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October 10, 2016

*We've been calculating I's and O's since med school, learn how real estate finance isn't all that different.*

At some point, we’ve all been the medical student tasked with collecting the I's and O’s of the patients on the floor. For those of you who have already forgotten what that is - it means finding out what the patient’s

I’s (intake)

and the

O’s (output)

are.

So in the nurses' flow sheets, you would find out how much they drank and/or how many IV fluids they've received. You’d note the amount of urine collected in the foley, but hey, don’t forget the patient threw up, so you have to take that into account as well. I always felt sorry for the person who had to calculate that amount.

Ultimately, by taking the i

ntake

and subtracting the o

utput

you can figure out whether the patient has a positive or negative fluid balance.

If you can do this calculation, you can pretty much do any calculation necessary to properly

evaluate

an investment property on paper.

By the end of this post, you’re going to know how to calculate the following:

- Cash Flow
- Net Operating Income
- Cash on Cash Return
- Capitalization (Cap) Rate

Think of your I’s as your

Income

and your O’s as your

Expenses

.

Income

is made up of the following:

- Rent
- Any additional income: laundry machine quarters, storage, parking

Expenses

are made up of the following:

- Principal payment (mortgage)
- Interest
- Property Taxes
- Insurance
- Maintenance
- Utilities
- Management

Just add up all of your income and subtract your expenses and you have your c

ash flow

.

Cash Flow

is also another name for what you

take home at the end of the day

(a positive or negative fluid balance).

(All the following examples are super rough estimates, but useful for understanding how to work the numbers.)

Example: Dr. Joe collects $8000 in rent every month and his expenses are $7000. He has $1000 of cash flow into his back account every month to do with as he pleases.

Easy start, right?

This cash flow therefore depends on how large of a

down payment

you put down or whether you

pay cash

for the property because that will affect what the mortgage is.

However, the

Net Operating Income

essentially assumes you’re paying

all cash

and that there is no mortgage. Therefore, it is not dependent on whether you finance it or not. This number comes more into play later on.

Example: Using the same property, Dr. Joe pays $4000 in mortgage payments. New operating income is then $8000 (income) - ($7000 in expenses - $4000 in mortgage) = $5000. Usually you'll see it annualized, so it's $5000 x 12months = $60,000.

Now, let’s say you wanna figure out how well this investment would do for you. You're going to want to

know the following two calculations:

Cash on Cash Return

tells you how much you're going to make on the actual cash you put into the deal.

amount initially invested

down payment + additional fees + rehab cost

The is typically what you put for the .

Example: Dr. Joe takes home $1000 in cash flow per month ($12,000 annually) and initially put in $120,000, so his cach on cach return is $12,000/$120,000 = 10% return.

Capitalization (Cap) Rate

. You'll often seen this number thrown around in the commercial and multifamily settings to let you know what comparable places are going for in a certain area.

If you want to know what percentage profit the property will make year after year, you'll want to know the

Example: From above, Dr. Joe's New Operating Income is $60,000 and the property was bought for $800,000. The cap rate is then $60,000/$800,000 = 7.5%.

So in summary, our friend Dr. Joe bought a building that:

- Puts $1000 of cash flow in his pocket every month
- Would give him $4000 of cash flow if he had paid for it in all cash
- Gives him a 10% return on his initial investment
- Every year produces a 7.5% profit.

Got it?

Now you know how to make the most important calculations when evaluating a rental property. In a future post, we'll go into how to go about finding these properties.

Never knew that rounding as a med student would prepare you for your next life as a real estate investor, right?

Let me know what you think below.

---

If this stuff gets you excited and you want a deeper understanding of these numbers, I'd suggest the book The ABCs of Real Estate Investing by Ken McElroy.

For more articles by Passive Income M.D., visit his

or find more of his articles on Physician's Money Digest

.

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