Investment Methods

Net Operating Income (NOI)

Net Operating Income (NOI) is the total income the property generates minus total expenses, not including debt service.

NOI = Income – Expenses

In general, NOI is calculated on a monthly basis using monthly income and expense data, and can then be converted to annual data simply by multiplying by 12.

Assessing Property Income

Gross income is the total income generated from the property, including tenant, laundry facilities, parking fees, late fees etc, and any other income that your property will produce on a regular basis.

The majority of a property's income generally derives from tenant rent. It is important you take into consideration unit vacancy and delinquency. You need to decide how you'd like to factor that into your analysis. My suggestion is to be conservative with vacancy and delinquency.

Assessing Expenses

In general, expenses break down into the following categories:

Property Taxes

Insurance

Maintenance

Management Service

Advertising

Lawncare

Utilities

Other*

*anything else we may have missed above

Any expenses listed as monthly should be converted to annual, and then we can total our expenses to find the annual cost of operating the property.

When To Use NOI

NOI is useful because it can tell you, at a glance, whether one property is a more lucrative investment than another property. This assumes they are comparable properties in comparable markets.

However, NOI has a few limitations, so don't use it as your sole criterion for evaluating a property. It leaves out important information – depreciation, principal, interest – all things that can significantly alter the ROI of a property.

Learn to calculate NOI and keep that knowledge in your toolkit. It will be important when you do your strategic and tactical analysis of any market you are looking to enter.

Cash Flow

Cash Flow is actually an extension of NOI. Now we are taking into consideration your debt service.

Begin with the Net Operating Income of the property.

Subtract the money out for debt service.

Subtract any capital expenditures.
This would be money spent for improvements on the property, whether they are deductible that year or not. This is actual cash spent.

Add any loan proceeds.
This is the money borrowed on a loan other than the original mortgage. If you made capital improvements, but took out a loan to pay for it, put that loan amount here as an addition.

Add any interest earned.
Should the property have loans or investments out that provide cash in as interest, add that in here.

You have now come to the result, which is the Cash Flow Before Taxes (CFBT) for this property.

Capitalization Rate

The first step to calculating CAP rate, or capitalization rate, for investment real estate, is to determine the sales price.

The second step to figuring the CAP rate for an investment property, is to determine the yearly Net Operating Income (or NOI) for the property.
In order to do this, take the monthly rent that you plan to receive for the property and multiply by 12 months.

Capitalization Rate = NOI/ Sales Price

An Example: If you expect to buy a property for 100K and you have an annual NOI of 8K your capitalization rate would be:

8K/ 100K = 0.08 or 8%

A normal capitalization rate should be anywhere between 8-10%.

As U.S. real estate sale prices have declined faster than rents due to the economic crisis, cap rates have returned to higher levels: as of December 2009, to 8.8% for office buildings in central business districts and 7.36% for apartment buildings – as per the Wall Street Journal

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Investment Property Evaluation Methods