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5 Key Ratios You Must Know To Go Property Investing
A ratio provides a number that expresses the relationship between different variables. Every mathematician or analyst will be well-versed in ratios. Using them to analyse your investments is critical in understanding a potential property to buy unless you are just buying a new launch because everyone else is doing so. On top of analysis, there are generally accepted standards or benchmarks the are used by professionals to judge whether an investment is worth it. 5 of the most important ratios are
1) Capitalization rate
2) Return on investment
3) Cash return on investment
4) Debt servicing ratio
5) Gross rent multiplier
1) Capitalization. Capitalization rate can be determined by dividing net operating income to the sales price.
It is useful in measuring the relationship between the property price and the income the property generates. Now that we have put these 3 variables into an equation, we can use them interchangeably to work out any one of the variables as long as we have 2 of them.
For example, if a property has an operating income of $50,000 and is being sold for $1m, will it be a worthwhile investment for you? Note that operating income is revenue less expenses. By plugging in the numbers into the equation, we will come down to a capitalization rate of 5%. If your target rate is 8%, this investment will have to go into the dustbin.
Now let’s turn that around. If the seller claims that the capitalization rate is 8% with net operating income (NOI) of $50,000, what would be a fair price for the property? The formula will work out to a price of $625,000. Now does that new launch you thinking of buying look more attractive or less?
So if a property with net operating income of $50,000 and capitalization rate of 8% is selling at $1m, we can say that it is overpriced by $375,000. A 60% premium. Not really a smart buy for an investor.
2) Return on investment (ROI). A total return on investment can be worked out by adding up remaining cash after mortgage to the principal reduction, and dividing that to your cash investment.
The total ROI is a great measurement of your total return as it takes into account your cash and noncash portions of your investment. The noncash portion is taken into account as it goes into your home equity which can be realized when you sell or take up an equity loan against property in future.
3) Cash return on investment. Unlike the ROI, this measure the return on real hard cash. Calculate this by dividing cash after debt over invested capital. While this ratio is not popular among investors who prefer to get an overall picture for their investments, it is useful for hardcore cash flow players who get by each month from cash flow.
4) Debt servicing ratio (DSR). This is a ratio that is affectionately used by lenders to assess whether a borrower will be able to comfortably repay his mortgage. You want to use it to see how much of operating income will be used up for mortgage payments. So you can easily understand this equation.
The maximum a lender will be willing to tolerate differs from bank to bank. So leave that part to them. What you want to find out though, is whether the cash flow generated by the property will be able to sustain it by itself. If the cash is not enough to service your mortgage debt, common sense will tell you to back off and run off into the sunset while the seller is not looking.
There are things to think about if you are insistent on getting the property. You could stretch the loan tenor and decrease monthly payments. This will increase your accumulated interest expense over time. You could increase rental immediately. This can scare off your tenants which will defeat the purpose of increasing rent collections. You could also put down a higher down payment to decrease the loan quantum. This will affect your ROI negatively, decreasing the attractiveness of the investment. So what are you going to do?
5) Gross rent multiplier (GRM). This ratio measures the relationship between expected income and property price. Expected income means that the expected revenue stream stated in the tenancy agreement.
You can see that the higher expected income goes, the lower the GRM will be. So you want the GRM to be as low as possible as that relates to a higher ROI.
To sum it up, capitalization rate the higher the better, ROI the higher the better, cash ROI the higher the better, DSR the lower the better and GRM the lower the better. The final ratios that you end up with will only make sense if you have a target number to hit or a market benchmark to compare with. You need these benchmarks to be able to use these ratios to judge whether a property is worth your investment.