Financial Calculations for Investment Real Estate
The purpose of this section is to define the key financial terms and calculations used to evaluate an investment property, and discuss the methods investors will typically use to place a value on an income property. We will review the following:
- 1. Income Approach
- a. Gross Annual Income
- b. Operating Expenses
- c. Net Operating Income
- 2. Capitalization Rate
- 3. Debt Service
- 4. Cash on Cash Return
- 5. Internal Rate of Return
Residential real estate is typically appraised and valuated based on the Sales Comparison method, where similar properties that have sold are used as a baseline, and adjustments are made for size, age, condition, features, location, etc. This method is not appropriate for the valuation of income producing real estate.
1. The Income Approach
Investors and appraisers use the Income Approach for estimating the value of income producing properties, such as commercial real estate and 2-4 family rental properties. The accurate use of the Income Approach requires accurate financial data to be available for not only the subject property, but also for recently sold properties in the area that will used to compare to the subject property.
Gross Annual Income: How much rental revenue is generated by the subject property, and how much could be generated if the current owner is charging too little rent? Current market conditions are evaluated to make an assumption of how many months the rentable units will be vacant. This is called the Vacancy Rate. If units are not occupied, comparable rents from other properties nearby are used, but an allowance for vacancy must be incorporated to account for the period of time that the unit is not generating rental income, (currently the Chittenden County vacancy rate is around 1.4%). After an allowance for vacancy is assumed, the result is the Effective Gross Income.
a. Gross Annual Income
- Unit A$32,000
- Unit B$30,000
- Total Gross Income$62,000
- Vacancy 1.4%$868
- Effective Gross Income$61,132
b. Operating Expenses
- Property Taxes
- Attorney and Accounting Fees
- Property Management
- Repairs and Maintenance
- Snow removal, trash removal, lawn care
- Rental commissions
Operating Expenses DO NOT include mortgage payments, which fall under Debt Service and are calculated after the Net Operating Income. Also not included are capital improvements, such as replacing window or a new roof.
c. Net Operating Income (NOI)
Net Operating Income is equal to a property's Effective Gross Income less its Operating Expenses. The clearest way to understand NOI is how much money the property generates before the mortgage is to be paid. Properties with stable rents and efficient operations are more profitable than properties that are costly to operate and have unreliable or low rental income.
- Effective Gross Income $61,132
- Operating Expenses $15,400
- NOI $45,732
2. Capitalization Rate
If I place my capital into service with this investment, what percentage return will I get on a current basis? Cap Rate is calculated by dividing the NOI by the Market Value (or purchase price)
- NOI $45,732
- Purchase Price $750,000
- Cap Rate 6.09%
The investor will be generating a 6.09% annual return on their capital. If the investor paid $750,000 cash for the property, they would receive a Cash on Cash Return of 6.09%. The higher the Cap Rate, the better the return. So if an investor buys a property for a price that produces a low cap rate, they are getting a lower return and the property is on the expensive side. If the Cap Rate is higher, the return is higher, so the price was more attractive.
Appraisers will evaluate similar properties that have recently sold to establish what the Market Cap Rate is for the area at any given time. If the market cap rate is 7% in the area, the property should sell for a price closer to $653,314. Market Value is calculated by dividing the NOI by the Market Cap Rate.
- NOI $45,732
- Market Cap Rate 7%
- Market Value $653,314
If the financial detail is not available for comparable properties, such as accurate information on the rental income or operating expenses, the market cap rate is subjective and should not be relied upon exclusively. An investor's desired return and investment objectives are the most important drivers of value for the small real estate investor. Calculating the true rate of return is key to matching
investors with properties.
If the investor purchases the property with a mortgage, that return must be calculated with the Debt Service incorporated into the calculation.
3. Debt Service (ROI)
52% of all residential properties bought as investments today are purchased with a mortgage. The principal and interest payments are called Debt Service and are incorporated at this stage to calculate an investor's Return On Investment (ROI). There are several methods for calculating ROI.
4. Cash on Cash Return
After the NOI is established and Debt Service is subtracted from it, what remains is Cash Flow.
- NOI $45,732
- Debt Service $34,000
- Cash Flow $11,732
In this example, the $750,000 property is acquired with a mortgage of $525,000 (30% down payment, or 70% Loan to Value Ratio). The mortgage payments equal $34,000/year and leave$11,732 in positive Cash Flow. Cash on Cash Return is calculated by dividing the Cash Flow by the investor's down payment.
- Down Payment $225,000
- Closing Costs $ 11,000
- Total Cash Invested $236,000
- Cash Flow $11,732
- Cash on Cash Return 4.97%
5. Internal Rate of Return (IRR)
This is where the rubber meets the road. What is the aggregated return of all cash flows, appreciation and equity built through paying down principal? The IRR calculation incorporates all of these factors into an annual percentage return on the investment. The IRR can be compared to other forms of investment, such as a mutual fund or savings account, to compare the results using a single percentage rate. Typically more risky investment will potentially produce a higher rate of return, and more secure investments produce a lower rate of return. This is precisely why real estate investing is so lucrative. Real estate is a stable and reliable asset if purchase and managed right. It is secure, and yet it produces relatively high rates of return.
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