Introduction to Real Estate Investment Part 2: Investment Calculations

In part 1 of our Introduction to Real Estate Investment Analysis series, we discussed the essential property details you need to look up before dipping your toes into the deep end. Then, after visiting Zillow looking for a potential investment, we examined a property along W Garfield Avenue in Hazel Park as our model.

Now, we’ll give you the rundown on how to conduct a genuine property analysis. Below, we’ll give you the tools necessary to begin your journey as a real estate mogul.

Net Operating Income (NOI)

NOI is a valuation method that shows the total income in operating the rental investment, exclusive of any debt or financing costs. It helps you determine the capitalization rate (to be discussed later on) that helps with calculating the property’s value—ultimately allowing you to compare properties based on the income they could potentially generate.

The formula is as follows:

Income - Expenses = NOI

In calculating income, remember to consider the average vacancy rate of the neighborhood as rental properties won’t always be occupied—no matter how good you are at marketing and attracting tenants. The vacancy rate will help you estimate your monthly income loss.

Here’s our calculation for the Hazel Park property:

For expenses, you need to take the following factors into account:

With these numbers, we can now calculate the NOI:

$14,400 - $6,618 = $7,782 NOI per year

There is no particular number for a good NOI. Instead, compare the NOI to similar properties in the particular area to see if the income is too low or the expenses are too high.

Simply put, the higher your revenues and the smaller your expenses, the more money you’ll earn from the property. It’s up to you to decide which among the prospective properties are most worth it to own, maintain, and rent out.

Cash Flow

Simply put, cash flow is the amount of cash income you get less the amount of cash expenses. Compared to NOI, cash flow takes debt service into account while excluding non-cash expenses such as depreciation. NOI measures profitability, while cash flow is viewed (even beyond real estate) as a measure of financial health.

To calculate how much money you’ll pocket after paying all the bills and expenses, use the following formula:

Gross Income - Expenses - Debt Service = Cash Flow

Using our Hazel Park example, the estimated annual debt service is $4,818. This means we’ll pocket around $2,964 per year. This shows that if you pay in cash instead of taking out a loan, you’ll earn more from your investment.

$14,400 - $6,618 - $4,818 = $2,964 cash flow per year

A healthy, positive monthly cash flow guarantees real profit over a long period of time. This is especially important for buy-and-hold investments like rental properties, where you’ll own and operate the property anywhere from 5 to 30+ years, depending on your strategy. The value of the property will only increase, as you enjoy stable cash flow from rent month after month.

If you want a faster way of checking this when analyzing multiple deals, you can use the industry-standard 1% Rule as a starting point. This rule says that the monthly rent should be at least 1% of the purchase price to understand if the property has the potential to yield positive cash flow.

Property Price > 1% of Monthly Rent

For our Hazel Park example, the property price of $119,000 means the monthly rent should be at least $1,190. However, the rent amount is only at $1,068—falling just slightly short of the 1% rule, which is not unusual for Class B properties.

Capitalization Rate

Often shortened to just cap rate, this calculation shows your property’s potential return independent of the buyer and financing a.k.a. the ROI if you paid in all cash. Cap rate is the NOI of a property in relation to the property value, which could either be the market value or purchase price.

This is important to accurately understand your operating costs and choose between investment options. You’ll be surprised just how much difference two similarly-priced properties would yield in annual ROI.

The formula looks like this:

NOI / Property Price = Cap Rate

For the property in Hazel Park, the calculation looks like this:

$7,782 / $119,000 = 6.54% cap rate

There’s no standard rate for a “good” cap rate, as it will depend on several factors such as the quality of the property, its location, and type. CBRE’s North America cap rate survey from 2019 shows that a multifamily home will be roughly 5%, which makes the home in Hazel Park quite promising.

Data Source: CBRE 1H19 North America Cap Rate Survey

Based on CBRE’s survey, the difference between suburban economy hotels (9.74%) and Class A urban apartment buildings (4.69%) could be as much as five percentage points.

Property class and type has a huge impact on what’s considered a good cap rate—which should influence your decision when choosing properties. The averages also help you determine if a property surpasses or falls below standards.

Cash-on-Cash Return (COC)

COC or Equity Dividend Rate determines the return and stability of an investment. The calculation measures the annual return you’ll make in relation to the mortgage you’ll pay in the same year.

COC is important in forecasting the rental property’s investment performance based on expected earnings and expenses.

The formula is:

Pre-tax Cash Flow / Cost of Investment = COC

For our example, the calculation is:

($14,400 - $4,818) / $147,560 = 6% COC

The pre-tax cash flow is calculated by taking your gross income and subtracting the debt services. In our case, it’s $14,400 subtracted by $4,818 to get a pre-tax cash flow of $9,582.

There is no standard COC rate. Some investors are happy with a stable COC return of less than 10%, while others will only consider a property with a whopping 20%. Generally, the higher the COC rate, the more the property can pay for itself in the long run.

While COC may sound identical to ROI, the latter is quite difficult to truly calculate for rental investments. You won’t know how much a rental property will give you in total before you sell it, therefore it doesn’t make much sense to calculate the ROI. Instead, use COC where you can accurately analyze the property’s cash return for every cash invested.

Summary of Key Calculations

Real Estate Investment in 2023

As of 2023, the US real estate investment market is showing signs of continued growth and stability. Despite the pandemic's impact on the economy and the initial downturn in the real estate sector, the industry has rebounded strongly.

That being said, interest rates are continuing to spike, with Central Bank raising rates to the highest point it's seen in 16 years. Case in point, 2 years ago, the mortgage interest rate for a property in Hazel Park was only 3.02%. But, this year, the average mortgage interest rate hovers around 6.79%, marking an increase of over $200 on your monthly mortgage payment.

However, with the federal government finally looking to lay off on the interest rate increases, real estate investments are beginning to look more lucrative. Overall, the US real estate investment market in 2023 remains a lucrative and attractive option for investors, with a positive outlook for the future.

Conclusion

All real estate billionaires (Donald Bren included!) understand how to analyze real estate investments before pouring their hard-earned money into properties. By mastering these key analysis methods, you can make sure you’re doing your due diligence and selecting the investments that are most likely to give you the profits you want.

Ready to get started? Get in touch with us and we’ll guide you through your real estate investment journey.

Also, make sure to visit our glossary of common real estate terms to brush up on your vocabulary and interact with other investors like a pro!

Comment below if you have any questions.