The first is NOI or Net Operating Income. NOI is the amount of net income (after expenses) the property is producing on an annual basis. NOI is calculated by taking the gross rental income and subtracting the property’s annual operating cost. The gross income is the total rents collected plus any other income from laundry, parking, storage or other misc. sources. Your expenses are all the cost associated with maintaining the property on an annual basis, including taxes and insurance. Your mortgage payments (principal and interest) are not included as expenses in the NOI formula. Your mortgage payments are known as “debt service” and will change from investor to investor due to differing down payment amounts, interest rates, and loan terms.
Understanding your property’s NOI is crucial to the calculation of our next investment term,…the “cap rate”. Cap-rates are used to determine the value of an income producing property and are found by dividing the net operating income by the property’s cost. The cap rate is great for comparing the value of one income property to another.
Typically any cap rate above 7 percent is considered a good investment, but obviously the higher the rate the better. As an interested buyer searching for properties, you should set a cap rate minimum based on what’s typically achieved for your area. Generally, the riskier the investments the higher the expected return …or rate. Higher cap rates are expected on older home and in less desirable areas.
ROI (return on investment) measures the annual return on the initial capital you invested. Your initial investment includes your down payment, closing cost, initial improvements and any other initial out of pocket cost associated with the property purchase. The calculation of ROI is slightly more complex than other financial measures and should be calculated using a reliable computer program or financial calculator. ROI allows you to compare income producing property to other investment assets (stocks, bond, or alternative investments) and determine whether your money is invested in its highest and best use.