Before going to look at any property, it’s important to analyze the numbers. Many people start investing in real estate when they are still working a full-time job, so there is no sense in wasting time looking at properties that don’t work on paper. While there are exceptions to every rule, it’s few and far between that you find a property so mismanaged that you can turn it around enough to work.
Today we are going to analyze the numbers on a real property that is currently on the market just outside of Ottawa. (Email me if you’re interested in finding out more about this property.)
So, what numbers will we be looking at today?
- Gross Operating Income (GOI)
- Total Operating Expenses (TOE)
- Net Operating Income (NOI)
- Financing Costs
- Capitalization Rate (Cap Rate)
- Cash on Cash Return (CoC)
Gross Operating Income
First and foremost, we will look at the Gross Operating Income (also known as GOI). The Gross Operating Income is the total income coming in. It includes all rent and may also include other revenue opportunities like parking, laundry, vending, etc.
Total Operating Expenses
Next up is the Total Operating Expenses (TOE). These include everything it takes to operate and maintain the property. Some of the main expenses include property taxes, insurance, water and sewer, heat, hydro, garbage, etc. Some secondary expenses can include marketing and advertising, accounting and legal, landscaping, pool care, snow removal, etc.
Note that every property is different in terms of expenses that will be out of your pocket vs your tenant’s. It is always best practice to get the annual expense totals of the previous year from the current owner. If any numbers look out of whack with other properties you are analyzing, ask questions and/or add a buffer amount to your estimations.
Don’t forget to include maintenance and property management fees here (if you have numbers, if not, it is common practice to use a percentage for reserves). Whether or not you choose to use a management company for your property, someone will be taking care of the property (even if it’s you) and should be paid accordingly. It is also important to your future resale value. Most investors will run numbers with the expectation of using a management company (so you’ll want to make sure you are still cash-flow positive with one). You will also want to include a vacancy reserve to cover any months your unit or property sits vacant.
Important note: If the numbers don’t work with the maintenance, management and vacancy reserves, the numbers don’t work. Too many investors either forget to add these in or leave these numbers out intentionally to make the property look better. These investors then turn into the horror stories you hear about because they are ill-prepared for any unexpected expenses or emergencies.
Net Operating Income
Finally, the number you have been waiting for, Net operating Income (NOI). Net Operating Income is the amount of income you collect from an investment property after you subtract the operating expenses and vacancy losses. Gross Operating Income minus Total Operating Expenses (note that it does not include financing expenses at this point). This number will tell you how well the property cash flows before you take into account any financing you may have on the property. This shows you what you can expect to bring in annually when you pay off the property.
Net Operating Income = Gross Operating Income – Total Operating Expenses
People frequently want to know what a “good” NOI is. Unfortunately, it’s not that easy. NOIs can vary widely and they are best used to compare your property against other similar properties (same area, number of units, etc.) This comparison can show you if your expenses are too high or your rents are too low, both of which can impact your cash flow.
As most investors are not buying properties in cash, the next numbers we’ll look at are the financing costs. First off, on investment properties, most lenders like to have you put at least 20% of the cost of the home as a downpayment. This leaves 80% of the cost of the home in a mortgage.
In our calculations, we’ve used a conservative 4.5% amortized over 25 years. This brings us to a very affordable mortgage amount.
Another formula we like to check when analyzing properties is the Debt Service Coverage Ratio (DSCR). This number is important as many lenders will consider it before giving you a loan. Most lenders prefer that your DSCR is equal to 1.2 or higher.
Capitalization Rate (Cap Rate)
The capitalization rate is used to assess real estate investment for their profitability and return potential. The basic formula to find the cap rate on a property is:
Cap rate = Net Operating Income/Current Market Value
Cap rate = $14,274/$184,900
A property’s cap rate is fluid and can change year to year based a number of factors. Changes to income (increase or decrease in rent collected), changes to expenses (increase or decrease in costs associated with the property) or changes to market value of the property (increases or decreases in market value).
As such, while the cap rate is an easy way to compare relative value of similar real estate investments on the market, it should not be the only factor in determining a property’s value. For example, the cap rate does not take into account leverage, equity growth, and future cash flows from property improvements, among other factors.
Return on Investment – Cash on Cash Return (CoC)
Cash on cash is a rate a return used to calculate the cash income earned on the cash invested into a property. It is sometimes referred to as the cash yield on a property. Real estate investors generally prefer to use CoC over the standard return on investment (ROI) calculation because cash-on-cash measures the return on cash invested, not the total cost of the property. This gives a more accurate picture of the investment’s performance.
Cash on cash return = Annual pre-tax cash flow/Total cash invested
The annual pre-tax cash flow on your property is simply the GOI minus the total operating expenses and your annual mortgage payment. Total cash invested includes the downpayment, any rehab costs you may incur and other transaction costs. In this example we are keeping it simple and just using the downpayment cost. So, using our example,
Cash on cash = $4,449.63/$36,980.00
Cash on cash = 12.03%
Remember, cash on cash is another metric that can be fluid. It is used to calculate the return on a particular time period, generally one year, rather than the life of the investment.
Put It All Together
There are numerous other calculations and formulas you can use to analyze a property. The above calculations are meant to give you a quick analysis of a buy and hold property. This will then allow you to decide whether a property is worth checking out in person or not, thereby saving you time in the long run.