Real estate investment, just like any other kind of investment, comes with its own set of risks and rewards. Being armed with the correct information and knowing how to deploy it makes the process much easier and more predictable.
There are many different modalities of real estate investment. But it’s probably obvious that the primary financial objectives are cash flow from rents, and then capital gain from a sale. Additionally investing in real estate can provide significant tax advantages.
Today we are going to talk about some of the basic terminology and metrics involved in the cash flow of a real estate investment. The same basic concepts apply whether the investment is a small studio in the Back Bay or a 75-unit apartment building in the suburbs.
The below spreadsheet is for a condo purchase, just to keep it simple. Also, it’s a cash purchase. As we’ll see in a later example, this purchase (as with many potential investment purchases in the downtown neighborhoods) may not work with financing.
- 1. Gross Scheduled Income: As the name implies, this is the total on-paper income that your lease(s) says that you will be receiving.
- 2. Gross Operating Income: This is the GSI minus 5% for potential vacancy. In Boston right now, it is unlikely that if your property is priced correctly and located and presented well, that you will have any vacancy. To my experience 5% is a pretty standard figure to use in these calculations. Many people like to use 8% for an approximate 1 month vacancy. If you are going to purchase and then take a month or two for improvements, you will want to figure that separately for your first year.
- 3. Net Operating Income (NOI): This is the coin of the realm. As the name implies, it is what is left over after you subtract your regular operating expenses (excluding financing) from GOI.
- 4. Expenses: Generally, if you are looking at a multi-unit building being offered for sale, you will probably be offered a pro-forma, listing the expenses of the building over the last year.
I can’t overstate how much that the pro forma needs to be the subject of much scrutiny and skepticism. Your due diligence is very much required. And many times, the pro-forma will say just that, relieving the sellers of liability for misrepresentation. I can help.
As I said, this sheet details the expenses of a small condo. For a larger building, there may be other details, such as accounting, management fees, snow removal, landscaping, etc.
Also, this sheet excludes any other initial expenses you may undertake. In many cases, the rationale for purchasing a particular property, such as a rental building would be to improve it, then rent and hold.
It is important to remember that most of your expenses will be tax-deductible as well, which is one of the big advantages of real estate investment. The profit doesn’t come solely from the sale, but also from the cash flow, which is leveraged by the tax advantage.
- THE METRICS: How can we compare potential investments to one another?
- 5. Capitalization Rate (Cap Rate): This is really the gold standard for comparing one real estate investment vehicle to another. It compares the NOI to the price paid for the property. In this case, the Cap Rate is 3.37, meaning that the NOI for the year is 3.37% of the price paid. Once again, it leaves any financing considerations, because it is used purely to compare one property to another. In the Boston area, if you can find a 5 cap, buy it! Or tell me about it so I can! Once you know the NOI of a property and you've established what you should expect the Cap Rate to be, you can calculate the value of the property using the formula NOI=Rate X Value. In other words, NOI/Rate=Value. So if the property has an NOI of $24,700 and the market Cap Rate is about 4 (.04), the value is $617,500. If you need a higher cap, the value to you would be lower, as in our spreadsheet scenario
- 6. Cash Flow: NOI minus financing costs.
- 7. Cash-on-Cash-Rate of Return (COCROR): This is essentially the same as Cap Rate, but it takes into account financing expenses, which can quickly turn an otherwise fantastic investment into a no-go, particularly these days. Take a look at the financed version of this purchase. In order to make this purchase carry itself, there would have to be around 40%+- down at the interest rate listed. And looking at the COCROR, you would obviously not be purchasing this property for the immediate cash flow. Are there other considerations, such as rising values in the area over the next few years? Can the properly easily be spruced up at low cost in order to juice up the rents? Also, any initial fix-up expenses should be calculated into your first year COCROR.
- 8. Gross Rent Multiplier (GRM): This is a commonly used metric, mostly used for on-the-fly, back-of-the-envelope valuation. The calculation is as follows: Gross Rent Multiplier = Sale Price/Gross Scheduled Income. One use of GRM is to calculate what you should expect that the the gross scheduled income should be based upon the market. So if you know the price of a property is $500,000 and the average GRM in that market is 10, divide the price by the GRM to get the total amount of Gross Scheduled Income you should be able to expect in that market at that price, which is $50,000/year. So you need to determine if in reality, you can actually do that. You can also use this formula to determine what a property's purchase price should be based upon the value of the leases in place.
- Cap Rate vs GRM: Cap rate is a much more valuable tool to use in valuation, because it takes into account the Net Operating Income rather than the Gross Scheduled Income. But GRM, once again, is a good basic tool to use at the beginning of your vetting process, prior to receiving all the details.
More complex investments: What we just discussed were basic cash flow metrics. There are other metrics that come into play for other types of real estate investment. Suppose you're thinking of purchasing a three family with three two bedroom units for $1m, with current leases totalling $6k/mo. Suppose you do $80,000 in renovations after the individual leases run out, gaining you another $200 per month in rent for each unit? Is it worth it? How will that impact the building's resale value? Do you want to convert to condos? What are the tax implications?
You get the idea. More to come....
