Five Key Ratios You Must Know When Investing in Real Estate
July 8, 2017
Capitalization Rate (Cap Rate)
Cash return on investment (Cash ROI)
The total return on investment (Total ROI)
The debt service coverage ratio (DSCR)
The gross rent multiplier (GRM)
These key factors help you to determine if a potential investment is worthy of your capital. I would encourage all investors to know your math on the property before you purchase anything.
Capitalization Rate = net operating income/ sales price
Cap rate measures the income generated by the property and the price it is being sold for.
Net operating income = gross income – total operating expense
It does not include mortgage expense but as if you were to pay cash for the property. NOI represents the portions of income that is yours to keep (before taxes and capital improvement, or the yield on your investment.
Cash ROI= remaining cash after debt service/ cash investment.
Cash Return on Investment (Cash ROI) is your cash rate of return on invested capital.
Cash ROI is calculated after debt service, whereas Cap Rate is calculated before taxes. So if you were to pay all cash on an investment property your Cash ROI and Cap rate would be the same.
Total Return on Investment (Total ROI) = (remaining cash after debt service + principal reduction) / cash investment
NOI takes into account the portion of the loan that is reduced each year by payments that are applied to the remaining loan balance, or the principal portion of the loan payment. Total ROI captures both cash and non-cash portions. The non-cash portion is similar to making those payments for 10, 20, or 30 years. The value is there in the form of increase equity in your house as you reduce the loan balance a little at a time over a period of years. The gain is realized and converted to cash at the time of sale.
Debt service coverage ratio = net operating income / debt payment
This ratio is extremely important to lender. It shows your ability to service the outstanding debt or make payments. The most common ratio averages 1.20. It also helps you as the borrower to determine whether there is adequate cash flow to service the debt.
If the deal does not provide sufficient cash flow to meet the DSCR requirements with a 20% or lower down payment chances are you will want to pass on the deal. Reminder, if you decide to just put a higher down payment down than you are reducing the cash and total ROIs. The whole purpose is to maximize your wealth.
GRM measures the relationship between the total purchase price of a property and its gross schedule income or simply the ratio of price to income.
Now, it might seem like the GRM is similar to the Cap Rate but there are two primary differences. The GRM measures gross revenue to price, while Cap Rate measures net revenue to price. The ratio is also inverted thus a larger GRM is preferred.