How to analyze the true value of a potential investment property.
How much do I pay for a property?
This can be the biggest challenge for new investors. How do I know how much to pay for a property? There are so many factors involved that it can feel a little overwhelming. In fact it scares some investors away from buying their first property. I’m here to tell you that it’s not rocket science. A class in using a spreadsheet program such as Microsoft Excel or learning to use a financial calculator might be the most difficult part of the process. There are several performance measurements commonly used when valuing property. Three measurements commonly used by investors include CAP Rate, Net Operating Income (NOI), and Return On Investment (ROI). There are many other ratios and measurements used in real estate finance such as Gross Rent Multiplier, Debt Service Coverage Ratio, Operating Ratio, etc. This information can be found in many finance books or at finance courses at your local Community College.
What is Net Operating Income (NOI)?
Net Operating Income is described as the amount that remains after all operating expenses have been paid. The basic formula is as follows:
Gross Income - Total Operating Expenses = Net Operating Income
There are many expenses outside of the mortgage payments, which come with rental properties. These expenses include, management fees, accounting fees, repairs, maintenance, utilities, taxes, insurance and the list goes on. All of these costs are deducted from the gross income from rent to equal the NOI. The key reason this calculation is when determining the Cap Rate.
What is a Cap Rate?
The Cap rate also known as capitalization rate is the ratio between the net operating income and the asking price of a property. The formula is as follows:
Net Operating Income/Sales Price = Cap Rate
This is the major factor that investors use to determine if a property is worth the asking price. You can use this calculation to obtain the true value of the property by solving for sales price rather than Cap Rate. A general rule of thumb is that the cap rate should fall between between 7 and 12 percent. This of course depends on the going cap rate for the property location. Smart investors should research the cap rates for a given area and compare the two. Typically a real estate agent that specializes in commercial property can help with this.
What is Return On Investment (ROI)?
Return On Investment captures the relationship between cash flow and investment capital. This ratio is actually referred to as Cash ROI, since it measures the amount of cash left after debt service and the amount initially invested. The formula is as follows:
Cash ROI = Cash after debt service (mortgage payments) / Invested Cash
The importance of this measurement lies in the fact that it calculates the monthly/yearly cash returns to the cash used at the time of purchase. This data is of particular interest to investors that rely on leverage when investing in real estate. There are other ratios used when evaluating ROI. These include Total ROI, and Net Income ROI.
Summary
Each of these measurements can be used by investors to assist in analyzing investment property. They can be used for long term buy and hold strategies and when house flipping. Using these formulas will help not only to minimize bad investment decisions but to help ensure that each property will produce a positive cash flow.
