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February 5th, 2011 |

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Financial terms every Property Investor should be familiar with

Investing in property is one of the best options if one is looking at a secure cash flow over a period of time. It enables one to safeguard capital while ensuring it grows overtime. However a lot of background effort needs to be done before making a property investment decision. The deal as with any other investment transaction is fraught with risks and uncertainty.

In any investment the long term goals are important. Before getting into the technicalities of property investment it is important to define the goals and expectations. One could be making the investment for purely financial returns, or to back some other venture or as part of an investment cycle for tax purpose.

A financial viewpoint

The financial terms and the associated numerical data provide a better picture of any property investment. However it happens that the rates and percentages calculated are relevant for certain investors only. Below is a list of the most common terms that are used in the property investment domain along with a brief explanation and method of calculation.

Return on investment, ROI: ROI measures the income flow from the investment relative to the amount invested; ROI is expressed as an annual percentage rate. The term “returns” is based on cash flow which could be post-deductions or as a gross income value while “investment” could include actual amount invested at any given time or the value of the property on the whole.

ROI = (Returns – Investment / Investment) * 100

Cash-on-Cash return: The cash-on-cash return is the ratio of pre-tax income from an asset to the amount of capital invested, expressed as a percentage. The pre-tax income is arrived at after deducting debt and other operating expenses.

Cash-on-cash return = (Annual pre tax cash flow / total cash invested) * 100

Net Operating Income, NOI: NOI is the income obtained after deducting all operating expenses which include maintenance, property tax (not income tax) insurance, vacancy and other related expenses. NOI most importantly does not include income tax and debt expenses representing solely the profitability of a property.

NOI = Gross potential income – Operating expenses

Capitalization rate or cap rate: Cap rateis the ratio between the net operating income, NOI produced by an asset and its capital cost. The cap rate helps in determining the profitability of an asset with respect to the total investment and time period.

Cap Rate = (Annual NOI / Cost or current market value) * 100

Gross Rent Multiplier, GRM: GRM is the ratio of the cost of a property to its total annual income before any expenses including mortgage payments and taxes. The GRM helps in comparing different investment options where the operating costs are relatively similar.

Gross Rent Multiplier (GRM) = (Sale Price / Potential Gross Income)

The data calculated using the above formulas supplemented with one’s tax situation and potential capital availability can help in deriving a clear financial statement of the feasibility of any property investment.

About the Author

Arlynn Robinson is an expert realtor agent from Arcadia, San Gabriel Valley who also advices clients as a property investment consultant.