One of the most important formulas an investor can use

If you are investing in real estate as a source of income or for a profit, one of the most important formulas you will come across is the capitalization rate of an income-generating property. If you’re a seasoned investor, a lot of this will seem dated to you, but to show how all the pieces fit together we’ll have to cover everything carefully.

The first is an acronym, NOI or Net Operating Income. Net operating profit is a subset of the more commonly used terms “EBIT” and “EBITDA”. EBIT is “Earning before interest and taxes” and EBITDA is “Earning before interest, taxes, depreciation and amortization.” For the most part, we can treat NOI as synonymous with EBIT, and since NOI is the most commonly used term when evaluating income-generating properties, we will use it in place of EBIT. As always, this type of advice is meant to give you a layman’s perspective; talk to your financial advisor about this.

NOI can be characterized as “Are we already making a profit?” It’s a very simple calculation – take the money that comes in, subtract the routine operating expenses (such as the rents that go out, utilities, maintenance costs that increased monthly, and wages), and what is left is your positive cash flow. or net operating income. This does not take into account the interest payments on the debt used to secure the property, nor the tax pinch. A more formalized accounting term also deducts depreciation and amortization of fixed expenses; while those are important if you are holding onto the property to generate income, from the perspective of someone considering a property purchase.

When evaluating commercial properties for purchase, NOI is one of the three critical evaluation criteria. In general, you want to buy properties that have a low NOI and improve them if you want to deliver the property quickly for a reasonable profit in a short period of time. If you are thinking of doing a “buy and hold” strategy of owning a rental property in order to generate regular income from it, you will want one with a good NOI, preferably one that can be improved for a little investment and gets better.

The next criterion to consider is the purchase price. The purchase price is determined by the market. It is what the seller (or the mortgage broker) is trying to obtain, based on similar properties in the region or on the physical characteristics of the property. In today’s real estate market, the asking price is particularly volatile. Take the sales price of six similar properties, discard the high value and the low value, and average what is left, and be sure to check this regularly – update this metric at least once a month.

For commercial or income-generating properties, there is also a third metric to consider, the capitalization rate. The capitalization rate is a measure of the ratio of the annualized cash flow (NOI) divided by the purchase price of the property. For example, if you are planning to buy an apartment building with 16 apartments, each of which generates $ 600 / month in rent, and has fixed monthly salary costs and a maintenance budget of $ 4,000 per month, the annual income Net is 12 of the 16 occupied units 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 is $ 400,000, the maximum rate is $ 38,400 / $ 400,000, or 9.6%.

The capitalization rate provides a “reality check” of the requested purchase prices; For most of the U.S., typical income property cap rates range from 3%, for properties with high rental values ​​and constant income generation, to more than 12-13% for impaired properties in bad neighborhoods. If you evaluate the present value of leases signed by tenants at a presumed cap rate of 7-9%, you will get a good indicator of how sensible the property’s selling price is.

For example, the property we mentioned earlier, which generates $ 38,400 in annual revenue at 75% occupancy, divided by 0.08, has a base price derived from a “capitalization rate” of $ 480,000. Your $ 400,000 asking price example is actually quite low based on typical market conditions. On the other hand, if the sale price were $ 700,000, with a capitalization rate of 5.4%, it is probably not something that you earn quickly as a buy-and-hold property, although you may be able to make a purchase. and the strategy of reselling with it with some success, if there are obvious improvements that can be made to improve tenure or justify rent increases.

While the capitalization rate and obtaining a “sell price” from the capitalization rate based on income are helpful, remember that all three factors: net operating income, purchase price, and capitalization rate are variable. intertwined. Look for things like seasonal rental patterns; For example, properties near college campuses attract new tenants with the ebb and flow of semesters. If you are looking for a “buy and hold” strategy, properties near college campuses may be worth it, although they are prone to a bit more maintenance issues than might be the case. If you are looking for a “buy and sell” strategy, look for properties that can be repaired and use the capitalization rate and NOI calculations to find properties that are undervalued by the market.

Whatever strategy you follow, remember that patience pays for itself in real estate investing. The goal is to make your money work for you, by buying income-generating properties for you to live in, or by purchasing properties that can be delivered within a year or so after capital improvements.