7 KPIs for Purchasing Rental Properties
When you’re looking to invest in real estate, you need to know more about a property than its purchase price and potential rent. Key performance indicators (KPIs) help real estate investors evaluate potential properties, reduce risk, and maximize profits. Having a solid grasp of KPIs shows your investors and partners that you have done your research and understand the best practices for investment properties. To help you solidify your understanding of rental property KPIs, we’ve put together a list of the seven most important metrics to help you assess potential properties.
Note: These metrics are geared toward residential units.
1) Net Operating Income
The net operating income (NOI) assesses how much money you’ll make from a specific investment property and whether the investment will generate enough income to cover the mortgage payments.
To determine the NOI, you’ll have to make some assumptions about the property’s annual operating expenses and potential rents.
Subtract the property’s operating expenses from the total income. Don’t include mortgage payments, capital investments, or interest in the operating expenses. But be sure to include all income, including laundry machine income, parking fees, etc.
Total Income − Operating Expenses = Net Operating Income
REI Hub has an NOI report in the report center, so once you’ve bought a property, you can track the NOI on a monthly and annual basis.
2) Internal Rate of Return
The internal rate of return (IRR) estimates the interest you will earn on each dollar invested in a rental property over the holding period. It tells you the percentage of the investment’s value that is profit and the property’s potential growth rate.
To determine the IRR for a property, you’ll need projected cash flows for each year you plan on holding the property. You’ll also need to know the present value of the property. The IRR formula is complicated since it accounts for compound interest earnings and uses multiple elements to produce a single percentage. We recommend you use Excel’s IRR function.
The IRR shows total gains over time, so it’s beneficial for investors who expect to keep properties as long-term investments. It’s also a useful metric to help you decide how long to hold on to a property before selling. A negative IRR means you’re likely to lose money on an investment. Investors typically look for an IRR of 10 percent or higher. In real estate, 18 to 20 percent is very good.
Despite its usefulness, this KPI has its limits. IRR doesn’t account for unexpected repairs, and it assumes a stable rental market. When you’re considering new investment properties, use IRR to compare properties of a similar size, use, and holding period.
3) Gross Rent Multiplier
The gross rent multiplier (GRM) helps investors compare buildings and estimate a building’s worth. As with the IRR, the GRM helps you determine if a potential property is a good investment and if the building is worth holding on to for the long term.
To calculate the GRM, divide the property’s market value by its annual gross rental income.
Property Market Value ÷ Annual Gross Rental Income = Gross Rent Multiplier
You’ll need your local market data and information about comparable properties, since those determine what a “good” GRM is. But the lower the GRM, the better. A low GRM means you’ll be able to pay off your rental property faster. Look for a GRM between 4 and 8.
Remember that GRM doesn’t account for vacancies or expenses, so don’t base your investment decisions off this metric alone.
4) Loan to Value
The loan-to-value metric (LTV) measures the amount you need to finance against the property’s current fair market value.
To determine the LTV, divide the loan amount by the appraised value of the asset securing the loan. For example, say a property is worth $150,000, and your loan balance is $80,000.
$80,000 ÷ $150,000 =.53 LTV
This ratio is important because lenders use it when they’re considering whether they’ll approve a loan. It also influences what terms a lender will offer. Generally, an LTV of 80 percent or less is good. If your LTV is higher than 80 percent, you’ll need mortgage insurance.
To lower your LTV, you can either make a larger down payment or choose a less expensive property.
If you already own a property, the LTV is the best way to track the equity you hold in a property. As you pay down the principal balance, your LTV goes down. If your home increases in value, that will lower your LTV as well.
5) Price to Rent Ratio
The price-to-rent ratio (PRR) helps people determine whether it makes more financial sense for them to rent or buy a home. Real estate investors use PRR to gauge the potential demand for rental property in an area. If you find a potential property in an area with strong demand for rental properties, you may earn a higher return.
To calculate the PRR, divide the median home price by the median annual rent.
Median Home Price ÷ Median Annual Rent = Price-to-Rent Ratio
The higher the PRR, the greater the demand for rental property in that area. Use this metric to compare similar properties in the same market. A PRR of 16 or higher usually shows that renting is more favorable than buying in that area.
A recent study from SmartAsset compared and ranked housing costs in cities across the US, highlighting potential cities for investors. Remember, PRR doesn’t account for affordability. This only shows the economics of buying vs. renting. If housing prices are too high for most people in an area, renting may be their only option.
6) 50 Percent Rule
According to real estate investors’ 50 percent rule, a property’s operating expenses should be about 50 percent of its gross income. You can use this quick calculation to estimate what the normal operating expenses of a property should be.
Operating Income × 50% = Operating Expenses
When using this calculation, don’t include the mortgage payments, property management fees, or homeowners’ association dues. However, you should include the property taxes, insurance, maintenance and repair costs, and utilities.
Use this rule as a guideline to help you avoid underestimating expenses and overestimating profits.
7) 70 Percent Rule
If you’re interested in flipping houses or buying a fixer-upper, the 70 percent rule will help you determine what your maximum allowable offer price should be. This calculation accounts for rehab costs and the property’s estimated value after the updates and repairs are completed. According to the 70 percent rule, an investor shouldn’t pay over 70 percent of a property’s after-repair value minus the renovation costs.
(After-Repair Value × 70%) – Rehab Costs = Maximum Allowable Price
To make sure this calculation is accurate, you’ll need to study market conditions, have a resale estimate, and get renovation estimates from contractors.
Takeaways
Using KPIs can help real estate investors quickly evaluate and compare potential properties to determine which property is worth a more thorough investigation. Although each metric is valuable in its own way, savvy investors use a combination of metrics to assess properties, reduce risk, and maximize profits. When you’re ready to expand your portfolio, use these seven KPIs for insights into potential properties.
