1. Net Operating Income – NOI
This is the one number that every income property owner should know as it’s an estimate of the annual income generated by a property. Although the formula is pretty straightforward, the devil’s in the details.
NOI = Gross rent*(1 – Vacancy Rate) – Operating Expenses (such as Property Management, Maintenance, Insurance, Property Taxes, HOA Fees, etc.)
Gross Rent: This should be a realistic assumption of the rent potential of a property. If the property is rented out, then this number is known with greater certainty. Otherwise, a smart investor should look at the rents charged for similar properties – SpendTree provides an estimate, but also consider checking listings on sites for renters.
Vacancy Rate: This is often overlooked by new investors, but needs to be considered. It’s unlikely that a property is going to be rented out consistently, so an appropriate vacancy rate greater than 0 needs to be incorporated. SpendTree provides vacancy rate estimates at the local, state/provincial, and national level.
Operating Expenses: This is generally the area of greatest variability. A shrewd investor will be sure to account for all known expenses, as well as an allowance for general repairs & maintenance. Note that financing costs (e.g. mortgage principal & interest payments), income taxes, capital expenditures (e.g. upgrades to the property), as well as depreciation of capital assets are NOT included in operating expenses for the purposes of NOI. This is because NOI is an estimate of the current annual profitability of a property regardless of future improvements, how the property is financed, or the owner’s personal tax situation.
NOI should NOT be considered an estimate of a property’s cash flow since it neglects to consider financing, personal taxes, and capital expenditures. It is, however, a relatively reliable way to compare the profitability of similar properties. All else equal, a property with a higher NOI suggests a better investment. When comparing properties, however, be sure to consider the cost of upgrades. Two properties that cost the same and yield different NOI’s may not mean that the higher NOI property is a better investment. The higher NOI property may require significantly more capital investment which may mean the total return may not be as great.
2. Cap Rate
An abbreviation for capitalization rate, the cap rate allows you to easily compare the annual profitability of different properties compared to their costs without considering financing.
Cap Rate = Net Operating Income / Total Cost
Everybody in real estate investing loves to talk about cap rates. Obviously a higher cap rate is better than a lower one, but as discussed above with NOI, it’s important that you compare apples with apples. For one, make sure that NOI is calculated consistently – there tends to be a wide discrepancy in the expenses that investors / agents tend to include or neglect in their calculations. You may also want to consider taking a normalized cap rate over a 5 or 10 year period since NOI in year 1 tends to be lower, especially if a property is vacant when purchased (SpendTree gives you a cap rate analysis over several periods).
Also, cap rates don’t consider capital expenditures, depreciation, or financing, so it’s important that this be used in conjunction with other metrics when analyzing a property.
The question a lot of investors love to ask is, ‘What is a good cap rate?’. The answer is that it depends. In markets that have historically seen great appreciation in home prices, cap rates tend to be lower as appreciation makes up a bigger portion of overall return. In markets with more modest appreciation, it’s not uncommon for investors to talk about cap rates above 10%. Any good investor should get to know the local market and understand expectations for cap rates. If a property’s cap rates appears significantly higher than the market, an investor should explore why this is the case. It may just be a great opportunity, but could also be a warning sign that the numbers are too good to be true.
3. Annual Cash Flow
As mentioned above, NOI does not consider all cash expenditures. It does not include mortgage payments, nor does it include capital expenditures or income taxes. Serious investors will want to consider both the pre-tax and post-tax cash flows they should be expecting from a property. At the end of the day, an income oriented investor is most concerned about what they’ll actually be able to spend from the investment.
Pre-Tax Annual Cash Flow = NOI – Capital Expenditures – Mortgage Payments
Post-Tax Annual Cash Flow = (NOI – Mortgage Interest Payments – Depreciation) * (1 – Marginal Tax Rate) + Depreciation – Capital Expenditures – Mortgage Principal Payments
Depreciation: Note that depreciation is a non-cash charge, so it doesn’t affect pre-tax cash flow. It does affect post-tax cash flow as it’s deductible for tax calculation purposes. That’s why we have to add it back in the post-tax calculation (it reduced income taxes owed in a year).
Mortgage Payments: Mortgage interest is a cash expense that goes directly to the bank, and hence is deductible for tax purposes. While mortgage principal payments do affect cash flow, they go directly to paying down your mortgage and so you still benefit from this and need to be taxed on these payments.
Calculating a reasonably accurate cash flow projection can be challenging, but we’ve done our best at SpendTree to provide you with this analysis in our reports. It’s an important consideration all real estate investors should know.
4. Cash-on-cash return
This is an important ratio to evaluate the overall performance of a property. It compares the total cash returned to the investor with the cash invested in the property.
Cash-on-Cash Return = (All property cash flows + cash received on sale) / Total Cash Invested
Cash Flows: This is essentially a sum of the annual pre or post-tax (depending on whether you’re calculating a pre or post-tax cash-on-cash) cash flows as discussed above.
Cash Received on Sale: This is the selling price – closing costs – remaining mortgage balance (and any mortgage penalties if applicable). If you’re calculating the post-tax cash-on-cash return, then you need to factor in taxes on the capital gain (the excess over what you invested that you receive back).
One problem with Cash-on-cash returns is that it doesn’t factor in the time value of money. If I double my money in 4 years, it’s obviously better than if I double my money in 8 years and for that, investors also need to consider the IRR. In conjunction, these two metrics are powerful in giving an investor an idea of how a property will perform.
5. Internal Rate of Return – IRR
The IRR is a number that uses the investment’s discounted cashflows against the initial cash investment. It is based on the idea that a dollar today is worth more than a dollar tomorrow. The IRR is the % that discounts all future cash flows so that its present value is equal to the total cash invested.
This is a tricky calculation to compute, and typically investors will use specialized software or excel to do this calculation. A simple illustration of this calculation would be a property that was purchased all in cash for $100k and then sold for $150k a year later. Assuming the property incurred no expenses and produced no income, the IRR would be 50% (150/(1 + 50%) = 100). Without getting too into the math, the IRR is often the number that professional investors will use to benchmark an investment’s returns since it considers time and absolute value of returns.
If you’re concerned at all about calculating these various metrics, you shouldn’t be. SpendTree’s software provides all these calculations and more at the click of a button. It’s free to sign up and should you have any questions about real estate metrics or the software, feel free to contact us at info@spendtree.com.
Happy hunting!