There are several key financial ratios that can be used to analyze the financial performance of a commercial real estate investment. Here six of the most important ratios to understand when making an investment in commercial real estate:
1. Debt Service Coverage Ratio (DSCR): This ratio measures the cash flow available to pay the property’s debt service obligations. It is calculated by dividing the net operating income (NOI) by the annual debt service payments. Let’s say you’re considering purchasing a retail property with a net operating income (NOI) of $100,000 per year and a total debt service of $80,000 per year, here’s an example of how DSCR would be calculated:
DSCR = Net Operating Income / Total Debt Service
DSCR = $100,000 / $80,000DSCR = 1.25
In this example, the DSCR is 1.25, which means that the property generates enough income to cover its debt service obligations with a comfortable margin. A DSCR of 1.2 or higher is generally considered a healthy ratio for commercial real estate investments.
2. Loan-to-Value (LTV) Ratio: This ratio measures the amount of debt relative to the value of the property. It is calculated by dividing the loan amount by the property’s appraised value. For example, let’s say you’re considering purchasing an office building for $10 million, and you’re financing the purchase with a loan of $8 million – here is how calculations would work:
LTV Ratio = Loan Amount / Property Value
LTV Ratio = $8,000,000 / $10,000,000
LTV Ratio = 0.8 or 80%
In this example, the LTV ratio is 80%, which means that the loan amount is 80% of the property value. Lenders typically require a maximum LTV of 80% for commercial real estate loans. The lower the LTV ratio, the less risky the investment is perceived to be by lenders.
3.Gross Rent Multiplier (GRM): This ratio measures the value of the property relative to its rental income. It is calculated by dividing the property’s sale price by its annual gross rental income. Here’s an example of how to calculate Gross Rent Multiplier (GRM) for a commercial real estate investment: Let’s say you’re considering purchasing a multi-family property that generates $300,000 in annual gross rental income and is priced at $3.6 million.
GRM = Property Price / Annual Gross Rental Income
GRM = $3,600,000 / $300,000GRM = 12
In this example, the GRM is 12, which means that the value of the property is 12 times the annual gross rental income. A lower GRM indicates a better value for the property. It is important to note that GRM is a simplistic ratio and does not take into account factors such as operating expenses and vacancy rates, so it should be used in conjunction with other financial ratios when evaluating a commercial real estate investment.
4. Capitalization (Cap) Rate: This ratio measures the expected return on investment based on the property’s income. It is calculated by dividing the property’s NOI by its market value. Here’s an example of how to calculate Capitalization (Cap) Rate for a commercial real estate investment: Let’s say you’re considering purchasing a shopping center that generates $500,000 in NOI and is valued at $8 million.
Cap Rate = Net Operating Income / Property Value
Cap Rate = $500,000 / $8,000,000
Cap Rate = 0.0625 or 6.25%
In this example, the Cap Rate is 6.25%, which means that the property generates a 6.25% return on investment based on its income. The cap rate is a useful tool for comparing the relative value of different commercial real estate investments. A higher cap rate generally indicates a higher return on investment, although it may also be associated with higher risk.
5. Cash-on-Cash (CoC) Return: This ratio measures the cash income earned on the invested capital. It is calculated by dividing the annual pre-tax cash flow by the total cash invested. Here’s an example of how to calculate Cash-on-Cash (CoC) Return for a commercial real estate investment: Let’s say you’re considering purchasing an apartment building for $5 million, and you’re putting down $1 million in cash. The building generates $400,000 in annual pre-tax cash flow.
CoC Return = Annual Pre-tax Cash Flow / Total Cash Invested
CoC Return = $400,000 / $1,000,000
CoC Return = 0.4 or 40%In this example, the CoC return is 40%, which means that the cash income earned on the invested capital is 40% per year. A CoC return of 8% or higher is generally considered a good target for commercial real estate investments. The higher the CoC return, the better the return on investment for the investor.
5. Gross Rent Multiplier (GRM): This ratio measures the value of the property relative to its rental income. It is calculated by dividing the property’s sale price by its annual gross rental income. Here’s an example of how to calculate Gross Rent Multiplier (GRM) for a commercial real estate investment: Let’s say you’re considering purchasing a multi-family property that generates $300,000 in annual gross rental income and is priced at $3.6 million.
GRM = Property Price / Annual Gross Rental Income
GRM = $3,600,000 / $300,000GRM = 12
In this example, the GRM is 12, which means that the value of the property is 12 times the annual gross rental income. A lower GRM indicates a better value for the property. It is important to note that GRM is a simplistic ratio and does not take into account factors such as operating expenses and vacancy rates, so it should be used in conjunction with other financial ratios when evaluating a commercial real estate investment.
6. Net Operating Income (NOI): This is a key financial metric used in the commercial real estate industry to measure the profitability of an investment property. It represents the income generated by the property after all operating expenses are subtracted. To calculate NOI for a commercial real estate investment, you need to subtract the property’s operating expenses from its gross rental income. Operating expenses typically include property taxes, insurance, maintenance and repairs, utilities, property management fees, and any other costs associated with operating the property.
NOI = Gross Rental Income – Operating Expenses
For example, if a retail property generates $500,000 in gross rental income per year and has $150,000 in operating expenses, the NOI would be:
NOI = $500,000 – $150,000 NOI = $350,000
In this example, the property’s NOI is $350,000 per year. NOI is a crucial metric that investors use to determine the financial viability of a commercial real estate investment. It is also used by lenders to determine the loan amount they are willing to provide based on the property’s income-generating potential.
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.
Should you ever need help with your commercial real estate accounting to better understand the above ratios on your investments, please don’t hesitate to reach out!
