Whether they’re seasoned or new, savvy real estate investors are always on the hunt for their next big profit. But deciding where to sink your hard-earned cash can be tough: return on investment and debt service coverage ratios don’t always tell the whole story about a property.
To help guide your decision-making when evaluating a real estate investment deal, we asked several seasoned investors to share their top metrics for quickly determining if a property is worth your time and money. After we determine that one exists, it’s generally a simple matter of calculating your return on investment to decide whether or not to pursue it. So if you are also looking for a guide, then congratulations, you landed at the right place. Let’s start;
Must-known Tricks for Evaluating a Real Estate Investment
- Net Operating Income
- Capitalization Rate (Cap Rate)
- Internal Rate of Return (IRR)
- Cash Flow
- Gross Rent Multiplier (GRM)
Net Operating Income
Net operating income, or NOI, is a key metric for measuring the viability of an income-generating property. To calculate it, you add together all the revenue streams from your property (monthly rents, for example) and subtract the building’s operating expenses (mortgage payments, insurance costs, water, and gas).
The result is your net operating income: the total amount you can derive from a building over time. It tells you if a specific investment will generate enough income to make mortgage payments.
Capitalization Rate (Cap Rate)
Capitalization Rate (Cap Rate) is the most important figure when evaluating a real estate property. It tells you how much of your return comes from all the rents, fees, and other income measures, not from the value of the building itself. It’s so important that more than 80% of all valuations for financial institutions use it as one of their primary valuation measurements.
Think about it this way: If you buy a $1 million building for $900,000 and lease it, making $100,000 a year in net operating income, your cap rate is 10 percent—a good return on your money. If you pay $1 million but produce only $50,000 in net operating income in the same time frame, your cap rate is 2.5 percent—not such a great return on your investment.
Internal Rate of Return (IRR)
Use IRR (Internal Rate of Return) to estimate the interest you’ll earn on each dollar invested in a rental property over its holding period. It’s the rate of growth that a property has the potential to generate. The calculation goes beyond net operating income and purchases price to estimate long-term yield.
Cash flow is an essential aspect of owning a rental property. If you’ve never calculated or looked at your cash flow, it could be time to take a closer look. Knowing your net cash flow can help you predict the future costs and income from your property – and plan for your future.
Gross Rent Multiplier (GRM)
The gross rent multiplier (GRM) is a metric used to evaluate a building’s price to income ratio. GRM helps investors compare properties and roughly determine a property’s worth. It’s calculated by dividing the property’s price by its gross rental income: GRM = property price / total annual rent. Gross rental income includes base rent, additional rental income, and income from other sources, such as parking, laundry, etc. A lower GRM tends to indicate more value.
There is a lot to consider when buying real estate investment. Use these figures to make the keenest possible assessment of your potential purchase, and create targeted goals for maximizing your return on investment.