The In's And Out's Of Financially Analyzing Investment Properties

The thought of crunching through financial formulas when analyzing multiple investment properties to determine which might be a "hot deal" may seem overwhelming to the beginner. However, it is important to understand that these financial formulas are only intimidating until you understand the calculations, how to use them, and the impact they have on your real estate investment success. Seasoned real estate investors live and breathe by these formulas when determining which properties to jump on, and which to run from. This whitepaper will walk you through some of the most common financial formulas and give you examples of how to apply each one.

Before jumping into the top formulas used in everyday analyzation, let's first address some of the terminology:

Annual Gross Rental Income - This represents the annual rent you collect on the property. Annual Gross Rental Income is calculated by simply totaling the amount of rent collected per year (12 months) from the tenant occupying the investment property without subtracting any expenses associated with owning and operating the investment property.

Annual Total Operating Expenses - This represents your annual cost to own and maintain the investment property, without taking into consideration any rental income. Annual Total Operating Expenses is calculated by simply totaling all of the expenses that you pay per year (12 months) associated with owning and operating the investment property. Some of these expenses include your mortgage or note payment, insurance, management fees, taxes, utilities (if not paid by the renter), and HOAs.

Annual Net Operating Income - Annual Net Operating Income is also commonly referred to as "Cash Flow". This represents the annual income or loss the investment property actually generates after collecting a years worth of rent and paying the annual expenses associated with owning and operating the investment property. Annual Net Operating Income is calculated by subtracting the Annual Total Operating Expenses from the Annual Gross Rental Income. So, the formula is:

Annual Net Operating Income = Annual Gross Rental Income - Annual Total Operating Expenses

Down Payment - This is the amount of cash out of your pocket that you bring to the closing table to buy the investment property.

Repair Cost - This is the amount of cash out of your pocket for repairs to the investment property.

Appreciation - Appreciation is the difference between what you purchased and sold the investment property for (Sale Price-Purchase Price).


Now that we understand some common terminology used in financial analyzation, let's take a look at the most common formulas used by real estate investment professionals:

Cap Rate - Short for Capitalization Rate, the Cap Rate is one of the oldest and most widely used formulas. Cap rate is a way of evaluating the return on investment for an investment property as it relates to the Purchase Price, and based on the amount of Annual Net Operating Income the property will yield (not including mortgage payments or considering income tax) in proportion to the purchase price of the property. The Cap Rate is calculated by taking the Annual Net Operating Income of the investment property and dividing it by the Purchase Price. So, the Cap Rate formula is:

Cap Rate = Annual Net Operating Income (not including mortgage payments)/Purchase Price
Note: when calculating Cap Rate, a higher resulting number is better.

Cap Rate Example: Let's say you purchase a property for $100,000 that produces an annual net operating income of $5,000; this property would have a Cap Rate of 5% (5,000/100,000). Based on this calculation the property will generate 5% of the purchase price in income (not considering income tax) per year. If you were looking at another property with a purchase price of $100,000 that produced an Annual Net Operating Income of $8,000, this would obviously be a better deal with a calculated Cap Rate of 8% (8,000/100,000).

Note: A typical Cap Rate for investment properties ranges between 5 - 8% with an 8% cap rate typically viewed by seasoned investors as the more desirable type of investment.

Cash on Cash Return - This is a much newer and becoming a more popular analyzation tool amongst real estate investors. The Cash on Cash Return of a property is often times referred to as a property's yield. Cash on Cash Return is a way of evaluating the return on investment of an investment property in relation to your out-of-pocket expense, based on the amount of Annual Net Operating Income the property will yield (not considering income tax) in proportion to your Down Payment and Repair Cost. The Cash on Cash Return formula is calculated by taking the Annual Net Operating Income of an investment property divided by the amount of your Down Payment and immediate Repair Cost. So, the Cash on Cash Return formula is:

Cash on Cash Return = Annual Net Operating Income/(Down Payment + Repair Cost)

Cash on Cash Return example: Let's say you purchase a piece of property for $100,000. You put $10,000 down on the property, and spend another $5,000 in repair costs once you own the property. Once you get a tenant, the property will produce an Annual Net Operating Income of $5,000. This property would be said to have a Cash on Cash Return of approximately 33%; (5,000/(10,000+5,000)). So the property will generate an annual income (not considering income tax) of 33% of your out-of pocket cost to acquire and perform the immediate repairs to the investment property. Cash on Cash Returns can range anywhere from negative figures to infinite, so it is difficult to say that there is a typical range.
Like Cap Rate, the higher the Cash on Cash Return, the stronger the property. In other words, if you are looking at 2 properties that both have a net operating income of $5,000, but one property requires less of a down payment or less repair costs, then that property would have a higher Cash on Cash Return and would be said to be a financially stronger property than the other. The opposite would also be true if you were looking at 2 properties, both requiring the same down payment and repair costs, but one property produced a higher amount of net operating income, then again that property would be said to be a financially stronger property.
In the case of Cash on Cash Return analyzation, it becomes critical to explore the effects that slight alterations in down payment vs. Annual Total Operating Expenses will have on your yield. Keep in mind that a down payment of 10% vs. 20% on the surface may look to produce a higher Cash on Cash Return (lower out of pocket expense in the down payment), but you have to remember that a 10% down payment will also have a higher mortgage expense that decrease the Annual Net Operating Income. It would need to be analyzed on a property specific basis to see which would be a better solution for that particular property.
This is where InvestorLoft.com's robust analysis tools ease the property evaluation process. With the simple click of the mouse, you can switch between down payment and mortgage alternatives to find the optimum yield combination for each individual property.

Annualized Return on Investment - Commonly known as ROI, Annual Return on Investment represents your total Return on Investment from the investment property per year, based not only on Cash on Cash Return, but also on all the appreciation realized in the property when you sell it. Obviously, it is impossible to calculate ROI until you sell your property and are able to calculate the appreciation in the property. ROI is the total amount of money made on a property divided by the total amount spent on a property, then divided by the number of years you had the property before you sold it. So the Annual Return on Investment formula is:

Annualized Return on Investment = ((Total Net Operating Income + Appreciation) / (Purchase Price + Repair Cost)) / the number of years you owned the investment property

Return on Investment example:
Let's say you purchase a property for $100,000 and spend an additional $10,000 in repairs and maintenance over a 2-year period. At the end of the 2 years, you have collected a Total Net Operating Income of $10,000 and you sell the property for $150,000. In this case, this property would be said to have an annualized ROI of approximately 27% per year. ((($10,000 income + $50,000 appreciation)/($100,000 purchase price + $10,000 repairs))/2 years). Like Cash on Cash Return, the ROI of a piece of property can range from negative figures to infinite.

When it comes to considering an investment property it is important to employ the crucial aspects of property analysis. Investorloft.com was designed to simplify and streamline property analysis process for real estate investors of all experience levels, including the beginner. Loaded with robust analytical tools Investorloft.com makes it very simple for you to calculate your Annual Net Operating Income (Cash Flow), Cap Rate, and Cash on Cash Return when evaluating potential investment property purchases. InvestorLoft.com can even help you calculate your ROI upon the successful sale of your property.

Financial analyzation of an investment property is a critical component of real estate investing. While most novice investors purchase properties with their eyes, seasoned investors shop with their calculators; many buying properties and selling investment properties without ever even seeing them! Why? You ask! The answer is simple; if you are purchasing a property to meet your specific investment objectives; what is more important… the carpet and paint… or whether the numbers make sense for your investment objectives? The most seasoned investors will tell you it's the latter! Financial analysis is one of the essential keys on your Road Map to successful real estate investmenting. IF you have any questions please contact us at Info@InvestorLoft.com where one of our experts will give you the attention you need.