In the exciting world of real estate investing you hear a variety of ratios thrown around.  These are often confusing because they are used in a variety of ways and often wrong.  Which means it is even more important to understand their intended functions.  This is the second of a three-part series defining real estate investment terms and ratios you should know as you analyze possible purchases.

In part two of this series we look at ratios used to interpret the strength of an investment property.  These are the term we see used by experts in defining the viability of an particular property as a good, or not good, investment.  This is not a comprehensive list, but touches upon the most important ratios:

  • Capitalization Rate (Cap Rate):  This is probably the most used metric in looking at investment properties.  Measuring the annual rate of return on rental real estate as a percentage, not including debt service.   It is the ratio between the net operating income (NOI) and purchase price of the property.  One of the major mistakes made is using Gross Income instead of Net Income, which will inflate the rate and make the investment look better than it is.   Another mistake is to include discretionary expenses in calculating NOI, affecting the ratio negatively and making the property look worse than it is.  Capitalization Rate is often used as a comparison between real estate and other types of investments.
  • Cash on Cash Return (CCR):  This is an investment metric measuring the return on the actual cash invested, or total cash outlay to buy the property.  It is measured annually and as a percentage. Taking cash flow and dividing it by total cash outlay, gives us the return on our cash.  This is useful specially when there is a mortgage on the home, giving insight on how well cash is working versus other potential investments.
    • Cash Flow/Total Cash Outlay including closing costs = Cash on Cash Return
    • Example: Cash Flow = $5,600, total cash outlay = $62,000 =  5600/62000 = 9% cash on cash return
    • A good CCR, acording to investors, is between 7 adn 12%.
  • Return on Investment (ROI):  Useful tool for comparing different types of investments.  Investors will strive for the maximum ROI for each dollar invested.  It is calculated by dividing the net income earned by the total invested.
    • Formula to look at Rental Properties on an annual basis: 
      • Cash Flow/total Cash Outlay at purchase = ROI
    • Formula for ROI at sale:
      • (Total Gain – Total Cost)/Total Cost
      • Real Estate components of overall Rate on investment can include:
        • Appreciation
        • Amortization
        • Cash Flow
        • Tax Benefits
      • A good ROI is above 8% for most investors.
  • Debt Service Cover Ratio (DSCR) or Debt to Coverage Ratio (DCR):  Measures the strength or ability of the property to pay the mortgage payment after expenses are paid out. This number is very important to lenders, who are looking for a 1.25 or higher, in order to issue a loan only on the strength of that property.
    • NOI/Principal and interest payment= DSCR/DCR
  • Internal Rate of Return (IRR): A metric indicating the average annual return investors have either realized or can expect to realize from a real estate investment over time, expressed as a percentage. The idea is to measure both time and profit in one single metric, to gauge the potential of the investment.

These are all ratios that help real estate investors measure the efficacy of their holdings or potential purchases. By using these metrics it is possible to determine how attractive an investment is, in relation to the risk profile and goals of the individual investor.  This is an important point, since each investor is different, there is no perfect number to define an investment for everyone. Each individual has to define their level of comfort. What is good for one person may not work for another. That said, each of these concepts is helpful in analyzing properties. 

In part three,  investment
financing terms are defined and explained