Is That Investment Property Worth Buying?
When you’re evaluating a residential property’s value as a potential investment, there are three numbers that you should pay attention to:
- the property’s target purchase price,
- its projected rental income, and
- the estimated expenses of owning the property.
Together, these numbers let you determine the property’s net operating income (NOI) and cash flow. You’ll use those numbers to analyze the property and assess its potential profitability.
Determine NOI and cash flow
As in the previous articles in this series, we’ll use the method described in the book “HOLD: How to Find, Buy, and Rent Houses for Wealth” to calculate NOI and cash flow and analyze the hypothetical property. (Or, if you’re using the Real Estate Investment Planning (REIP) program, once you’ve entered the numbers for your potential investment properties, REIP will calculate these amounts for you.)
1. The formula for calculating the NOI of a property is:
NOI = net rental income (NRI) – expenses (excluding mortgage)
For example, let’s say you’re analyzing two different properties: Property A is a single-family home, and Property B is a duplex.
Property A: 30-year net rental income of $1,320.50 – $583.50 in expenses = a 30-year net operating income of $737.00 per month or $8,844 per year
Property B: 30-year NRI of $1,876.25 – $805.81 in expenses = a 30-year NOI of $1,070.44 or $12,845.28 per year
It already looks like the duplex is a better option, but remember, cash flow is king.
2. To determine the cash flow, you’ll use the NOI you just calculated in the formula:
Cash flow = NOI – debt service (mortgage payment)
For our hypothetical properties, that means:
Property A: NOI of $8,844 – mortgage payment of $8,034.53 = annual cash flow of $809.47
Property B: NOI of $12,845.28 – mortgage payment of $10,980.52 = annual cash flow of $1,864.76
Now it seems like the duplex option is a slam-dunk decision! Not so fast.
Analyze your options
Now that you’ve determined the NOI and cash flow, enter them in your HOLD property analysis worksheet. After entering NOI and cash flow numbers, you can play with the numbers to see which property is best for your portfolio. This step involves reviewing and adjusting financing (perhaps reducing the term or rate to increase cash flow or payoff term), purchase price (do renovations yourself and offer a lower bid), and rental income (add value and raise the rental rate). These adjustments can help you determine which property or terms best meet your wealth-management goals.
There are several analysis shortcuts that can assist you with estimating the value and return that your property investment will generate:
- Capitalization rate — Cap rates let you quickly compare property valuations. Calculate the cap rate by dividing the property’s NOI by its fair market value. The higher the number, the better.
- Rent-to-value ratio — This calculation compares NRI to fair market value. To find this number, divide the property’s gross monthly rental income by its fair market value. Some investors say that if you have a 1% ratio, you’ll have a positive cash flow, but that’s not always true, so find out what that percentage is in your market.
- Cash-on-cash return — This shortcut calculates the return on your initial investment (down payment and repair costs) in year one. Find this number by dividing cash flow by your initial investment. Decide on a cash-on-cash target, and drop any properties that don’t hit that percentage.
Analyzing an investment property by using the HOLD worksheet takes some time and effort. REIP makes the process easier by running your numbers and calculating a detailed analysis that includes:
- a first-year property analysis,
- a 30-year performance projection, and
- a loan amortization and cash flow analysis.
Want to see REIP in action? Check out the HOLD REIP Overview and Property Analysis Overview videos on the holdreip.com website.