NJ Homes By David

     Investing in Real Estate involves the purchase, ownership, management, sale and/or lease of real estate with no intention as a primary residence—yet rather, to earn profit from it.

When we talk of investment in Real Estate, we are talking about the residential or commercial real estate, both have common parameters in terms of general concept, but a different approach in terms of benefits and sets of challenges.  Residential real estate consists of: one family home and/or 2 to 4 units of rental residences and multifamily units anything from 5 units and above.  While Commercial real estate cover broader aspect and include anything like office, retail, hotels, industrial, warehouse, special purpose buildings and multifamily housing building ( 5 units an above), malls, lands, garages, etc.

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       Here I want to provide these basic elements when it comes to investment, which are terms mostly used in Residential Investment, and some basic investment math used as well as a reference. 

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NET OPERATIVE INCOME (NOI). This the most common parameter used in real estate investment, to analyze the profitability of income generating investment.  Basically it is the sum of all positive sources of income generated by the property – GOI (Gross Operative Income):  All rental incomes, and any other source of ordinary income.  Minus all expenses generated by the property OE (Operative Expenses) which typically are: Taxes, Insurance, all Utilities (Water, sewer, gas, electricity, oil), property maintenance, management, and estimated vacancy ratio.  Also keep in mind debit service—mortgage payment—is not included or factored.

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     NOI= GOI (Revenue) - OE (Operating Expenses).

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CAPITALIZATION RATE. Also, this is a very well-known parameter for investors.  This measures the performance of the investment in a specific area. This parameter should be already established by each investor before deciding to make an investment; some investors will be comfortable with 6% or 7% depending on the investor's perspective, and others will prefer 9% to 10%.  Of course, the higher the CAP RATE, the better will be the investment performance.

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     CAP RATE = NOI/ASSET VALUE

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ASSET VALUATION.  Valuation of the property is the most important part when you buy or sell a property.  Primarily as a realtor, we use the income capitalization approach to market a commercial large income property, and the same concept may also work for small income investment.  This approach comes very handy for rough calculation determining a fair market value of the property.
 

     ASSET VALUE = NOI/CAP RATE.   

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For example, if someone intends to purchase a property with Gross income of $60,000 a year with a CAP Rate of 6%,  then the value of the property  will be $60,000/6% = $1,000,000.

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So the key element to determine the value of property when you are purchasing, is to ask and determine all factual income, and see all NOI expenses. The CAP RATE reference parameter should be already established by the investor.  Just for example, if the investor's CAP RATE is 10% with the same property with $60,000 NOI, then the purchase property value will be $60,000/10%=$600,000.  This should give you an idea where the same property has 2 different values just based on the CAP RATES analysis.  So, it is very important to know how much your CAP RATE is, so as not to overpay for a property.

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Important note:  If an investor buys a property in Cash (no debit service), this CAP RATE becomes your Rate of Return. However, most transactions involve mortgage financing and the lender also will see these parameters in consideration before approving your loan.  Just to follow with the example above, if the lender looks up  the financial information of the property with NOI=$60,000 and CAP RATE 10%,  this lender will be more willing to give a mortgage for purchase price $600,000, with 30% down payment which is $180,000, and the mortgage will be $420,000. 

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CASH FLOW.  Cash flow is the byproduct of investment in real estate on a monthly or yearly basis.  You have all of your income and your operative expenses, which we call NOI.  The only missing part is the cost of lending if you have a loan in the investment.  Now if you discount your mortgage payment, and you still have extra cash as a result of it, that means you have a positive cash flow. This is not a return on your investment, but a simple way to see how the business is performing if you want to see monthly or yearly.

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Since most purchases are with loans, the lender will observe carefully the NOI and Debit Service Coverage Ratio.

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DEBIT SERVICE COVERAGE RATIO (DSCR).  This measures whether you have sufficient income cash flow to meet your debt service obligation.

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     DSCR = NOI/ (Interest Principal)

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RETURN ON INVESTMENT (ROI).  The main reason to make an investment is to make profit and increase your wealth.  This parameter will help you to determine how much profit is made on an investment as a percentage of the cost of that investment.  In other words, the percentage of the money you recover after all deductions or costs in reference to the money invested.  Which can be expressed as follows.

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     ROI = (Gain - All Cost) / All Cost

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These are the most common parameters used in the real estate investment.  Keep in mind to have long-term plans, increasing the income and reducing the cost is a key factor and depends upon your management skills.