This article aims to demystify some of the metrics, which is just a fancy word for measurements, we want you to be familiar with when analyzing a real estate deal. As a First Gen Investor, you may have a lot of questions including…
- What does a good property look like, numbers-wise?
- How do I not overpay for a property?
- How much money will I take home?
As a responsible real estate investor you will want to analyze the properties you purchase, or at least have someone on your team who does it for you. There are many different formulas and numbers to understand what you are getting into.
In this article, we will review:
1. Cash on Cash Return (CoCr)
2. Net Operating Income (NOI)
3. Cap Rate (Cap)
4. Pure Cash Flow
These metrics do not tell the story by themselves. They tell you just a part of how profitable a property can be. There are other factors we will address in future articles, but these four give a foundation on metrics commonly used in the industry.
We will use the following numbers from a duplex we purchased, as an example.
Cash on Cash Return (CoCr)
Cash on Cash Return simply put, is the income earned on the amount of cash invested.
Below is the formula for Cash on Cash Return:
Cash on Cash Return = Annual Income Received / Total Cash Invested
What does this look like with real numbers? Let’s use the sample duplex from above.
Cash On Cash Return = (12 x $292) / $36,400
Cash On Cash Return = 0.0959 or 9.6%
At First Gen Foundations, we like to have a positive cash flow for any property we buy. Cash on Cash Return is typically going to be higher in lower appreciating markets. These are usually on the lower end of the socioeconomic ladder.
You typically want to be above 4% CoCr and below 13%.
If the CoCr gets too high, it can be an indicator of a rougher neighborhood than you want to be in. Those neighborhoods will typically have higher crime and the tenant pool tends to take less care of your property (this comes out of your reserves and eats into your cash flow).
The inverse is that you might be in a 4% or negative CoCr in a high appreciating market. You will make less cash, but the overall value of the property and steady rents make a compelling case for people who prefer a “more stable” investment.
Net Operating Income (NOI)
Net Operating Income is defined as your revenue, less operating expenses which does not include your mortgage or interest. This is a key metric because it gives you information on the property’s ability to generate revenue and profit, which is why you are getting into real estate. This helps you know how much money you will have available to service your loan.
Let’s take a look at operating expenses. These include general maintenance, property taxes, utilities, property management fees and other recurring expenses that keep your property running. Because of our conservative underwriting philosophy, we like to keep a contingency for capital expenditures, so we calculate this in our NOI.
Let’s take the numbers from our sample property to calculate the NOI:
Using the information provided in the sample property, you know your mortgage is $530 per month. You can now calculate that you should be able to turn a profit on this property. Again, one metric alone is not strong enough to tell you to pursue a property, but the more you know, the more you go into a project with your eyes wide open.
Cap Rate (Cap)
The cap rate in real estate is the equivalent of the return on an investment in the stock market. It is the proportion of an asset’s income to the capital that was first invested, or its current value. This helps you see what portion of the investment’s value is profit. Your cap rate equals the asset value divided by your net operating income (NOI). This will be the property’s sale price when in the acquisition phase. This metric is used in a particular market to understand the pricing of properties in a specific neighborhood.
CAP Rate = Net Operating Income / Purchase Price
Using our sample duplex from above:
CAP Rate = $9,864 / $112,000
CAP Rate = 0.088 or 8.8%
Similar to the Cash on Cash Return, you don’t want to be in an area where the Cap Rate is too high. Higher Cap Rates are indicative of higher risk areas. While, the higher the Cap Rate, the higher the cash reward; if that number begins to get in the mid to high teens, you have a risk tolerance higher than most.
Pure Cash Flow
The last number, and maybe our favorite, is your Pure Cash Flow. This, sometimes called Free Cash Flow or simply Cash Flow, is your gross revenue minus ALL of your expenses.
As of now, we know that we have the following information
Gross Revenue – Operating Expenses = Pure Cashflow
$1,300 – $1,008 = $292
Using this calculation, you see that you take $292 per month before taxes. You might be thinking, this is where Uncle Sam gets me. What if I told you that is not the whole story. There are amazing tax benefits you can take advantage of as a real estate investor. We will address some of these in another article.
Here is a preview…
You get to keep most, if not all of your Pure Cash Flow.
We at First Gen Foundations have created a place where you learn what it takes to become a real estate investor. Let us know what you think. What other topics would you like us to write about?
We look forward to hearing about how you are building your First Gen Foundations!
President and Co-Founder, First Gen Foundations
Proud to be a First Gen Investor