If you have been looking at investment properties, you have probably seen a whole list of letters such as NOI, IRR, CoC, etc. listed in the marketing packages. These are all acronyms for various economic return variables that are used to compare investments. If you have gotten to my blog, you probably know the meaning of at least some of these, but here is a quick list and explanations for the most commonly used terms. We're going to split this into a two part series to keep our brains from melting due to mathematical overload.
GOI - Gross Operating Income = GRM is simply how much income the investment brings before any expenses or debt service are subtracted.
Potential Rental Income
- Vacancy & Credit Loss
=Effective Rental Income
+ Other Income
= Gross Operating Income
NOI - Net Operating Income = NOI is the Gross Operating Income minus all of the operating expenses. NOI does not take into account debt service so this number is before your mortgage payment is made. Operating expenses are all of the expenses (except debt service) that are incurred to operate the properties. These include; insurance, taxes, utilities, repairs & maintenance, management, etc.
Gross Operating Income
- Operating Expenses
= Net Operating Income
CCR (or CoC) - Cash on Cash Return = CCR is a measurement of the investments performance or the yield on the cash that you have invested. CCR is a relatively good metric for comparing investments across different asset classes, i.e. stocks compared to real estate. It is the percentage of pre-tax cash that you earn on the amount of cash you invested.
CCR = Annual Pre-tax Cash Flow/Total Cash Invested
IRR - Internal Rate of Return = IRR is another measurement of the investments performance. IRR is often the gold standard of comparison between different investments because it takes in to account the initial investment costs, cash flows, and sale proceeds. So instead of just looking at the monthly cash flows you get a better measurement of the overall profitability or loss. A higher IRR is better. The IRR calculation is complicated enough that it is best left to a financial calculator or computer program where you input the data and it spits out the IRR number.
Cap Rate - Capitalization Rate = Cap Rate is probably the most used analysis term in real estate. Personally, I think cap rates are a little over-rated because they don't factor in items such as equity growth through appreciation and paydown of the loan, but I'll save that argument for another day. The cap rate is simply an estimate on your returns used to compare different properties or markets. As cap rates go up, the return on your investment goes down (when you are the seller). As a buyer, you want a higher cap rate.
Cap Rate = NOI/Property Value or Cost
GRM - Gross Rent Multiplier = The easiest way that I have found to explain GRM is that it is the number of years of gross income that it would take to pay for the property in full. So if a property is listed for $500,000 and the annual gross income is $100,000 the GRM would be 5. There may be a few caveats to that definition but here is the formula:
GRM= Market Value/Annual Gross Income
It is very important to understand these numbers and how to calculate them. Even if you don't start out memorizing all of the formulas, write them down somewhere or create a spreadsheet with the formulas. Knowing the metrics is the key to successful investing and without a working knowledge of these comparison tools, you are blindly searching for a good property.
Next week we'll go over six more important calculations and you'll be on your way to becoming a underwriting master mind!