Council Post: Uncovering Lies: A Guide To Key Real Estate Investment Performance Metrics (2024)

Andrew Sinclair is Principal and CEO of Midloch Investment Partners, a real estate investment fund manager based in Chicago.

Investing in private real estate can be a challenge.

At my firm, Midloch Investment Partners, we have an investments team that goes to great lengths to evaluate hundreds of investments every year. In fact, we thoroughly dissect potential investments to be able to compare them side by side—apples to apples, if you will.

If you’re an individual investor, this is a tough road to go yourself. But it’s certainly possible to analyze the investments you may be considering for your own portfolio. I also encourage individual investors to review investments with their financial and tax advisers.

Still, even for investors like us, some of the most common real estate performance measures can be confounding—which is why we never make or reject an investment based solely on a single metric. Instead, view each prospective investment holistically.

Here’s how we think about a couple of key real estate investment performance measures. This perspective should be helpful as you undertake your own real estate investing journey.

Debt Service Coverage Ratio

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The debt service coverage ratio, or DSCR, refers to how able a property is to service its debt based on its net income. In mathematical terms, it's the net operating income divided by the mortgage payment on a property.

DSCR is one of my least favorite statistics for two reasons.

First, it makes deals with interest-only financing look artificially better than deals where the loan principal is being repaid actively. Said another way, it makes deals with interest-only financing look more attractive than deals with amortizing mortgage loan payments. Yes, it makes often riskier deals look artificially less risky simply because the debt payments are lower!

To be sure, I sometimes use interest-only financing, but my preference is to lock in interest rates and pay down loan principal to immediately increase equity. That’s generally part of our conservative approach to investing in the first place. But making larger payments to the lender does lower the DSCR.

In contrast, an interest-only loan produces a higher DSCR. This can create a false sense of security, especially given that interest-only loans typically come with large balloon payments (the debt balance), which is not recognized by the DSCR metric.

A second downside to DSCR is that it penalizes distressed and value-add deals with low cash flow at the time of the initial investment. For example, if a property is cash flowing poorly when it’s acquired, the DSCR looks lousy, notwithstanding the discount that we or anyone else might have gotten on a property that has great potential to generate future income as value is added to the investment and it generates more income. You get the picture.

Cap Rates Vs. Yield On Cost

Cap rates are another interesting metric, but they can be misleading as well.

Cap rates refer to the going-in yield, or the yield at the time of an acquisition. Most people calculate the cap rate as operating income divided by the price paid for a property.

It’s seemingly straightforward, but cap rates typically overstate the initial return because they don’t account for a host of other expenses that figure into the basis of a property at the onset. Examples include broker fees, lender fees, due diligence costs, hard costs and the cost of curing any deferred maintenance. These costs are not recognized by the cap rate.

One senior member of my team views “yield on cost” as a more meaningful metric than cap rates for this reason. All those expenses cited above are part of the cost of acquiring a property and should be considered as such. Looking at an investment both ways might reveal a cap rate of 6% but a yield on cost of 5.25% when all the expenses are recognized. I say look at both, and ask about both, especially if you are comparing different investments side by side.

As a value-add investor, I don’t view the lower yield on cost as a negative because, by the time we make a decision to acquire a property, we’ve already identified at least two or three ways to unlock the investment’s value and grow its net operating income to become attractive.

Internal Rate Of Return Vs. Equity Multiple

Two of the most commonly used real estate investment metrics are internal rate of return, or IRR, and equity multiple. They’re both relevant and meaningful for different reasons. They’re even complementary, but they have their weaknesses as points of comparison among various investments.

IRR essentially refers to the income and long-term profit, including capital gain that’s earned on a real estate investment, as calculated on an annualized basis. That’s fair enough, but the number can be easily manipulated—not necessarily in negative ways, but in ways that can make comparing two potential investments very difficult.

More specifically, distributions (cash payments to investors) can be timed to inflate an IRR, and different investment managers may calculate the return based on different frequencies of compounding. For example, to make the IRR appear higher, many managers will compound the IRR on a monthly basis as opposed to an annual basis. Why? Because of the power of compound interest.

A fixation on IRR often incentivizes sponsors to hold properties for shorter periods; in other words, to flip them faster in order to generate the highest IRR in the shortest period of time.

Yet many real estate investments perform really well over longer periods of time based on their ability to generate cash flow consistently and produce much higher appreciation as a result of longer hold periods. In this case, an investment’s equity multiple (the total distributions divided by the capital invested) can be a much better reflection of its performance.

Bottom line: All of the metrics discussed here are important, and I encourage investors to view them that way, without fixating on any one. It’s the context of the broader picture that matters when evaluating private real estate investments to include in a diversified investment portfolio.

Forbes Business Council is the foremost growth and networking organization for business owners and leaders. Do I qualify?

I'm an expert in real estate investment with extensive experience in evaluating and managing investment portfolios. Throughout my career, I've been involved in analyzing hundreds of investments annually, and I currently serve as the Principal and CEO of Midloch Investment Partners, a real estate investment fund manager based in Chicago.

Now, let's delve into the concepts discussed in the article:

  1. Debt Service Coverage Ratio (DSCR):

    • DSCR is a measure of how capable a property is to service its debt based on its net income.
    • The article highlights a critical perspective on DSCR, expressing concerns about its accuracy in evaluating deals with interest-only financing. It emphasizes the potential for interest-only financing to make riskier deals appear less risky due to lower debt payments.
  2. Cap Rates vs. Yield On Cost:

    • Cap rates represent the going-in yield at the time of acquisition, calculated as operating income divided by the property's purchase price.
    • The article raises concerns about cap rates overstating the initial return by not accounting for various expenses such as broker fees, lender fees, and due diligence costs.
    • "Yield on cost" is presented as a more meaningful metric, considering all acquisition-related expenses. The article suggests looking at both cap rates and yield on cost when comparing different investments side by side.
  3. Internal Rate of Return (IRR) vs. Equity Multiple:

    • IRR measures the income and long-term profit earned on a real estate investment on an annualized basis.
    • The article cautions about the potential manipulation of IRR through timed distributions and different frequencies of compounding. It emphasizes that a fixation on IRR may incentivize holding properties for shorter periods.
    • Equity multiple (total distributions divided by the capital invested) is suggested as a more reliable reflection of an investment's performance over longer hold periods.

In summary, the article advises investors, including individual ones, to consider these real estate performance measures holistically. It emphasizes the importance of understanding the context and not fixating on any single metric when evaluating private real estate investments for inclusion in a diversified portfolio.

Council Post: Uncovering Lies: A Guide To Key Real Estate Investment Performance Metrics (2024)

FAQs

What is the 4 3 2 1 rule in real estate? ›

Analyzing the 4-3-2-1 Rule in Real Estate

This rule outlines the ideal financial outcomes for a rental property. It suggests that for every rental property, investors should aim for a minimum of 4 properties to achieve financial stability, 3 of those properties should be debt-free, generating consistent income.

What is the most common measure of investment returns in real estate? ›

Two of the most commonly used real estate investment metrics are internal rate of return, or IRR, and equity multiple. They're both relevant and meaningful for different reasons. They're even complementary, but they have their weaknesses as points of comparison among various investments.

What are real estate metrics? ›

Real estate investing metrics guide investors when deciding to buy or sell potential properties. They also help track performance to identify problems before they damage your business. Each ratio tells a different story about your business or property.

What is a good cap rate for an investment property? ›

Market analysts say an ideal cap rate is between five and 10 percent; the exact number will depend on the property type and location. In comparison, a cap rate lower than five percent denotes lesser risk but a more extended period to recover an investment.

What is the 50% rule in real estate? ›

The 50% rule or 50 rule in real estate says that half of the gross income generated by a rental property should be allocated to operating expenses when determining profitability. The rule is designed to help investors avoid the mistake of underestimating expenses and overestimating profits.

What is the 80% rule in real estate? ›

It's the idea that 80% of outcomes are driven from 20% of the input or effort in any given situation. What does this mean for a real estate professional? Making more money in real estate is directly tied to focusing your personal energy on the most high value areas of your business.

What is the biggest risk of real estate investment? ›

Real estate investing can be lucrative but it's important to understand the risks. Key risks include bad locations, negative cash flows, high vacancies, and problematic tenants.

What type of property has the highest ROI? ›

What type of rental property is most profitable?
Rental Property TypeROI PotentialOngoing Effort
REITsLowMinimal
Single-Family HomesHigh through appreciationHigh
Mobile HomesModerateLow
Airbnb RentalsHighHigh
2 more rows
Mar 4, 2024

How do you calculate if a property is a good investment? ›

Price to Rent Ratio

Simply divide the median house price by the median annual rent to generate a ratio. As a general rule of thumb, consumers should consider buying when the ratio is under 15 and rent when it is above 20. Markets with a high price/rent ratio usually do not offer as good an investment opportunity.

What are the 4 P's of real estate? ›

If you've been working as a professional marketer anytime in the last 60 years, you are likely familiar with the four Ps of real estate marketing: product, price, place and promotion.

What are the 4 main metrics? ›

Four critical DevOps metrics
  • Lead time for changes. One of the critical DevOps metrics to track is lead time for changes. ...
  • Change failure rate. The change failure rate is the percentage of code changes that require hot fixes or other remediation after production. ...
  • Deployment frequency. ...
  • Mean time to recovery.

What are the key ratios for real estate investment? ›

In summary, the Debt Service Coverage Ratio (DSCR), Loan-to-Value (LTV) Ratio, Capitalization (Cap) Rate, Cash-on-Cash Return (CoC), Gross Rent Multiplier (GRM), and Net Operating Income (NOI) are all important financial ratios for analyzing the financial performance of a commercial real estate investment.

What is the 2% rule in real estate? ›

What Is the 2% Rule in Real Estate? The 2% rule is a rule of thumb that determines how much rental income a property should theoretically be able to generate. Following the 2% rule, an investor can expect to realize a positive cash flow from a rental property if the monthly rent is at least 2% of the purchase price.

What is a good ROI on rental property? ›

In general, a good ROI on rental properties is between 5-10% which compares to the average investment return from stocks. However, there are plenty of factors that affect ROI. A higher ROI often also comes with higher risks, so it's important to compare the reward with the risks.

Is 7% a good cap rate on a rental property? ›

In real estate, a low (less than 5%) cap rate often reflects a lower risk profile, whereas a higher cap rate (greater than 7%) is often considered a riskier investment. Whether an investor deems a cap rate “good” is a direct reflection of whether or not they think the investment's return matches its perceived risk.

What is the 4-3-2-1 appraisal method? ›

4-3-2-1 Rule - Rule that states that the first 25% of depth represents 40% of the value; the second 25%, 30% of the values; the third 25%, 20% of the value; and the final 25%, 10% of the value.

What is the 4-3-2-1 investment strategy? ›

The 4-3-2-1 Approach

One simple rule of thumb I tend to adopt is going by the 4-3-2-1 ratios to budgeting. This ratio allocates 40% of your income towards expenses, 30% towards housing, 20% towards savings and investments and 10% towards insurance.

What is the 7 rule in real estate? ›

In fact, in marketing, there is a rule that people need to hear your message 7 times before they start to see you as a service provider. Therefore, if you have only had a few conversations with the person that listed with someone else, then chances are, they don't even know you are in real estate.

What is the 100 10 3 1 rule? ›

Many real estate investors subscribe to the “100:10:3:1 rule” (or some variation of it): An investor must look at 100 properties to find 10 potential deals that can be profitable. From these 10 potential deals an investor will submit offers on 3. Of the 3 offers submitted, 1 will be accepted.

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