What Is Real Estate Benchmarking?

Real estate benchmarking is the standard of measurements for real estate properties' financial characteristics. Each financial characteristic represents a way it can earn income for its owner. A real estate investor will set his or her ideal number for each indicator and use the numbers to evaluate whether a real estate property is worth investing in. Real estate benchmarking was designed to help real estate investors avoid the kind of reckless speculation that ultimately caused the real estate bubble to burst in the late 2000s. While indicators are not infallible, they go a long way towards ensuring that investors will earn some profit on their investments.

Understanding Real Estate Benchmarking

During the height of the real estate bubble, real estate investors tended to invest in property based on what they thought the properties were going to be rather than what the properties actually were at the moment. For example, many of them invested in properties in low-income neighborhoods in hopes that those neighborhoods would gentrify and they would be able to sell the properties for much higher prices. While some investors were able to earn profits this way, most weren't so lucky. The real estate market plunged, and they were left with properties that were worth even less than they originally were.

Real estate benchmarking is designed to take the guesswork out of real estate investing. It gives the investors mathematical equations that allow them to judge property based on how much it's worth right now and what kind of profits it was able to generate in the past. The results of those calculations are known as benchmark indicators. In order to decide whether to invest in a piece of property, an investor will compare benchmark indicators to his or her benchmarks. Benchmarks represent how profitable the real estate property has to be in order to warrant investment. An investor will need to figure out benchmarks ahead of time.

Benchmark Indicators

There are several different benchmark indicators investors can use. The most commonly used benchmark indicators include these:

  • Gross rent multiplier--This benchmark indicator is a ratio between the sales price and the income the current landlord earns every year. It is used to determine how quickly the investor will be able to earn back the money he or she spent to buy the property. The lower this number is, the sooner the investor will be able to make a profit.
  • Cash on cash return--This benchmark indicator represents the ratio between the annual income the investor will earn (before taxes) from renting out the property and the down payment he or she made on the property. The resulting number is expressed as a percentage. The bigger the percentage is, the bigger the return will be.
  • Internal rate of return--This benchmark indicator measures the financial efficiency and desirability of the investment property. The higher the number is, the more money the investor will be able to get back for every dollar he or she spent on the property (which includes both the initial purchase price and maintenance costs).
  • Debt-coverage ratio--This benchmark indicator is used to determine whether the income the investor earns from the property will be enough to make mortgage payments on the property. The higher this number is, the less likely the investor is to fall behind on mortgage payments.
  • Break-even ratio--This benchmark indicator estimates how vulnerable the investor is to defaulting on the property if the rental income decreases. The lower the ratio is, the less vulnerable the investor is.
  • Loan-to-value ratio--This benchmark indicator measures the ratio between the mortgage loan balance and the property's current market value and expresses it as a percentage. The lower the number is, the better.
  • Net cash flow--This benchmark indicator measures how much income the investor will have left after regular maintenance expenses. The higher the number is, the better.
blog comments powered by Disqus