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One thing that’s commonly asked of me from non-commercial agents and investors alike is what all the different terms mean. Net Operating income (NOI), Cap rate, Cash on Cash, Internal Rate of Return (or IRR) and Net Present Value, or NPV.
Knowing these terms and how to calculate them is essential to anyone who invests in real estate. This is especially true for new investors. If you’re learning or if you’re a bit unfamiliar with where to start, be sure to watch me “How to Start Investing” video.
I’m going to explain each one of these the same way I explain it to my clients in my two part video. In this video we’ll discuss Net Operating Income, Cap Rate and cash on cash. In my “Investing Terms Part 2” video we’ll tie in the internal rate of return and net present value. To start off, let’s take a look at a make believe commercial investment property.
Here we have a property listed at about $2M. To keep numbers simple, let’s say after all expenses, but NOT including the mortgage principle and interest, it nets $150k/year. Now this $150k is called the “Net operating income”.
Net Operating income, or NOI for short, is what you make after accounting for taxes, insurance, vacancy & credit loss, repairs, management (if any), utilities and other miscellaneous costs. Again, this is NOT including a mortgage principle and interest. Now we simply plug it into a formula that I always remember as “IRV”. Income over Rate equals Value
Income is the NOI we just discussed, which in this case is $150k/year, rate is the Cap Rate, and Value is the price of the property. Now this formula can go multiple ways just like a simple math. If we plug in our Income and our value, but don’t know our rate, we simply solve it by dividing by Value
Going back to our example, we know our Income, we know we need to divide it by our value and then solve our cap rate. $150,000 divided by $2m is .075, or 7.5% – which is our cap rate. Now, a lot of people get so stuck on the cap rate, they forget that it’s not the best way to analyze a property’s potential.
When you think of a cap rate, think of a photograph or a snapshot. A cap rate is simply a quick snapshot of a property for just ONE YEAR as it stands and WITHOUT any financing.
Since I’ve explained what NOI is and how to find the Cap Rate lets figure out how we determine Cash on Cash. Pretend you don’t have the full $2M to buy the property cash, or presume you want to use leverage as discussed in my “Using Leverage Properly” video and instead plan on putting a 35% down payment and getting a loan for the rest.
Well, a cap rate is really no longer going to give you an accurate depiction of how much money you’re making now is it? Remember, you’re not putting $2M in the bank anymore; you’re talking about only putting $700k into the bank and obviously you’re not going to make $150k/year because now you have a loan to pay for!
First, I’ve listed the potential loan here. It’s a 65% loan to value amount, meaning you put down 35% they’ll give you 65%. The interest rate is 5.5%, amortized over 30 years. This will give us an Annual Debt Service of $88,575. Annual Debt service is really just a fancy way of saying Mortgage Principle and Interest.
We now have $700k invested as our down payment, and that $150k/year is now down to $61,425 after paying the debt service. Solving for cash on cash is a very similar formula as the IRV Cap rate formula. Take the income per year, which is now $61,425 and divide that by the initial investment of $700k which will equal .08775, or 8.775%.
We’re going to use this same example in my “Investing Terms Part 2” video, so be sure to watch that one next time you have a few minutes. In the meantime, be sure next time you analyze a property you take into account what kind of return it could make with and without leverage.
Sometimes it could make all the difference. Sometimes it might convince you that it’s just better off to pay cash for the property you’re looking at. Regardless of which it is, feel confident knowing you can calculate the difference between both scenarios using the NOI and make an informed decision…now that’s good to know.
Contact Davide Pio Today | SF Bay Area Real Estate
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