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.