Common Metrics/Terms an Investor Uses to Analyze Commercial Real Estate
It’s not a secret that numbers drive real estate investment decisions. But the real question is, which metrics are valid? Which metrics matter? Depending on your investment goals and property type, some metrics are more important than others. The following metrics/terms real estate investors commonly use when making portfolio decisions:
1. Capitalization Rate (Cap Rate)
Cap rate is mostly used for apartment complexes and commercial buildings. Capitalization rate can also be used for houses and small multifamily properties, but the flip side is that operating expenses are unpredictable with houses since you can’t know how often or how bad your turnovers may be. Cap rate allows you to compare properties in the same asset class with different characteristics that make direct comparison impossible. The disadvantage of the Cap rate is that it’s only a snapshot. It says nothing about the expected growth in expenses, rents, property value, and whether using leverage will increase your return.
2. Cash Flow
When evaluating rental properties, it’s vital to figure out your expected monthly cash flow. When determining total expenses, you should include:
- Property taxes
- Flood and hazard insurance
- Property management
- General maintenance and upkeep
- Capital expenditures
- Vacancy rate
3. Return on Investment (ROI)
RoI is helpful for analyzing how well a deal did in the past. This measurement is always good to have because you can’t adjust your future investing unless you know how your previous investments performed.
4. Internal Rate of Return (IRR)
The internal rate of return is used to measure a project’s profitability, accounting for initial investment costs, cash flow, and property sale proceeds. The higher the IRR, the more appealing the project.
5. Gross Operating Income (GOI)
Gross operating income is used to figure out how much capital it takes to run a property. GOI figure removes the estimated losses in tenant vacancies or credits from the potential operating income.
6. Net Operating Income (NOI)
Net operating income explains how much money the property will earn after all operating expenses are paid. Basically, this metric is the total income (rent, parking, and any other monthly fees) minus expenses (vacancy, credit losses, property taxes, insurance, management fees, utilities, etc.).
7. Cash-on-Cash Return
Cash-on-cash return is used for ‘buy and hold’ investors, and it tells what your return will be in the first year of holding a specific property. It can also help in deciding whether to use leverage (and what kind of leverage), as it’s easy to calculate how cash-on-cash return will change if you reduce your invested cash by adding debt, which also increases the accompanying debt service.
8. Loan-to-Value Ratio (LTV)
This metric is used by lenders and financial institutions to assess risk. The higher the LTV, the more risk is involved with the loan. A high LTV can add additional costs to the investment, either through interest rates or requirements to buy additional insurance.