Investments 101


The full-spectrum real estate approach involves assisting clients with both purchasing and selling investments.  When prospecting properties a good broker looks first at the numbers.  Running the numbers and knowing how to interpret them for clients are critical to selling investment property.  Understanding and practicing these standards is what separates a bona fide commercial real estate broker from just a broker.  

Brian DApice holds a B.S. in Accounting as has applied that knowledge with investment property sales. Brian's accounting background has given him the competitive edge with multi-family and mixed-use property transactions. In working with and analyzing data such as the Capitalization Rates (Cap Rates) and Debt Service Coverage Ratio (DSCR) almost daily, Brian's broad business knowledge can benefit you.

In bringing buyers and sellers together, Brian educates clients on the financial information pertinent to both sides of the transaction so the most educated opinion can be determined. Some of the most important basic factors are:

  • Net Operating Income
  • Gross Rent Multipliers
  • Cash-On-Cash Returns
  • Capitalization Rates
  • Debt Service Coverage Ratio

Net Operating Income (NOI) is equal to a property's annual gross income, less operating expenses.  Gross income includes both rental income and other income such as laundry.  Basically, any and all income associated with a property.  Operating expenses are costs incurred during the operation and maintenance of a property.  They include all non-interest baring expenses such as repairs & maintenance, insurance, management fees, utilities, supplies, property taxes, etc.  The following are not operating expenses: principal and interest, capital expenditures, depreciation, income taxes, and amortization of loan points.

NOI is used in two very important real estate ratios.  It is an essential ingredient in the Capitalization Rate (Cap Rate), which is used to estimate the value of income producing properties. The other ratio the NOI is most relevant in would be the Debt Service Coverage Ratio (DSCR).  Investors and mortgage professionals use the DSCR to measure a property's ability to cover the annual operating expenses and annual mortgage payments.  A DSCR of 1.0 is breakeven.  Most lenders require minimum DSCR of 1.20.

                                      Net Operating Income
Estimated Value =  ------------------------------------
          
                                         Capitalization Rate


Example: Assume we are evaluating an income producing property in Salem, MA during the calendar year 2007. The Market Cap Rate of that area was 8%. We are evaluating a similar income property that is currently for sale in this area with a net operating income of $68,815.

   68,815
------------- = $860,188

      .08

The Net Operating Income is a factor in several other real estate ratios and an essential part of an income property's Income Statement.

The Gross Rent Multiplier (GRM) is a ratio that is used to estimate the value of income producing properties.  The GRM provides a rough estimate of value.  Only two pieces of financial information are required to calculate the GRM of a property, the sales price and the market value of the total gross rental income. Brian uses a monthly Gross Rent Multiplier, but some investors use a Yearly GRM.  The monthly Gross Rent Multiplier is equal to the Sales Price of a property divided by the potential monthly rental income and the Yearly GRM is the Sales Price divided by the yearly potential rental income.

                                                     Sales Price
Monthly GRM =   -----------------------------------------------

                                   Potential Monthly Gross Income


Example 1:  If the sales price for a property is $824,900 and the potential monthly rental income for a property is $10,600, the GRM is equal to 78. The “potential monthly rental income” is equal to the amount of rental income if the property was at full occupancy. Vacancies are not a factor.

   824,900
-------------- = 78
    10,600

When comparing similar properties in the same market, the lower the GRM, the more profitable the property.  This assumes that operating expenses are proportionate for the properties being compared.  Since the GRM calculation doesn't include operating expenses, this might not hold true for comparable properties where higher operating expenses may occur.

Estimated Market Value = GRM X Potential Gross Income

Example 2:  Lets use Salem, MA for the calendar year 2007. The average monthly GRM was 82.  We can use that data to estimate the value of comparable properties for sale in that market.  If our monthly potential gross income is $10,600, we would estimate its value at $869,200.

82 X 10,600 = $869,200

A market GRM can provide a rough estimate of value, but it does have some limitations. The GRM does not include a property's operating expenses and vacancy rate. The Capitalization Rate is a more reliable tool for estimating the value of income producing properties since vacancy amount and operating expenses are included in that calculation.  The GRM is only useful in providing a rough estimate of value.

Cash on Cash Return is a percentage that measures the return on cash invested in an income producing property. It is calculated by dividing before-tax cash flow (NOI less Debt Service) by the amount of cash invested (amount of your down payment) and is expressed as a percentage.

                                                 Before-Tax Cash Flow
Cash on Cash Return  =  -------------------------------------
                                                     Cash Investment


Example: If before-tax cash flow for an investment property is equal to $10,000 and the cash invested in the property is $150,000, the cash on cash return would be 6.6%.

   10,000
-------------- X 100 = 6.6%
  150,000

The Cash on Cash Return is used to evaluate the profitability of income producing properties. The property with the largest cash on cash return generates the greatest return on investment.

The cash on cash return calculation has some limitations.  It does not take into account an investor's income tax situation and it does not consider a property’s appreciation potential.

A property in one market may have a better Cash on Cash Return then a property in a different market, but it may not appreciate as fast because of the location.  One location may be more desirable than the other.

The Capitalization Rate (Cap Rate) is a ratio used to estimate the value of income producing properties.  Basically, it is the market value of a property expressed as a percentage. The Cap Rate is the net operating income divided by the sales price. Investors and real estate professionals use the cap rate to estimate the purchase price for income producing properties.

                                 NOI
Cap Rate =    ----------------------

                          Market Value

A Market Cap Rate is determined by evaluating the financial data of comps (similar properties, which have recently sold in a specified range).  It provides a more reliable estimate of value than a market Gross Rent Multiplier (GRM) since the Cap Rate utilizes the property's actual financial details. The GRM only considers a property's selling price and gross rents.  The Cap Rate incorporates a property's selling price, gross rents, other income, vacancy amount and operating expenses thus providing a more reliable estimate of value.

                                                         NOI
Estimated Market Value =    ----------------
 
                                                     Cap Rate

Cap Rate Example:  A property has a NOI of $68,815 and the asking price is $824,900.

     68,815
---------------- X 100 = 8.34%
    824,900

Estimated Market Value Example:  (Salem, MA – calendar year 2007) A property has a NOI of $68,815 and Cap Rates in the area for this type of property averaged about 8%.

    68,815
--------------- = $860,188
       .08

The Cap Rate may vary in different markets for reasons such as location, crime rate and general condition of the area.  You would expect lower Cap Rates in newer or more desirable areas of a city and higher Cap Rates in less desirable areas to compensate for the added risk.

When you obtain a market Cap Rate, you can then use this information to estimate what similar income properties are worth.  This will help you to gauge whether or not the asking price for a particular piece of property is over or under priced.

Brian's Advise:  If you happen to come across an investment property that meets or exceeds a Cap Rate of 8% and you feel the location and tenants are a good fit for you, BUY IT!

The Debt Service Coverage Ratio (DSCR) measures an income producing property's ability to cover the monthly mortgage
payments.  It is the one variable used by all mortgage professionals to ultimately determine weather a note will be approved or not. The DSCR is calculated by dividing the Net Operating Income (NOI) by a property's annual debt service (mortgage payments). The higher the debt coverage ratio value, the more income there is available to cover the debt service, thus less the risk.

                                               Net Operating Income
Debt Coverage Ratio =  -------------------------------------
                                                Annual Debt Service

Example:  An investment property has a net operating income of $68,815 and annual debt service of $55,000.  The DSCR for this property would be equal to 1.25. This means that the investment property generates 25% more annual NOI than is required to cover the annual mortgage payments.

   68,815
------------- = 1.25
   55,000

Many lending institutions require a minimum debt coverage ratio value to procure a loan for income producing properties.  The DSCR requirements for lending institutions in Massachusetts are generally between 1.20 and 1.25.

This content was originally authored for Investopedia in 2007, updated in 2016 by Brian DApice