Any well diversified investment portfolio will have some portion of its assets invested in real estate. Real estate investments have a low correlation with the stock market, offer competitive returns (especially over the last decade), and have a high tangible asset value, which makes their value more stable in a downturn than that of other financial instruments.
When evaluating potential real estate investments, there are three metrics every prudent investor should take into consideration. These metrics differ slightly from how stocks, bonds, and other equities are valued, though, on the whole, seasoned investors will find the concepts somewhat similar. Nonetheless, we wanted to cover these three fundamental concepts as an introduction for investors who are considering adding real estate to their investment portfolio.
Net Operating Income (NOI)
The Net Operating Income (“NOI”) of a commercial property is calculated by taking the property’s projected operating income and then subtracting the projected operating expenses, including property taxes. The NOI does not include federal or state income taxes or financing expenses, which is why it is also known as EBIT (earnings before taxes and interest). This calculation can be made for the first year of the hold period, or for any other year, including the year of sale. (Note: When projecting the NOI for a future year, it’s important to properly account for expected vacancy costs.)
When evaluating prospective properties for purchase, investors will need to critically evaluate a property’s NOI for every year of the projected hold period to arrive at an accurate market value. Such analysis will be based not only on historical results for the property, but also on reasonable projections for future leasing and operations. In short, the valuation of a property is only as good as the NOI projection it is based on.
A capitalization (cap) rate is used to calculate the value of a property based on projected NOI for a property. This calculation can apply to both commercial real estate properties and residential rental properties. In the simplest terms, the cap rate is the ratio of Net Operating Income to property value. As an example, a property selling for $10 million that generates an NOI of $1 million would be said to have a capitalization rate of 10%. Another way to put this is that you can expect a 10% return on your investment of $10 million if you earn $1 million in annual net operating income.
A higher rate of return is obviously desirable, but investors should keep in mind that as with other investments, a higher rate of return can often imply a higher risk to be undertaken by the investor. Since properties with a higher cap rate can have a higher risk premium, and investors should have a good understanding of the factors that create this risk.
Risk can be manifested in a sub-prime location, infrastructure issues, property condition, or other issues in obtaining full occupancy. Investors should also keep in mind that cap rates are market driven, which means they can also adjust based on what investors are willing to pay at any point in time. This article and infographic offer a good way of quickly grasping the factors that affect cap rates.
The cash-on-cash evaluation is an important way of accounting for the costs and benefits of financing, which many real estate investors rely on to purchase properties. With current interest rates near record lows, there’s little reason to buy a property entirely with cash, unless favorable financing terms cannot be obtained by the investor, and so long as unlevered returns exceed the cost of the debt (i.e. positive leverage).
The cash-on-cash return is comprised of the ratio of annual pre-tax cash flow to the total amount of cash invested. A cash on cash return can be calculated on a one-time basis or on a cumulative basis over the hold period. An investor who takes advantage of financing has to commit a certain portion of the Net Operating Income to cover the costs of that financing. To consider an example, let’s say you purchase a $10 million property with $2 million down, the property generates a Net Operating Income of $1 million per year, and the annual debt service is $500,000. Based on this scenario, the cash-on-cash return is 25% ($1,000,000 NOI less $500,000 debt service divided by $2,000,000 cash investment). However, investors should keep in mind that the cash-on-cash analysis is a quick calculation and not meant to be definitive; ultimately, performing a discounted cash flow analysis will reveal much more about the detailed projected cash inflows and outflows for a property over the entire desired hold period.
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Keeping these three basic metrics in mind will be helpful when doing initial, back-of-the-napkin calculation to determine the viability of a real estate investment. Of course, when the time comes to commit a large portion of your funds to real estate, there’s much more to it than that.
At RMC Realty Advisors, we offer a full range of discovery and due diligence services designed to help both first-time and experienced real estate investors through all phases of the investment lifecycle, from acquisition to disposition, helping to ensure their success. These services include:
- Critically evaluating financial underwriting assumptions, then performing sensitivity analyses to effectively underwrite acquisition opportunities
- Developing operating budgets, multi-year cash flow projections, and asset valuations
- Preparing cost-benefit (hold/sell) analyses to support property repositioning, rehabilitation, and other capital improvement programs
If you have any questions about the concepts outlined above, or to get help in evaluating a potential or current real estate investment, contact RMC Realty Advisors today.