Successful rental property investment requires real estate investors to strictly gauge the financial performance of all potential rental property investment opportunities.
As a result, a number of useful ratios, multipliers, and other analytical measures have been developed as “indicators” the investor can use to determine specific levels of a property’s anticipated cash flows and profitability.
These ratios and measures are part of the real estate analysis, and are commonly displayed in reports such as an APOD and Pro Forma Income Statement.
In this article we’ll consider four of those indicators (with formulas). It should be noted, however, that the results of these calculations are only useful if they can be compared to similar information gleaned from comparable properties in the local market area.
1. Economic Value
This is a measure of value from the real estate investor’s standpoint, and may be more or less the market value of the property (though not necessarily). It is determined by the investment property’s net operating income and a capitalization rate that the investor requires to attract his or her capital to the project.
In other words, regardless what value has been placed upon the rental property by the market, the “true” value to the investor (in this case) is what he or she deems will appropriately satisfy their investment objectives.
Formula
Net Operating Income (specific property)
divided by Capitalization Rate (individual investor)
equals Economic Value
Example
Let’s say a property generates a net operating income of $461,867 and the investor’s desired cap rate is 10.8%. In this case, the economic value (what the rental property investment is worth to the investor) would be $4,276,546.
$461,867
/ .108
= $4,276,546
If this economic value is equal to or greater than the subject property’s fair market value, then the investment property could prove worth pursuing; otherwise, maybe not.
2. Operating Expense Ratio
This ratio provides an indication of what percentage of the gross operating income is being consumed by operating expenses.
The investor’s purpose here is to compare the subject investment property’s operating expense ratio against that computed for other similar properties and then to reconcile substantial differences.
Anything other than the norm, for instance, could be an indication that the subject property’s operating expenses are somehow unique, or perhaps that they may not have all been correctly ascertained. In other words, why such a difference?
Formula
Operating Expenses
divided by Gross Operating Income
equals Operating Expense Ratio
Example
Let’s say the subject property’s operating expenses are $251,998 and its gross operating income (rental income minus vacancy credit and loss) is 713,865. In this case, the operating expense ratio for the rental property investment is 35.30%.
$251,998
/ 713,865
= 35.30%
Naturally, this is just one small element about the subject rental property investment. But a substantial difference in ratios when compared to similar other rental property should raise a red flag that requires a closer look.
3. Break-even Ratio (BER)
This ratio (also called default ratio) is the percentage rate of gross operating income that is consumed by operating expenses and debt service combined.
Its purpose is to estimate how vulnerable an income property is to defaulting on its debt in cases where rental income should decline. This is often a benchmark ratio used by lenders when underwriting commercial mortgages as well.
Formula
Operating Expenses + Debt Service
divided by Gross Operating Income
equals Break-even Ratio
Example
Okay, we already know (from the previous examples) that our subject rental property investment has a gross operating income of $713,865 and annual operating expenses of $251,998. Now let’s say that the debt service would be $255,354. The result would be a break-even ratio of 71.07%.
$251,998 + 255,354
= $507,352
/ 713,865
= 71.07%
These means that the money going out to service the property is 71.07% of the income it generates. Lenders typically look for 85% or less, so this property fairs well in this case.
4. Debt Coverage Ratio (DCR)
This ratio provides information on the extent to which the net operating income covers debt service. The objective for the investor here is to insure that the property can pay for itself without having to “feed it” out-of-pocket.
Formula
Net Operating Income
divided by Debt Service
equals Debt Coverage Ratio
Example
Okay, by dividing the property’s net operating income of $461,867 by the debt service of 255,354, the result is a debt coverage ratio of 1.81.
$461,867
/ 255,354
= 1.81
A ratio of 1.0 indicates enough net income to make the mortgage payment, and lenders typically like to see 1.15 or greater (i.e., 15% more income than the payment). So, either way, this rental property investment appears to produce ample income to cover the mortgage payment.
Illustration (click image to enlarge)
So You Know
ProAPOD provides three rental property investment software solutions that each automatically compute these performance indicators and post to the appropriate reports.
