In prior articles, we covered key return fundamentals and cap rates. While those tend to be the most commonly discussed, there are a few other key performance indicators (KPIs) we want to mention that you should consider as you evaluate real estate investment opportunities.
NOI = Net Operating Income
In more simplified terms, NOI equals Revenues minus Operating Expenses and represents the operating profit generated by the property before debt service, CAPEX, or other extraordinary items. As such, the two key components of NOI are revenue and expenses.
- The Revenue line item represents the sum of total rental income generated by the property plus other income (e.g. pet fees, laundry fees, valet trash fees, utility reimbursements, other fees, etc.). More often than not, when you review the operating statements of a property you will see that expressed on a gross basis as total scheduled rental income with a vacancy and other reserves (bad debt, concessions, other reserves, etc.) factored in as separate line items to arrive at net rental revenue. You will often hear that referred to as effective gross income.
- The Expense line item captures all operating expenses related to the property, which typically include but are not limited to property taxes, property management fees, insurance, repair and maintenance, utilities (if landlord paid), contract services (e.g. pest control, landscaping, etc.), general and admin expenses, replacement reserves, etc. Typically operating expenses are 50% of the effective gross income discussed above. However, the expense ratio may vary based on the property type/age/location. For example: (i) it is not uncommon for larger properties to operate at a 40-45% expense ratio based on economies of scale or (ii) to see a 30% expense ratio for properties in Denver, CO.
Break-Even Occupancy – unit count and %
As the name of this KPI may imply, it measures at what point of occupancy does revenue generated by the property cover the property expenses (including debt service) just enough to break even. It is calculated as total operating expenses plus debt service divided by gross potential rental income. You may see that measured as both a unit count basis and a % basis. A break-even of 80 units count on a 100 unit property for example, simply means that occupancy can decrease from 100 units to 80 units before it breaks even. Similarly, a break-even of 80% simply means economic occupancy (which captures both physical vacancy and bad debt, concessions, loss to lease, etc.)) can drop to 80% before the property breaks even. A break-even of 80% or less is generally considered good. Any number larger than 90% implies there is a very little cushion or room for error in case of potential deterioration. As a reference point, agency lenders would often have a 90% physical occupancy minimum.
Modified Break Even: This KPI is similar to Break-Even Occupancy, except that the sum of total operating expenses and debt service is divided by gross effective income. As such, it indicates how much income (which may include other income streams beyond rent and also captures economic vacancy) can fall before the property breaks even. This metric is often more favored by lenders and is one I like better. A break-even ratio of 80% would indicate revenues could drop by 20% for the property to reach a break-even profit level.
DSC = Debt Service Coverage
DSC equals the NOI divided by the principal and interest debt service. Effectively it measures the ability of the cash flow generated by the property (NOI) to service the debt (debt service). Most often lenders would require a min of 1.25x DSC, though this number can range from as low as 1.10x to as high as 1.30x. As an operator, you want to have some cushion. We typically target a DSC min of 1.5-1.6x. And in a worst-case scenario, you do not want your DSC to fall below 1.0x, which simply means the property does not generate enough cash flow to cover the minimum debt obligation. If that occurs, the owners would be required to cover the deficit (or take other action to cure the bank covenant default).
Reserves
Simply put, this is your rainy day bucket. Good practice would be to set aside 4-6 months of reserves. It is also not uncommon for the lender to establish what these reserve minimums are. However, whether mandated by the lender or not, one should always set aside reserves upfront (in addition to the replacement reserves captured in the p&l) as unexpected expenses will and do happen.
Should you have any questions or want to learn more about real estate investing or for an overview of our target markets, please reach out to info@dbacapitalgroup.com.
Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.