Investing in real estate can be a great way to build wealth, for a few reasons.
Real estate is easy to finance, so you usually don’t need the full purchase price in cash.
You can earn income while the value increases.
There are all sorts of tax advantages, if you know how to play the game right.
That said, it’s important to build your real estate portfolio intentionally and to evaluate your investments each year, so you know whether you should make a change.
One of the biggest mistakes I see real estate investors make is never evaluating their properties after they purchase them. So what should you be doing to evaluate your properties?
There are a few different metrics I like to use when helping the individuals and families I work with evaluate their properties, but before we go through them, it’s essential to understand that none of these mean anything unless you’re diligent about your bookkeeping. Without accurate inputs, the metrics will do you no good.
Here are some metrics for evaluating individual properties. Good or bad values for all of these metrics are highly subjective - dependent on the investor’s goals, type of property, and location.
Net Operating Income (NOI)
Capitalization Rate (Cap Rate)
Cash Flow
Cash on Cash Return
Adjusted Cash Flow
Adjusted Cash on Cash Return
Net Operating Income (NOI)
How it’s calculated: Take the gross rents and subtract out all expenses other than debt. Below is an example.
Gross rents: $12,000/year
Expenses (excluding debt payments): $4,000/year
NOI: $8,000/year
NOI helps you understand the returns of the property as if there was no debt on it. This is important for comparing properties that have different financing characteristics.
Capitalization Rate (Cap Rate)
How it’s calculated: Take your NOI and divide it by the current value of your property.
Assume the property from the prior example has a value of $160,000. Taking $8,000/$160,000 gives us a 5% cap rate.
Cap Rate helps you compare the returns of properties that have different values without taking into account the debt on each property.
Cash Flow
How it’s calculated: Take the gross rents and subtract out all expenses, including your debt (or just take NOI and subtract out your debt payments). This one is pretty self-explanatory - it’s the amount of cash you’re receiving from that property.
NOI: $8,000/year
Debt Payments: $6,000/year
Cash Flow: $2,000/year
Cash Flow helps you compare properties as they are (and it also helps you plan for the future). Most real estate investors already have an idea of what their cash flow is on each property, and it’s often the focus of new investors.
Cash on Cash Return
How it’s calculated: Take the cash flow of the property and divide it by the equity in the property.
Property Value: $160,000
Debt Balance: $120,000
Equity: $40,000
Cash flow of $2,000/$40,000 of equity gives us a cash on cash return of 5%.
Cash on cash return is probably the most actionable metric because it’s a way for you to compare to other real estate investments as well as other, non-real estate investments. If your cash on cash return is 1%, and you could take the equity in that property and invest it elsewhere for higher cash flow, it might make sense to do that.
Adjusted Cash Flow
Up until this point, the metrics are well known and established. However, in my capacity as a financial planner for individuals and families, it’s important to personalize the analysis a little more, so I tend to use an “adjusted” cash flow alongside the other, more common metrics.
When I calculate adjusted cash flow for the people I work with, I take into account additional items, like the tax benefit they’re receiving for the depreciation deduction as well as the amount of debt payments for the coming year that will be applied to principal. Adjusted cash flow will always be higher than the traditional cash flow metric because it does a better job of accounting for the benefits of investing in real estate.
Adjusted Cash on Cash Return
As you may have guessed, I calculate this by taking adjusted cash flow and dividing it by the equity in the property - but again, it’s a little more complicated. There are costs involved in selling a property, so instead of just taking the adjusted cash flow divided by the equity in the property, I divide it by an adjusted equity.
Some of the costs I take into account include closing costs, realtor commission, and taxes that will be due upon the sale. Of course, if the investor is considering a 1031 exchange to defer the taxes that would be due upon the sale, we leave the taxes out of the equation.
The adjusted cash on cash return is my best attempt to compare individual properties to any other type of investment, and it informs decisions to sell or exchange properties.
Conclusion
Are these the only metrics to evaluate your investment properties? Of course not. But they’re a decent starting point.
You can build your real estate portfolio through patience and elbow grease, but continuously evaluating your properties can add some finesse to the process and help you work smarter.
As always, keep in mind that you don't have to go it alone. I’m Austin Preece, a financial planner in Eau Claire, Wisconsin, and I work virtually with people across the US. Check out my website to see what it's like to work with me and reach out if you have any questions.
If you found this post helpful, help spread the word! Share with friends and family that you think may benefit as well. But remember, this is solely for educational purposes - it's not advice.
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