Successful real estate investing requires that operating decisions be made on a timely basis. Some involve day-to-day operations while others involve long-run strategies based upon the investor’s portfolio considerations.
As a result, real estate investors make use of a pro forma operating statement with anticipated and forecast levels of cash flow for management plan decisions regarding investment property performance. A number of useful ratios, multipliers, and other analytical formulas have been developed to make better use of that information.
Here are some of those formulas, though it should be noted that the results of these calculations are only useful if they can be compared to similar information gleaned from comparable properties.
1. Economic Value is a measure of value from the standpoint of the real estate investor and may be more or less the market value of the property. It is determined by the investment property’s NOI and a capitalization rate that a real estate investor requires to attract that specific investor’s capital to the project.
Formula: Economic Value = Net Operating Income (specific property) / Capitalization Rate (individual investor)
2. Operating Expense Ratio provides an indication of what percentage of the gross operating income (GOI) is being consumed by operating expenses. If the investment property varies substantially from the operating expense ratios of similar competing property, the differences might be attributed either to better management of expenses or to the discovery that all expenses may not have been ascertained.
Formula: Operating Expense Ratio = Operating Expenses / Gross Operating Income
3. Break-even Ratio (BER; also called default ratio) provides the investor with the percentage that operating expenses and debt service will consume of gross operating income. Its purpose is to estimate how vulnerable an income property is to defaulting on its debt in cases where rental income should decline, and is often a benchmark ratio used by lenders when underwriting commercial mortgages.
Formula: Break-even Ratio = [Operating Expenses + Debt Service] / Gross Operating Income
4. Debt Coverage Ratio (DCR) provides information on the extent to which the net operating income covers debt service. A ratio in excess of 1.1 indicates that there should be net income remaining after servicing the mortgage, though lenders typically like to see an NOI cushion and therefore require a DCR of 1.15 or greater on their investment property loans.
Formula: Debt Coverage Ratio = Net Operating Income / Debt Service
