Which financial ratios do you need for the real estate deal analysis?
The topic of analyzing the real estate deal seems daunting to many people. And indeed, there many ratios that could be used and many of them are providing you with different information and insights. That's why I would like to share with you how I have grouped the ratios that I often use.
I differentiate 3 groups of ratios for the real estate deals. The First Group is the group with ratios that don't make any difference whether the cash inflow is from the current period or any other period in the far future. The amounts are taken with their nominal value and the time value of money is not taken into consideration. And the second characteristics of these ratios is that don't account for any risk of the particular cash inflow. Is it coming from a very risky project or from the very safe one – the ratios don't reflect this.
The ratios from this group are the Gross Operating Income, The Net Operating Income, the Cap Rate, the Return and the Rent Multiplier.
These ratios are simple deviation of two numbers and they are very useful for quick analysis of the transaction. They will help you to make quick comparison of your potential deal with the alternative ones and to compare the performance of your potential investment with the overall performance of the market. In this respect the effectiveness of the first group ratios should not be underestimated.
The Second Group of ratios deliver actually everything that the first one is missing. They will provide you with accurate estimation of the present value of your cash flows and they will take adequate care of the risk of your project. These ratios are dealing with dynamic cash flows consisting of numerous periods.
On top of this the main ratio among them – the Net Present Value will deliver just a number as an end result. This number is dimensionless, meaning that it is easy to compare with other project that have different magnitude, risk and duration. Despite of this you will get a fair comparison that you might use for your analysis.
The main ratios of this group are the Present Value (PV), the Net Present Value (NPV) and the IRR. As mentioned these ratios are more sophisticated compared with the ratios of the first group and can't be normally calculated on the back of the envelop.
They require the usage of a financial calculator or computer. Some of them like the IRR will give you a percentage as a result indicating the probable profitability of the potential project and others like the Net Present Value will deliver an absolute number that will give actually pretty good idea how much richer you will become if you undertake the analyzed project.
I have to confess that I am a big advocate of the Third Group of financial ratios. This group includes ratios that reflect the level of debt in the transaction. Because the level of debt depends on the investor's decision and preferences, I often say that the ratio of the third group measure actually the performance of the investor and not the performance of the asset itself. The main idea of these ratios is to deliver accurate estimate about the ability of the project to maintain the chosen level of debt (DSCR), about the Return of the investor's equity in the transaction (ROE) and about the cost of capital in an existing portfolio with certain risk profile and profitability characteristics (WACC). All these parameters depend on the level of debt in the transaction and must be accounted for when the investor chose the level of debt in the project.
The ratios included in this group as it become already clear are the Return on Equity (ROE), the Weighted Average Cost of Capital (WACC) and the Debt Service Cover Ratio (DSCR). The latter is used very often by the banks to estimate if the cash flow of the proposed project will be sufficient to cover the service of the debt and the other costs and covenants related to the debt maintenance.
If you have already a portfolio of real estate units and you have debt in this portfolio the calculation of the WACC will become crucial for you, because the WACC could be/should be used as a discount rate in the NPV calculation for future potential projects. You must know this number.
The Return on Equity is the main reason why you need debt in the transaction. It boosts dramatically the investor's return and makes the real estate investment so attractive that it is almost not comparable with anything else on the market. There are however some prerequisites that must be taken into consideration otherwise the debt could be very harmful to the investor's equity.