Real estate investment is a complex business. Many diligent investors use sophisticated techniques to conduct their due diligence. Ratio analysis is one such sophisticated technique. This technique is similar to ratio analysis carried out when evaluating the financial statements of publicly traded corporations. This ratio analysis also includes specific terms and quirks only used in real estate investment. This article will explain the ratio analysis for real estate investments from an individual point of view. What should a person consider when buying a rental? Here are some commonly used ratios.
Rate of Loan to Value
At an individual level, the loan-to-value (LTV) is one of the most significant numbers that investors and banks look at. These two stakeholders are looking at the same number from very different perspectives.
For example, the bank looks at the loan-to-value ratio to protect its investment—for example, a property with a loan-to-value ratio of 90%. If the value of a property is $100, then the bank will have financed $90, and they are entitled to a claim over the property. If the value of a property drops by 10%, then the bank’s investment will still be secure. The bank offers better terms and rates when the loan-to-value ratio is low.
Individuals also use the loan-to-value ratio to determine the leverage they will take on when purchasing a property. A high loan-to-value indicates a risky investment, as even a slight change in property prices can cause the investment to go into the red.
Debt to income ratio
When individuals buy real estate for their purposes, they will apply this ratio for personal consumption or as an investment. The debt-to-income ratio indicates how easy it will be for a person to pay back a mortgage.
Mortgage payments, for example, should be at most 33% of monthly income. If mortgage payments exceed 33%, the person may be at risk for financial hardship.
Calculate the annual mortgage payment and divide it by the individual’s net yearly income. Multiplying the number by 100 will convert it to a percentage. If the rate exceeds 33%, then there is a high risk.
Multipliers for Gross and Net Income
This number determines the amount an individual will pay as a capital investment for a rental property. For example, if this number is 18, an investor pays $18 upfront to control an annual rental income of $1.
The market value of the home is used as the numerator. The denominator can be the gross or net rental income after subtracting taxes and expenses.
We get the gross multiplier when we use gross income as the denominator. However, we get the Net Income multiplier if we use net income as the denominator.
Rental Yield
A rental yield is a number that is calculated similarly to bond yields on the bond market. In the numerator, the annual rent generated by a property is considered. In most cases, the property’s rental value is used as the numerator. There are no rules for ratio calculation, and each investor uses their heuristics.
The price paid for the property will be used as the numerator. The price paid for a property can be different than its current value. The property may have been purchased for $100 by an investor, but now it could be worth $135. We will still use $100. This is for a simple reason. The yield can only be determined after the investment value is considered. This is not an abstract figure. It tells us a property’s current Return on Investment (ROI).
Capitalization Rate
The capitalization rate is the same as the rental yield. There is one significant difference. Rental yield is calculated using gross rental income as the numerator. The capitalization rate ratio, however, uses net income. The income is generated after subtracting all taxes and operating expenses from the rental income generated by the property. The same denominator is used, i.e., The price the investor pays for the property. The property’s price will not change based on its market value, as this does not calculate hypothetical opportunity costs. It calculates the actual return on investment for a particular property.
There is no way to exhaust the ratios you can use to evaluate a home. Every investor has a way of using ratio analysis. As a general rule, investors should remember that real estate is mainly about managing cash flow and must be able to generate and sustain predictable increases in cash flows.