Demystifying Real Estate Investment Metrics: When and How to Use Them

Introduction

Is investing in real estate a potentially lucrative venture? Absolutely. But here’s the catch: to grab profitable deals, you need some understanding of the key financial metrics. Terms like Cap Rates, NOI, IRR, and Equity Multiple can seem complex at first. In this blog, we’ll break them down to help you know when and how to use them effectively when evaluating your real estate investments.

As housing is a need-drive asset, rental income proves to be a consistent and steady source of income, even during economic downturns. As inflation rises, the rental income increases as well, thus outpacing inflation and offering multifamily investors a hedge against inflation.

Understanding Returns

When you’re investing in real estate, one of the most critical questions is, “How much money will I make from this investment?” To answer that, you need to focus on the following return metrics:.

a. Net Operating Income (NOI)

NOI represents the property’s profitability potential. It’s a vital indicator of the property’s ability to generate income. It accounts for the income a property generates depending on the rental revenue and operating expenses. It does not take non-operating expenses, like mortgage interests into account.

NOI = (Gross Operating Income + Other Income) – Total Operating Expenses

A higher NOI represents a profitable investment

By adhering to specific guidelines, investors can sell a multifamily property and reinvest the proceeds into another property, all while deferring taxes. This strategy requires careful planning, adherence to IRS regulations, and professional guidance.

b. Cash Flow

Cash flow is another essential return metric that reflects the actual income you receive from the property after covering all expenses, including mortgage payments and operational costs. What makes cash flow different from NOI is that Cash Flow covers both the mortgage payments and operational costs, while NOI only takes operating expenses into account.

Understanding your cash flow is crucial for assessing your cash-on-cash returns. This means knowing how much money a property generates each year compared to the money you put into it.

c. Equity Multiple

The equity multiple measures how many times your initial investment you can expect to receive in returns over the investment’s lifespan. So, a 2x equity multiple would mean that your invested money has been doubled by the end of the investment lifecycle. Thus, it makes an excellent metric for understanding long-term profitability.

d. Cap Rate

The capitalization rate, also known as the cap rate, measures the yearly return potential of the property, assuming the property is purchased in cash and not on loan.

Cap rate = Net Operating Income/Market Value

High cap rates offer high returns but also involve high risk. While low cap rates involve low risk, it also means a more extended period to recover the investment.

Analyze the Time Value of Money

Internal Rate of Return (IRR) is the most common metric used to determine the time value of money, that is the time it takes to earn the return.

Imagine you have two investment opportunities:

a. Investment #1:

Promises a $250 million return in year one.

b. Investment #2:

Offers a $250 million return, but you’ll have to wait until year four to see it.

In this case, Investment #1 presents a higher IRR because the $250M return occurs earlier in the holding period.

Thus, IRR is a useful metric when comparing two properties with different hold periods.

Evaluation Risk

Investing in real estate involves risks, and it’s crucial to mitigate them. To evaluate the risks associated with your investment, consider these metrics:

a. Doubt-Services Coverages Ratio (DSCR)

DSCR assesses a property’s ability to cover its debt obligations through its operating income. It is calculated by dividing the net operating income by the total debt service.

A high DSCR indicates a lower mortgage default risk. For multifamily properties, 1.20-1.25x  makes an average minimum acceptable DSCR.

b. Break-Even Occupancy

Breakeven Occupancy Ratio = (Total Operating Expenses + Total Debt Service) / Potential Rental Income

As shown in the formula above, break-even occupancy is a ratio of total expenses associated with the property and the total rental income. This ratio represents the minimum occupancy level required for the property to cover its operating expenses and debt service. Thus, a break-even occupancy of 95% represents that the property has to be 95% occupied to be able to cover all the operating and debt expenses. This metric helps you understand the property’s resilience during economic downturns.

CONCLUSION

Each financial metric discussed in this blog serves a unique purpose in evaluating real estate investments. By knowing when and how to use these metrics, you’ll be better equipped to make informed investment decisions.

As a passive investor, we can understand the time constraints you have while evaluating a potential deal. Hence, we ensure that we cut no corners during our due diligence process and provide you with detailed information that we gather. We are here to help you at every step of your investment journey and answer as many questions as you have. If you are looking to start your investment journey alongside us, schedule a call, and let’s talk about your investment goals and design a strategy to align with them.