4 Important Investment Terms

When I first started out in Commercial Real Estate I was clueless to the lingo that everyone was throwing out. I basically smiled and nodded and at the end of the day I would go home and Google. Now, after four years on the job, I find myself being one of those people just throwing out the real estate jargon like everyone should assume what I am talking about. So, in an attempt to not be one of those people, here are 4 terms I found very useful when I was starting out!


1 - Net Operating Income (or NOI): The NOI is calculated by determining the property’s first year Gross Operating Income and then subtracting the Operating Expenses for the first year. Gross Income (less) Operating Expenses (equals) NOI. The Gross Operating Income of property is the total income a property can expect to receive from all sources over a one year period. The Operating Expenses are the expenditures needed to keep the property operating during the same period.
Sample Calculation:
$500,000 Gross Operating Income
Less
$300,000 Operating Expenses
Equals
$200,000 Net Operating Income
The NOI of a property comes directly from the operations of a property and disregards mortgage payments or other additional expenditures the property owner may make, such as tenant improvements or leasing commissions.


2 - Capitalization Rate (or Cap Rate): Most investors will start their financial analysis of a property by calculating the NOI in order to be able to calculate a Capitalization Rate (Cap Rate) according to the following formula:
Net Operating Income
Divided By
Property Price
Equals
Cap Rate
The Cap Rate is expressed as a percentage rate. Cap Rate is typically calculated based on the first year of operations of the property and an all cash purchase of the property.
Sample Calculation:
$200,000 Net Operating Income
Divided By
$2,000,000 Property Price
Equals
10%
A Cap Rate can be looked at as a first year return to the investor comparing how much the investor would receive from operations with the price that would be paid in an all cash purchase of the property. It is a measure of performance the investor can look at to compare how their money is working for them in one property compared to another property or investment.
You can also use the Cap Rate method to determine what you would pay for a property. For instance, if you want a 9% return on your money and you know the property has a Net Operating Income of $200,000 you would pay no more than $2,222,222 for the property.
Sample Calculation:
$200,000 Net Operating Income
Divided By
9.0% Cap Rate
Equals
$2,222,222 Maximum Property Price




3 - Cash on Cash Return: Many investors who use financing to acquire properties use the Cash on Cash method to compare first year performance of competing properties. Cash on Cash takes into consideration the fact that the investor does not have to have all cash to purchase the property, but also will not keep all of the NOI because they must make their mortgage payments from their NOI.
First, the investor must determine the amount they must invest to purchase the property or their Initial Investment.

Sample Calculation:
$2,050,000 Price + Costs
Less
$1,550,000 Loan
Equals
$500,000 Initial Investment
Next, the investor must determine the first year Cash Flow from operations, including the payments due on the financing.

Sample Calculation:
$200,000 Net Operating Income
Less
$140,000 Payments
Equals
$60,000 Cash Flow
divided by $500,000 Initial Investment
Equals 12% Cash on Cash Return
With the calculation of the Cash Flow and the Initial Investment, the investor can make another comparison of how their money performs in this property compared to other properties. By calculating Cash on Cash the investor can calculate a first year percentage return on their investment in the property.
The Cash on Cash percentage can be looked at as a first year return to the investor comparing how much the investor would receive in cash flow from the property when the property is purchased using financing. It is a measure of performance the investor can look at to compare how their money is working for them in one property compared to another property or investment, when financing is used. Many investors use the Cash on Cash percentage in their investment decisions as more accurately reflects their results than does the Cap Rate which ignores the financing used to purchase the property and the payments that must be made on that financing from the NOI of the property.


4 - Return on Investment (or ROI): This is performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.  To illustrate how leverage works in a real estate investment, we'll take the following investment parameters:
Purchase price of a duplex rental property of $400,000
Financing at 4.5% interest for 30 years
$3300 annual expenses for taxes, insurance and repairs
Rental of $1300/month for each of the two units
Let's look now at the ROI (Return on Cash Invested) with different cash up front down payments:
$400,000 paid in full in cash:
$31,200 in rents - $3300 expense = $27,900 NOI
$27,900 / $400,000 = 7.0% ROI

10% or $40,000 cash down payment:
$21,792 in mortgage payments + $3300 expense = $25,082 cash out
$31,200 in rents - $25,082 = $6,118 NOI
$6,188/ $40,000 cash in front = 15.0% ROI
As you can see, even though your risk increases with leverage, it might be a wise choice when you can increase your ROI by as much as 100% (15.0% is 114% increase over 7.0%) over the full cash in front option. And of course you've freed up over $360,000 to invest elsewhere.

Time to Buy? 8 Great Reasons to Take the Plunge!

#1: Bigger equity margins. Many investors look to secure a 20% or 30% discount (or better) when they buy investment property. For a $200,000 single family home, this means a minimum $40,000 equity margin at the time of purchase. For a $600,000 commercial property, this same discount means a margin of $120,000. The math speaks for itself in terms of growing your net worth in commercial real estate.

#2: Over the long haul, few investments provide better long-term return than real estate. Equity increases through mortgage pay-down and value appreciation. If you can hang on during the peaks and valleys, real estate investment has long since passed the test of time.

#3: Better income potential. This business is fueled by the income it generates and, with most properties having larger numbers of units, the income is usually both predictable and significant. One vacancy is not the end of the world and there is definite strength in numbers. If you put all your money towards a single family home or small-bay condo unit for retail or industrial users - all your "eggs are in one basket" so to speak. One vacancy means your whole mortgage payment is out of your pocket!

#4: Less competition for product. For the same reasons why you may have passed over commercial real estate in the past (or at least been hesitant about pursuing it), so too will many of your peers. A very small percentage of real estate investors ever venture into commercial properties and that means those deals that are out there have fewer people looking to buy them.

#5: Less hands on work needed by owners of Commercial units. Commercial properites have less management requirements for two key reasons. One, the actual physical needs of the property are condensed, meaning 20 units don't have 20 roofs to keep up with. Second, one (including me) will reccommend to hire a property manager to look after your property - this will free up your time for your real estate investment business and not have to deal with the day to day issues of the residents of your building. This cost will get added into the cost-benefit analysis during your due diligence period when you go to buy the building.

#6: Sellers are more creative. With commercial properties, the purchase requirements are often more limiting, at least in terms of what it takes financially to get to the closing table. Funding is abundant but lack of down payment funds often limits many investors. Because of this, the chances of securing seller financing are much better with commercial properties than their residential counterparts, simply as a way to complete more sales. Vendor-take-back mortgages are a prime example of the seller's ability to be creative. Often buyers can only come up with 10% or 15% down and the bank won't support the cash to close. Sellers can be that solution and offer to bridge that gap with a secondary mortgage!

#7: Worried about money - financing is easier to secure than you might think. It is a reasonable argument that smaller real estate investments are much harder to fund than larger ones. In short, it isn't just about the size of the purchase. It's about the quality of the investment and a commercial real estate investment will always make more sense on paper than a comparable one for residential property. With CMHC backed mortgages and traditional loans, apartments are yielding some of the best mortgage rates in the industry right now!

#8: There is actually product to choose from! In the last two to three years, Calgary has had little product available for the investor. As the economic situation has tilted, it is a favourable environment for buyers. Cap rates are 2 to 3% higher than even a year ago and there is an even an opportunity to buy properties with untapped potential (renovations, etc).

So what are you waiting for? Waiting for banks to increase their interest rates while it sits their waiting patiently to grow?...Or is it time to get your money to finally start working for you!