The Net Operating Income (NOI) of a property is calculated by
determining the property's first year Gross Operating Income
and then subtracting the Operating Expenses for the first
year. In essence it's the money you collect minus the money you
spend to operate the property. Gross Operating Income - Operating
Expenses Net Operating Income The Gross Operating Income of
property is the total income a property can expect to receive from
all sources (rents, laundry, vending, cell phone tower on property,
etc) over a one year period. The Operating Expenses are the
expenditures needed to keep the property operating during the same
period. Sample Calculation: $500,000 Gross Operating Income -
$300,000 Operating Expenses $200,000 Net Operating Income The
NOI of a property comes directly from the operations of a property
and disregards mortgage payments or other additional expenditures
the property owner may make,such as tenant improvements or leasing
commissions.
CAPITALIZATION RATE
(Cap Rate) Many investors start their financial analysis of a
property by calculating the NOI in order to be able to calculate a
Capitalization Rate (Cap Rate) according to the following formula:
NOI / Property Price = Cap Rate
The Cap Rate is expressed as a percentage rate. Cap Rate is
typically calculated based on the first year of operations of the
property and assumes an all cash purchase of the property. Sample
Calculation: $200,000 NOI / $2,000,000 Property Price = 10% Cap
Rate A Cap Rate can be looked at as a first year return to the
investor comparing how much the investor would receive from
operations assuming an all cash purchase of the property. It's main
purpose is to enable investors to compare how their money is working
for them in one property compared to another property or investment.
Many institutional investors purchase their properties for all cash,
not using any financing. For them, the Cap Rate is a valuable method
of comparing properties. Individual investors often use financing
and it may be more appropriate for them to use additional methods of
comparing first year returns.
CASH ON CASH
Many investors who use financing to acquire properties use the
Cash on Cash method to compare first year performance of competing
properties. Cash on Cash takes into consideration the fact that the
investor does not have to have all cash to purchase the property,
and therefore will not keep all of the NOI because they must make
their mortgage payments from their NOI.
To calculate Cash on Cash the investor must first determine the
amount they must invest to purchase the property or their Initial
Investment. Total Purchase Price + Costs - Amount
Financed Initial Investment Sample Calculation:
$2,050,000 Price + Closing Costs - $1,550,000 Loan $500,000
Initial Investment Next, the investor must determine the first year
Cash Flow from operations, including the payments due on the
financing. NOI - Debt Service Cash Flow Before Tax (CFBT)
Sample Calculation: $200,000 Net Operating Income -
$140,000 Debt Service $60,000
CFBT With the calculation of the Cash Flow Before Tax and the
Initial Investment, the investor can make another comparison of how
their money performs in this property compared to other properties.
By calculating Cash on Cash the investor can determine the return
based on the investor's actual out of pocket investment. Cash Flow =
Cash on Cash/Initial
Investment Sample Calculation:
$60,000 Cash Flow / $500,000 Initial Investment =12% Cash on Cash
Return The Cash on Cash percentage can be looked at as a first year
return to the investor comparing how much the investor would receive
in cash flow from the property when the property is purchased using
financing. It is a measure of performance the investor can look at
to compare how their money is working for them in one property
compared to another property or investment, when financing is used.
Many investors use the Cash on Cash percentage in their investment
decisions as more accurately reflects their results than does the
Cap Rate which ignores the financing used to purchase the property
and the payments that must be made on that financing from the NOI of
the property.
Kerri Hamilton is a commercial broker, CCIM
Candidate, instructor and Founder of the Commercial Investment
Education Institute, LLC which teaches commercial real estate
investment to both novice and seasoned investors in a friendly
and easy to understand manner. As an investor like you, she
understands your concerns and your needs.
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