Real estate investments can be very lucrative and help build wealth for an individual, but it doesn’t go without risk. That’s why it is incredibly important to do your due diligence and know your numbers to lower the risk of an investment going south. Here are a few key stats that will help you evaluate whether or not you’re looking at a good deal.
1. Financing the Deal
Every deal requires some type of financing and is the foundation of every real estate transaction. While some deals may be financed through cash, others will be financed through a mortgage. The mortgage payment itself is a big factor in considering whether a deal is worth it. The payment will factor into what your operating expenses will be which will help you determine what your net operating income (NOI) will be.
Once you have your NOI, you can determine your debt service coverage ratio (DSCR). When obtaining a loan for an investment property, lenders will also be looking at whether or not your cash flow is enough to pay your debt obligations. DSCR is calculated by dividing the net operating income by total debt service. A ratio below 1.0 indicates that there will not be enough cash generated to cover debt payments. There is not a definite ratio that every lender accepts but a ratio between 1.2-1.4 is ideal.
2. Stats Tied to the Rent
One way of generating income from a property is through rent. The first stat to watch is the price to rent ratio which is a measurement of median home prices to median rent of the market. A high price to rent ratio is not considered to be a good investment opportunity.
The second stat tied to rent you want to consider the gross rental yield. This is a percentage that can be calculated dividing the yearly rent collected by total cost of the property and then multiply by 100. It’s essentially the return on your investment before taxes and expenses.
3. Cap Rate
Capitalization (cap) rate is important in commercial investment because it gives you an idea of what your return on investment will be. It is calculated by dividing the NOI by the cost of the property. A higher cap rate will give you a higher return, but typically means more risk. A high cap rate could indicate that the value of the property is low due to vacancies or lack of demand. It’s important to find the right balance of risk and return that you’re comfortable with.
Calculate these numbers to help make a sound decision on whether an investment is worth the risk.