This video explores the income potential of a property. Investors will be concentrating on this aspect of the transaction – some may come to you with a good knowledge of all the acronyms and verbiage surrounding investment property while others will have much less of an idea of how to calculate the income potential.
Getting clear on some of the language and some simple formulas you can use will come in very handy when you are faced with hard questions.
In order to analyze the potential of a property, you need to know about cap rate, cash on cash return, and NOI.
This will all be explained……
Cap rate
The cap rate is a convenient and quick method to determine if the value or purchase price of an investment meets the investor’s criteria. The cap rate alone, however, should not be the sole reason to purchase a property. Investors must perform proper due diligence and consider other factors such as location, demographics, growth, supply vs demand, loan-to-value, and debt coverage ratios to determine if an investment is worth the risk.
A cap rate is simply calculated by dividing the Net Operating Income (NOI) by the purchase price and focuses on the property alone and not the financing used to buy the property. (We’ll come to NOI in a moment). It is expressed as a percentage and is the annual return expected on an investment.
You may have investors who are fixated on a cap rate and you may want to steer them to look at other metrics as well such as cash on cash return.
Cash on Cash Return (COC)
The CoC measures the received cash flow (pre-tax) compared to the amount spent to acquire the property and is used to evaluate cash flow from income-producing assets.
Because CoC ROI does not include investment, it’s a great tool for an investor to evaluate the profitability of a property before investing in one.
The formula for calculating CoC divides the total cash invested by the NOI.
Net Operating Income
Since the NOI features in the previous two formulas, it is important to have this on hand for each property you are showing. It plays a role in the valuation of the rental business side of the property purchase.
Lenders will also look at the NOI when determining if they will lend on the property. It tells them whether the income is likely to cover expenses + mortgage payments, or not.
Calculating NOI is a little more involved.
It measures the amount of cash flow generated by an investment property after operating expenses, but before principal and interest payments, capital expenditures, depreciation and amortization.
The NOI is determined by establishing Gross Operating Income (GPI) by deducting the value of vacant periods from the annual potential income, then deducting the total operating expenses from the GPI.
Operating expenses do not include PITI (Total mortgage payments including Principal, Interest, Taxes & Insurance)
Good vs bad cap rates
- Returns will vary depending on location (High demand areas will have lower cap rates than those where demand is lower).
- Investors may be willing to forego higher cap rates for future appreciation potential.
- Typically with STR, the bigger the home the higher the return (depends on the destination)
- Seasoned investors will be looking for a 7% or higher cap rate (their expectations are not always realistic)
Occupancy
If a property would need 38+ weeks to break even that makes it a risky investment for inexperienced investors.
If the minimum break-even weeks are 25 or less and the property is in a good location, the investment would be considered a lower risk if factors such as nightly rate and operating expenses are accurately estimated.
The investor should not be using the property personally in any peak or high season period if he wants to increase rental income
Be careful when you talk to clients that you do not make any guarantees of income or promises of occupancy. This business has risks and any investor needs to understand there are many variables that can impact the success of an investment. They should do their due diligence and research before investing.