Whether you’re building a real estate portfolio or you’re confirming that your existing properties are performing well enough to remain in your portfolio, you need specific ways to measure the financial success of a property. And that’s where these real estate investing metrics come in.
There are many ways to measure the financial success of an investment. But in this article, we’re going to show you the 10 most important metrics for real estate investing. You’ll learn what each metric measures, why it matters, and how it’s calculated.
Two important notes before we start:
- Some real estate investing metrics only apply to certain asset classes or circumstances. Take the loan-to-value ratio as an example. If you pay cash for the property, rather than financing some of the purchase with a loan, this metric wouldn’t apply. So, while we’re breaking down the top 10 most important metrics for real estate investors, you won’t necessarily need all of them for your next investment.
- Because of the nature of investment metrics and their acronyms, there is a lot of real estate jargon in this article. If you come across a term you don’t recognize, you can check out our real estate industry terms for quick definitions.
With that, let’s get to the list!
1. Return on Investment (ROI)
ROI is a universal investment metric that allows investors to see how much profit they make from an investment, expressed as a percentage of the amount invested. ROI is how many investments are evaluated because it gives you a quick look at the yield you can receive from each dollar invested.
The traditional method of calculating ROI in real estate is to divide your investment gains by your investment cost.
Let’s say, for example, that you purchased a single-family fixer-upper for $500,000 and invested $200,000 in renovating the main house and building an accessory dwelling unit (ADU) on the property. Then you sell the completed project for $850,000. To calculate ROI, you would divide your total profit of $150,000 (the $850,000 sales price minus the $700,000 total investment cost) by the $700,000 investment cost. This gives you an ROI of 21.4%.
But let’s take this a step further and talk about annualized ROI. Annual ROI is useful when comparing investments with different time frames because it allows investors to see how each investment performs over a standard one-year period.
To calculate the annualized ROI, divide the total ROI by the number of months the project took to complete, then multiply by 12.
In our example above, let’s assume it took 15 months to complete the house flip with ADU addition. If we divide 21.4% by 15 months, we get 1.42, then multiplying this by 12, we get 17.12. So our annualized ROI is 17.12%
Calculating ROI on Rental Properties
ROI on rental properties looks a little different because you have monthly rental income rather than a one-time windfall from the sale (although you could have that as well when you’re ready to sell the property).
To calculate ROI on rentals, take your annual rental income minus your annual operating costs, and divide that number by the remaining mortgage loan balance. This will tell you how your operating income compares to the balance to be paid on the loan.
Here’s an example.
Let’s say you take out a loan of $400,000 to buy a second home as a rental property. A few years into the investment, you’re earning $48,000 per year in rental income, and you have annual expenses of $4,800 for things like property taxes, insurance, and maintenance. You’ve also paid down a bit of your mortgage balance, so your current balance is $375,000.
In this case, you would subtract your annual operating costs of $4,800 from your annual cash flow of $48,000 then divide this by the current loan balance of $375,000 to get .1152. This means your ROI would be 11.52%.
2. Internal Rate of Return (IRR)
Internal rate of return (IRR) is a complex calculation that allows you to account for the time value of money using a “discount rate,” which works like an interest rate in reverse. Rather than calculating the future value of today’s investments, as interest rates allow us to do, discount rates calculate the present value of future investments.
Let’s say you find a $100,000 investment opportunity with annual cash flows of $12,000 per year. You want to earn 12% per year, and you expect that you’ll be able to earn a $25,000 profit from the sale of your property in five years based on local appreciation rates.
Using a financial calculator (because manually calculating IRR is not worth the time or effort), we find that the IRR for this investment is 15.66%.
For more information on calculating IRR and understanding how IRR differs from ROI, see our article, IRR vs. ROI.
For more information on calculating IRR and understanding how IRR differs from ROI, see our article, IRR vs. ROI.
Appreciation simply means the growth in value of an asset over time. So appreciation in real estate is the increase in the value of a property over the time you own it. Knowing the appreciation rate tells you how much more your property is worth today than when you purchased it. And, projecting appreciation rates helps you estimate the profitability of selling the property in the future.
Appreciation is calculated by dividing the change in value by the starting value.
For example, if you purchased a single-family home ten years ago for $400,000 and it is worth $750,000 today, your appreciation rate would be 87.5% ($350,000 change in value divided by $400,000 starting value).
In the same way that we calculated annualized ROI, you can calculate annualized appreciation to find the average appreciation per year. Just divide the total appreciation by the number of years the asset was held. In our example, 87.5% divided by 10 years equals 8.75% per year.
4. Cash Flow
Cash flow is the amount of income your investment generates on a regular basis. In real estate investing, this often relates to rental income collected (plus other rental fees like parking and pet rent). But it could also refer to dividend income from investing in securities like stocks or REITS (Real Estate Investment Trusts).
You can calculate gross cash flow or net cash flow. Gross cash flow is the total of all income collected, essentially your revenue. Net cash flow is total income minus total operating expenses.
For example, if you own a duplex generating $8,000 per month, your gross cash flow is $8,000 per month. If you have monthly expenses of $5,000 on this duplex (because of the mortgage, insurance, taxes, and maintenance), your net cash flow is $3,000 per month.
Many investors wonder if they should focus on cash flow or appreciation. The answer is that it depends on your investment goals. Importantly, rental properties offer both ongoing cash flows and long-term appreciation, making this a strong investment strategy.
5. Net Operating Income (NOI)
Net operating income (NOI) is very similar to net cash flows. Here’s the difference: NOI doesn’t account for all property expenses. Notably capital expenditures, mortgage amortization, and income taxes.
But that doesn’t mean NOI is any less important of a metric than net cash flows. NOI is particularly useful because it is used to calculate other profitability metrics (as we’ll see when we discuss cap rates next).
To calculate NOI, take the total operating income generated by the property, then subtract the expenses specific to the ongoing operations of the property (such as insurance premiums, legal fees, utilities, property taxes, repair costs, and janitorial fees).
If you have a duplex generating $8,000 per month in rent, and your monthly operating expenses total $2,500, for example, you’re NOI would be $5,500.
6. Capitalization Rate (Cap Rate)
A cap rate in real estate is a profitability metric reserved for commercial properties. This includes asset classes like retail storefronts, office space, and, interestingly, residential properties with more than four units.
To calculate the cap rate, divide the net operating income by the current property value or projected purchase price.
Let’s say you recently purchased a fully occupied 5-unit apartment building for $2,000,000. This property produces an annual cash flow of $180,000 and incurs annual operating expenses of $36,000. As we know from discussing NOI, the NOI for this project would be $144,000 (180,000 - 36,000). And, because the property was purchased recently, we can use the $2 million purchase price as the market value.
So, to calculate the cap rate, we divide 144,000 by 2,000,000, and we get .072. This means that our cap rate is 7.2%.
7. Cash-on-Cash Return (CoC)
Cash-on-cash return (CoC) measures the profitability of a real estate investment in terms of how much cash is generated compared to how much cash is invested over a specific period. This tells you how hard each invested dollar is working for you in a given timeframe.
To calculate CoC, divide your pre-tax cash flow for the period by your cash invested during the period.
Here is an example:
Let’s say you buy a large plot of vacant land for $1 million. You put $100,000 cash down as the down payment (financing the remaining $900,000). You also pay $10,000 in closing costs from cash out-of-pocket. A year later, you sell $1.1 million. At this point, you have made $25,000 in loan payments, reducing the principal loan balance by $5,000.
In this case, your total cash invested is $135,000 ($100,000+$10,000+$25000) and your income generated is $205,000 (the $1,100,000 sales price minus the $895,000 remaining loan balance). So, your CoC return is 51.85% ($205,000 - $135,000) ÷ $135,000).
8. Loan-to-Value (LTV) Ratio
The LTV ratio tells you how much of a property’s worth is financed (as opposed to how much of the property’s worth you own, which is called equity). This ratio is critical when taking out a new mortgage loan, refinancing an existing mortgage, or borrowing from your equity in a property. Most lenders set a maximum LTV ratio for borrowers, which can potentially limit your financing options.
LTV is calculated by dividing the loan amount by the value of the property.
For example, if you have a million-dollar property with a mortgage loan balance of $600,000, your loan-to-value ratio is 60%.
9. Vacancy Rate
Vacancy rates are used to find out how much of a rental property (or portfolio) is currently unoccupied. Unoccupied units are not generating income, so high-performing investments typically have low occupancy rates. Having said that a vacancy rate of 0% may indicate that your rental prices are too low. If you are pricing your rental units competitively, you will see some turnover, which requires units to be vacant for short periods.
Vacancy rates are calculated by dividing the number of vacant units by the total number of units.
For example, if you have a 12-unit apartment building, and you have 1 unit vacant, your vacancy rate is 8.3% (1 divided by 12).
10. After Repair Value (ARV)
ARV is used when calculating the potential returns of properties undergoing extensive renovations.
ARV is calculated by simply estimating the value of the property once the renovation is complete. If your renovation is quick, you can use current sales of comparable properties to estimate the ARV. If your renovation will take longer than a year, you may also want to consider projected market trends to more accurately estimate the future value of the property once the renovation is complete.
Let’s say you’re renovating a vacant 4-unit residential structure. You expect the renovation to take around 15 months because you are doing much of the work yourself. Current, recently renovated comps are selling for $2 million today, but sales prices for this type of property are trending up by around 3% per year and are expected to continue at that rate. In this case, your ARV might be $2,060,000 ($2,000,000 plus a 3% increase).
Invest Alongside the Experts with Gatsby Investment
Are you feeling overwhelmed with all these metrics and financial calculations? Don’t let that stop you from investing in real estate. With Gatsby Investment, you can have the experts take care of the analysis for you!
The team at Gatsby Investment carefully assesses the return potential of hundreds of properties to choose the best possible deals for their investors. All you have to do is review the hand-picked investment opportunities to find the project(s) that you are most excited about. Gatsby even publishes the projected ROI and annualized ROI for each property so that you can compare potential yields.