Real estate investment can be a lucrative way to build wealth, but it’s important to know what you’re getting into before you buy. Investing in real estate requires a lot of research and due diligence, and one of the most important things to consider when evaluating a potential investment property is the key metrics that will help you determine whether the property is a good investment.
At MY SMART COUSIN, we want you to get into property ownership! We can help by providing expertise and resources for budding Real Estate Investors, and homebuyers of all stripes–especially those looking to buy a house for the price of a car! As Real Estate Investment Coaches, we work closely with aspiring real estate investors, focusing especially on Black and Brown folks and women, to position you for success in developing and executing your plan for investment and building generational wealth.
In this article, we’ll explore the key metrics you need to consider when analyzing real estate investment properties.
THE IMPORTANCE OF EVALUATING POTENTIAL INVESTMENT PROPERTIES
Evaluating potential investment properties is crucial to making informed and profitable investment decisions. Here are some reasons why:
- Financial analysis: Evaluating potential investment properties allows you to analyze the financial viability of a property. By considering factors such as the purchase price, potential rental income, operating expenses, financing costs, and potential appreciation, you can determine the potential return on investment (ROI) and whether the property is worth investing in.
- Risk assessment: Evaluating potential investment properties allows you to assess the risk involved in the investment. By evaluating factors such as location, market trends, and potential repairs and maintenance costs, you can determine whether the property is a low-risk or high-risk investment.
- Investment strategy: Evaluating potential investment properties allows you to determine whether a property aligns with your investment strategy. For example, if your investment strategy involves long-term hold properties, you would evaluate a potential investment property differently than if your strategy involves flipping properties for quick profits.
- Negotiation: Evaluating potential investment properties allows you to negotiate with the seller from an informed position. By knowing the potential value of a property and its potential risks and rewards, you can negotiate a fair purchase price and terms.
- Long-term success: Evaluating potential investment properties ensures that you make informed investment decisions that set you up for long-term success. By thoroughly evaluating potential investments, you can avoid making costly mistakes and increase your chances of generating consistent returns over the long term.
KEY METRICS YOU NEED TO CONSIDER WHEN ANALYZING REAL ESTATE INVESTMENT PROPERTIES.
- CASH FLOW
Cash flow is one of the most important metrics to consider when evaluating a potential investment property. Cash flow refers to the amount of money you have left after all expenses have been paid, including mortgage payments, property taxes, insurance and maintenance costs.
A positive cash flow means that the property is generating more income than it’s costing you to maintain, while a negative cash flow means that the property is costing you more money than it’s generating. Ideally, you want to invest in properties that have a positive cash flow, as this means you’ll be making money on your investment. Notably, cash flow does not include the growth or appreciation in the value of the property over time.
- CAP RATE
Cap rate, short for capitalization rate, is another important metric to consider when analyzing investment properties. The cap rate is the rate of return you can expect to earn on your investment, based on the property’s income and value. A high cap rate indicates a higher potential return on your investment, while a low cap rate indicates a lower potential return. The cap rate is calculated by dividing the property’s net operating income (NOI) by its current market value.
- CASH-ON-CASH RETURN
Cash-on-cash return is a measure of the return on investment based on the amount of cash invested. This metric takes into account the amount of cash you’ve invested in the property, including the down payment and any other closing costs, and compares it to the amount of cash flow you can expect to receive each year. A high cash-on-cash return means that you’re earning a high return on your investment, while a low cash-on-cash return means that you’re not earning as much on your investment.
- GROSS RENT MULTIPLIER
The gross rent multiplier (GRM) is a metric used to determine the value of a rental property based on its gross rental income. The GRM is calculated by dividing the property’s purchase price by its gross rental income. The lower the GRM, the more affordable the property is relative to its rental income.
A high GRM indicates that the property is more expensive relative to its rental income. When comparing properties, it’s important to consider the GRM in conjunction with other metrics, such as the cap rate and cash-on-cash return, to get a more complete picture of the property’s potential return on investment.
- DEBT SERVICE COVERAGE RATIO
The debt service coverage ratio (DSCR) is a metric used to assess a property’s ability to generate enough income to cover its debt obligations, which principally comprise the principal and interest payments on the mortgage.
The DSCR is calculated by dividing the property’s net operating income by its annual debt service. Lenders typically require a minimum DSCR of 1.25 to 1.5, which means that the property’s net operating income is at least 1.25 to 1.5 times its annual debt service. Or said another way, lenders tend to breathe easier when the net operating income generated from a property is at least $1.25 to $1.50 for every $1.00 in debt payments that must be made. A higher DSCR indicates a lower risk for the lender, as the property is generating enough income and then some to cover its debt obligations.
THE MONEY WRAP UP
When evaluating a potential investment property, it’s important to consider a variety of metrics to determine its potential return on investment. Cash flow, cap rate, cash-on-cash return, gross rent multiplier and debt service coverage ratio are all important metrics to consider when analyzing investment properties. However, it’s important to remember that these metrics should be used in conjunction with each other to get a more complete picture of the property’s potential return on investment. By taking the time to evaluate these metrics, you can make more informed decisions about which investment properties are right for you.
YOU CAN ALSO READ: HOW TO NAVIGATE THE RENTAL MARKET DURING ECONOMIC UNCERTAINTY
FOLLOW US: @MYSMARTCOUSIN