals are 5-7 years. 3 to 4 years to maximize the NOI and then 2 to 3 years to establish a track record of stable income.
Tip: Buy at target IRR of 20%+
6 – Equity Multiple (EM)
Equity Multiple = Total Cash Distributions / Total Equity Invested
Example: (total cash flows from above): $273,000 / $150,000 = 1.82
Another popular real estate investing metric is equity multiple. The EM is a ratio used to help understand total cash return over the life of an investment.
The EM differs from the IRR in that it does not take into account the length of the investment period or the time value of money.
Because it does not factor in discount to present value and does not take risks or other variables into account, EM should not be looked at in isolation. Paired with IRR however, you have a powerful combination of metrics.
The EM is a static factor, meaning it will not deviate year-to-year based on income or expense fluctuations.
Tip: Buy at target EM 1.5+
While it may seem intimidating and confusing to analyze a property in so many ways, know that ultimately it comes down to your goals and objectives as an investor. From there it’s a matter of identifying the metrics that give you the confidence you need to make acquisition decisions.
The biggest key to becoming good at analysis is like anything else, practice, practice, practice!
An easy way to do this is to search for properties for sale (try loopnet.com), determine market rents for the area (use rentometer.com), and then use the numbers you know and research the ones you don’t to fill in the blanks.
Accuracy and good estimates on unknown numbers is also important, so pay attention here as well.
What you will discover is that the difference between a risky and great investment is the number of metrics that all tend to fall in line with the tips above.
If you find a property that will cash flow at a solid number then the cap rate and total return projections will also be good.
I’d love to hear your preferred metrics and analysis process, so please comment below.
As always, we love sharing the path to financial freedom, so if you enjoy these articles let me know by sharing to your favorite social network.
Have a great Holiday Season and let’s ring in 2020 with bigger and better deals!