Relax and get your ratios out
Whether you choose the time just after Christmas, or towards the end of the financial year it's important to make some time to review and plan for the year ahead.
During the year, we run detailed portfolio reviews for our clients, and I use the Christmas / New Year vortex week as performance review time for my portfolio, and the end of the financial year to set our personal goals.
While you may not want to go into the 60+ point detail that we undertake, outlined below are the top 10 performance indicators you can use to assess your property's performance over the past year.
This is just a straight calculation of annual income against annual expenses. Calculate the annual totals and divide by 12 to get an indication of your monthly cash flow.
If you can cover the mortgage principal, interest, taxes and insurance with the monthly rent, you are in good shape as a landlord. Just make sure you have cash reserves in hand to cover that payment in case you have a vacancy or need to cover unexpected maintenance costs. If you know a particular property has negative cash flow, hopefully you can mitigate this with depreciation and tax rebates, or other properties in your portfolio can cover the loss.
Whether your property is covering costs or not, if you perform this calculation you will at least be clear on what needs to happen to balance your portfolio returns.
2. Gross rental yield
Gross rental yield is a measure of a property's performance. It represents the amount of rent you achieve in a year as a percentage of the property value. Typically for properties that are cash flow positive the rental yield is higher at around 8% or more.
Gross rental yield = (Annual rental income / Property value) x 100
3. Cap rate / net rental yield
A more valuable number than the gross rental yield is the capitalization rate, also known as the cap rate or net rental yield, because this figure includes operating expenses for the property. This ratio can be calculated by starting with the annual rent and subtracting annual expenses, then dividing that number by the total property cost and multiplying the resulting number by 100 for the percentage. Total rental property expenses include repair costs, taxes, landlord insurance, vacancy costs and agent fees.
Net rental yield = [(Annual rental income – Annual expenses) / Total property cost] x 100
4. Total yield
This looks at the total return of a property as a percentage of the property value. This is a combination of rental yield and capital growth. The total yield by itself is a simple measure however knowing the make up is more important – ie 15% total growth could be 5%pa rental return and 10%pa capital growth or the reverse.
5. Cash on cash return / or Return On Investment (ROI)
A much easier way to calculate the returns on rental properties is to figure the cash-on-cash return. This return is simply the amount of cash you initially invested into the property compared to the income generated by that property. Cash-on-cash does not factor in unseen returns like appreciation, equity pay down, or even tax benefits. The great thing about cash-on-cash return is if you can make a decent return just from the income, then all the other benefits are a bonus.
6. Loan to value ratio (LVR)
Loan-to-value ratio calculates the difference between the loan balance and the market value of a property expressed as a percentage. Most investors learn this ratio first as it will provide an indication of what equity you have available to use for another purchase.
Loan to value = Loan amount divided by value of the property. For example = $320,000 divided by $400,000, to results in an LVR of 80%.
7. Break-even ratio (BER)
The break-even ratio provides investors with the percentage that operating expenses and debt service will consume gross operating income. This is also typically used by lenders when underwriting commercial mortgages to measure how capable a property is in managing its debt.
Break-even Ratio = [Operating Expenses + Debt Service] / Gross Operating Income
For example, if our property has a combined total of $47,145 for operating expenses and debt service (interest payments) along with a gross income (rental return) of $57,000 the BER is 82.71%. In other words, money going out to run the property consumes 82.71% of the money coming in.
8. Debt Coverage Ratio
This provides investors information on the extent to which the annual net income covers annual debt. A debt coverage ratio (DCR) in excess of 1.0 indicates that there should be net income remaining after servicing the mortgage, whereas less than 1.0 means that there is not enough income generated to pay the mortgage.
Debt Coverage Ratio = Net Income / Debt Service (interest payments)
For example, if our property has an annual debt of $21,645 along with a net income of $31,500 the result is a DCR of 1.46 (rounded). In other words, the income is 146% greater than the mortgage payment and therefore will cover the debt with money left over.
9. Capital growth
Capital growth is the increase in value of your property portfolio over time and should be considered alongside the property's yield. Melbourne and Sydney, in particular, have had periods that have seen home owners with properties in some suburbs doubled in value over a short period of time. On the other hand, the value of properties in Darwin and Perth have gone down.
There are a number of free calculators online that can do the calculation for you, but it isn't too difficult to work out manually. The first step in the calculation of the average annual capital growth rate is to determine the market value at the start and end of the intended investment period. Next, subtract the difference, and then divide this amount into the 'starting price'.
For example : Property one – purchased for $500,000 in December 2015, increased to $600,000 in December 2016. This represents an increase of $100,000. Divide $100,000 into $500,000 resulting in a capital growth percentage of 20%.
10. Rental growth
Perform a similar calculation (as per capital growth) to determine changes in rental growth. Match this change against your suburb rental growth to measure the performance of your property. Your local real estate agent or property manager should be able to provide you with realistic suburb rental rates.
Now you have insights the key indicators can deliver, we suggest you add this information to your property review spreadsheet. If you don't have one of these set up already, take the time now to establish a spreadsheet with all your base information – for example purchase price, purchase costs, weekly rent, interest rates etc.
Ideally, set up auto calculations in your spreadsheet so you can easily calculate the ratios for each property you own. This should include your home as well. There are many more ratios and equations you can use to monitor performance, so if you have any favourites be sure to add them to your list.
Okay . . .so you might need some of that Christmas chocolate or Winter wine to get through the initial process, but after you have completed the review you will have the clarity you need to make quality decisions about the properties you have, and what types of property you need to buy next to balance out your portfolio.
Author: Debra Beck-Mewing
Debra Beck-Mewing is the Founder and CEO of The Property Frontline. She has more than 20 years' experience in buying property Australia-wide, and is skilled in helping buyers use a range of strategies including renovating, granny flats, sub-division and development. Debra is experienced in identifying tailored opportunities, homes and sourcing properties that have multiple uses. She is a Qualified Property Investment Advisor, licensed real estate agent and also holds a Bachelor of Commerce and Master of Business. As a passionate advocate for increasing transparency in the property and wealth industries, Debra is a popular speaker on these topics. She is also an author, podcast host, Editor in Chief of Property Portfolio Magazine and participates on numerous committees including the Property Owners' Association.
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Disclaimer – This information is of a general nature only and does not constitute professional advice. We strongly recommend you seek your own professional advice in relation to your particular circumstances.