Understanding and following critical financial metrics are essential to monitoring the performance of your Real Estate investments. These investments span various product types such as office and retail, including development and operations. These Key Performance Indicators (or KPIs) are equivalent to checking the vital health signs of your investment or business. These assist Owners and Managers in isolating problem areas needing correction. In this article, we will focus specifically on Homebuilding, and the terms ratio, metrics, and KPIs will be used interchangeably. The key financial ratios in homebuilding analyze profitability, efficiency, liquidity, leverage, and return on investments.
The Balance Sheet and Income Statement are used to calculate these financial ratios. Metrics derived from the Balance Sheet measure the critical relationship between Investors and Lenders, while the Income Statement metrics evaluate the business operations. Although many more ratios can be derived from the financial statements, understanding these Key Performance Indicators is imperative in achieving an optimal real estate business. These metrics provide a standard of measurement for past performance, allowing comparison to industry peers, and can be used to help forecast trends. Homebuilding offers an excellent case study of how these KPIs can be applied.
Profitability Ratios present the operational performance for various expense categories in the income statement. These ratios are derived from an expense divided by sales or revenue. Management must establish target KPIs derived from industry peers and feasibility. Comparing the metrics of these major expense components allows management to see challenges, focus areas, and underperforming departments. The critical metrics for Profitability ratios follow the income statement order and are as follows:
Income Statement Ratios (all divided by Sales)
Revenue (Sales)
- Cost of Sales: Cost of Sales Ratio
Land Land Ratio
Direct Construction Cost Direct Construction Cost Ratio
Gross Profit Gross Profit Ratio
- Total Operating Expenses: Operating Expense Ratio
Indirect Construction Cost Indirect Construction Cost Ratio
Financing Expense Financing Expense Ratio
Sales & Marketing Sales & Marketing Ratio
G&A Expense General & Administrative Expense Ratio
Net Profit Net Profit Margin
The above illustrates how seeing the ratios in correlation with the income statement format will make it much easier to memorize.
Efficiency Ratios unveil how well the company uses its resources, such as sales and inventory, and are derived from numbers on both the Income Statement and Balance Sheet. These ratios evaluate how quickly it generates revenue from its assets and inventory. The numerator is Sales in both the Asset Turnover and Inventory Turnover Ratio. The denominator is either Assets or Inventory on the Balance Sheet.
Asset Turnover Ratio = Sales / Assets
Inventory Turnover = Sales / Inventory
The higher figures reflect more efficient use of resources to generate revenue. An example of an Inventory Turnover Ratio with Sales of $48,500 and inventory of $18,250 is 2.66 (48,500/18,250 = 2.66). Adjusting this ratio to illustrate as months will show approx. 4.6 months (365/2.66 = 137 days). Custom builders will have longer turnover times compared to production builders. A builder must understand the industry and market benchmarks for cycle time comparison and adjust accordingly, usually through construction process improvements or the spec home inventory.