Real Estate examination Ratios Investors Should Understand
Real estate investing requires operating decisions be made on a timely basis. Some for day-to-day operations and others for long-run investment strategies based upon the real estate investor’s portfolio considerations.
For that reason, real estate investors typically make use of a proforma operating statement for management plan decisions. The proforma incorporates expected and forecast levels of cash flow and often includes a number of useful ratios, multipliers, and other analytical formulas developed to make better use of that cash flow information.
In this article, we will discuss several of those ratios and formulas.
1. Economic Value – This is a measure of value from the standpoint of the real estate investor. In other words, it shows what value the character is to the investor. Economic value is determined by the character’s NOI and a capitalization rate appropriate enough to the real estate investor to attract that specific investor’s capital to the project.
Formula: Economic Value = Net Operating Income (specific character) / Capitalization Rate (individual investor)
For example, say the investor has established that the best cap rate for a specific area is 6.0 and wants to determine the economic value for an apartment complicate that produces a net operating income of $30,000. The consequence would be $500,000 (30,000/6.0). In other words, if the character is priced over $500,000 the investor knows that the economic value has not been met, and consequently might not warrant a closer look.
2. Operating Expense Ratio – This provides an indication of what percentage of the gross operating income (GOI) is being consumed by operating expenses. This is helpful to understand because the investor can make some determinations about a character based on the operating expense ratios of similar similarities.
In other words, if similar competing similarities typically have an expense ratio of, say, 42% and the subject investment character has, say, a 36% ratio, the investor learns something about the character. That either is has better management of expenses or that all of the expenses associated with the character may not have been ascertained.
Formula: Operating Expense Ratio = Operating Expenses / Gross Operating Income
3. Break-already Ratio – This ratio (also called default ratio, or BER) provides the investor with the percentage of gross operating income operating that operating expenses and debt service will consume. It is often a benchmark ratio used by lenders when underwriting commercial mortgages because it estimates how unprotected an income character is to defaulting on its debt should rental income decline.
Formula: Break-already Ratio = [Operating Expenses + Debt Service] / Gross Operating Income
4. Debt Coverage Ratio – This ratio (also known as DCR) provides information on the extent to which the net operating income covers debt service. In other words, it indicates to investors and lenders whether the character produces enough income to cover the loan payment.
Formula: Debt Coverage Ratio = Net Operating Income / Debt Service
For example, a ratio of 1.0 method that the character just produces enough income to make the loan payment without a penny to spare. while a ratio of, say, 1.20 method that the net operating income produced by the character is 120% higher than the debt service and consequently can make the mortgage payment with 20% to spare. In this case, lenders typically look for an NOI cushion and require a DCR of 1.15 or greater.
Okay, here’s some advice.
Bear in mind that these ratios (though very easy to compute) alone does not provide enough information to make a prudent investment decision. They are only useful when integrated as part of a complete real estate examination. It is wise for you to understand these ratios, nonetheless, always be prepared to validate and crunch all the numbers before you make your real estate investment.