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.