With any income property investment, two cash flows must be understood by the real estate investor and anyone else working with real estate investing: Cash Flow Before Tax, and Cash Flow After Tax.

Cash Flow Before Tax (CFBT)

Cash flow before tax is defined as net operating income (NOI) minus debt service (mortgage payment). Cash flow before tax is useful in defining the investor’s return on initial equity. This return is termed cash-on-cash return or broker’s net or, in appraisal, the equity dividend rate.

Cash Flow After Tax (CFAT)

Cash flow after tax is defined as cash flow before tax (CFBT) minus tax benefit (income) tax paid or plus income tax savings). This measure includes benefits derived from depreciation deductions and any other form of tax shelter that has the net effect of raising the rate of return on the investment.

ProAPOD® real estate investment software calculates both.

Our real estate investing software solution ProAPOD® Basic 6.0 calculates cash flow before tax.

Our real estate investment software solution ProAPOD® Premium 10.0 (includes full tax shelter) considers both, cash flow before tax and cash flow after tax.

Our real estate investor software solution ProAPOD® Investor software also considers both, cash flow before tax and cash flow after tax.

Net operating income (or NOI) is a measure of an income property’s net income from all sources before allocations for debt service or tax (payments or savings) are calculated, and in turn, the NOI plays a large role in a variety of real estate investment and holding period decisions.

For example, market values are based on NOI, financing considerations are based on NOI, and investment decisions are based on this cash flow.

Net operating income is the amount of cash flow remaining after vacancy and all operating expenses are paid. Computed by deducting operating expenses from gross operating income (or GOI), net operating income is simply income less expenses.

Most important to the real estate investor, NOI represents the amount cash flow (or funds available) to pay the mortgage.

As a result, lenders are very interested in knowing a property’s net operating income in order to determine whether the property generates sufficient cash flow to cover the debt service. They use a return called debt coverage ratio (DCR) which is calculated by dividing the net operating income by the annual loan payment.

Although lenders normally require nothing less then 1.00 (indicating that the NOI is exactly equal to the loan payment), they typically require a more aggressive DCR in the range of about 1.20 (a higher NOI to loan payment ratio by 20%, or enough cash flow to service the payment with money to spare).

Those acquainted with real investing who have computed capitalization rate (or cap rate) will also recognize net operating income. The formula for capitalization rate is NOI divided by sale price.

Perhaps now with some insight about the cash flow net operating income represents, you can understand why cap rate has become such a popular return. Cap rate measures the percent of net operating income to price (or property value).

A good analysis of investment property gives the real estate investor (or property management firm operating on behalf of the investor) a basis for setting rents and estimating income and expenses.

It is important, therefore, that an investment property analysis consider the following five questions.

Where does the property fit in the market?

Assess how the income property is currently being used and compare it to similar income properties in that market segment.

What do you expect from the property during your holding period?

This concerns your investment objectives and period of time you plan to keep the property. For example, whereas you may be interested only in raising the rental rates to competitive market rates and then selling the property, perhaps your goal is to create a steady flow of income for your retirement with the intent to someday hand it over to the next generation.

What are the physical and economic characteristics of the property?

If the units are leased (as they typically are with commercial real estate), it is important to determine the duration of the leases. Whereas, existing leases of short duration may hamper or prevent you from making substantial property improvements, alternatively, this may be viewed as an opportunity to renovate and improve the quality of space and seek out new tenants at higher rental rates on longer term leases.

How do the rents for the subject property compare to the competition?

Market derived rents are a function of market-driven conditions and contract negotiations. Based on location, age and type of construction, size of units, and features and amenities found in the market, how does the property stack up to similar rental property? Is there reason to think they can be improved with better management or negotiation, or do they appear too high to believe you can replace the current owner and maintain them?

What are the operating expenses?

Estimating future operating expenses requires a close examination of previous operating statements and then creating your own pro forma income statement based on your estimation of future expenses.