Which tool will give me the right answer?
I apologize for taking so long with this post, sorry business comes first.
Recently, I analyzed an investment for a client and as I was going over the analysis with him and I felt some of my comments might be interesting to readers of this blog. In a previous post we discussed Cap Rate as a measure of an investment well quite frankly it is only one of a number of metrics I like to use. The following are some of the metrics along with their formulas you can consider in evaluating an investment.
Loan to Value Ratio (%)
LTV = Loan Amount x 100 ÷ Market Value
Debt Service Ratio (DSR)
DS = Net Operating Income ÷ Debt Service
Capitalization Rate (Cap Rate)
Also called Broker’s Yield
Cap Rate(%) = Net Operating Income x 100 ÷ Market Value
Cap Rate (%) = NOI x 100÷ MV
or Market Value = Operating Income x 100 ÷ Cap Rate (%)
MV = NOI x 100 ÷ Cap Rate (%)
Return on Equity (ROE)
A.K.A. Cash on Cash Return
Also called: Equity Dividend Rate (EDR)
Where: Equity = Market Value – Mortgage and Debt Service = Principal & Interest Payment
ROE(%) = (Net Operating Income – Debt Service) x 100 ÷ Equity
ROE (%) = (NOI–DS) x 100 ÷ (MV–Mtge.)
Potential Gross Income Multiplier (PGIM)
Also called Potential Gross Rent Multiplier (PGRM)
PGIM = Market Value ÷ Potential Gross Income
PGIM = MV ÷ PGI
Effective Gross Income Multiplier (EGIM)
Also called Effective Gross Rent Multiplier (EGRM)
EGIM = Market Value ÷ Effective Gross Income
EGIM = MV÷ EGI
Default Ratio (Break-even) (%)
Using Potential Gross Income
DR = (Operating Expenses + Debt Service) x 100 ÷ Potential Gross Income
Using Effective Gross Income
DR = (Operating Expenses + Debt Service) x 100 ÷ Effective Gross Income
Loan to value ratios are decreasing due to the market conditions and the banks’ caution regarding falling property values, bankers have told me they are generally looking at 75%, 70% or lower for most commercial real estate deals if the property fits their risk profile. Yes, the banks will not entertain some properties because they are to risky, restaurant properties is one example.
Banks use the Debt Service Ratio (DSR) in their loan decision process, historically a minimum of 1.20 DSR was considered. The higher the DSR is the better.
In our last post we discussed cash flow as an investing goal, Return on Equity (ROE) or Cash on Cash Return measures the return on the cash invested versus the cash flow received from the property. Most investors give this measurement metric a greater weighting in their investing decision. As we previously discussed accuracy of financial information is critical to this metric.
Potential Gross Rent Multiplier (PGRM) or Effective Gross Rent Multiplier (EGRM) generally can be used to evaluate similar properties, obviously the lower the multiplier the better. The class, location and risk level of the property effects the multiplier value. Just as with Cap Rate this metric should not be used alone to make a property buying decision.
My favorite metric is the Default Ratio or Break-even (%) it measures the relationship between income, expense and debt. I will repeat, it is subject to the accuracy of the data you receive from the seller. This metric basically tells you if the property can support the debt placed on the property. The magic number is 85%, if the default ratio is greater than 85% this investment may be risky. Using the effective gross income will introduce the vacancy rate into the formula and would be the recommended method. When used in conjunction with the other metrics discussed, a more reasoned investing decision can be made.
In any market a complete analysis of the investment is always the wise choice.