New Financial Route

How do you know when you’ve found a “good deal” when looking at investment properties online? I wanted to take some time to discuss different valuation methods for investment properties that investors use to determine whether a certain deal is worth pursuing.

Three common deal analysis calculations for real estate investments are CAP rate, Cash on Cash (CoC) return, and Internalized Rate of Return (IRR). Each of these metrics has their advantages and disadvantages and should be used together when evaluating a potential investment opportunity.

CAP Rate

The calculation of CAP rate is based on a concept called Net Operating Income, or NOI, which represents the amount of income an asset generates after expenses.

Net Operating Income (NOI)

For the NOI calculation, the gross income of a property is the rent (along with other income-generating assets such as coin-operated laundry, rented garage spaces, etc..). The expenses of a property include property taxes, insurance, and maintenance. Many investors also consider property management fees and vacancies in these calculations. For evaluation purposes, we multiply the monthly net cashflow by 12.

For example, a property that rents for $2000/month with expenses of $300/month generates a monthly operating income of $1700/month. The NOI is then $1700*12 = $20400.

Calculating CAP rate

To calculate the CAP rate, divide the NOI by the value of the property:

CAP = NOI/Asset Value * 100

If we use the above example with the home price (asset value) of 200000, the CAP rate would be 20400/200000 * 100 = 20%.

What’s considered a good CAP rate?

A good CAP rate depends on a variety of factors such as location and property condition. In general, though, a CAP rate between 5 and 10 percent is desirable. Higher CAP rates usually correlate with riskier investments, and lower CAP rates conversely correlate to less risky investments.

Cash on Cash Return

Another popular valuation method is Cash on Cash return (or CoC). For this calculation, the costs of property acquisition are considered (i.e. loan origination fees, closing costs, etc…). CoC is a particularly useful metric for a property bought with a loan, which is often the case. This metric is more investor-dependent since it depends on a variety of factors such as the down payment amount, interest rate and loan fees.

To calculate CoC, take the total expected income of the property and divide it by the total costs:

CoC = Net Cash Flow/acquisition costs and repairs * 100

If one property is bought in cash and another is bought with a mortgage, the Cash on Cash return and CAP rate should be the same. The CAP rate, on the other hand, is based solely on property valuation and income produced. This makes the CAP rate a popular way to compare the return of one property to another.

For example, suppose that you have a property that you buy for 200k that rents for $2000 a month. With a 20% downpayment and interest rate of 7.103%, the monthly mortgage payment would be $1076. If we add an additional $424 dollars in expenses, the total expenses would be $1500/month. The average monthly cashflow would be $2000-$1500 = $500. The first year cashflow would be $500*12 = $6000.

In terms of the initial investment, we can assume closing costs of 3% of purchase price for simplicity. In this case, that would be $4800. The total cost would be $44800, assuming this is a “turn-key” property that does not need any immediate repairs. The CoC in this case would be $6000/$44800 * 100 = 13.39%.

What’s considered a good Cash on Cash return?

The amount of cash-on-cash return for a property depends on many factors, but 8-12% is generally considered to be a decent return.

Internal Rate of Return

Internal Rate of Return (IRR) is another common method for evaluating return on investment, although this one is more complicated. It measures the profitability of an investment based on the concepts of Discount Rate and Net Present Value (NPV) . This calculation depends on the cash flow of the property for five years and the initial investment.

What’s considered a good IRR?

15-20% is considered a solid IRR.

Conclusion

These are three common calculations that are used to evaluate investment properties. There are a couple other metrics not covered in this post (such as DSCR) that I would like to explain later. In terms of “good” numbers for an investment deal, you may find that no properties would be worthwhile in your locale. In general, it’s harder to find profitable, cash-flowing deals in expensive areas than it is in more affordable areas.

I will write a post about I personally do my property evaluation soon.

Thanks for reading!