Despite the anecdotal evidence that investing in property is a sure-fire way of accumulating wealth, it’s by no means a given. In fact, the truth is that somewhere between 90 and 95 percent of first-time investors in real estate fail in their first year, and of the survivors, 40 percent will fail within five years.
A successful rental property investment requires an in-depth analysis of its potential profitability. Investors should consider certain key metrics when assessing income, expenses, and risk. Understanding and analyzing these metrics will ensure you make informed, profitable decisions.
In this post we’ll cover metrics to help you make an educated investment. All the key metrics measure a rental property’s potential income, the expenses incurred in achieving that income, and the assessed risks from factors such as market conditions, economic changes, or increased local competition. Personally speaking, my initial ‘go to’ metrics are the cap rate for stable cash flowing properties, and the internal rate of return (IRR) for investments that will need capital expenditure (often referred to as value add deals). If those meet my minimum threshold for consideration, I’ll review the other metrics.
Nett Operating Income (NOI)
In simple terms, net operating income (NOI) is the income generated by a property minus direct operating expenses.
Net Operating Income (NOI) = (Rental Income + Ancillary Income) – Direct Operating Expenses
Investors in rental real estate consider NOI the industry’s standard measure of profitability. However, it doesn’t consider equally important non-operating expenses such as depreciation, interest, income taxes, capital expenditures, or financing costs.
A rental property with a positive NOI greater than comparable properties would be considered a good investment, while clearly, those with a negative NOI are unprofitable operations you’ll want to avoid.
Capitalization Rate (Cap Rate) Metric
The cap rate combines the elements of income and risk to assess a property’s expected rate of return, determining its attractiveness as an investment and whether it is correctly priced.
Cap Rate = (NOI ÷ Current Market Value or Purchase Price) x 100
The cap rate is a useful metric for comparing properties’ values with similar risks and returns. With a given NOI and a market-related cap rate, you can assess what purchase price to offer in a transaction.
A low cap rate is associated with a low-risk property with a stable income. In contrast, a high cap rate indicates a higher return but at a higher level of risk. Which is most appealing to you as an investor depends on your investment strategy.
Internal Rate of Return (IRR) Metric
The IRR is the annualized interest rate applied to the initial capital investment to reach the final value at the end of the investment period.
Where the cap rate metric uses income for a single year, the IRR measures the total return over the entire investment period. The income is annualized and includes both operating income and the estimated appreciation in value over time.
As an investor, you should consider using the IRR, particularly when assessing the profitability of a long-term investment. It gives a more accurate estimate than the “snapshot” provided by the cap rate but has its limitations:
- Cash Flows: The IRR is highly sensitive to the timing of cash inflow and expenditure, so it can be misleading if they don’t go according to plan.
- Holding Periods: The IRR from an investment will be inflated if its holding period is shortened or lowered if it is extended.
Cash Flow is a Key Metric
Cash flow is a simple but key metric. It is the amount of money remaining at the end of a period (monthly or annually) after paying all expenses, including the mortgage. Positive cash flow illustrates that the property can more than cover its costs and provide an income while it appreciates over time.
Cash Flow = Total Income – Total Expenses
Gross income includes:
- Rental income, with a contingency for unexpected vacancies, late payments, and defaults
- Ancillary income such as parking fees, management or administration fees, marketing charges or charges for using roof space, storage, or anything unrelated to the rental stipulated in the lease
Gross expenses include:
- Local and state property taxes
- Property owner association (POA) fees
- Maintenance and repairs
- Insurance
- Debt financing costs
Cash-On-Cash Return (COCR) Metric
COCR is the key metric defined as the ratio of total cash earned in a given period to the total cash invested in the property. The formula is:
Cash on Cash Return = (Annual Pre-Tax Cash Flow ÷ Total Cash Invested) x 100
COCR also called the cash yield on a property, is one of the most important rental real estate metrics. It is especially beneficial for investors who finance a property purchase with a mortgage rather than paying for it in cash.
Gross Rent Multiplier (GRM)
The GRM is one of the simpler metrics investors should consider when assessing the profitability potential of a rental property. It’s an easy way for you to compare similar rental real estate units within a location. The formula is:
GRM = Property Purchase Price ÷ Annual Gross Rental Income
The lower the GRM, the better the rental performance relative to price. However, as an investor, you need to be aware that this calculation doesn’t consider the operating expenses relating to the property. While it’s a worthwhile metric for comparison purposes, it doesn’t measure profitability.
Debt Service Coverage Ratio (DSCR)
The DSCR is an important metric, particularly when you use mortgage finance. It measures a property’s ability to generate sufficient income to service all debt obligations. A DSCR that is less than 1 is an indication that there is insufficient income.
DSCR = NOI ÷ Annual Debt Service (Mortgage Payments)
The DSCR is a key metric for lenders, who are unlikely to provide finance that income cannot cover adequately.
Loan To Value (LTV) As a Key Metric
From my experience in property finance, I know how important this metric is to financial institutions when deciding on the viability of a loan. Investors willing to risk their own equity in property are far more likely to receive better interest rates and terms.
LTV = (Loan Amount ÷ Assessed Value or Purchase Price) x 100
As an investor, the lower the LTV, the better your cash flow and the more profitable your investment. Lenders tend to be wary of loans where the LTV is higher than 90%, but this depends on current market conditions, interest rate trends, and demand for property.
The Occupancy Rate Metric
The occupancy rate of a rental property can be expressed as a percentage of the total units in the building. However, I prefer to define it as the ratio of occupied space to total usable rental space, using floor area rather than the number of units.
There are other sides to this key metric:
- The vacancy rate is the inverse of the occupancy rate, so an 80% occupancy rate translates to a 20% vacancy rate.
- You can measure it in physical terms by using the floor area or number of units as your criterion. However, measuring the occupancy rate in economic terms of rental income gives a more accurate picture of the effect on profitability and the property’s financial health.
Conclusion
The nine key metrics I’ve covered are by no means the only ones helpful in analyzing rental properties. However, as an investor, I recommend that you consider them valuable tools in maximizing profitability and reducing the risks involved in your rental property investments.