Many real estate investors hesitate to expand their investments from single family houses into apartment buildings, and commercial properties. The sheer size of the undertaking can be intimidating. How do you even begin to evaluate a property of that size?
Evaluating the physical characteristics of the property (structural elements, utilities, a deferred maintenance plan) may have many similarities, but the financial analysis when looking at a new deal at first can be very simple, or as they say, back of the envelope. As the numbers get bigger, the same fundamentals apply.
Short for “capitalization rate,” the cap rate takes the place of the “sales comparison” model used to appraise single-family houses. After all, the annual yield of an investment is one major factor in determining your opinion. The cap rate method allows one to compare apples to apples when looking at yield of a purchase.
Cap rate is determined as follows:
Cap Rate = Net Operating Income ÷ Price.
“Net operating income” (or NOI) for short, is the income of the property minus the operating expenses. These usually include:
- Property taxes
- Property insurance
- Repair and maintenance
- Contract services
- Management and payroll
IMPORTANT: Net operating income is a yearly figure.
IMPORTANT: Debt service (i.e. your mortgage payment) is not included as an expense when calculating the NOI or the cap rate.
Cap rates in todays market can range between 2% and 12%. The theory is that the lower the cap rate, the less risky the market considers the investment. A “hot” market can result in properties getting bid up and pushing cap rates down because values change as income stays constant. This is called “cap rate compression.”
Cash-on-cash return is exactly what it sounds like. The cash flow of a property is the cash after all expenses (including debt servicing) divided by the amount of cash you actually put in. In other words, cash on cash is the cash that ends up in your pocket each year as a percentage of the cash you invested in it.
IMPORTANT: Invested cash is NOT the sales price, just the cash you put in.
The basic formula for determining cash-on-cash return is as follows:
Cash-on-Cash = (Gross Income – Expenses – Debt Service) ÷ (Down Payment + Out of Pocket Closing Costs + Immediate Repair Budget)
Note that the debt service, i.e. mortgage payment, is included in this figure. All income-and-expense figures, are annual, not monthly.
Debt Service Coverage Ratio
If you plan to buy your property with a mortgage, you should look at the debt service coverage ratio (DSCR), because it is important to know how much coverage you have on the debt servicing relative to the income, also the lender certainly will be interested in this number. Many lenders want to see a DSCR of 1.20 or better. It’s a way for lenders to know what their margin of risk is if the rent goes down.
The formula for DSCR is as follows:
DSCR = (Gross Income – Operating Expenses) ÷ (Debt Service)
IMPORTANT: All numbers are annual, not monthly, including the debt service (i.e. mortgage payment).
When you do this calculation, you discover how many times over the property’s net income can cover the mortgage payment. In the case of a DSCR of 1.25 (aka 125%), you plan to be able to pay 100% of the mortgage payment, with 25% left over as cash flow or reserves.
Most investors use these numbers to evaluate bigger deals, like apartments and commercial complexes. Regardless of the deal size, the numbers work in the exact same way help to isolate just a few economics of the deal to help make opinions and decisions.
Another more complex but valuable metric is the Internal Rate of Return. Read this article for me – Understanding The IRR metric.