Financial Analysis Ratios & Multiples to Know
In our Ultimate Guide to Finding Real Estate Investments, we talked about the importance of setting up a lead generation system so you have lots of investment properties coming across your desk to analyze and can choose from the best.
Since you’ll be screening 100’s of potential investment deals, you will need to learn the different rules of thumb that can be used as quick screening tools in order to reduce the amount of junk properties from your list of properties to do further due diligence on.
Disclaimer: never buy a property based entirely upon one of these methods and financial ratios. These methods are a way to filter out the 99% of properties that are not good deals and only focus on the best. Do further due diligence once a property passes initial screening using these rules of thumb.
Part 1: Rules of Thumb
First we will start with the general rules of thumb you can use when building your financial analysis spreadsheet to see if the deal will work out numbers wise.
Rule of Thumb #1: The 50% Rule
This rule states that for a real estate investment, the non-mortgage expenses will usually average out to about 50% of the rent long term.
For example: If you own an 8 unit building that brings in $5,000 per month in rent, you can probably expect that over the long run this property will cost $2,500 per month in vacancies, maintenance, and other non-mortgage charges.
Purpose – to ensure that you leave yourself 50% of the income to cover mortgage debt payments. If a loan is going to cost more than 50% of your gross income each year then the rule would advise not to purchase that property because you’ll risk being negative cash flow after paying all the non-mortgage expenses.
Rule of Thumb #2: The 2% Rule
This rule states that the real estate investment should rent for 2% of the purchase price.
For example: If you pay $50,000 for a property, it should rent for $1,000 per month as this would be 2% of the purchase price.
Purpose – This rule is to ensure you can get enough rent from the investment property to cover expenses and produce a cash flow.
It’s tough to find deals that will rent for 2% so you may have to settle for less than 2% such as 1.5% but you shouldn’t go below 1%.
Make 1% be the minimum price floor in order to avoid getting into negative cash flowing properties.
Here is a quick video on the 1% rule but you should ideally apply the same principles in finding a 2% property instead.
Rule of Thumb #3: The 70% Rule
This rule states that your purchase price plus repairs should be 70% of the ARV (after repair value).
The after repair value is what we discussed in the single family home section about what your property would sell for using comps of other homes that recently sold.
Once you know this ARV comp, you can multiply it by 0.70 and subtract out your estimated cost of repairs to come up with a purchase price.
The purchase price usually ends up around 45% to 55% of the ARV depending on how much repairs are needed.
For example: If similar homes have recently sold for $100,000 and you estimate repairs to cost $20,000 on your potential investment property, then multiply 0.70 by $100,000 to get $70,000 and subtract out your $20,000 in repairs to get a max purchase price of $50,000.
Purpose – to ensure you have room to profit from the flip after purchase price and rehab costs. Closing costs and realtor commissions will also eat into that 30% margin you are leaving yourself so your net profit might not be the whole 30%.
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Part 2: Multiples & Ratios
Along with quick rules of thumb, there are also ratios and multiples you can use to compare investments and help in your decision making.
The Gross Rent Multiplier (GRM) – the gross rent multiplier, also known as the gross income multiple, compares the purchase price to the annual gross rent that the investment property can produce. For example, if you purchase a property for $50,000 that rents for $10,000 a year, then your GRM would be 5 as the purchase price is 5x the rents ($50,000 / $10,000 = 5).
The Operating Expense Ratio – compares the expenses to the overall income of the property. For example, if you had $10,000 in annual rents and had $6,000 in expenses, the operating expense ratio would be 0.60 or 60%. Ideally, we estimate the operating expenses to be 50% when analyzing a property but it can be higher such as 60% leaving us just 40% income to cover debt repayment.
The Break Even Ratio – the number of months the property needs to be rented to collect enough income to cover operating expenses. For example, you have a property renting for $1,000 per month and annual operating expenses are $6,000. You would need to have this example property rented for 6 months to break even.
The Debt Service Coverage Ratio – comparing the net operating income the property produces before debt to the debt payment total. You want this ratio to be greater than 1 in order for the property to have more net income than the debt service cost. Banks will typically require a property to yield a 1.25 DSCR or higher.
Example: You have an investment property that produces $10,000 in annual rents and has $5,000 in operating expenses.
The net operating income before debt would therefore be $5,000. Then you have debt payments that total $3,000 annually.
Take your net income of $5,000 and divide it by the $3,000 debt service cost to get a 1.6 DSCR. Had your net income been $3,000 you would have a 1.0 DSCR and a net income of $2,000 would yield a 0.67 DSCR.
When it goes below 1 it means you will be negative cash flow after paying your debt costs. Always find properties that yield above 1 to avoid over leveraging.
These rules of thumb, financial ratios, and financial multiples are great places to start when analyzing an investment property so that you save time and prevent putting in wasted effort to analyze a deal further if it doesn’t pass initial screening.
On the other hand, these are just rules of thumb and can also hurt you if you stick to them too strictly.
Two issues are that you’ll pass up some good deals that may have worked out well had you done further analysis and secondly, these rules of thumb don’t always work as markets change.
In a hot market, for example, you’ll struggle to find a rental property that meets the 2% rule because prices have risen so much and rents haven’t kept up.
So it will appear that the rent to price ratio is 1% or less, nowhere near your goal of 2%.
Take these thoughts into consideration when analyzing your market! Best of luck to you.
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