Real Estate Investing for Beginners: Top 3 Key Metrics You Need to Know

Venturing into real estate investment can seem overwhelming, especially for beginners. However, understanding a few key metrics can greatly simplify the process. So buckle-up! Today, we'll delve into the top three metrics you need to know as a beginner: Net Operating Income, Cap Rate, and Cash on Cash Return.

1. Net Operating Income (NOI)

Net Operating Income is a crucial metric in real estate investment. It represents the annual income that a property generates after all operating expenses have been deducted, but before mortgage payments and taxes.

How to Calculate NOI:

Calculating NOI is fairly straightforward. You start with the property's annual gross income (this includes rent and any other income the property generates) and then subtract all operating expenses.

Here's the formula:

NOI= Gross Income - Operating Expenses

Example: $100,000 = $200,000 - $100,000

Operating expenses include costs such as property management, maintenance, repairs, utilities, property taxes, insurance, and homeowner's association fees. It's important to note that these are costs associated with the operation and maintenance of the property.

Should Capital Expenses Be Included in NOI?

Capital expenses, such as a new roof, are not included in the NOI calculation. These are considered investment in the property that will improve its value over the long term, and are not part of the day-to-day operational costs.

Why NOI is Important:

NOI is a critical measure of a property's profitability and financial performance. Investors and lenders look at NOI to assess the income-generating potential of a property. It shows how much income you are really making from a property after all the necessary costs have been accounted for.

What a Good NOI Looks Like:

A good NOI varies widely depending on factors such as the type of property, its location, and the local real estate market conditions. Generally, a positive NOI indicates that a property is generating more income than it costs to operate, which is a good sign for investors. A negative NOI, on the other hand, may suggest that the property's expenses exceed its income.

Remember, a higher NOI is typically better because it suggests the property is more profitable. However, the NOI should be considered alongside other metrics like the Cap Rate and Cash on Cash Return to give a complete picture of a property's financial performance.

2. Capitalization Rate (Cap Rate)

The Capitalization Rate, or Cap Rate, is a metric used in real estate to estimate the potential return on an investment property. It's expressed as a percentage and is calculated by dividing the Net Operating Income (NOI) by the property's current market value.

How to Calculate Cap Rate:

Here's the formula for calculating the Cap Rate:

Cap Rate = (NOI / Current Market Value of the Property)*100

Example: 10% = ($100,000/$1,000,000)*100

This calculation shows you the percentage of your investment you could expect to earn back in one year, assuming the property was purchased in cash and before factoring in any mortgage payments or capital expenses.

Why Cap Rate is Important:

The Cap Rate is a useful tool for comparing different investment opportunities. It can give you a quick snapshot of a property’s income potential and profitability in relation to its price. It's particularly valuable when comparing properties of similar types in the same market area.

Cap Rates and Risk:

The Cap Rate can also provide insights into the level of risk associated with a property. Generally, a higher Cap Rate may indicate a higher-risk investment. This is because a higher Cap Rate typically means the investor is expected to take on more risk, such as properties in less desirable locations, or properties requiring more maintenance or management.

On the other hand, a lower Cap Rate often corresponds to a lower-risk investment. Lower Cap Rates are commonly associated with premium properties in prime locations that are expected to have steady, reliable cash flows. However, these lower-risk properties often come with higher price tags.

What a Good Cap Rate Looks Like:

There isn't a universal "good" Cap Rate, as it can vary significantly depending on the local real estate market and the specific details of the property. However, it's important to compare Cap Rates for similar properties in the same market to get a sense of what a competitive Cap Rate might be.

However, if you were looking at two identical properties with identical income you would want to choose the property with the higher cap rate. Why? Because this would mean you were getting more money (income) per dollars spent (purchase price). As a rule of thumb, the higher the cap rate the more money you are presumably getting back in your pocket.

3. Cash on Cash Return (YIELD)

Cash on Cash Return, also commonly referred to as Yield, is a return on investment (ROI) measure used in real estate investing that calculates the cash income earned on the cash invested in a property. It is a valuable metric because it reveals the yield or actual cash-on-cash yield, an investor can expect to receive on a property.

How to Calculate Cash on Cash Return:

The calculation is pretty straightforward:

Cash on Cash Return = (Annual Pre-tax Cash Flow / Total Cash Invested)*100

Example: 20% = ($50,000 / $250,000)*100

The "Annual Pre-tax Cash Flow" is the net income from the property (after all expenses, but before *taxes), and "Total Cash Invested" includes your down payment, closing costs, and renovation costs.

*Excluding property level taxes. Those are included in operating expenses and thus NOI.

Why Cash on Cash Return is Important:

Cash on Cash Return is a valuable metric because it considers the investor's initial cash investment and the actual cash flow the property generates. It's particularly valuable for investors who finance their property with debt, as it takes into consideration the impact of using leverage (mortgage financing).

What a Good Cash on Cash Return Looks Like:

What is considered a good Cash on Cash Return can vary significantly depending on the market and individual investor's strategy. However, a good starting point might be anywhere from 8% to 12%. Anything below 8% could be risky, as it may not significantly outpace traditional investment returns. Conversely, a higher Cash on Cash Return might suggest a more lucrative (though potentially riskier) investment.

Keep in mind that real estate investing involves various factors and the Cash on Cash Return should not be the sole decision-making factor. Always consider other metrics like the Cap Rate and NOI, as well as the property’s condition, location, and market trends.

Conclusion

So there you have it - a breakdown of three essential metrics for beginner real estate investors: Net Operating Income, Capitalization Rate, and Cash on Cash Return. Each of these metrics provides a unique perspective on the potential profitability and risk of a real estate investment.

As you venture into real estate investing, remember to use these metrics as tools to assist you in making informed decisions. It's important to understand each of these metrics individually, but also how they interact and influence each other within the context of a particular investment opportunity.

If you have any further questions about real estate investing, or if you're looking for a property to invest in, please don't hesitate to reach out to us at marinajeanmgt@gmail.com. At Marina Jean Management, we're here to support you on your journey to success in real estate investment.