Top Key Ratios Every Real Estate Investor Must Know

David Cohn
Aug 17, 2021
commercial real estate

Savvy commercial property investors understand that choosing an investment property means more than just looking at its potential revenue and purchase price. They also use essential real estate calculations and ratios to maximize their profit while minimizing risk.

It’s essential to learn these ratios if you want to monitor your current commercial properties or evaluate potential investments quickly and intelligently.

Whether you’re new to the commercial property investing day more simply need a refresher, here are the top CRE investing metrics to keep in your arsenal:

Net operating income or NOI

Think of the property’s NOI as a high-level income statement; it shows how much money you can make from the property in question.

To get your net operating income, subtract all operating expenses from the total revenue that the property generates. For example, if you run a commercial multifamily building or apartment complex, don’t forget to include any income the property makes from parking spot fees, laundry machines, and other such services.

When listing down operating expenses, it’s important to consider any legal fees, utilities, and property management fees you have to pay regularly.

You should never include mortgage payments, taxes, capital expenditures, or interest in the calculation. These are not categorized as operating expenses.

You can use the net operating income to judge a commercial property’s ability to make enough revenue and profit. This metric tells you if an investment makes enough money to allow you to pay the mortgage payments comfortably and on time.

Capitalization rate

Better known as cap rate, this ratio shows what percentage of property’s value is profit. If you trade in the stock market, you can think of the cap rate as the return on your stock investments. It’s essentially the ratio between your original capital investment or the property’s current value and the income it produces.

To calculate the cap rate, take the asset value and divide it by the property’s NOI. The asset value is the property’s sale price if you’re still in the acquisition phase. If you already own the property, then the asset value is its current value.

What is the ideal cap rate? Generally speaking, higher cap rates indicate higher returns—which ultimately means higher risks. This is why properties in riskier markets typically have higher cap rates than those in more significant and more stable markets.

Internal rate of return or IRR

This metric estimates the interest you might earn on your investment in a commercial rental property for the length of time you decide to hold it. It shows the property’s potential rate of growth and is used to estimate longer-term yields. It isn’t easy to calculate the IRR manually, so it’s best to use an online calculator.

Do note that the IRR assumes zero unexpected repairs and a stable leasing/rental environment. So while this metric can help compare commercial properties that are similar in terms of holding period, use, and size, it does have its limitations.

Cash flow

This number shows the net cash left at the end of the month after all expenses are paid, and rents are received. It’s a snapshot of how well a property is doing in terms of generating revenue.

The cash flow is probably the simplest but also one of the most critical real estate metrics. A negative cash flow means that you have a hard time making a profit or paying your bills.

It can also indicate mismanagement; perhaps you’re spending way too much on associated expenses, or maybe some delinquent tenants make late or incomplete payments that ultimately impact the bottom line.

Cash on cash return

In its simplest terms, the cash-on-cash return reveals how much money your cash investment in the property earns.

However, unlike other property metrics such as the net operating income, this formula considers your mortgage and debt service.

Here’s how to get the current cash on cash return on a property: Divide the net cash flow (after debt service) by the total money you invested in the deal.

The cash-on-cash return can help you make decisions about the most optimum way to finance a potential investment. You can also use it when choosing and comparing two potential commercial property investments and forecast potential returns during years when capital expenditures are anticipated.

Loan to value or LTV ratio

You’ve probably heard of the LTV ratio if you’ve ever applied for a mortgage before. This number matters to buyers looking to get financing for their projects because it measures the amount that needs to be financed against the current fair market value of the property. You can also use the LTV ratio to track your equity in a commercial property.

Most commercial mortgage lenders don’t finance 100% of an asset’s value. Instead, they want the borrower to have some equity in the property to lower their risks and protect their investment.

The amount they are willing to lend you to buy a property is the LTV ratio. The difference between the property’s total value and the percentage the bank or lender is willing to finance is how much cash you have to put into the project.

So if the bank agrees to do an 80% LTV, you have to come up with a 20% down payment to secure the loan. This means that property worth $1,000,000 will require a $200,000 down payment (plus closing costs).

If, after ten years, you’ve managed to pay down the mortgage to $500,000 and the value of your commercial property doubles to $2,000,000, the LTV then becomes 25%.

Operating expense ratio or OER

This metric indicates how well you’re managing a property’s expenses relative to its income. It’s a good measure of profitability. What makes this ratio unique is that it takes depreciation into account.

To get your OER, divide all operating expenses (minus depreciation) by the active income.

You ideally want a lower OER to indicate that you’ve managed to minimize expenses relative to the property’s revenue. However, several issues can cause your OER to rise over time.

For example, perhaps you’re not staying on top of routine maintenance, leading to more expenses later. Or maybe the annual rent increases don’t match expense increases.

You can calculate a property’s OER using specific costs to see the exact reason why it’s rising so you can address the problem.

Debt service coverage ratio or DSCR

This is a comparison of a property’s operating income and its overall debt levels. To get the DSCR, take the net operating income and divide it by debt payments.

Lenders will want to see your property’s DSCR to assess your ability to repay the loan. Most banks require this number to be in the 1.25 to 1.5 range. However, a 1.75 DSCR is even better and may help you get lower interest rates.

Now that you know the key in real estate ratios in commercial property investing, you can use them as a guide when deciding to purchase or sell potential investment properties.

These metrics can also help you track the performance of your existing properties so you can see any issues before they damage your profitability. It’s essential to consider each ratio in the context of your investment goals, the overall market, and the property itself.