Insights

In a recent article, we discussed the use of capitalization rates to estimate the value of a piece of income-producing real estate. Our discussion concerned the relationship among three variables: Capitalization Rate, Present Value and Net Operating Income.

We may have gotten a bit ahead of ourselves, since some of our readers were unclear on the precise meaning of Net Operating Income. NOI, as it is often called, is a concept that is critical to the understanding of investment real estate, so we are going to backtrack a bit and review that subject here.

Why do you invest in income-producing real estate? Perhaps you are looking for cash flow. Possibly you anticipate some tax benefits. Almost certainly, you expect to realize a capital gain, selling the property at some future time for a profit. Your projection of the future worth of the property, therefore, can be a vital element in your investment decision.

You might employ the Back Door approach if you have a use looking for a site. You know what you want to build and can reasonably estimate the kind of rental revenue it can generate. The question for you as the developer is, “Will that revenue be sufficient to justify the cost of development?” Presumably, this technique is called “back door” because you’ll back into the maximum project cost that the use will support. Then, like Hamlet examining Yorick’s skull, you’ll ponder it until you decide if you can actually do the deal. In short, if your intended use will support a project that costs $x and no more, you must decide if you can you develop it for those $x.

In an earlier article we discussed the first of two ways that developers traditionally use to look at the feasibility of income-property projects. That one was called the “Back Door” approach. It will come as no surprise to learn that we call the other method the “Front Door” approach. The difference between these two approaches lies in what you consider to be the unknown variable. With the Back Door, you believe you know the rental rate that you can obtain for the space once it is built. You also know the cost of financing your project and what you consider to be an acceptable rate of return on your own equity investment. Blend this all together and what you’re really saying is that you know the revenue stream and want to figure out is the maximum total project cost that you can support with that revenue stream.

We frequently hear a question that goes something like this: “I’m considering the purchase of an income property where the seller will take back a second mortgage for the entire down payment. Why can’t your software figure out the rate of return on a zero-cash-down investment?” You’ve surely heard the excuse, “It’s not the software’s fault” more times than you care to recall. This time, however, the blame really does not fall upon the software, the hardware, the astronauts, Bill Gates, el niño or any of the other usual suspects.

Unless you make your living by helping people complete their returns, you probably prefer to spend as little time as possible thinking about income taxes. The rules and forms are generally opaque and the process is often stressful. However, there is at least one concept in the U.S. tax system that is both very simple and really important, and yet I find that it is unfamiliar to many.

If you watch what’s happening with the stock market, you’re probably ready to reach for the Dramamine. It’s like being trapped in a really fast elevator, except the buttons don’t take you where you expect to go. Maybe somebody else is controlling the ride. You realize that most of the people you see who have achieved genuine financial independence have done so with real estate. Your next step is to figure out how you can do the same.