1. Cap Rate – The basic definition of a cap rate is the hypothetical yield on a property, assuming it was bought for cash. (Read this BP piecefor more detail.)
Here’s the equation:
The lower the number, the lower your yield. The higher the number, the higher the yield. Your competition is what would that money earn in a bank or treasuries. Why go to any work if you can’t beat those competitors?
Remember, big-city markets typically have lower cap rates because they’re deemed safer investments. Smaller markets typically deliver higher yields because they’re considered higher risk investments.
This is often the first question you ask your broker when he sends you a deal. “What’s the cap rate?” The equivalent might be a PE ratio in stock investing, except the lower the PE, the higher the yield.
Net operating income (NOI)—real estate’s equivalent to corporate finance’s EBIT — is defined as your gross income minus expenses.
The cool thing about real estate is that — beyond rent, which should obviously account for 95+ percent of your asset’s income —there are only so many ways you can generate revenue, none of which should distract you from the main source…which is rent!
And here’s the kicker: the value of your asset is derived directly from the income it produces. Not supply and demand, not the S&P, not the economy, but from how much money you can manage to squeeze from it.
In other words, if you can figure out how to increase your NOI, you’re well on your way to building your fortune.
As an owner, the metric is vital for no other reason than if you’re mismanaging your expenses, you’re eating into your profits and thus the value of your asset. As a potential buyer, mismanagement could mean big money for you.
Here’s the formula: NOI/annual debt (“total debt service”).
A ratio of one puts you at breakeven — meaning there’s just enough to cover your interest payments. Banks won’t go for that; they want you to have a cushion. (Fannie Mae and Freddie Mac want you at 1.2x for multifamily loans.)
Even more importantly, what’s left over after debt service is your free cash flow — your pocket money after the bank’s gotten its piece. If you’re a cash flow investor, this is a serious one to monitor.
To calculate your returns, especially when starting out, look at the return on capital invested; money-in, money-out. That is the cash-on-cash ROI metric.
Here’s the formula: cash flow divided by cash invested.
Say you have a $1.5 million apartment building with $50,000 in annual cash flow that you bought at an 80 percent LTV (meaning 20 percent down). That’s $300,000 down invested in the down payment:
$50,000/$300,000 = 16.67%.
A serious real estate investor knows these metrics backward and forward, just like a financial analyst uses everyday PE ratios (Price Earnings Ratio0 and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).
We buy and sell properties throughout the greater Kansas City area. We specialize in buying distressed homes, then renovating and reselling them to home buyers and landlords. Terra Firma Property Solutions: excited to be part of the economic rejuvenation of Kansas City and its surrounding areas.
Call us today at (816) 866.0566