(Editor's Note: I find that many physicians intellectually know that investing in real estate is a good thing, however I find that these same people are intimidated by it. Therefore, many never take action. However, just like most things in life, fear and intimidation can be countered by education. I hope these type of “nuts and bolts” posts help to do just that, remove barriers to getting started if that's what you're interested in.)
At some point, we’ve all been the medical student tasked with collecting the I’s and O’s of the patients on the floor. For those of you who have already forgotten what that means – it means finding out what the patient’s I’s (Intake) and the O’s (Output) are.
So in the nurses flow sheet, you would find out how much they drank and/or how much IV fluids they've received. You’d note the amount of urine collected in the foley, but hey, don’t forget the patient threw up, so you have to take that into account as well. I always felt sorry for the person who had to calculate that amount.
Ultimately, by taking the Intake and subtracting the Output you can figure out whether the patient has a positive or negative fluid balance.
If you can do this calculation, you can pretty much do any calculation necessary to properly evaluate an investment property on paper.
By the end of this post, you’re going to know how to calculate the following:
- Cash Flow
- Net Operating Income
- Cash on Cash Return
- Capitalization (Cap) Rate
Think of your I’s as your Income and your O’s as your Expenses.
Income is made up of the following:
- Any additional income: laundry machine quarters, storage, parking
Expenses are made up of the following:
- Principal payment (mortgage)
- Property Taxes
Just add up all of your income and subtract your expenses and you have your Cash Flow.
Cash Flow is also another name for what you take home at the end of the day (a positive or negative fluid balance).
(All the following examples are super rough estimates but useful for understanding how to work the numbers.)
Example: Dr. Joe collects $8000 in rent every month and his expenses are $7000. He has $1000 of cash flow into his back account every month to do with as he pleases.
Easy start, right?
This cash flow therefore depends on how large of a down payment you put down or whether you pay cash for the property because that will affect what the mortgage is.
However, the Net Operating Income essentially assumes you’re paying all cash and that there is no mortgage. Therefore, it is not dependent on whether you finance it or not. This number comes more into play later on.
Example: Using the same property, Dr. Joe pays $4000 in mortgage payments. Net operating income is then $8000 (income) – ($7000 in expenses – $4000 in mortgage) = $5000. Usually you'll see it annualized so it's $5000 x 12months = $60,000.
Now, let’s say you wanna figure out how well this investment would do for you. You're going to want to know the following two calculations:
Cash on Cash Return tells you how much you're going to make on the actual cash you put into the deal.
The amount initially invested is typically what you put for the down payment + additional fees + rehab cost.
Example: Dr. Joe takes home $1,000 in cash flow per month ($12,000 annually) and initially put in $120,000 so his cash on cash return is $12,000 / $120,000 = 10% return.
If you want to know what percentage profit the property will make year after year, you'll want to know the Cap (Capitalization) Rate. You'll often seen this number thrown around in the commercial and multifamily settings to let you know what comparable places are going for in a certain area.
Example: From above, Dr. Joe's Net Operating Income is $60,000 and the property was bought for $800,000. The cap rate is then $60,000 / $800,000 = 7.5%
So in summary, our friend Dr. Joe bought a building that:
- Puts $1000 of cash flow in his pocket every month
- Would give him $4000 of cash flow if he had paid for it in all cash
- Gives him a 10% return on his initial investment
- Every year produces a 7.5% profit.
Now you know how to make the most important calculations when evaluating a rental property. In a future post, we'll go into how to go about finding these properties.
Never knew that rounding as a med student would prepare you for your next life as a real estate investor, right?
If this stuff gets you excited and you want a deeper understanding of these numbers, I'd suggest the book The ABCs of Real Estate Investing by Ken McElroy.