Whether you’re planning to contract with a Property Manager (PM) or manage the property yourself, knowing the financial and operational metrics of your business is critical. If you’re hiring a PM you should have metrics centered around Investment Cost, Revenue and Expenses. If you’re managing yourself you should also be prepared to measure Conversions, Bookings, Booking Sources, Lead Time, Average Daily Rate (ADR), etc. In the first part of this article, we’ll focus on the financial metrics since it applies to both situations.
This blog post intends to give you general guidance on managing your finances and property. Situations are different for each investor so I recommend consulting with a CPA for tax planning purposes. The guidance given here is simply to build a suitable understanding of the financial elements so you can make an informed decision when working with professionals.
Doing it Yourself or Using a Property Manager: Setting Expectations
If you’re using a property manager, they should be able to give you a revenue projection and help you build a Pro-forma so you can anticipate expenses and income. Before we dig in too far, let’s set some expectations on terms that are typical in the market so you can compare apples-to-apples. Let’s start at a very high-level, with just a description of the most important expense and income types – along with how they relate:
- Booking Revenue – revenue collected based on the nightly rate. This does not include cleaning fees or Hotel Occupancy Taxes collected.
- Operating Costs – costs associated with operating the business (for example utilities, insurance, property tax, marketing, toiletries, etc.). This does not include the cost associated with Capital Improvements (A/C Units for example) or Financing (principal and interest of a mortgage).
- Net Operating Income (Calculated as Booking Revenue minus Operating Cost)
Booking Revenue – when someone discusses the amount of revenue a property is expected to generate, this would be calculated as booking revenue. It’s the amount collected for the advertised nightly rate for each night rented. Specifically, this number does not include Hotel Occupancy Taxes or Cleaning Fees. If there are additional fees being collected by the PM (early check-in, additional cleaning, etc.), those fees will not be included in this number since they are not passed along to the owner.
Note: it’s customary for the PM to collect and remit all Hotel Occupancy Taxes (local & state) along with managing payment for all cleanings.
Operating Costs – the majority of the expenses you incur on a property will be considered Operating Expenses (or OpEx). These include utilities, property tax, insurance, lawn care, pool maintenance, linens, toiletries, etc.). Any large improvements (replacing A/C unit or Roof for example) would be considered a Capital Expense (CapEx). The biggest difference between the two categories is when you’ll be able to recognize the cost on your books (capital expenses could be amortized for as many as 27.5 years). The best way to distinguish the two: OpEx are expenses consumed within a year; CapEx are expenses where the item will last multiple years.
To further clarify, the following items do not qualify as Operating Expenses: capital improvements, mortgage payments, and depreciation.
Net Operating Income – deducting your Operating Cost from your Booking Revenue will give you your Net Operating Income (NOI). Not to confuse you, but Net Operating Income is different from Taxable Income. There are some other factors to consider before determining your Taxable Income (depreciation, capital expenses, etc.), but NOI is how you determine cash-flow and is instrumental in many of our metrics.
NOI = Booking Revenue – Operating Expenses
Calculating the Value of your investment
Now that we’ve calculated the NOI, we can use that figure to make several calculations on the value of your investment. There are many metrics real estate investors use. I’m not a speculative investor so I typically focus on those centered around cash-flow and intrinsic value (known as Value Investing). You’ll quickly see the benefit of excluding certain expenses when calculating NOI (such as mortgage, depreciation, etc.). The purpose is to identify the income stream (NOI). It’s the income stream that’s important to investors when discussing how one property performs compared to another.
ROI (return on investment): pretty simple to utilize
ROI = (NOI / Investment)
Comment: Investment is the cost of the property and any capital improvements made in preparing the property for rent.
- NOI (Booking Revenue of $30,000 – Operating Expenses of $12,000) = $18,000
- Investment ($120,000 purchase price + $50,000 improvements) = $170,000
- ROI = (NOI of $18,000 / Investment of $170,000) = 10.5%
Cash-On-Cash (CoC): calculates return on the amount of actual cash spent to purchase/improve a property in a situation where the property has been mortgaged. In this case, the principal and interest of the mortgage will be included when calculating Cash-Flow.
Note: the intention here is to calculate Cash-Flow: cash coming in (booking revenue) minus cash going out (Operating Expenses + Principal and Interest of Mortgage). Divided by Total Cash Invested: amount of cash used to purchase the property (usually your down payment).
Unlike stock investments, one advantage of real estate investments is the ability to leverage (using financing to generate more money than you’re paying in interest).
Cash-Flow = (Booking Revenue minus Operating Expenses minus Mortgage P&I)
Total Cash Invested = (Down payment, including closing costs, and capital improvements)
Cash-on-Cash (CoC) = (Cash-Flow / Total Cash Invested)
Using the Example Above:
- Cash-Flow (Booking Revenue of $30,000 – Operating Expenses of $12,000 – Mortgage Payment of $10,000) = $8,000
- Total Cash Invested (Mortgage Down Payment of $40,000 + $10,000 capital improvement)
- CoC (Cash-Flow of $8,000 / Total Cash Invested of $50,000) = 16%
You’ll notice the return when calculating CoC is higher compared to ROI. The reason is the rate of return on your investment is higher than the rate of your mortgage. You’re able to capture a higher return by leveraging a mortgage.
CapRate: usually reserved for commercial property investments, it calculates the property value based on NOI and sales price.
CapRate = (NOI / Property Value)
Using the Example Above:
- CapRate (NOI of $18,000 / Property Investment of $170,000) = 10.5%
Does that number look familiar? It should! When evaluating a purchase without financing, CapRate is the same as ROI. Where CapRate comes into effect is in evaluating an offer compared to other properties in the area for sale. (Remember: this only applies to commercial properties, but it’s an essential metric to understand).
Let’s look from a buyer’s perspective: a property is displayed with a CapRate of 10%
- Property asking price of $200,000 at a CapRate of 10%
- That indicates the properties current NOI is $20,000 / year
CapRate is used instead of property comps when establishing a sales price. In the case of residential property, appraisals are conducted based on the sales price of similar properties in the same area. In commercial real estate, CapRate is used to generate a price that aligns with how productive the property is in generating revenue and managing the operating costs.
Let’s look from a sellers perspective: we have a property with an NOI of $20,000 / year
- Property generates $20,000 of Net Operating Income (NOI) each year
- Commercial properties in the same area are selling at a CapRate of 8%
- Sales Price (NOI of $20,000 / CapRate of 8%) = $250,000
Were you surprised by the sales price? For the seller, a lower CapRate means they are selling the property at a lower return on investment for the buyer. Assuming the area justifies a lower return on investment, which means a higher sales price for the seller.