Comparing Investment Property
Comparing investment property can be a challenge unless you are using the most appropriate investment property formulas. Lets start with some common investment property terms to make sure you are clear on the terminology
NNN Lease (commonly referred to as a triple net lease). A lease in which the investment property tenant pays all expenses (taxes, insurance, and maintenance) common in commercial leases.
Net Operating Income (NOI) The annual net cash flow of an investment property afterdeducting operating expenses but before deducting mortgage payments. For example, an investment property that generates $135,000 in gross income had has $35,000 in taxes, insurance, and expenses would have a NOI of $100,000.
Cap Rate. NOI of an investment property expressed as a percentage of the purchase price, similar to the P/E ratio of a stock. For example, a $1,000,000 property with $100,000 in NOI would have a cap rate of 10%, or if you were looking for a 10% cap rate on a $500,000 building, you need to see a NOI of $50,000.
For short investment property hold periods, it is common to evaluate the Cash on Cash return. For example, a $100,000 property with a $10,000 annual profit will have a 10% cash on cash return.
For longer hold periods, I prefer calculating the Internal Rate of Return (IRR). You will need some experience with a financial calculator but this method is the only way to include the time value of money when evaluating properties. IRR looks at how many dollars are invested, when they are invested, how many dollars come out and when. Using an IRR comparison really can help you evaluate different property and can yield some surprising results!. If you need help with this calculation, send me an email and I will be happy to run it for you as time permits. I will need to know, the term (how long you plan to hold), initial cash investment (including closing and any initial repair costs), monthly cash flow (positive or negative), and the cash payout when you sell (don't forget sales commissions, etc.,). Using the IRR calculation has also helped me restructure the holdings of experienced investors by pointing out underperforming properties that need to be sold or boost cash flow. For more information about this please see the page on my Certified Mortgage Planning Specialist designation.
You will also want to look at the impact of leverage on the deal. Add your Cap Rate to your anticipated appreciation rate. If the result is lower that an available mortgage rate, you are experiencing Negative leverage and this may not be the best deal to finance although a cash deal may still make sense. Obviously, if your Cap and appreciation rates are higher than the mortgage rate and you have a Positive use of leverage.
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