Investment Property Primer
Analyzing the Numbers
Return on Investment (ROI)
The performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments.
ROI is calculated by adding the cash return, mortgage pay down, and appreciation. Investors use different calculations and tools to calculate the returns on their real estate investments:
Capitalization Rate (Usually called a "Cap Rate" for short) is simply your annual net operating income divided by your purchase price. The higher the Cap Rate, the better.
Cap Rate = Annual NOI / Purchase Price
Important Note on Running Your Own Numbers: While a cap rate is one of the most common formulas used to for real estate investment analysis, ALWAYS be sure to check the calculation and make sure the person presenting it to you has calculated it properly. For example, MANY sellers quietly omit the maintenance and vacancy assumptions (which in the example above would change the Cap Rate from a 7.7% to 9.2%, which is a huge difference!). If you were to just compare "cap rates" without confirming how they have been calculated, you would be seriously misanalyzing the properties. This is why it is crucial for you to understand how these formulas work so that you can apply them yourself when doing your own real estate investment analysis.
Now, even when calculated properly, a cap rate does not take into account any financing you may have used to leverage your purchase. So, the final formula we will discuss here goes one additional step.
Net Operating Income (NOI)
Your Net Operating Income (NOI) is your total gross scheduled rent minus all your expenses—property taxes, insurance, HOA fees if any, property management fees, "vacancy" and "maintenance" estimates.
NOI = Gross Scheduled Rent – Operating Expenses - Maintenance and Vacancy Estimates
Important Note on "Vacancy" and "Maintenance": Smart investors always make sure to factor in "vacancy" and "maintenance" estimates when analyzing properties, even new or fully renovated turn-key properties that have tenants in place at closing. This is because if you hold a property over the long term there will eventually be tenant turnover, vacancy and maintenance, all of which cost you money and affect your cash flow. Maybe your property will have no vacancy for 3 years, but then the tenant leaves and your property is vacant with no income for 60 days until a new tenant moves in. Or maybe you have no repairs for a couple years, but then you have an expensive one. Well, if you account for all that up front and amortize your estimated vacancy and maintenance across every month (we usually suggest estimating at least 5% of the monthly rent for maintenance and 7% of the monthly rent for vacancy), then you are not caught off guard when it occurs, because you factored it in from the beginning.