Investors use a variety of methods to help them evaluate potential investment opportunities. These range from as unscientific an approach as a hot tip from a realtor who has inside connections, to general rules of thumb, to advanced mathematical models. The goal of the Investors Toolbox Series is to identify all of these mathematical models and present them in an integrated manner showing their relationship with each other.

A comprehensive approach to real estate investment involves the use of all or part of 10 essential performance measures;

1. Net Income Return on Investment
2. Cash Return on Investment
3. Total Return on Investment
4. Net Operating Income
5. Capitalization Ratio
6. Debt Service Coverage Ratio
7. Turn Over Ratio
8. Gross Rent Multiplier
9. Operating Ratio
10. Break Even Ratio

The use of ratios in the analysis of income producing property is essential to properly and completely understand their respective values. Furthermore, ratios provide a gauge or general rule of thumb so that a specific property’s value can quickly be determined relative to similar properties that may be available.

Two precepts must then be remembered when applying ratio analysis. The first is the notion that Value is Relative. The smart investor knows that perhaps more important than any other part of the investment process is having a thorough understanding of the concept of real estate values. Steve Bergs likens this process to buying a car… If you are anything like most people, you’ld probably look at the newspaper ads first, call a few of them to get a firm understanding of what the Low, Mid and High price points are. After that, you would probably look at cars in each price point to see distinct differences. Having shopped around quite a bit, you may already be familiar with a car’s price and what represents “good value”. Good value in this case means a car that is equal or less than fair market value relative to others with similar features. Finally, you’ll begin the arduous task of negotiating price and terms. If you can’t reach an agreement, then its off to the next seller until you find a deal that works for you. Since an investment property is probably 10 times more expensive than a car, then it would make sense to spend at least as much the same time and effort shopping for that investment property.

Using the logic above, we can establish the precept that, Value is Relative. This logic leads us to the second precept that Performance Measurements Are Relative. The idea that Value is Relative leads us to conclude that measurements used to determine that “Value” must also be relative. For example, what might be considered a good Cap Rate (Capitalization Rate) in one area may be considered a poor one in another area. A Cap Rate of 8% may be considered good in Makati but extremely low in Ortigas.

The idea that Value and Measurement is Relative is essential for investors to both understand and apply. Without this knowledge it would be very easy to overpay for a property. Be sure to factor these precepts when analyzing potential investment opportunities.

Our next topic in this series is the one thing that all investors have in common and that is the desire to answer the question “How much will I make on my Investment?”. Stay tuned to find out how smart investors are able to answer that question using the mathematical models described above.

What is a cap rate? Whenever searching for an investment such as a stock, currency, commodity, real estate, or any other type of investment, typically an important factor is what is my return on investment? If you’re new to the real estate game or trying to learn more you probably have not heard of a cap rate or have, but don’t quite understand what it means. This article will discuss what a cap rate is and what a bad cap rate is and what a good cap rate is.

To start, simply put, a cap rate is just a return on investment. It applies to any real estate investment you may be considering and the cap rate will help you determine if the investment is worthwhile. To calculate the return you must take the net operating income and divide it by the price you pay for the property, and then multiply it by one hundred. That will give you the percentage of return for the investment property.

Example: A 500 SQm Single Family Home in Paranaque has an NOI of 600,000. If you buy it for Php 7,000,000 you’ll be purchasing it at what rate?

Cap Rate = NOI/Value
Cap Rate = 600,000/ 7,000,000
Cap Rate = 8.5%

The next question, how do I know what a good return is? Well, the answer to that question is it depends on certain variables. The most important concern for any deal should be that the return is greater than the interest rate of your mortgage. For example, if you have a property that has an 8% return and you are looking at mortgages for the property. It is best to have a mortgage below 8%, ideally the lower the better of course. The reason for this is that if the interest rate exceeds the return, then you are essentially paying for every percentage point past your return on that mortgage. It means you lose money, typically a lot.

Thus, it is best to always have a return that is much higher than the interest, not always possible, but best to aim for it. You probably now can figure out what a bad cap rate is based on what I have just discussed, but I would like to add one thing. We now have established what a good cap rate is and what is bad. This does not mean go and buy any investment property that is less than the return. You must make sure that there is a reasonable safety net, for example an interest rate of 5.8% and a return of 8%.

In the real estate business you must realize there is a possibility of vacancies, there are unexpected costs, and more. If any of your costs end up exceeding expectations or you have a vacancy, the property will quickly result in a negative cash flow. Thus, you will be spending money to keep your property a float.

The benefit of using Cap Rate as a measure is that its quick, easy and almost every real estate investor uses it. The Cap Rate is a great tool to compare a property’s performance to that of similar properties.