If you're investing in real estate as a source of income, or to turn a profit, one of the most important formulas you'll encounter is the capitalization rate on a revenue producing property. If you're an experienced investor, a lot of this is going to seem old hat, but to show how all the pieces fit together, we're going to have to cover everything carefully.
The first is an acronym, NOI or Net Operating Income. Net Operating Income is a subset of the more commonly used terms "EBIT" and "EBITDA". EBIT is "Earnings Before Interest and Taxes" and EBITDA is "Earnings Before Interest, Taxes, Depreciation and Amortization". For the most part, we can treat NOI as a synonym for EBIT, and since NOI is the term most commonly used when evaluating income generating properties, we're going to use it instead of EBIT. As always, this sort of advice is meant to give you a layman's perspective; do talk to your financial advisor about this.
NOI can be characterized as "Are we turning a profit yet?" It's a very simple calculation take the money that's coming in, subtract the routine operating expenses (like rents going out, utilities, maintenance costs that accrue monthly, and salaries) and what's left over is your positive cash flow, or net operating income. This does not take into account interest payments on the debt used to secure the property, or the pinch from taxes. A more formalized accounting term also deducts depreciation and amortization of fixed expenses; while those are important if you're holding on to the property for income generation, from the perspective of someone considering the purchase of a property.
When evaluating commercial properties for purchase, NOI is one of three critical evaluation criteria. In general, you want to buy properties that have a low NOI and improve them if you want to turn the property over quickly for a reasonable profit in a short period of time. If you're looking at doing a "buy and hold" strategy, of owning rental property for the purposes of generating regular income from it, you'll want one with a good NOI, preferably one that can be improved for a little bit of investment and improvement.
The next criterion to consider is purchase price. Purchase price is market driven. It's what the seller (or the mortgage broker) is trying to get for it, based on similar properties in the region, or on physical features of the property. In the current real estate market, the asking value price is particularly volatile. Take the sale price of six similar properties, throw out the high value and the low value, and average what's left, and be sure to check this regularly update this metric at least once a month.
For commercial or revenue generating properties, there's also a third metric to consider, capitalization rate. Capitalization rate is a measure of the ratio of annualized cash flow (NOI) divided by the purchase price of the property. For example, if you're looking at buying an apartment building with 16 apartments, each of which generates $600/month in rent, and has fixed monthly costs in salaries and maintenance budget of $4,000 per month, the net annual income at 12 out of 16 units occupied is (600*12= $7,200-$4,000) or $3,200 per month. Multiply this by 12, or a net annual income of $38,400, for an average occupancy of 75%. If the purchase price of the property were $400,000, the cap rate is $38,400/$400,000, or 9.6%.
Cap rate provides a "reality check" on requested purchase prices; for most of the US, typical income property cap rates range from 3%, for properties with high tenancy values and steady income generation, to upwards of 12-13% for run down properties in bad neighborhoods. If you assess the current value of the leases signed by tenants at a presumed cap rate of 7-9%, you'll get a good bellweather on how sane the asking price of the property is.
For example, the property we mentioned above, that generates $38,400 in annual income at 75% occupancy, divided by 0.08, has a "cap rate" derived baseline price of $480,000. It's example asking price of $400,000 is actually pretty low based on typical market conditions. On the other hand, if the asking price were $700,000, with a cap rate of 5.4%, it's probably not something you're going to earn out on quickly as a buy and hold property, though you may be able to pursue a buy and re-sell strategy with it with some success, if there are obvious improvements that can be made to improve tenancy, or justify rent increases.
While Cap Rate, and deriving an income based cap-rate "asking price" are useful, remember that all three factors Net Operating Income, purchase price, and cap rate are all intertwined variables. Look for things like seasonal renting patterns; for example, properties near college campuses bring new tenants in with the ebb and flow of semesters. If you're looking for a "buy and hold" strategy, properties near college campuses can be quite worthwhile, albeit prone to a bit more maintenance woes than might otherwise be the case. If you're looking for a "buy and sell" strategy, look for properties that can be fixed up, and use the cap rate and NOI calculations to find properties that are undervalued by the market.
Whichever strategy you pursue, remember that patience pays for itself in real estate investment. The aim is to make your money work on your behalf, by buying properties that either generate an income for you to live off of, or by buying properties that can be turned over within a year or so of capital improvements.
Tony Seruga, Yolanda Seruga and Yolanda Bishop of Maverick Real Estate Investments, Inc. work with builders, developers and other players in the commercial real estate industry to acquire and develop properties. They use progressive investment strategies that have proved extremely profitable. In addition to their own deals, they teach both seasoned and inexperienced investors how to be big players in the game. Visit the website for more info.