Real estate is not only about investing when the market conditions are low and then selling high. This might be a common notion but only for those who think that real estate is somewhat speculative like the stock markets. In reality, real estate is straitjacketed by a number of formulas that act as guidelines for the ultimate goal – maximising returns on investments in the shortest possible time. Whether to invest or not in real estate is a matter of math and you should follow set principles and formulas if you want to be a success in this sector.
Here are some of them that you will surely find useful.
- Cash on cash return – This is a measure of the cash returns you get at the end of the year against the cash invested at the beginning of the year. It is a net figure after accounting for vacancy when cash inflow will be NIL, credit losses, operating expenses, other income and debt repayments. The advantage here is that it is a simple formula and does not need complicated calculations to estimate the cash flow over a number of years. On the other hand, by taking into account only one year of operating data it does not permit long term forecasts of payables and receivables.
- Cap rate – The capitalisation rate or cap rate in short is a measure of the worth of the property as well as a way to estimate the performance of the property and the rate of return on investment. The cap rate takes into account vacancy, credit losses, operating expenses and other income. To arrive at this formula multi period projections and estimates of cash flow is not required. The disadvantage here is that the cap rate does not take into account debt financing and that for large high end properties can be substantial. It also considers the first year of operating data only.
- Operating Expense Ratio – Real estate market players always focus on maintenance of property and the quantum of expense outflow from income. This is calculated by the Effective Gross Income Ratio (EGI). For example, if an office rental property in say the State of Victoria frequently has to hire the services of commercial plasterers in Melbourne to keep the premises in good condition, this ratio will be high. It shows that the real estate player is not getting as much returns as is desired.
- Debt Service Coverage Ratio / Loan to Value Ratio – Debt Service Coverage Ratio (DSCR) is taken to be the Net Operating Income (NOI) divided by total annual amount for debt servicing. This is a formula that banks apply when financing a property. This ratio is fixed by the Bank as a part of its lending policy. The loan to Value Ratio (LTV) basically is the ratio of the loan amount to the property value. This is another critical constraint that is a part of a bank’s lending policy. When financing a property, the lesser of the two ratios is taken to arrive at the loan amount.
- Gross Rent Multiplier – This is the ratio of the sales price over potential rental income (PRI). In its simple form, it is an indicator of value of the property in relation to market trends. One disadvantage of this formula is that it considers data for one year only and excludes debt financing, operating expenses, taxes or risk – all factors that are crucial to the real estate industry.
These are some of the ratios that real estate dealers and investors need to keep an eye on if they have to maximise their returns on investments.