It’s important to gain an understanding about the financial characteristics of the deal you are investing in, but many investors don’t know how. In this blog, we’ll discuss the major real estate metrics and how to use them to make wise decisions when buying, holding, or selling private real estate.
Before we get started, my name is Logan Moore.
I’m a due diligence analyst for private real estate transactions. I work with financial advisors, family offices, and high net worth individuals to help them identify alternative investments that align with their values. For a few pieces I did on the topic of evaluating private investments, check out the links below.
And now – let’s get into it!
#1 NOI and operating expense ratio
NOI stands for Net Operating Income. It is what is left over after you subtract out all the operating expenses from the property’s top line income (usually rent and other ancillary income). NOI is the difference between this income and the operating expenses associated with the property, such as taxes, utilities, insurance, and maintenance. NOI tells you how much profit the property generates regardless of the capital structure (i.e. the amount of debt). It is a useful metric for comparing two or more properties to determine which one is more profitable.
Operating expense ratio is the inverse to NOI. It is found by dividing the operating expenses by the operating income of the property. The lower, the better. It is important to have an understanding of what a “typical” operating expense ratio is for the asset class you are evaluating. For example, multifamily (apartments) tends to be less operationally intensive than senior living, so it is expected that the former would have a lower operating expense ratio than the latter, all else equal. Also, it can give you a back of the napkin estimate about the underwriting of the asset; an operating expense ratio that is outside the typical range may indicate aggressive underwriting or the potential for operational improvements.
These two ratios can tell you how efficiently a property runs. If the expenses are too high relative to the income earned, there is potential for distress. Before investing, it would be wise to discern which changes would need to be made to achieve higher profitability.
#2 LTV and LTC
Loan to Value Ratio
The Loan to Value ratio is expressed as the amount of debt divided by what the property is worth. The former includes the mortgage used to acquire the property but may also include other forms of debt such as second lien debt, construction loans, preferred equity, etc. The value of the property is typically determined by an appraisal.
Loan to Cost ratio
The Loan to Cost ratio is expressed as the amount of the financing for a property divided by the total cost to get the property to its ideal operating condition. For a new development, this is the construction cost. For an existing property, this includes the purchase price plus any capital expenditures needed to improve the property.
LTV and LTC are often used together. When these ratios are high, generally over 80%, it means the amount of debt on the property is high relative to what it’s worth. It is an expensive investment and is not a good candidate for lending (in the bank’s eyes).
Investors should evaluate LTV and LTC carefully and proceed with caution regarding any outliers. Higher LTV or LTC indicates a greater potential for loss to the LPs if the property does not perform as expected or there is a decline in the value of the asset.
#3 DSCR
DSCR stands for Debt Service Coverage Ratio. This metric compares NOI against the principal and interest payments for a property. If this ratio is below 1.0, it indicates poor financial condition and high risk of default because the property does not generate enough profit to pay its debt. While a ratio greater than 1.0 indicates a higher ability to meet debt obligations, it is not a guarantee that the project will perform well. Additionally, lenders will often have a higher coverage requirement when making new loans and/or on an ongoing basis. This provides them some cushion in case things do not work out perfectly. DSCR should be assessed along with other solvency ratios.
#4 Cost per unit and cost per foot
Cost per unit is useful in evaluating any property that has a fixed number of rentable spaces, such as multifamily, self-storage, RV parks, senior living, etc. It is the cost of the entire property divided by the number of units.
Cost per square foot is a straightforward calculation of the property’s cost divided by total square feet. This can also be evaluated using only rentable square feet (i.e. excluding common areas that do not generate revenue).
Cost per unit and cost per foot are useful when comparing rental properties. They can help assess if one property is more or less expensive than another property after accounting for difference in size or number of units. They are also used in concert with rental rates to determine if projected rents can cover the cost of the property and what the likely cash flow will be for both the unit and the property overall.
#5 Occupancy and Vacancy rates
These are very straightforward measurements. Occupancy rate is the percentage of a property’s units that are occupied, while vacancy rate is the inverse (the percentage that are unoccupied).
The Occupancy and Vacancy rates of a property are a good indicator of its demand and cash flow potential. These can vary seasonally and with economic trends depending on the asset types. Vacancies are usually caused by either demand fluctuations, poor property conditions, or other shortcomings in the business plan. High vacancy rates may be a red flag, or they may be an indicator of a poorly run asset that has upside potential through better management, and should be evaluated in conjunction with vacancy rates for other properties in the area.
Are you looking to get started?
Thanks for reading to the end of this blog about real estate deal metrics. Did you decide that private real estate investing is worth it for yourself or your clients? If so, let’s set up a time to talk.
I am a due diligence analyst and financial advisor with over eleven years of experience evaluating investments and would be happy to provide insights that can help you get started.
