By Brian Patton, CCIM, Capital Realty Advisors
There are three primary financial terms that affect how we determine the value of real estate. Without a working knowledge of these terms, investors and realtors are at a disadvantage in the market place. These terms may sound difficult to grasp but are an integral part in understanding how we determine the value of real estate and are important for commercial and residential investors alike.
Net Operating Income
Net operating income refers to the income received from an investment prior to any mortgage debt being deducted from the equation. In general, net operating income (NOI) is defined as the total possible rents minus a vacancy rate and any operating expenses.
NOI is used to help compare investments without the uncertainty of what mortgage product you’ll be using. The vacancy rate is a general rule of thumb depending upon market conditions and the type of investment. It is expressed in a percentage of gross rents. Operating expenses are those normally recurring expenses such as property taxes, insurance, management fees, repairs, etc.
So, a simple example would be an investment with $13,000 in potential yearly rent, minus a 7 percent vacancy rate, and $2,000 in operating expenses, would give us a NOI of roughly $10,000 per year.
Capitalization Rate
The second term, capitalization rate, is probably least understood of all. The cap rate, for short, is an easy way to compare investments by the amount of net cash flow and their subsequent value. A simplified definition for cap rate is the cash on cash return on your investment if you paid cash for the property. The formula for the capitalization rate is: cap rate = NOI/Value.
Let’s look at an example. If the NOI from our previous example is $10,000 and you determine that the property is worth $100,000, then your cap rate would be 10 percent. So, if you paid $100,000 in cash for the property you would receive $10,000 in income; and hence, a 10 percent return. That 10 percent is also your cap rate. The cap rate, as well as the NOI, has nothing to do with financing of the property. It is merely a simplified equation to determine value of a property.
Internal Rate of Return
The third term, which is more encompassing than the previous two, is the Internal Rate of Return (IRR). Some refer to this as the Return On Investment (ROI). IRR takes the best of the previous two terms and injects the mortgage debt into the picture. It also injects the amount of your initial investment into the equation.
A quick study of IRR will prove why investors use financing. Let’s use our previous example of a property with $10,000 of NOI. With 20 percent down on this investment and a 30-year mortgage of 7 percent, the annual income would be reduced to $3,613, due to the mortgage debt. But, the IRR would increase to 18 percent. This increase would be achieved even with selling the property for what you paid for it and holding it for five years. This is a definitive example of how financing greatly enhances your return on the investment.
While you can invest in real estate and never understand these financial terms, having a working knowledge of them will provide greater clarity on your future real estate decisions.
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Brian Patton, CCIM, is a broker, author, and frequent speaker at the Georgia Real Estate Investors Association, the largest real estate association in the nation.