Return on Investment (ROI)

Purchasing an investment of any sort requires analysis to ensure that your money is working as hard as it can for you. In reality, you are not purchasing bricks and boards and windows and doors, you are purchasing an income stream - that is, an anticipated economic benefit. We need to use objective metrics to judge whether the income stream we are purchasing is competitive with other potential investments (whether real estate or otherwise). To evaluate investment property, the most important piece of data is the net operating income, or NOI (see the definitions in the Education Center). Many other calculations depend upon NOI. Small changes in NOI can sometimes radically affect metrics, so its accuracy is very important.

Once you have NOI, you can calculate an appropriate present value (purchase price) from several metrics.

Capitalization rate

"Cap rate" is calculated as:

Net operating income(NOI) divided by the purchase price

It is a measure of the return on investment. Turned around, it can be used to project a purchase price with an expected cap rate.

Yield Capitalization

A more complex form of income capitalization is yield capitalization, which looks further into the future and attempts to estimate return over a projected holding period (typically 10 years). Yield capitalization involves the concept of a discount rate, defined as a rate used to convert future cash flow into present value. In this method, cash inflows and outflows are projected for each year during the estimated holding period. Then the annual net cash flows are converted to a present value equal to the purchase price of the property.

The discount rate (compound interest in reverse) that does this represents the return of investment (just as the cap rate does in direct capitalization). In addition, since the property is assumed to be sold at the end of the holding period, yield capitalization also involves the use of a terminal cap rate (i.e., the appropriate cap rate to be applied to the NOI of the year following the end of the holding period in order to determine the anticipated sales price at that time). Yield capitalization requires the use of a computer program and obviously is based on assumptions that may or may not prove to be accurate.

Float and Desire

This is a method of calculating a purchase price with these five pieces of data:

1. NOI,
2. Down payment (as a percent of the purchase price)
3. Loan to value (LTV) ratio (as a percent)
4. Desired Cash on Cash (as a percent),
5. The loan constant

The idea is that the NOI must support two cash flows - the investor's desired cash flow, and the bank's debt service. If we add those two cash flows together and divide into the NOI, we can arrive at a purchase price that will support them. The formula is:

Present value (PV)  =  NOI / ( (Percent down) x (cash-on-cash) + (LTV x loan constant))

Let's illustrate this with an example. Suppose a property produces $50,000 in NOI, the investor desires a cash on cash return of 5%, will put down 25% (leaving an LTV of 75%), and the bank is loaning money at 7% fixed for 30 years. The loan constant would be 0.0798363 (Hint: use Excel with a loan amount of $1, one years payments). Let's plug in the values:

PV = $50,000 / (0.25 * 0.05 + 0.75*0.0798363) = $690,825.

This purchase price will satisfy the investor and the bank (but perhaps not the seller!).

Cash on Cash

This is calculated as

Cash Flow Before Taxes (CFBT) / (the initial investment)

CFBT is determined from (NOI - mortgage payments). This is even more useful than Cap Rate because it takes into account the mortgage payments.

Debt Coverage Ratio

What your banker cares about! It is equal to the NOI divided by the loan payment.

Return on Equity (ROE)

ROE is calculated as (CFBT) / (equity). This is the surprising one. It is equal to Cash on Cash the first year, but thereafter usually decreases because your equity grows faster than NOI (due to depreciation and mortgage retirement).

Risk and Demand

Beyond the financial metrics are measures of local demand for property. One important measure is absorption, which is discussed in the Education Center.