A Project Will Produce An Operating Cash Flow Of Real Estate Analysis Ratios Investors Should Understand

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Real Estate Analysis Ratios Investors Should Understand

Real estate investment requires timely operating decisions. Some for day-to-day operations and some for long-term investment strategies based on portfolio considerations of real estate investors.

For that reason, real estate investors typically use proforma operating statements for management planning decisions. A pro forma includes expected and forecast levels of cash flow and 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 many of those ratios and formulas.

1. Economic value – It is a measure of value from a real estate investor’s point of view. In other words, it represents what the asset is worth to the investor. Economic value is determined by the property’s NOI and the capital rate appropriate for a real estate investor to attract that particular investor’s capital to the project.

Formula: Economic Value = Net Operating Income (Specific Asset) / Capital Rate (Individual Investor)

For example, an investor has established that the best cap rate for a particular area is 6.0 and wants to determine the financial value of an apartment complex that generates a net operating income of $30,000. The result would be $500,000 (30,000/6.0). In other words, if the property is worth more than $500,000, the investor knows that the financial value has not been met, and therefore cannot warrant a closer look.

2. Ratio of operating expenses – It indicates the percentage of gross operating income (GOI) consumed by operating expenses. This is useful to understand because investors can make certain determinations about assets based on operating expense ratios for similar assets.

In other words, if the same competitive asset has an expense ratio of, say, 42% and the subject investment asset has an expense ratio of, say, 36%, the investor learns something about the asset. Either there is good cost management or all the costs associated with the property are not fixed.

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

3. Break-even ratio – This ratio (also called the default ratio or BER) provides the investor with the percentage of total operating income that will be used for operating expenses and debt service. This is often a benchmark ratio used by lenders when underwriting commercial mortgages because it estimates how vulnerable an income property is to loss of rental income if it defaults on its loan.

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 net operating income covers debt service. In other words, it indicates to investors and lenders whether the property provides enough income to repay the loan.

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

For example, a ratio of 1.0 means that the property has generated enough income to pay off the debt without leaving a penny left over. So, a ratio of 1.20 means that the net operating income produced by the property is 120% greater than the debt service and therefore it can make the mortgage payments with a balance of 20%. In this case, lenders typically look for a NOI cushion and require a DCR of 1.15 or higher.

OK, here’s some advice.

Note that this ratio (although very easy to calculate) 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 analysis. It is wise for you to understand these ratios, however, always be prepared to validate and crunch all the numbers before you make your real estate investment.

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