Real estate investors know that real estate is a numbers game. To find a successful investment you have to be able to analyze the investment property using some key metrics. We will be discussing the key metrics below. Using the following formulas can give you a high-level overview to determine if you want to move the property to the second round of analysis. That way you can analyze more deals in less time and find your ideal real estate investment opportunity that fits your long and short-term strategy.
1. The Cash-on-Cash Return (CoC)
The Cash-on-Cash return (CoC) is a simple calculation of the rate of return you can expect on a property. The CoC looks at the cash you invest as a down payment plus any other costs and the cash flow before taxes. This number indicates the yield you may expect on your real estate investment and it is used to compare investment opportunities. Keep in mind that the CoC does not tell you the whole story. It shows the rate of return on your cash flow before taxes, and it does not include mortgage amortization. Also, unless you are using a 5-year cash flow model, its only giving you a return on year 1 of real estate investment.
CoC = Annual Pre-Tax Cash Flow/Total Cash Invested
2. The Net Operating Income (NOI)
The Net Operating Income (NOI) is a key number in analyzing the potential of an investment property. The NOI represents the gross amount of income you can expect to receive from the property, minus your expenses. Note that the NOI does not take your mortgage payments or other debt services into consideration. The NOI is generally calculated on a monthly basis. If you want an annual figure, multiply by 12.
Your income includes rental income and other income from the property. Depending on the property type, other income would income pet charges, coin-op laundry fees, covered parking charges, etc. Your expenses include property tax, maintenance, insurance, advertising, utilities, landscaping, and a professional property manager if you intend to have one.
NOI = Monthly Gross Income – Monthly Expenses
3. The Capitalization Rate (Cap Rate)
The Capitalization Rate or Cap Rate is simply the ratio between the NOI (Net Operating Income) of the property and the sale price of the property. It will provide you with the rate of return you can expect to achieve. The Cap Rate assumes the property is being purchased with 100% Cash/Equity and does not take any debt service into consideration. As the Capitalization Rate goes up, the price/earnings valuation multiple goes down. The Cap Rate is a convenient formula for comparing potential investment properties. Then you can decide if the income potential is great enough to warrant investigating this particular property further.
Cap Rate = NOI/Sale Price
4. The Cash Flow
To find out the income potential of the property taking income, expenses, and your debt service into consideration, you have to look at the Cash Flow. The Cash Flow is the NOI minus the amount you pay for your debt service. Even if your Cash Flow covers your mortgage payment principal, interest, insurance, and tax, it is a good idea to keep cash reserves on hand in case of a vacancy or unanticipated costs for maintenance.
Cash Flow = NOI – Debt Service
5. The Return on Investment (ROI)
The Return on Investment (ROI) is your annual Cash Flow divided by your Cash Invested. Your ROI is higher when your Cash Flow is higher, or when your investment is lower. Your goal is to make more money with a smaller investment. Your ROI is a good picture of how much money you will make in a year on the investment property because it includes your investment and your financing. Remember, ROI doesn’t include your mortgage paid off each year.
ROI = Annual Cash Flow/Cash Invested
Tips for Accurate Financial Analysis
Keep in mind that the accuracy of your analysis depends on your inputs/assumptions used in the calculations. The quality of your input will determine your output. Verify your assumptions via multiple sources like brokers, property managers, market reports, rental agents, etc. Key assumptions to verify are rental rates, vacancy rates, gross income/expense ratio, taxes, insurance, and property management charges. As an informed investor, you will need to have a good understanding of the rental market, vacancy rates, and anticipated expenses so you can make educated assumptions that can boost your success. Remember to compare apples to apples in your calculations. If you are using a monthly figure for one element in the formula, stick with a monthly figure for all elements.
Real estate is a popular investment choice because it can offer a stable asset that produces an immediate cash flow. You can leverage the capital investment to build wealth faster…
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