The real estate investment industry involves a lot of math, and understanding real estate finance includes knowing a lot of formulas and ratios. Sometimes it’s easy for even the best of us to forget or confuse many real estate formulas. This post will serve as a helpful guide to common real estate formulas you should know.
The capitalization rate, also just called the cap rate, is used by many investors to quickly determine what a property is worth, or to measure the performance of a property they already own. The advantage of the cap rate is that it takes into account vacancy, credit losses, other income, and operating expenses. It also doesn’t require a multi-period projection of cashflows. The disadvantages of the cap rate are that 1) It only looks at the first year of operating data, 2) It doesn’t take into account debt financing.
Cash on Cash Return
The cash on cash return measures the first year cash return of against the cash invested at the beginning of the year. The advantage of the cash on cash return is that it takes into account vacancy, credit losses, other income, operating expenses, AND debt financing (unlike the cap rate). It also is a simple formula that does not require projecting out cash flow over multiple years. The downside of using the cash on cash return is that it only takes into account one year of operating data.
Gross Rent Multiplier
The gross rent multiplier is the ratio of sales price over potential rental income (PRI). This is a simple measure that can give you an indication of value relative to market trends. The downside to this formula is that it only takes into account one year of data, and does not take into account operating expenses, debt financing, taxes, or risk.
Loan to Value
The loan to value ratio (LTV) is simply the ratio of the loan amount to the value of the property. This is a critical constraint banks face when financing a property, and ultimatey the value side of the equation is typically restricted by a third party appraisal.
Debt Service Coverage Ratio
The debt service coverage ratio (DSCR) is expressed as net operating income (NOI) divided by total annual debt service. This is another critical constraint banks face when financing a property. Typically both the loan to value ratio and the debt service coverage ratio will be determined by a banks loan policy. These are both important formulas to know because a loan amount will almost always be limited by the lesser of the two constraints. In other words, the maximum loan amount will be limited by either LTV or DSCR.
Operating Expense Ratio
The operating expense ratio is simply the total operating expenses divided by effective gross income (EGI). This ratio is a useful measure that shows you what percentage of income is consumed by operating expenses. Looking at operating expense ratio trends over time in a multi-year analysis can sometimes reveal important trends.
Internal Rate of Return
Internal rate of return (IRR) for an investment is the percentage rate earned on each dollar invested for each period it is invested. IRR is also another term people use for interest or yield.
Net Present Value
Net present value (NPV) is an investment measure that tells an investor whether the investment is achieving a target yield at a given initial investment. NPV also quantifies the adjustment to the initial investment needed to achieve the target yield assuming everything else remains the same.
Understanding IRR, NPV, and discounted cash flow analysis is critical for real estate investors, but it’s not immediately easy to grasp. Here’s another post that will give you a more intuitive understanding of IRR and NPV, and here’s one that will give you a better grasp of discounted cash flow fundamentals.