When you buy a regular home to live in, all you need to do is study the comparable sales in its neighborhood to come up with a purchase price and make an offer to the seller accordingly. This is the basic. However, the approach to determine an investment property’s value is a lot different.
The reason why the approach for an income property is different is because of the objectives behind buying a property. A regular buyer moves into the property and makes it their home, while an investor’s sole objective is to make money out of it. Needless to say, an income property’s value will be determined by how much income it can generate.
So the question is: How do you calculate a property’s potential income?
Well it’s not some guesswork. You can’t just count the number of units on your finger tips and add up the estimated rents from each one of them to determine its income. Here are some mathematical calculations you need to perform in order to know whether you’ve got a good deal.
Net Operating Income (NOI)
A property’s net operating income is its total revenue after deducting operating expenses.
NOI = total revenue – operating expenses
NOI is always before-tax calculation of income that a property generates. In case you get a negative figure after using this NOI calculation formula, then it’s called Net Operating Loss or NOL.
Let’s compare the differences between NOI and cash flow. Cash flow is the amount of CASH income in a given period of time minus the amount of CASH expenses in that same period, while NOI income includes all expenses, even non-cash expenses such as depreciation, deferred maintenance, etc.
NOI is a true measure of the profitability of an investment; cash flow is a measure of net cash generated for a certain period of time. It can be manipulated by deferring maintenance, not recognizing real depreciation, etc.
NOI does not take into account mortgage payments, while cash flow does.
If you have taken out a mortgage on the property, then
Cash Flow = NOI – (mortgage principal + interest)
Capitalization or cap rate
If you have many real estate opportunities to choose from, you shoot for the one that offers highest cap rate. It can also help you determine your exit strategy. In other words, the cap rate can tell you whether you should sell the property or not after managing it as a landlord for a period of time. If the property appreciates in value and its net operating income remains the same, then the cap rate goes down, singling that selling the property may be the right financial step.
Here is the formula to calculate a property’s cap rate:
Cap Rate = (Net operating income / value of the property) X 100
Operating expense ratio (OER)
The Operating expense ratio is a measure of what it costs to operate a piece of property compared to the income that the property brings in. The operating expense ratio is calculated by dividing a property’s operating expense by its gross operating income. Investors using the ratio can further compare each type of expense, such as utilities, insurance, taxes and maintenance, to the gross operating income, as well as the sum of all expenses to the gross operating income.
Cash on cash return
Your cash on cash return measures the income a property generates in cash on the cash you invested in buying it.
Debt coverage ratio or debt-service coverage ratio
You can calculate DCR by dividing net operating income by total debt payments on a property.
DCR = Net Operating Income / Total Debt Service
You should use cap rate, cash flow, NOI, cash-on-cash return and debt coverage ratio formulas to determine if an income property is a good investment.