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Real estate investing is a sophisticated business. There are sophisticated techniques that are used by many diligent investors to carry out their due diligence. One such sophisticated technique is called ratio analysis. This technique is very similar to the ratio analysis that is carried out while evaluating the financial statements of publicly listed corporations. However, there are certain idiosyncrasies and terms that are used only in real estate investments that form a part of this ratio analysis too. This article explains the real estate investment focused ratio analysis from an individual’s point of view i.e. what should one person look at when they focus on buying a rental property. Here are some of the most commonly used ratios.
At an individual level, the loan to value (LTV) ratio is probably one of the most important number that is looked at by both banks as well as investors. Both these stakeholders look at the same number for very different reasons.
For instance, the bank looks at the loan to value ratio for the purpose of the security of its own investment. Consider for instance, a property with a loan to value ratio of 90% i.e. if the value of the property is $100, then the bank has financed $90 and has a claim on the property. Now, if the value of the property falls down by 10%, the value of the bank’s investment is still secure. The bank therefore provides better interest rates and other terms when the loan to value ratio is lower.
Individuals also look at the loan to value ratio to find the degree of leverage that they are taking on while buying a property. A higher loan to value ratio signifies a risky investment since even a small movement in the property prices would make the investment go in the red.
This ratio is used by individuals when they buy real estate for personal use i.e. for personal consumption or investment. The debt to income ratio basically predicts the ease with which a person will be able to make mortgage loan payments.
For instance, it is widely recognized that mortgage payments should form no more than 33% of a person’s monthly income. If the mortgage payments are greater than 33%, then the person is at risk of falling under financial duress.
This number is obtained by calculating the annual mortgage payments and then dividing the same by the person’s net annual income. To convert the number into a percentage, we can multiply it by 100. If the number is greater than 33%, then the risk is high.
This number is used to calculate the amount of dollars that a person is paying as capital investment to gain control of an annual rental value. So, for instance, if this number is 18, then an investor is paying $18 upfront, to gain control of an annual income of $1 in subsequent periods.
This number is calculated by using the market value of the property in the numerator. In the denominator, one can use the gross rental income generated or the net rental income generated after subtracting all the taxes and expenses.
If we use the gross income in the denominator, we get the gross income multiplier whereas if we use the net income in the denominator, we get the net income multiplier.
The rental yield is a number which is calculated like we calculate the bond yield in the bond markets. The annual rent generated by the property is used in the numerator. Usually, the gross rental value is used in the numerator and no deductions are carried out. However, there are no fixed rules to ratio calculations and every investor calculates the ratios based on their own heuristics.
In the denominator, the price paid for the property is used. Notice that the price paid for the property may be different from its current market value. An investor may have bought the property for $100 and now it may be worth $135. However, we will use the $100 figure. The reason behind this is simple. Yield can only be calculated once the value of your investment is considered. This is not a notional figure. Rather it tells us the exact Return on Investment (ROI) that a buyer is currently obtaining on their property.
The capitalization rate is similar to the rental yield number. However, there is one important difference. The rental yield uses the gross rental income in the numerator. However, the capitalization rate ratio uses the net income i.e. the income that is generated after deducting all operating expenses and taxes from the rental income that is generated by the property. The denominator remains the same i.e. the price that the investor has paid for the property. Once again, the price will not fluctuate based on the market value of the property since this number is not a notional calculation of opportunity costs. Rather, it is the factual calculation of the return on investment on a given property.
The list of ratios that can be used to evaluate a property can never be exhaustive. Ratio analysis is an art and every individual investor uses it in a different way. However, as a general thumb rule, one must remember that real estate investing is largely a cash flow management business and that investors must focus on their ability to generate and sustain predictably increasing cash flows.
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