Real estate can be an attractive investment vehicle because of the high potential for profits and the seeming ubiquity of opportunities on the market. It also offers varying degrees of participation, making it accessible for people from all walks of life. While these things are often true, they don't tell the whole story and over-eager investors can get out of their depth quickly without a strong understanding of the underlying business. Especially as the dollar amount of the investment rises, so too does the associated risk. Without a rock-solid strategy in place, you could find yourself in trouble and run the risk of losing your property.
The Hard Money Co. relies on a few metrics that go a long way in determining the success, or failure, of any project. Though these don't tell the whole story of an investment, they are an essential starting point to develop an understanding of the financial performance of a property.
The Mortgage
Simply put, your mortgage payment is the total of your debt obligations on a given asset. These most often include items such as principal repayment, interest, tax obligations, and property insurance, but can include other non-standard items as well. When a property is set to serve as your primary residence, traditional lenders like to see a debt-to-income ratio of around 36%. This means that your mortgage would account for roughly one-third of your gross income over a given period. A number of other factors can come into play that will lend leeway to this figure. Your credit score, cash on hand, or other assets can convince lenders to raise their debt-to-income requirements.
For investment properties, the conventional rules for your mortgage payment can change. This is especially true if the rental property is actively generating income while in your possession. In an instance where your rental income exceeds the mortgage, the impact of your personal debt-to-income ratio is diminished substantially.
As with each of the following metrics, the specific value of your mortgage payment isn't enough to make a determination on the strength of your investment, but you must have a comprehensive understanding of it.
Down Payments
If you are purchasing a home for you to live in, you may be able to get by with a down payment of as little as 5%. Lenders, particularly those such as the federal government, recognize that the inherent risk of default is lower on these owner-occupied properties and as a result are inclined to finance a larger amount. This is not the case for investment properties. Lenders in this space often require a down payment of 20-25% and occasionally will go even higher. Additionally, there are requirements on the procurement of these funds, meaning that you typically can't use gift funds or other one-off sources of capital. Lenders will also have a host of other requirements that will inform what the down-payment requirement will be. These can include credit scores, property appraisals, rent comparisons, and debt-to-income ratios.
The Hard Money Co. uses a slightly different approach when determining our down payments. As an asset-based lender, we look at the value (not the price) of a property to determine whether the risk is tolerable. This means that we will offer up to 65% of the After Repair Value (ARV) of the property. The difference between that amount and the purchase price will be our required down payment (less closing costs, which we are able to fund). The better the fundamentals of your investment are, the more likely you will be to see a reduced down payment.
Rental Income
Though you can expect the rental income from your tenants to help pay your mortgage, you can not necessarily assume that a lender will view income as credible for purposes of your loan. Investors typically need to have a two-year history of property management and rental income to validate this revenue stream. You may also be required to own rent-loss insurance and have a detailed accounting of your monthly cash flows.
Cash Flow
Cash flow is simply the positive or negative amount of cash generated from your investment in a given time period. This considers all associated costs including principal payments, interest, taxes, insurance, repairs, marketing, and other fees. The obvious goal is to generate positive cash flow in perpetuity, though negative cash flow in certain periods can be tolerated when unexpected costs arise.
Price-to-Income Ratio
Price to Income is one of the important metrics used to determine the value of a property's relative income in a particular community. It is a simple division of the median household price over the median household income. For instance, if a price of a home is $400,000 and the median household income is $100,000 then the ratio is 4.0. This number alone may not tell you much, but when used as a comparison between different communities and when viewing the ratio as a trend, you can draw conclusions about the trajectory of your investment.
Price-to-Rent Ratio
This is similar to our previous metric and compares income to rental prices in a market. Generally speaking, the lower this ratio, the more inclined investors should be to buy property in a community. The higher the value, the lower your return on investment will be. There are other considerations to make when assessing a property, but this one has a direct effect on the potential of your cash flows.
Gross Rental Yield
The Gross Rental Yield is the amount earned on a given property compared to all of the costs associated with that property. These can include purchase price, closing costs, renovations, etc. The yield is communicated as a percentage, so if you generate $10,000 on a $100,000 property, your gross rental yield will be 10%.
Capitalization Rate
The capitalization rate offers a slightly more detailed metric than the gross rental yield but follows a similar methodology. Here you include all operating expenses ranging from property management fees to marketing expenses, cost of capital, agent fees, insurance, and more. This capitalization rate gives you your final ROI and which are foundational metrics in determining if your property is a sound investment, or if your capital is better allocated elsewhere.
Conclusion on Real Estate Metrics
It should go without saying that this is not everything you will need in order to develop a successful investment strategy. There are countless other metrics that will lend insight into your project and they are as diverse as the circumstances surrounding your investment. There is an encyclopedia of resources available online that you can look towards to find similar investment strategies like the one you're employing. And though they will likely have additional information, they will almost all include the metrics we've covered here today.