In this blog, we will point out the most important real estate metrics that are used in real estate investment property analysis.
What are the most important metrics in real estate investment property analysis?
1- Net operating income (NOI)
A very important term in real estate investment property analysis is the “net operating income”, or “NOI”, a real estate metric that measures the ability of a rental property to produce an income stream from operations. Basically, NOI is the total annual rental income that a real estate rental property generates after deducting all expenses incurred from operations. Total annual income is simply the monthly rent of the investment property multiplied by 12, while operating expenses are property-related expenses excluding any financing or tax costs such as mortgage payments and rental income tax.
The net operating income formula is as follows:
Net operating income (NOI) = Potential rental income – Operating expenses
Operating expenses include real estate property taxes, management fees, property insurance, maintenance, and accounting costs. On the other hand, it excludes costs such as financing costs, income taxes, depreciation, and major capital expenditures.
The net operating income is a simple real estate investment property analysis metric. However, real estate investors should be aware of what is included and excluded from the NOI calculation for better interpretation of real estate metrics.
2- Cash flow
Cash flow is another important real estate investment property analysis metric that shows real estate investors the annual total profit of their real estate property. Cash flow is equivalent to net operating income after deducting debt service expenses, i.e., mortgage payments.
The cash flow formula is as follows:
Cash flow = Net operating income – Debt service expenses
A positive cash flow indicates that a real estate investment property is generating profits, and a negative cash flow indicates that real estate investors should walk away as the investment is actually generating losses.
3- Gross potential income (GPI)
Gross potential income is a simple calculation but very important in real estate investment property analysis. GPI is the total rent a real estate property could realize if it was fully occupied (no vacancies) and all tenants pay their rent. Another term used for GPI is gross potential rent.
Example on how to calculate GPI: Assume you rent out a 5-unit real estate property for $800 per month per each.
Gross potential income = 5 x $800 x 12 = $48,000
GPI is one of the first indicators that real estate investors look at when they want to purchase a real estate property, as it indicates how profitable it can be.
4- Gross operating income (GOI)
Gross operating income, also known as effective gross income (EGI), is simply the gross potential income of a rental property after deducting vacancies and credit losses. GOI is a more realistic real estate investment property analysis metric, because in reality, it is not easy to rent out a real estate property for 365 days every year and sometimes tenants do not pay their full rent.
GOI = GPI – (Vacancy losses + Credit losses)
Using the same numbers from the example above, assume that your units will be vacant 5% of the time and 3% of the credit is lost.
Vacancy losses = 0.05 x $48,000 = $2,400
Credit losses = 0.03 x $48,000 = $1,440
GOI = $48,000 – ($2,400 + $1,440) = $44,160
5- Net present value (NPV)
Net present value is a term widely used in real estate investment property analysis to determine if a rental property can generate future cash flows that have a present value larger than the amount of cash initially invested in the real estate property. In other words, NPV tells real estate investors whether their target rate of return will be achieved, and therefore, whether the real estate investment is attractive enough.
The NPV formula is as follows:
NPV = ∑ Cn/(1+r) ^n – Ci
Cn: Cash flow for period n
r: Required rate of return
Ci: Initial cash investment
A positive NPV indicates that the required rate of return is met, while a negative NPV means that the present value of future cash flows is less than the amount invested in, and, therefore, the required rate of return is not met.
6- Internal rate of return (IRR)
The internal rate of return is the discount rate (r in the equation above) at which the NPV of future cash flows equals zero. In more simple terms, IRR is the percentage rate at which a real estate investment grows, or shrinks.
IRR is used to measure the attractiveness of a real estate investment. If the IRR of a future investment exceeds the investor’s required rate of return, then that investment is desirable and vice versa.
7- Cap rate
Cap rate is a rate of return that measures the profitability of a real estate investment. It is simply calculated by dividing the net operating income of a rental property by its market value.
Cap rate can be used to:
- Compare different real estate investment opportunities, so real estate investors use cap rate to decide whether or not an investment is worth it.
- Assess the performance of a real estate investment.
- Cap rate of real estate comps can be used to valuate a property.
8- Cash on cash return
Cash on cash return is a real estate metric that measures returns directly related to the amount of cash you put down on the investment. It is calculated by dividing the net annual cash flow by the cash investment.
The Bottom Line
Understanding real estate investment property analysis methods is essential to succeed in real estate investing. Therefore, real estate investors should be familiar with the above mentioned real estate metrics and use them to make real estate investing decisions. Finally, use an investment property calculator such as the one provided by Mashvisor, it will save you time and effort!