Firstly, in real estate (especially commercial), analyzing the financials of a deal is called ‘underwriting.’ If you’ve ever gone to buy your own personal residence I’m sure you’ve heard the phrase “your file is with the underwriter.” That’s because the bank is underwriting YOU and your financial ability to repay the loan. In commercial multifamily (5+ units) the bank is underwriting the building’s ability to pay for itself!
But you, whether you’re active or passive, also need to underwrite the building to see how it’s performing now and how you can improve the performance in the future.
Here are some basic terms and calculations you need to know:
1. Net Operating Income (NOI) = Income – Expenses
The NOI is basically the foundation from which most other returns are calculated. The term may sound like there’s something more involved, but it really is just the money left after all expenses are paid and reserves (such as vacancy, maintenance, etc.) are set aside. I often see people refer to Cash Flow as Income – Expenses, but that’s not entirely correct (unless you paid for the property in cash OR you are including debt service as part of the expenses). One thing to remember with real estate terminology, the NOI does not include the debt service/mortgage payment (principle and interest), but Cash Flow does.
Here’s a few examples of some typical income and expenses, although this list is not exhaustive:
2. Capitalization Rate (Cap Rate) = NOI ÷ Property Value
The Cap Rate is the expected annual rate of return for capital invested into a real estate deal. Cap Rate assumes the property is purchased with cash and not with a loan – like NOI, debt service is NOT included in the calculation! This is because loan terms can drastically affect the final cash flow, and terms can vary widely based on a number of factors. So in order to compare apples to apples, cash is assumed for the purchase, because cash is the same for everyone. Cap Rates are mostly used as a comparison of value similar deals in a market.
Each market has their own range of Cap Rates that buildings are “trading” (or selling) for – which can fluctuate over time based on what’s happening in the market. The lower the Cap Rate, the higher the price or value of the building. Low Caps and high prices normally indicate a hot market or a more stabilized/higher end building. On the other end, the higher the Cap the lower the price/value. While lower Caps can symbolize more stability and less risk, the opposite holds for higher caps – there’s the potential for more risk because something with the building is destabilized… that’s why you get “rewarded” with a higher return. But this is also where a lot of operators target implementing a “Value-Add” strategy. You purchase a destabilized property at a lower value and use strategies to increase that value by stabilizing the property and decrease the Cap.
Although Cap Rates are helpful for comparison purposes, they shouldn’t be used as the sole indicator of an investment’s strength because they don’t consider leverage or future cash flows, among other factors. There aren’t any clear ranges for a good or bad Cap Rates, and they largely depend on the context of the property and the market.
3. Cash-on-Cash Return = Annual Cash Flow ÷ Total Cash Invested
Cash-on Cash is a rate of return that calculates the amount of cash flow relative to the amount of cash invested in a property investment and is calculated on a pre-tax basis. Just like loan terms are different for different borrowers and that’s why it’s not included in NOI, tax rates are different for everyone, so in order to have the Cash-on-Cash metric to be apples to apples for all the investors involved in a deal, it’s calculated without consideration for taxes. At the end of the day, it’s a very important return to measure how much distributions you can expect to get in a given year based on the capital you can invest – its’ all about cash flow!
…have some clarity, or just confused?
Here I just wanted to cover a few of the more important return metrics, but there is SO much more to the underwriting process and what goes into determining if a deal is worth pursuing. Your investment strategy and ultimate goals will influence the type of asset you pursue and the type of business plan that should be implemented.
Hope this was helpful and don’t hesitate to reach out for clarification or just to network, I’m happy to help any way I can!
… Happy investing!