Ratios Real Estate 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 pro forma operating statement for management plan decisions. The proforma incorporates anticipated 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 property is to the investor. Economic value is determined by the property's NOI and a capitalization rate suitable enough to the real estate investor to attract that specific investor's capital to the project.

Formula: Economic Value = Net Operating Income (specific property) / 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 complex that produces a net operating income of $30,000. The result would be $500,000 (30,000/6.0). In other words, if the property is priced over $500,000 the investor knows that the economic value has not been met, and therefore the property 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 for investors to understand because he or she can make some determinations about a property based on the operating expense ratios of similar properties.

In other words, if similar competing properties typically have an expense ratio of, say, 42% and the subject investment property has, say, a 36% ratio, the investor learns something about the property. It either has a good handle on the management of expenses or some or all of the expenses indicated for the property may be skewed or improperly ascertained.

Formula: Operating Expense Ratio = Operating Expenses / Gross Operating Income

3. Break-even 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 vulnerable an income property is to defaulting on its debt should rental income decline.

Formula: Break-even 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 property produces enough income to cover the loan payment.

Formula: Debt Coverage Ratio = Net Operating Income / Debt Service

For example, a ratio of 1.0 means that the property just produces enough income to make the loan payment without a penny to spare. Whereas a ratio of, say, 1.20 means that the property's net operating income is 120% higher than the debt service and therefore does produce enough income to 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 full real estate analysis. Always be prepared to validate and crunch all the numbers before you make your real estate investment decision.

James Kobzeff is the developer of ProAPOD - leading real estate agent software solutions since 2000. Work with rental property today. Create APODs, proformas, and other rental property analysis presentations in minutes! Learn more at => http://www.proapod.com

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