An opportunity may seem like a good deal, but how will you ever know for sure without looking at the numbers? Surely, the appearance or location of the building alone can’t automatically make it a good deal. Here are three key metrics you can use when investing in commercial real estate.
Net Operating Income (NOI)
The first metric we will discuss is called net operating income (NOI). NOI is basically a measure of how much annual income is left after paying for the required operating expenses. However, it should be noted that this figure does not include income taxes, interest and principal payments, asset depreciation and capital expenditures. Keep in mind, you will still need to cover these costs from your NOI.
To calculate the NOI of your investment property, you need to subtract relevant operating expenditures from your overall revenue. So what is counted as revenue and expenditures? For operating revenue, this refers to any income generated from the investment property. This can be in the form of rental income, as well as other services like parking. On the other hand, operating expenses involve any costs involved in the upkeep and maintenance of your property. This could include property management fees, insurance coverage, utilities, property taxes and other repair costs.
And of course, you definitely want your NOI to be positive. Otherwise, it means you have spent more money running a property than the amount of revenue it has generated in that year.
Capitalization Rate (Cap Rate)
The second metric to be discussed is called the capitalization rate, often shortened to cap rate. The cap rate essentially represents your return on investment. It compares the annual income you expect to generate from the investment to the market value of the property. This makes it much simpler to compare various investment opportunities – look for the one with the highest return. Of course, this isn’t the only thing you should consider to determine the best investment, but it can be a great place to start.
To calculate the cap rate, take your NOI and divide it by the market value of the property. Please note that we use the market value and not the purchase price of the property. Typically, investors will use this to analyze the first year of a project. You can assume this rate of return will remain constant, but that would require the property’s market value and its annual income to also remain constant. In a perfect world, this may hold true but unfortunately you shouldn’t expect it. The cap rate can fluctuate depending on movements in the two aforementioned variables. For example, let’s assume the NOI stays constant. In the case where the market value rises, the cap rate gets smaller. In the reverse situation, the opposite is true – the cap rate will get larger. You can also calculate the cap rate at other future years, but this will require you to discount future NOI values. We won’t get into the time value of money just yet, but you can read more about it here (link to future time value money article). So just remember that this provides a good baseline to start, but you should always be aware of volatility.
The cap rate is a great measure to help you decide which investments are worthwhile. Also be sure to compare this rate to industry standards of different investment opportunities.
Cash on Cash Return
The final metric we shall discuss is called cash on cash return. This is similar to the cap rate in that it calculates a rate of return, however, there is a fundamental difference. The cash on cash provides a rate of return based only on the actual cash you invested, rather than the entire market value of the property. It does not account for the capital you have obtained through financing options.
Think about it this way, rather than dividing your annual NOI by the total market value, you will divide it by your down payment. Hence, the cash on cash return is equal to your annual NOI divided by your down payment. Again, much of the same theory applies to this measure as the cap rate. Specifically, this assumes consistency in your annual NOI. However, you can calculate this rate on a year to year basis to account for any fluctuations.
So there you have it. These are three key metrics to get you started in the practice of commercial property investing. Today's market is filled with many opportunities for the savvy investor. Our Rich Dad Education trainers will introduce you to proven strategies that can help you launch your career as a successful real estate investor and develop a "Rich Dad Mindset."
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