In Part 1 of What Are All Those Acronyms? we went over six very important financial measures used to analyze the performance of a real estate investment. This week we will go over six more acronyms and their formulas, including the one that I think is the most important measure of the bunch. Understanding these terms and what they mean makes the difference between a newbie investor and someone that is able to truly look at a deal for it is worth.
ROI - Return on Investment = ROI is probably one of the most used terms in analyzing investments. This measure is relevant across all asset types and classes. It measures the income or gain on the investment as a percentage of the investment cost. There are two widely used formulas for ROI.
Net Income/Cost of Investment
Investment Gain/Cost of Investment
ROE - Return on Equity = ROE is very similar to ROI but instead of using the cost of the investment, your income or gain is divided by the equity. In the case of stocks, equity would be the shareholders equity (companies assets less debts). In real estate equity would be the value of the property less any debt on the property. This is a good one to watch when holding investments for a longer period because as the equity increases (through appreciation or debt paydown) the ROE will decrease. As the ROE decreases, it is often wise to find ways to re-invest the equity at a higher ROE.
LTV - Loan to Value = LTV is a term that you will most often encounter when applying for a mortgage. It is simply the percentage of the loan amount to the value of the house.
Loan Amount/Value of Property
DCR - Debt Coverage Ratio = DCR is another ratio that lenders that will look at when you are taking out a loan on an investment property. The DCR is the percentage of the annual debt service that is covered by the annual net operating income. In simplified real estate terms: how much of the mortgage payment is covered by the rental income (hopefully at least 120% for most lenders)
Net Operating Income/Total Debt Service
OER - Operating Expense Ratio = The OER is a measurement of how much it costs to operate a property compared to the income provided by the property. It is the percentage of operating expenses to the gross revenue.
Total Operating Expenses/Gross Revenue
TER - Total Equity Return = I saved the best for last! In my opinion, the Total Equity Return on an investment is the best measurement when comparing properties. TER captures the return from the cash flow, the appreciation, and the paydown of the loan compared to the original cash invested. Some markets might see great cash flow but no appreciation while others might appreciate rapidly but see very little cash flow. The Total Equity Return is a great way to measure the best blend of cash flow, appreciation, and leverage to maximize your overall wealth creation.
(Annual Cash Flow + Annual Asset Appreciation + Annual Paydown of Debt)/Initial Cash Invested
All of these calculations will give you a slightly different look at an investment's performance or help you in underwriting the deal to see how it is expected to perform. It isn't really necessary to memorize the formula for each one but at least have a spread sheet that will calculate the metrics based on your inputs of the variables. This allows you to compare different investments and ensure that you are on track to meeting your goals. After you analyze enough deals, you will get good at "ballparking" some of the important calculations to see if it is worth your time to delve deeper into the deal.