Ratio Analysis of Real Estate
Financial decisions are the most important decisions of anyone’s life. To invest in any financial instrument, one needs to take a wise and accurate decision. For taking an appropriate decision, analysis of financial instruments is a crucial part.
We would like to make you familiar with the analysis of Real estate which will assist you in taking accurate investment decisions related to Real Estate.
Real Estate investment can be analysed by using Ratios. The first Ratio in the line is:
Capitalization ratio: It explains the expected income to be generated by property or in simple words, how much an expected income the property will generate. When an investment decision is taken, everyone is concerned about the returns the investment will generate. The Capitalization ratio will help to answer this question. In technical words, it is discount rate of perpetuity. The Capitalization ratio is calculated:
Capitalization Rate = Net Operating Income (NOI)/Property Value
We will explain you in simple words with an example: If Mr. X buys a property worth Rs. 10,00,000/- which generates the income(NOI) of Rs. 1,50,000. The Capitalization Rate will be 150000/1000000=15%.
As the Property Value increases, the capitalization rate decreases making it less favorable for Mr. X because the Mr. X could have sold that property for increased rate and invested that money into some other financial investments.
Capitalization rate is one of the factors used to analyze Real Estate, there are many in the queue. The next comes is very familiar factor Internal Rate of Return (IRR)
When a person invests into the real estate, the first question comes to his mind is- how much IRR the project will generate?
IRR is an average annual return an investment will generate. In Capital Budgeting, IRR is a discount rate where Net Present Value (NPV) of all cash flows from a particular project equals to zero.
Higher the IRR of a project, it is more favorable to invest in the project. IRR is generally taken into consideration while analyzing Real Estate investment as it takes into account time value of money.
The IRR is calculated like XIRR either with help of Excel function or Financial Calculator.
The next factor in the cue is Cash on cash return
Investopedia explains Cash on cash return as Cash income generated from the cash invested.
The formula for calculation is
Cash on cash return= Cash flow from investments before taxes/cash invested
For example: If Mr. X buys a property of Rs. 20,00,000/- with down payment Rs. 6,00,000/- and the cash flow generated from rent per month, less expenses is Rs. 7000/- (note: here we have not considered factors like tax, depreciation and other losses incurred)
The cash flow generated annually will be 7000*12= 84000
Cash on cash return= 84000/600000=14%
This factor cannot be considered the sole factor to analyze real estate investment as there are many limitations like:
1. The calculation does not consider depreciation, tax and other losses
2. It is simple interest calculation and compounding effect is ignored
Hence, Cash on cash return is considered for analysis if other factors for analysis are calculated accurately.
Usually, before investing we think about how much return an investment is generating. The next factor in the queue will explain this.
Return on Investment (ROI) is total return earned on investment. The investment should be undertaken, if the ROI is positive or higher.
The formula to calculate ROI is:
Annual increase in value & income/Cash invested
The Formula explains how much you earn in terms of cash invested or expenses incurred. Return on Investment will help to make accurate investment decisions.
The above mentioned were the few factors used to analyze real estate investments. We hope the article will help you analyzing real estate investments. In our next article, we will explain the other factors used to analyze Real Estate Investments.