Real Estate Metrics Explained

*Disclaimer: None of the content explained in this article serves, nor shall be considered as financial or investing advice. This piece is merely meant for educational purposes.

When analysing a potential real estate investment, there are multiple standalone factors that need to be examined, which in turn will help us determine whether or not a given investment option is profitable, legally compliant, and has long-term viability. These factors are numerous, although some stand out more than others due to how much information they indicate about the property in question, and how accurately they can predict future performance. In this article, we will examine four metrics, namely, the Internal Rate of Return, the Net Operating Income, the Cap Rate, and the property’s Cash Flow.

Real Estate is a rather complex market, which in fact makes it one of the markets with the highest entry barriers to date. This is the main drive behind Propchain’s vision, to give everyone access to real estate regardless of their financial or educational background. One of the reasons real estate has high entry barriers is due to the existence of non-financial factors that come into play, such as legal compliance, quality of infrastructure and amenities, information asymmetry, and more. In this piece, we will only be addressing financial indicators as they are more easily dissectible for beginner real estate investors.

Internal Rate of Return (IRR)

The IRR is a metric used to evaluate multiple investment options and not real estate exclusively. You will find stock market investors, business owners, as well as real estate moguls using this metric for more clarity prior to investing in a property. In simple terms, the IRR is a profitability metric that uses the NPV (Net Present Value) of an investment to measure its long-term returns. The IRR is a discount rate which if assumed, makes the NPV of all cash flows related to a given investment = 0.

When analysing the purchase of a few different options, financial analysts agree that on purely financial terms, the option with the higher IRR should be picked. For instance, a property with an IRR of 12% is less preferable than a property with an IRR of 15%. However, you may pick other options that have a lower IRR if it has other amenities that you prefer! For instance, a gym facility, a pool, its location, etc.

Net Operating Income (NOI)

Similar to the IRR, the NOI is also a profitability index that assess the costs of operating and maintaining a property against the income it generates.

This metric is pretty straightforward to calculate and analyse. Some operating expenses and costs include maintenance costs, utility bills, renovation costs, and unexpected damage fixes. Some income sources of property include rental income, and insurance claims. The NOI usually only considers recurring expenses and returns, however.

For example, a property that requires a payment of $250/month in maintenance and utility costs, makes $2,000/month in rental returns. The NOI of this property is $2,000 — $250 = $1,750.

Quite straightforwardly, a property with a positive NOI is more financially favourable than properties with negative NOIs. Following the same logic, a property with a higher NOI is more financially favourable than one with a lower NOI. You could however opt to invest in a property with a lower (but still positive NOI) due to its amenities, and other non-financial reasons.

Cap Rate

The Cap Rate is an index that requires the use of the NOI in its formula. The mathematical formula to calculate it is (NOI / Market Value) x 100.

Cap Rates are percentages used to compare the rates of return on different property investment options, based on their NOI and market value. Let’s illustrate this below using two hypothetical properties.

Property 1: NOI = $1,000,000; Market Value = $20,000,000

Property 2: NOI = $2,000,000; Market Value = $50,000,000

Cap Rate Property 1 = (1,000,000/20,000,000) x 100 = 5%

Cap Rate Property 2 = (2,000,000/50,000,000) x 100 = 4%

From this simple analysis, we can see that even though Property 2 has a higher NOI than Property 1, it has a lower return rate relative to its market value, which could indicate that it is not operating at its fullest potential (i.e., has room for more amenities, is too expensive to rent out year-round and thus has a lot of vacancies…)

Cash Flow

Perhaps the most namely indicative metric of all-stated ones, the Cash Flow is a simple inspection of the cash flows a given property has. Cash Flow is a term used to describe the inflow and outflow of a given property.

Usually, the component of this metric is already accounted for in other metrics such as the NOI and IRR as they are far more indicative and pertinent, but a property investor usually prefers properties with simple Cash Flows that are predictable and manageable. A property with a Cash

Flow of around 2 components (rental income and yearly maintenance checks and/or cleaning costs) is optimal in most cases. Though more important metrics come into play when making a real estate investing decision, a complicated Cash Flow could be enough to push an investor away from a property.

The complexity of Real Estate investing is not one that is true in nature, as simple metrics like the ones outlined in this article are used by all investors no matter their level of knowledge or wealth. The remaining barriers are financial and related to transparency — both issues being addressed in Propchain’s infrastructure and ecosystem, with fractionalised Real Estate being guaranteed full-transparency on the blockchain.

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