Hello! 

So I finally finished our property wide portfolio analysis. Here's an example of the 2022 KPIs I'm measuring for a few of the properties in the portfolio. 

A couple important notes on calculations and definitions: 

• Equity is defined as the FMV estimate less the loan balance (if there is a loan). FMV estimates use market knowledge and appraisal estimates when available.
• Cap Rate is the 2022 NOI divided by the FMV estimate. I actually used this number to adjust the FMV estimate where needed, if I saw a cap rate that was obviously too high or low for the market.
• Return on Capital. This is the 2022 Cash Flow (CF) divided by the total capital (cash) invested in the deal, included original down payment, closing costs, capex, etc. In year 1, this would be the cash on cash.
• Return on Equity. This is the 2022 CF divided by the total Equity in the property as defined above. 
• Return on Asset. This is the 2022 CF divided by the FMV for the property as defined above. 
• Profit Margin. This is the 2022 NOI divided by the 2022 Income for the property. 
• Expense Ratio. This is the 2022 Operating Expenses divided by the 2022 Income. 
• Leverage Ratio. This is the loan balance as of 2022 divided by the FMV as defined above. 

Also it is important to note that it should be assumed for this discussion that these properties are operating at peak performance, i.e. all value add has already been implemented. We're talking about financial performance here.

Question: How do you decide which properties are underperforming financially?

1. At first I thought the only metric I really needed to pay attention to was the Return on Equity (ROE). After all, this is telling me the current return on my cash invested. But then I realized a few problems with this... 

2. First, the definition of "Return" in this case means Cash Flow. Cash Flow is after things like Tenant Improvements, CapEx, and Leasing Commissions. So if the property got a new roof or had a major new tenant lease in the given year, this could wildly reduce your ROE. I mean, if it got a new roof, it certainly didn't perform well that year from a cash flow perspective, so it is a good metric, but not the full picture if you're analyzing for a buy/sell decision.

This can be fixed by looking at the NOI instead of the cash flow, which excludes the non-operating expenses listed above. This is the Cap Rate KPI, by definition.

However, a low Cap Rate isn't necessarily only because NOI is low. It's also a function of the market. Markets that command higher prices will have lower cap rates. So does a low Cap Rate necessarily mean you should sell?

3. The next problem with Return on Equity is that it's ignoring the option of adding debt to debt-free properties (for example, Properties C & E above) or refinancing others. Return on Equity may increase by adding leverage to a debt-free property. This brings us to the Return on Asset metric which removes the debt factor across the board and compares return of all properties based only to their FMV.

So the question here is how do we combine these metrics of Return on Equity, Cap Rate, and Return on Asset to make a uniform consensus on the financial performance of a given property compared to others? 

And what other financial metrics should be taken into consideration that we might be missing?