The meaning behind NOI, Cap Rate, and Cash on Cash Return

[James Ross]

Hello Fellow Newbies!

I've been doing what all good newbies do when struggling to overcome analysis paralysis, namely reading books!  And while doing so, the significance of some of the terms are starting to coalesce for me.  In this case this was thanks to the ABCs of Real Estate by Ken McElroy, which I highly recommend.  Some of it has a more apartment investing flavor than single family home, but even if your focus is on single family homes like mine is at present, I've learned a lot.  Let me be clear, though, I'm a newbie with only one rental property under my belt so far.  So I am NOT an expert.  Do your own research and read up on these and other important terms.  Read lots of books and, of course, the forums!

I wanted to share a few related numbers whose meaning is starting to click for me, both in the hopes of having actual experts confirm that I'm understanding them aright and to hopefully help others just starting out in their path.  This may be very obvious to some people, so my apologies if so.  I may also be wrong in some (or all) parts.  In the immortal words of Ralph Wiggum, "I'm learnding."

Net Operating Income
First, we have the Net Operating Income. NOI is, simply, your monthly income minus all monthly expenses EXCEPT loan principle and interest. Income is your expected rent plus things like parking fees, vending machines, laundry fees, or anything else that might come with a property (generally just rent for buy and hold single family homes). The expenses are things like vacancy, property management, HOA fees, pool maintenance, lawn care, landlord insurance, taxes, utilities, airbnb membership costs, capital expenditures, etc. Anything YOU (rather than the tenant) will be paying for.

Since NOI includes everything except your loan expenses, it is very helpful in determining if your income from the property will cover the payments on your loan each month (based on down payment and interest rate). As such, it can help you determine an offer price that will work. Your cash flow is NOI - Loan P and I. If your NOI is $1000 and loan principle and interest would be $1100, then you need to make a lower offer or pass on the property.


Capitalization Rate
Next, we have Capitalization Rate.  This is your NOI divided by the purchase price and multiplied by 100 to get a percentage.  Now, for the purchase price this does not mean the seller's asking price.  In general the seller's asking price has nothing to do with your offer.  Your offer should be based on what will make the property cash flow enough to be worthwhile to you.  Whether the seller accepts it or not depends on the market, how motivated they are, and how well you and your team negotiate.  So, what we do is move some terms around to come at a good offer price.  Rearranging things, we get offer price = NOI / Cap Rate.  This means that once you have your NOI, you need to know what Cap Rate you find acceptable. 

This is something I'm still figuring out how to determine myself, but each market has a typical cap rate that you can use a ballpark number.  Talk to other investors, property managers, real estate agents, and the like from your target market to see what they use for cap rate.  Take your NOI and divide it by what you consider an acceptable capitalization rate in order to arrive at an offer price that will work.  My understanding is that where NOI (and the loan terms) will tell you if you will cash flow, Cap Rate will tell you how good an investment the property is likely to be (higher cap rate = better investment).  You can refine what Cap Rate is "acceptable" with experience.  By talking with real estate agents and others familiar with the market, you can also determine if this offer price is even remotely realistic and, thus, if the property is worth pursuing.  It can save you a lot of time.


Cash on Cash Return
And third we come to Cash on Cash Return. This is pretty straightforward in that it is your monthly profit (cash flow) divided by the cash you put into the property (down payment, renovation costs, repair costs, advertising for tenants, initial cleaning, LLC setup fees, etc). Your profit is NOI - loan principle and interest. The cash put into the property includes all setup fees and expenses. These vary based on loan terms, the property, and the intended use of the property (short term rentals, for example, have extra setup fees compared with long term rentals). The length of time it takes to do the renovations and repairs will greatly affect your CoC Return as well. Each month of expenses that is not covered by rent counts as cash you are putting into the property, and thus lowers your CoC Return.

Cash on Cash Return is another way of measuring how good an investment is, one that is a little more near and dear to the heart than Cap Rate in my opinion.  If you know what you want your CoC Return to be, it will help you determine how much you can sink into a property for renovations and adjust your offer or negotiate loan terms until the down payment is acceptable.  If the cash on cash return is too low, it may be time to consider not putting in the gold plated toilet seats and self cleaning showers.  It's important to know what renovations will give you the biggest increase in profit for the lowest price in the least amount of time.   


Thanks for reading!  I hope that this post is useful to at least some new investors.  For myself, I find that if I organize my thoughts and put them out in public for people to praise or mock, I find out if I in fact know what I think I know.