The real estate investment market does not operate by “gut feeling,” and neither should you. In order to make the best investment decisions, you should evaluate potential deals, properties, and projects by using quantifiable information and established numerical tools. In short, you need to get the right data and use it in the right way. Fortunately, this data and the ways to use it is not some trade secret or proprietary algorithm. When you evaluate a potential real estate investment, getting the appropriate information will not be difficult. And as for using it in the right way, below are four crucial metrics that are invaluable for determining the potential success of a real estate investment.
Cap rates are the lingua franca of commercial real estate, and just like any common language, cap rates are used in a variety of ways depending on the context. The simple definition of a cap rate is the yearly income of an investment divided by the price of the asset itself. For those new to real estate investing, cap rates can be a confusing inverse of the common impulse to buy low and sell high. When it comes to cap rates, it’s (typically) better to buy high and sell low.
A full understanding of cap rates can help investors determine the strength of a market, the potential for appreciation, and the amount of risk associated with the investment. These determinations, however, draw upon a number of different metrics. It is worth noting—and repeating—no single metric can tell you how well a real estate investment will perform. A successful investor will analyze an investment through multiple perspectives using a variety of numerical tools to get a complete picture of a prospective investment.
Commercial real estate investments like multifamily properties, office buildings, and retail assets are valued differently than smaller properties like single family homes. There is a measurable income associated with commercial real estate, and the investment does not rely solely on the appreciation of the property value for its returns. Net Operating Income (NOI) tells investors exactly how much income they can expect from the operation of a given property.
Specifically, NOI is calculated by starting with the sum of all the income associated with the operation of the property, things like rent as well as fees for things like parking and various amenities, and subtracting all the operating expenses like maintenance, landscaping, and utilities. Because NOI is net “operating” income, expenses unrelated to operation, like asset management fees and debt service, are not a part of NOI.
3. Cash on Cash
Cash on Cash is a broader metric than net operating income. While net operating income is a limited view of the cash inflows and outflows related to the operation of a property, cash on cash captures NOI in addition to the costs related to financing a project. These include mortgage and loan rates.
To calculate the cash on cash return, you need to first take the net operating income and subtract any costs related to financing the property. You then divide this amount by the amount invested in the property. Cash on cash can be calculated at the level of the individual investor and can be adjusted for different roles, like a limited partner or a sponsor of an investment.
The Internal Rate of Return (IRR) is a relatively simple concept, but its calculation is slightly more complicated. To oversimplify, IRR measure measures the rate of return on an investment. The factors and considerations affecting this measurement complicate this simple definition, but not in a way that is difficult to understand.
The Internal Rate of Return (IRR) is a relatively simple concept, but its calculation is slightly more complicated. To oversimplify, IRR measures the rate of return on an investment. The factors and considerations affecting this measurement complicate this simple definition, but not in a way that is difficult to understand.
4. Debt-Service Coverage Ratio
What percent of your cash flow will you need to cover your debt obligations? This is your Debt-Service Coverage Ratio (DSCR). To find this value, you take your net operating income (see above) and divide it by all of the debt obligations associated with the investment. The DSCR is an important metric because it provides an easy snapshot of how cash flow measures up against financing costs. Cash on cash measures cash inflows and outflows against the investment itself, but DSCR only looks at the NOI divided by debt obligations.
Using Commercial Real Estate Investment Metrics
If you only use one of these metrics, you will be making a mistake. To repeat my earlier point, no single metric can tell you how well a real estate investment will perform. A property can have an attractive cap rate, but the projected IRR could paint a completely different picture. You might find a property with an NOI that makes sense when interest rates are low but makes little sense when rates go up.
These measurements are an important starting point to making successful investment decisions, and Gray Capital is committed to helping you at every stage of your investment journey. With the latest news, research, and reports, our free weekly newsletter will keep you informed of the most important trends and ideas shaping the commercial and multifamily real estate market. Click the link below to sign up.