There a number of factors that allow for evaluating real estate investments from a financial point-of-view. Financial are typically easy to get and easy to compare so a good place to start when evaluating properties.
Lets start with the easiest financial metrics to get and is typically a good first step in narrowing a larger list of properties. Price-to-Rent (PTR) or Rent Multiplier (RM) is easy to calculate since asking price is known and rents are typically available on real estate listing sites such as CIMLS or will be included in the marketing package. You can simply divide property’s asking price by annual gross rent income in order to calculate the RM. Of course, the property with lower number is a better buy.
Lets say you have narrowed your list and want to get a more refined measure of value. Capitalization Rate or Cap is the next measure to consider. Cap is typically expressed as a percent and can be calculated by dividing the net income (gross income minus expenses) by the asking price. For example if you have a property with asking price of $5,000,000 and net income of $300,000. Then Cap is (100*(300,000/5,000,000) or 6%. The higher the Cap, the better the investment!
Once the choice has been narrowed to one or two property the further analysis such as Return on Investment (ROI) and Internal Rate of Return (IRR) help in evaluating the real estate investment compared with other capitalization utilization opportunities.
ROI is a financial metric that is widely used to measure the size of possible return from an investment. It measures gain or loss from an investment relative to its cost. For example the cost of capital, management and maintenance is considered to calculate the return. ROI is useful in evaluating potential return from a real estate investment compared with other types of investments.
IRR requires more involved calculations, but there are plenty of free applications online to do the calculation for you. You need to provide assumptions or estimates such as expected income/expenses now and change in the future. IRR is used in capital budgeting to estimate the profitability of potential investments. IRR is a discount rate that makes the Net Present Value (NPV) of all cash flows from a particular project equal to zero. It is also called the discounted cash flow rate of return. The term internal refers to the fact that the calculation excludes external factors, such as the risk-free rate, inflation, the cost of capital, or various financial risks.
As you have observed each successive metrics is more involved, but they are required to fully evaluate any commercial real estate investment against other opportunities. Financial analysis is a required step along with other factor to consider market condition, quality of product, demographics of the region to name a few.
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