American HouseThis Article contains a summary of real estate investment analysis and the financial tools used to evaluate a real estate investment.

1. Net Operating Income

A basic measurement of a property’s income-generating potential is its annual net operating income (NOI).  This is simply its operating income from tenant rents and other sources (such as revenues form parking or laundry machines) less the operating expenses of the property, such as maintenance, property taxes, insurance and utilities (to the extent not paid by tenants).[1] Mortgage payments are excluded, as they arise from the financing of the property and not its operations.

2. Cap Rates

A common measurement used in the real estate industry is the capitalization rate (or “cap rate”). This is defined as the current NOI generated by the property divided by its market value. For instance, the average cap rate for an office building in a given market over a 30-year period might be 8.5%, so that if a building were selling for $10,000,000 we would expect its annual NOI to be $850,000. In a “hot” market where lots of buyers are bidding on properties, we would expect prices to rise and thus cap rates to be below their historical averages.  In our example, if the same property were selling for $11,000,000 with the same NOI, its cap rate would be 7.7%.[2] Conversely, in “soft” markets we would expect prices to fall and cap rates to rise.  Cap rates can also be used to compare prices on individual properties that are similarly situated.

3. Calculating Cash-on-Cash Return

If an investor buys a property with all cash, then the property’s current NOI can be used as an estimate of the investor’s expected first year cash return on that investment (often referred to the “cash-on-cash” return). In this case, the investor’s cash-on-cash return expressed as a percentage of the amount invested is equal to the cap rate. If the investor buys the property using mortgage financing, then the amount invested is the difference between the purchase price and the amount financed (also called “invested equity”) and the cash-on-cash return is the net cash flow received by the investor in the first year (i.e., the difference between the property’s NOI and the mortgage payments for that year) divided by the invested equity.

Usually, the leveraged cash-on-cash return will be higher than the unleveraged cash-on-cash return (and thus the cap rate), which is why real estate investments are usually leveraged.  To give an example, suppose a property is selling for $10,000,000 and has annual NOI of $850,000.  Mortgage financing is available for 75% of the purchase price; the mortgage terms are a 7.0% interest rate and a 30-year amortization period. A financial calculator or computer spreadsheet program calculates the monthly mortgage payment as $49,898. The leveraged and unleveraged returns are calculated as follows:

Unleveraged. Cash-on cash return = $850,000/$10,000,000 = 8.5%.

Leveraged. Mortgage amount = $10,000,000 * 75% = $7,500,000.

Mortgage payment = $49,898 per month = $598,772 per year.

Cash-on cash return = ($850,000-$598,772) / ($10,000,000-$7,500,000)

= $251,228/$2,500,000 = 10.05%.

In general, leverage will produce a higher cash-on-cash return whenever cap rates are higher than mortgage rates.[3]

4. The Five Ways that Real Estate Investments Make Money

For fixed income investments like bonds, which pay the investor regular interest payments at a fixed rate, or mortgage investments, which pay regular installments of principal and interest, the cash-on-cash return conveys in a single number the annual return on the investment.  In contrast, real estate investments have the potential to provide other types of returns besides the cash-on-cash return.

The return from a real estate investment can be divided into five categories. The first four contribute to what is known as the pre-tax total return of the investment.  When the fifth one, the tax benefits of the investment, is added, the after-tax total return can be determined.

Cash-On Cash Return

The first year’s cash-on-cash return, which has already been discussed, is widely used as a rough estimate of a real estate investment’s return.  Although it does not take into the other factors discussed below, it does provide a good first approximation of the investment’s performance and has the advantage of being simple to calculate.  However, unlike a bond or CD, a real estate investment’s cash-on-cash return, which is tied to property rents and expenses, is not fixed for the duration of the investment’s life.  In our example, the first year’s unleveraged return was its NOI ($850,000) divided by the cost of the investment (10,000,000), or 8.5%. Unlike interest on a bond, however, the NOI in future years may change.  This brings us to the next category:

Appreciation from Increasing NOI

By inverting the formula for the cap rate, a property’s value at any time equals its NOI divided by its cap rate: value = NOI/cap rate.  Over the long run, rents and operating expenses can be expected to rise with inflation, so in a stable real estate market where cap rates remain constant, as the property’s NOI increases its value should also increase.  This steady appreciation in NOI is what makes real estate an excellent hedge against inflation.  There are two components to this increase:  (1) the cash flow paid to the investor will increase every year and (2) the value of the property when sold will be higher than its original purchase price.

As an example, suppose a property is purchased for $10,000,000 having annual operating income of $1,300,000 and annual operating expenses of $450,000.  Its NOI is thus $850,000 and the cap rate is 8.5%.  What will be the property’s value in one year if we assume that inflation is 3% and that cap rates will remain constant?  What will be the cash-on-cash return in the second year? The annual operating income and operating expenses will rise by 3% to $1,030,000 and $154,500; the difference, $875,500, is the NOI one year later.  The property is now worth $875,500/8.5%, which equals $10,300,000. This is 3% increase over the price paid one year earlier, which is what we would expect. If the property was purchased with all cash, then the first year’s cash-on-cash return equals its initial cap rate, or 8.5%. The cash-on-cash return for year two is $875,500/$10,000,000, which equals 8.755%. As expected, this is a 3% increase over the first year’s cap rate.  If the investment were leveraged, the second year’s cash-on-cash return would increase even more.

Thus, in stable markets unleveraged real estate can be expected to yield increasing returns during the term of the investment and increasing property values corresponding to the rate of inflation. Leveraged real estate can be expected to yield increasing cash-on-cash returns and property values at a rate somewhat higher than the inflation rate.  As discussed in the text, a value-added strategy strives for NOI rate increases that are significantly higher than the inflation rate.

Market Appreciation

There is a second way that real estate can appreciate in value.  Lets again return to the inverted form of the cap rate formula used in the previous section:  Property value = NOI/cap rate. In the previous section we saw that if the cap rate remained the same, as NOI rises with inflation, or by value management, the property value also rises.  Now if we instead assume that NOI will remain constant, we see that a decrease in the cap rate will also lead to an increase in the property’s value.

As discussed above, cap rates can be used to represent the price level of properties of a given class in a given market. For example, in certain city office building cap rates over the past 30 years might have averaged 8.5%, with a range of 6% to 10% during that time.  If a property is purchased when cap rates are high, then it will appreciate as cap rates fall, even if there is no change in the property’s NOI. In this case the investor is benefiting solely from the improvements in the market as a whole. For example, if an investor bought a property for $10,000,000 at a 9% cap rate, the property’s NOI would be $900,000 per year. If cap rates then fell to 7%, and the property’s NOI did not change, the Property would be worth $900,000/7%, or $12,857,143.  As discussed in the text, this is the basis of most opportunistic strategies.

Mortgage Principal Reduction

Most leveraged real estate investments have mortgages with equal payments of principal and interest, just like home mortgages.  In this case, a portion of each payment is applied to reduce the principal of the mortgage, so that at the end of the mortgage the principal has been completely paid off. In the case of a real estate investment, the NOI from the property is being used to pay down the mortgage principal.  When the investor receives his or her cash flow distribution, this principal payment has already been deducted and is not included in his or her cash-on-cash return. It thus represents a separate element of return.

To see this, let’s return to the example used in the discussion of the leveraged cash-on-cash return. The property is purchased for $10,000,000 and has annual NOI of $850,000.  Mortgage financing is available for 75% of the purchase price at 7% over 30 years, resulting in annual mortgage payments of $598,772.  The mortgage is thus $7,500,000 and the equity invested is $2,500,000. Annual net cash flow after mortgage payments is $850,000 – $598,772 = $251,228.  This represents a 10.05% cash-on cash-return on the $2,500,000 equity invested.

Now suppose the investor sells the property at the end of the year, and that the NOI and the market cap rates have not changed.  The sales price will be then the same as the purchase price-.$10,000,000.  The $7,500,000 mortgage must now be paid off and the investor then gets the remaining cash. According to our financial calculator or computer spreadsheet, of the $598,772 paid to the lender, $76,186 represented principal payments and the rest was interest.  So the mortgage principal remaining outstanding is $7,500,000 – $76,186 = $7,423,814.  This leaves $2,576,186 for the investor. Since the investor’s equity investment was only $2,500,000 he or she has received a $76,186 profit in addition to the $251,228 received during the year as his or her cash-on-cash return. This represents an additional 3.05%.  The combined return is ($251,228 + $76,186)/$2,500,000 = 13.1%.

Tax Benefits

In comparing alternative investments, it is always important to be consistent in comparing returns on a before-tax or after-tax basis. For most fixed income investments, the after-tax return will always be less (and in fact equal to the pre-tax rate multiplied by the investor’s average tax rate), because interest received on a bond, CD or mortgage is generally fully taxable as ordinary income.[4]  In contrast, real estate investments usually provide some tax benefits.  REIT dividends are taxed as ordinary income only to the extent they represent operating income.  They will be taxed at the lower capital gains rates to the extent they represent gains from sales of portfolio properties, and as tax-free returns of capital to the extent they represent returns of capital to the REIT from property sales (although these will reduce the stockholder’s basis in his stock, which will in turn increase his capital gains when he eventually sells the stock).

Private real estate investment funds are usually organized as LPs or LLCs, and as discussed in the text, the tax attributes of the investment are passed through to investors.  Examples are deductions for mortgage interest payments and depreciation on buildings, improvements and equipment. Gains on sales of the fund’s properties will generally be passed through as capital gains.[5]  Thus, unlike a bond or CD, a real estate investment generally will have an after-tax return that is higher than its pre-tax return.

5. Measuring the Total Return of the Investment

Ignoring tax benefits for the moment, we have seen that there are four elements that contribute to the total return on a real estate investment: (1) the initial cash-on-cash return, measured as the first year’s cash flow paid to the investor as a percentage of his or her equity investment; (2) the increases to the cash-on-cash return during the life of the investment, and the resulting increase in the value of the property as NOI increases due to inflation (and, possibility, the fund manager’s skill and effort); (3) appreciation in the property’s value due to a rising real estate market, as represented by a cap rate at the time of sale that is lower than the cap rate at which the property was purchased; and (4) the mortgage principal reductions, paid out of the property’s NOI, which are realized when the property is sold and the net profit taken by the investor.[6]

There are a number of ways to combine these elements into a single number that represents the overall return of the investment in a manner that, when applied to bonds, CDs and other simple investments, produces a result that is consistent with traditional measurements of investment yields. The most widely used is the internal rate of return (IRR).  Conceptually, the IRR is a straightforward application of the basic insight of modern investment analysis: that the present value of a dollar today is always greater than the value of a dollar on a given date in the future, because a dollar today can be invested to yield more than a dollar on the future date.

From the point of view of the date on which the investment is made, each subsequent receipt of cash from the investment can be “discounted” to a (lower) present value as long as the interest rate is specified and the date of receipt is known.  This present value amount, if invested at the assumed interest rate, will exactly yield the future value of the payment in question on the date of receipt. For example, the future value of $1.00 one year from now is $1.03 if interest rates are 3%. An equivalent statement is that the present value at 3% of $1.03 one year from now is $1.00. For a specified future value, the higher the interest rate used, the lower the present value will be, because an investment of the present value amount will then increase at a faster rate.

The present value of a real estate (or other complex) investment can be calculated by adding up the present values of all of the separate payments received by the investor during the life of the investment. Again, using a higher interest rate will result in a lower total present value, while a lower rate will produce a higher present value.  The IRR is then defined as the interest rate that produces a total present value for the investment that is exactly equal to the amount of the initial equity invested.[7]

Any type of investment, no matter how complicated its schedule of cash flows, can be reduced to an IRR,[8] making it a powerful tool for analyzing and comparing a wide variety of investments.  In the context of real estate investment funds, the IRR is used in two primary ways:  (1) to analyze investments (and potential investments) by the fund in individual properties, or in its entire portfolio over the life of the fund, and (2) to analyze the investor’s investment in the fund. The IRR of the fund’s portfolio over the life of the fund will always be higher than the IRR realized by the investors, because of deductions for management fees, carried interests and fund-level operating expenses, as well as timing delays between receipts by the fund from its investments and payments made to fund investors.


[1] While capital expenditures (such as the replacement of a roof) are not technically operating expenses, good practice is to reduce NOI each year by a percentage (typically 3 to 5 percent) to take into account future capital expenditures.

[2] In order to simplify the presentation, the numerical examples in this Appendix all assume that there are no transaction costs, such as brokerage fees, closing costs and loan points. Adding transaction costs to the examples would complicate the calculations but would not alter the points being illustrated.

[3] This is not strictly true, because a small part of the mortgage payment goes to repay principal on the mortgage.  It is always true if the mortgage is a “bullet” loan, where payments of interest only are made during the loan term and the full principal comes due at the end of the loan as a “balloon.”

[4] If the bond or mortgage was sold before maturity at a profit or loss, the gain or loss would be taxable as capital gains or losses, with some exceptions.  And of course, interest on municipal bonds is tax-free.

[5] One exception is for condominium and certain other types of subdivision developments, where the finished units may constitute inventory, in which case gains from their sales would be taxed as ordinary income.

[6] More so than the other three, there is a real possibility that the third element can reduce the investment’s total return. This will happen if the property is sold in a down market or was purchased at the peak of an up market, in either case represented by a cap rate at the time of sale that is higher than the cap rate at the time of initial purchase.

[7] There is no exact formula for calculating the IRR; it must be arrived at by trial and error until the right percentage rate is found where the sum of the present values of the cash receipts on the investment exactly equals the amount of the equity invested.  In practice, this is done on a financial calculator or computer spreadsheet program, which have “iterative” programs that come up with the answer in a small fraction of a second.

[8] For investments that require additional equity to be invested by the investor over the course of the investment, the additional equity investments must also be discounted to present value.  In this case, the IRR formula can sometimes produce more than one result.  This is usually not a concern when analyzing real estate investments.