6 Most Important Insights When Evaluating an Area for Real Estate Investing
To invest wisely, you must consider the property you’re investing in. Real estate investment metrics are essential for evaluating a potential investment in a short amount of time, especially towards residential investments.
Investors, both veteran and new, can use these insights for real estate investing. They are easy to use and provide essential data to all investors. Different metrics matter for different phases of the real estate investment process.
There are the 6 most important insights and metrics when evaluating an area for real estate investing.
1. Cash Flow
Cash flow is the net amount of cash and cash equivalents coming out of a real estate investment. It is calculated by subtracting the cash inflows by cash outflows, or total incomes by total expenses. Simply put, it’s how well a business is doing.
Cash Flow = Total Incomes -Total Expenses
Cash flow matters because it determines whether or not you can pay bills or make a profit. A negative cash flow means expenses need to be re-evaluated and too much is being spent on a property, and adjustments will need to be made.
Positive cash flow is a quality of an investment that would significantly reduce the risk of a real estate investment, in case the value of the house depreciates or personal emergencies happen, like losing your job, positive cash flow means the income of an investment will cover expenses. Positive cash flow also helps to invest more in real estate or for living expenses. There’s a reason retired investors often monitor cash flow as a real estate metric — because cash flow money from rentals often pays day-to-day expenses.
2. Cash-on-Cash Return (CCR)
Cash flow can also be used to evaluate Cash-on-Cash Return (CCR), which is important because it evaluates an investment’s performance. It divides cash flow (before taxes) by the total cash invested into a property. For example, someone who used $200,000 for making a down payment and financing of a property and has an estimated pre-tax cash flow of $20,000 would have a 10% CCR.
CCR = (cash flow total cash invested)
Usually, best practices aim for at least a 10% CCR. Some say a range from 8-12% is better. Some investors will only consider cash-on-cash returns of 15% or higher, so what a “good” cash-on-cash return is varies significantly from investor to investor.
This gives enough financial stability in case properties have unexpected repairs, and saves an investor from paying out of pocket for the maintenance of a property. At least a 10% CCR allows enough cash flow to pay for unexpected expenses. The cash-on-cash return also takes expenses like financing costs into account, which others do not. It can help you determine the best way to finance an investment, as well as choose between competing investments. It is important to remind investors tax is excluded from to CCR equation. Since each investor pays a different income tax, using CCR without taxes equalizes the comparison of different properties across investments.
3. Net Operating Income (NOI)
Another metric for determining money made from an investment property is net operating income. It is determined by subtracting operating expenses from total income of a property. It’s important to note net operating income (NOI) does not take mortgage payments into account, since mortgage payments are not an operating expense. It’s also important to note other forms of income like vending machines, a laundromat, or parking lots may make additional income. Operating expenses might be property taxes, insurance, and maintenance and repair costs.
Net Operating Income = Total Income of Property – Operating Expenses
The NOI is important because it judges a building’s ability to make profit, and whether the profit is substantial enough to cover mortgage payments. It’s important to note NOI can be an unpredictable value depending on possible vacancy rates, inaccurate estimated rents, and management of a property.
The value of the NOI is to give one metric for purchasing decisions, and to see how profitable an investment might be in a given year. Remembering the NOI does not include expenses like mortgage and tenant improvements is also important. NOI still does dictate the profitability of a rental or commercial property in many respects — lenders may even look at NOI to decide whether they will approve or not approve a loan. Banks often look at the number, among others, to determine whether they will help finance a property.
4. Capitalization Rate
The Capitalization Rate, also known as the Cap Rate, is the number used in real estate to show the rate of return on a property. It’s used to estimate the net income of an investment property.
To understand Cap Rate percentage, you also need to know how it is calculated. According to James Chen at Investopedia, the Cap Rate is determined by dividing the net operating income (NOI) by property asset value. For example, if the NOI of a property is $10,000 and the sale price is $100,000, the Cap Rate is .10, equivalent to 10%.
Cap Rate =Net Operating IncomeProperty Asset Value
It’s also essential to note the Cap Rate uses the current market value over the purchase value of a home.
Important factors to note for changing Cap Rates include fluctuating market values and fluctuating yearly incomes, all of which need to be considered within a housing market. The Cap Rate is one essential factor, but it should not be relied upon as the only reason why you should invest in a property. Cash flow and the changing value of money are also factors to consider, as well as account leverage. It’s best used for comparison of several potential investment properties in one market or neighborhood, Jeff Rohde at Roofstock says.
We at Hard Money IO provide a free Cap Rate calculator to help you determine the rate of return for your real estate investment.
5. Loan-to-Value (LTV) Ratio
The Loan to Value Ratio is the amount of money you can get from a lender in comparison to the total value of a property.It is a risk assessment portfolio buyers use before approving a mortgage. A higher LTV ratio means a riskier loan, and a subsequently higher interest rate for the loan. As a result, lenders often use LTV to determine how much they require as down payment. Most real estate investors want to put down as little as possible to obtain the best interest rate, often of an LTV of 80% or lower.
The LTV ratio is determined by dividing the appraised property value by the mortgage amount.
Loan to Value Ratio = Mortgage Amount/Appraised Property Value
For example, a lender who offers an 80% LTV ratio for a property that appraises at $300,000 would lend up to $240,000. The rest ($60,000) would have to come from the borrower as a down payment on the property.
LTV is important for real estate investors because borrowers want to minimize risk and show they’re less likely to default on payments. With a lower LTV, if you default on a payment, the lender can recoup a greater amount of their investment. Larger down payments usually results in a safer investment, for both the borrower and the lender. Many lenders will look at the equity of a home to determine the likelihood of payments being made, and on time. It is in your best interest to have a lower interest rate and pay a bigger down payment, when you can afford it. For some investors, this might mean waiting to build money and assets until a specific down payment can be afforded.
6. Return on Investment (ROI)
This one might seem simple — return on investment means how much money you make from your investment. It is a simple formula of return divided by investment. But return on investment could be strangely difficult to calculate, according to Jean Folger at Investopedia. Many factors go into calculation of ROI, including mortgage, downpayment, regular expenses, and maintenance costs. It is important to be precise in calculations and include all expenses, and ROI can be calculated differently when a house is paid for with cash or a mortgage.
Cash transactions are simple to calculate, but financed transactions are more complicated. They need to include factors like the downpayment, typically higher closing costs, out of pocket expenses, and remodeling costs. Ongoing costs with a mortgage also need to be considered for an average return on investment. Return on investment is an important calculation to make so you, as an investor, can determine whether costs and expenses exceed ROI. These real estate investment metrics are all very important to evaluating an area for investment. It is important to understand the advantages and disadvantages of each investment and what works best for you.
We at Hard Money Lenders IO are hard money lenders who provide many of these resources at your disposal. We can help you search for lenders who will minimize your expenses and guarantee safer investments. We can help you take every multiple expenses into account as you seek ways to finance a real estate investment. Above all, we can help you decide whether investing in an area of real estate is the right choice for you. We can help you compare separate choices of real estate to achieve the best return for your investment.
Adam Smith has spent the last 5 years in the Private Money Lending world helping real estate investors secure financing for their non-owner occupied real estate investments. When he’s not thinking about real estate, Adam is an avid Jazz music fan and fisherman.