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Basics of Real Estate Investment Analysis
Identifying a good Real Estate Investment
Assume that the properties are income (rental) producing properties. If either or both are
currently being rented, you would want to see not only what the rents have been, but
what expenses have been.
You might also be able to see that the current owner may be deferring maintenance on
items if you notice that little or no money has been spent in areas where experience has
taught you that money should be spent. Also watch for overstatements of rent and other
income and understatements of expenses.
The next step would be to prepare an operating cash flow. This is just a projected income
statement. It will include your best estimate of what the rent and other income from the
property will be. Sometimes the rents the current owner is charging are too low for the
current market and you will be able to raise them when the leases of the current tenants
expire. Or maybe the occupancy rate is currently lower or higher than the rest of the
market and you feel an adjustment is required. Whatever the case, you will need to come
up with realistic estimates of all income and expense items and develop your cash flow
statement.
Ratio Analysis
Once this is complete for each property, you can calculate several ratios to compare
properties.
Debt Service Cover Ratio = Net Operating Income (NOI) / Annual Debt Service
Operating Expense Ratio = Operating Expenses / Effective Gross Income
Price per Floor Area = Purchase Price / Lettable floor area (ft
2
or m
2
)
Rent per Floor Area = Potential gross income / Lettable floor area (ft
2
or m
2
)
Expenses per Floor Area = Operating expenses / Can be Net or Gross floor area.
Identify recovery from tenants under the terms of the lease (i.e. Net or Gross lease)
Net Operating Income (NOI) = Net operating income (NOI) / Lettable floor area (ft
2
or
m
2
)
Break Even ratio = Operating expenses
1
- Reserves for Replacements
2
+ annual debt
service / Potential Gross Income
3
(PGI)
Yield or capitalisation rate (Cap rate) = Net operating income /Capital Value
Cash on cash return or Equity dividend rate = Before tax cash flow / Equity i.e. (NoI
ADS)/(1-LTV * Price)
Mortgage Constant = Annual debt service / Original mortgage balance (If the loan
constant is less than the cap rate, the result is positive leverage)
Loan to Value ratio (LTV) = Mortgage amount / price (This is at the point of purchase,
over time this ratio will change due to appreciation of the property and the declining
balance of the mortgage)

1
Ideally this should be split between Fixed and Variable (those costs that vary with the level of
vacancies)
2
Replacement Reserve is the setting aside of funds to pay for anticipated future major expenses.
They may be operating reserves (e.g. repair of a roof) or capital reserves for upgrading the
property (e.g. air conditioning electrical or mechanical equipment retrofitting, improving the
parking area, etc.
3
Some analysts use Effective Gross Income, so it is important to state basis of calculation and why
PGI or EGI has been selected. Either approach can be used to calculate the same breakeven rent.

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Application
The practical application of these ratios is important. Assume you are comparing two
properties:
Property A requires a down payment (Equity) of 25,700 and has a before tax cash flow
of 3,200.
Property B requires a down payment of 35,000 and has a before tax cash flow of
3,850.
For property A, the cash on cash return is 12.45% (3,200/25,700)
For property B, the cash on cash return is 11.00% (3,850/35,000)
So, as far as cash on cash return is concerned, property A is the better investment.
Use these ratios to calculate the value of a property or the maximum equity you would
be willing to make on a property.
For example, consider a property that has before tax cash flow of 7,200 and as an
investor, you have determined that your minimum cash on cash return needs to be 11%.
You calculate 7,200 / .11 = 65,454.
This means the maximum down payment you could make for a 7,200 before tax cash
flow is 65,454.
Because the calculation is based solely on before-tax cash flow relative to the amount of
cash invested, it does not take into account the investor's tax position, nor does it take
into account any appreciation, depreciation, the time value of money or other risks
regarding the property. Nonetheless, it does do a quick read comparison between
investment opportunities and between similar income-producing properties.
Go through this same process with each ratio and compare each property.
Defining Return on Equity
Return on Equity (ROE) is a straightforward investment measure. The traditional method
of calculating ROE is pretty clear- cut: Take the cash flow after taxes and divide it by the
initial cash investment.
Return on Equity = Cash Flow After Taxes / Initial Cash Investment
This is just a step away from the, Cash-on-Cash measure (aka Equity Dividend Rate).
The only difference is that Cash-on-Cash uses the cash flow before taxes. It is a quick
and dirty way to evaluate an investment, without having to write a cash flow.
Whichever of the two appeals to you more the measurement will give you a quick sense
of how the cash flow measures up to its cost.
There is a less traditional approach, however, used in real estate investment analysis
that can tell you something quite different about your income-property investment. This
not-so-standard method differs in its definition of equity. Instead of looking at the
actual cash invested, you look instead at potential equity at a particular point in time.
That equity is not the cash actually invested, but rather the difference between what the
property is worth and what is still owed in mortgage financing. So, if you look at the
equity after one year (or two or three), you will be taking into account the growth or
decline in the propertys value as well as the amortisation of the mortgage.
The formula now looks like this:
Return on Equity = Cash Flow After Taxes / (Sale Value less Mortgage Balance)
This measurement becomes interesting if you apply it in a multi-year projection. Assume
that you make projections about a propertys performance over a number of years and

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that you include in those projections the potential sale value and mortgage balances for
each year.
Whether or not you actually sell the property in any particular year, you accept the idea
that your equity at a given time is the difference between what your property is worth
and what you owe on your mortgages. By this reasoning, the return on equity measures
not how you cash flow performs in relation to how much you originally invested, but
rather how it performs in relation to how much you currently have tied up in this
property.
What difference does it make? Consider this situation; you project that your propertys
cash flow and sale value will increase each year but when you calculate the ROE you find
the ROE starts going down at some point even though the value of the property and the
Cash Flow After Taxes continue to go up. Is this a mistake? No, it can occur if the equity
grows at a rate that is faster than the growth in cash flow. With this definition, the equity
can grow when the value of the property increases or the mortgage balance decreases
or both. Mortgage amortisation typically accelerates over time, so that alone can
accelerate the growth in your potential equity. ROE is a simple ratio, so if the equity
grows faster than the cash flow, then the Return on Equity will decline over time.
What does this decline mean to you as an investor? It means you have more and more
potentially usable cash tied up in this property and that the return on that cash is
declining. Is that a bad thing? Not absolutely it depends on the alternative uses for the
money. If you were to refinance, could you purchase another property and earn a greater
overall return? If you sold, could you use the funds realised to reinvest into a larger or
better property, one with a better long-term upside?
If the answer to any of these questions is yes, or even maybe, then using this alternative
method calculating ROE can give you the framework you need to maximum your
investment. However it is still not a time value of money metric.