Keeping up with Real Estate Investment - Some Good Indicators

Today I want to go over some typical investment criteria I take into account when looking at investments. If you are starting out, or a long time investor, there is no doubt that everyone should utilize these crucial indicators.

The first and most popular I find is called CAP RATE. This can be defined as net cash flow divided by purchase price.
i.e. Cap Rate = Net cash flow / Purchase price

A cap rate is an important indicator of the overall performance of a property. Obviously there are other indicators that will take into account how well a property performs, but the cap rate will give you a quick snapshot on where the property stands.

If you are looking at a property will a lower cap rate, there are some factors you can change to improve your conditions. First, you purchase price. A discounted purchase price will definitely raise your cap rate due to lowering the denominator of the equation. Second, raising rents and therefor increasing net cash flow. However, this may affect your third factor, vacancy. The more vacant a property has, the lower your net cash flow. Raising rents may not exactly help vacancy, but if you are creative in your marketing and good with management, your vacancy should never be a huge issue. Fourth, your operating expenses. Keep them in check. Sometimes people selling property may advertise a great cap rate, but when you look deeper you find they "forgot" to mention there utility bill is three times what it should be.

A good cap rate would be something above an 8. I would be very skeptical with anything above 15, as this usually could be something too good to be true.

Next I want to talk about CASH ON CASH RETURN. This is calculated by taking net annual pretax cash flow divided by total cash invested.
Cash on cash return = Annual Pretax cash flow / total cash invested
This is also a great indicator as it determines what your personal return on an investment would be. This can give a quick snapshot of how a property is doing. Very similar to cap rate, this indicator however would be greatly affected on how you finance the property. A good way to compare this indicator is think of it as what your ROI (return on investment) would be.

Speaking of financing, the last item I want to talk about is DSCR (Debt service coverage ratio). DSCR is simply a ratio of net operating income to your debt service. Lenders will look at this to determine if financing this property would make sense. Obviously, anything less than 1.00 isn't covering the debt service, so why would a lender finance? A good DSCR would be something above 1.25. If you stay above this, you should have a good chance of getting financing.

There are plenty of other factors to talk about, but I feel these three are pretty important and are the three I look at before I look any further. You should not base an investment on these alone, but do weigh them heavily.

JP