Explanation of Important Commercial Real Estate Investment Analysis Terms

These terms are important for you to understand as they are the ones most commonly used by the professionals with whom you will be working. This is not intended to be a glossary, but an explanation of the terms through an example.

Net Operating Income (NOI)

The Net Operating Income (NOI) of a property is calculated by determining the property’s first year Gross Operating Income and then subtracting the Operating Expenses for the first year.

Gross Operating Income
Less
Operating Expenses
Equals
Net Operating Income

The Gross Operating Income of property is the total income a property can expect to receive from all sources over a one year period. The Operating Expenses are the expenditures needed to keep the property operating during the same period. (See the article Cash Flow Model for a more thorough explanation.

Sample Calculation:

$500,000 Gross Operating Income
Less
$300,000 Operating Expenses
Equals
$200,000 Net Operating Income

The NOI of a property comes directly from the operations of a property and disregards mortgage payments or other additional expenditures the property owner may make, such as tenant improvements or leasing commissions.

Capitalization Rate (Cap Rate)

Many investors start their financial analysis of a property by calculating the NOI in order to be able to calculate a Capitalization Rate (Cap Rate) according to the following formula:

Net Operating Income
Divided By
Property Price
Equals
Cap Rate

The Cap Rate is expressed as a percentage rate. Cap Rate is typically calculated based on the first year of operations of the property and an all cash purchase of the property.

Sample Calculation:

$200,000 Net Operating Income
Divided By
$2,000,000 Property Price
Equals
10%

A Cap Rate can be looked at as a first year return to the investor comparing how much the investor would receive from operations with the price that would be paid in an all cash purchase of the property. It is a measure of performance the investor can look at to compare how their money is working for them in one property compared to another property or investment.

Many institutional investors purchase their properties for all cash, not using any financing. For them, the Cap Rate is a valuable method of comparing properties. Individual investors often use financing and it may be more appropriate for them to use additional methods of comparing first year returns.

Cash On Cash

Many investors who use financing to acquire properties use the Cash on Cash method to compare first year performance of competing properties. Cash on Cash takes into consideration the fact that the investor does not have to have all cash to purchase the property, but also will not keep all of the NOI because they must make their mortgage payments from their NOI.

First, the investor must determine the amount they must invest to purchase the property or their Initial Investment.

Total Purchase Price Plus Costs
Less
Amount Financed
Equals
Initial Investment

Sample Calculation:

$2,050,000 Price + Costs
Less
$1,550,000 Loan
Equals
$500,000 Initial Investment

Next, the investor must determine the first year Cash Flow from operations, including the payments due on the financing.

Net Operating Income
Less
Payments on Financing
Equals
Cash Flow

Sample Calculation:

$200,000 Net Operating Income
Less
$140,000 Payments
Equals
$60,000 Cash Flow

With the calculation of the Cash Flow and the Initial Investment, the investor can make another comparison of how their money performs in this property compared to other properties. By calculating Cash on Cash the investor can calculate a first year percentage return on their investment in the property.

Cash Flow
Divided By
Initial Investment
Equals
Cash on Cash

Sample Calculation:

$60,000 Cash Flow
Divided by
$500,000 Initial Investment
Equals
12% Cash on Cash

The Cash on Cash percentage can be looked at as a first year return to the investor comparing how much the investor would receive in cash flow from the property when the property is purchased using financing. It is a measure of performance the investor can look at to compare how their money is working for them in one property compared to another property or investment, when financing is used.

Many investors use the Cash on Cash percentage in their investment decisions as more accurately reflects their results than does the Cap Rate which ignores the financing used to purchase the property and the payments that must be made on that financing from the NOI of the property.