Before going into some real estate strategies, here are some key financial assumptions in modeling out the return on investment for your real estate investment.

Real Estate Operating Assumptions

Net Operating Income (NOI)

Net operating income is the revenue of the property or property portfolio less any operating expenses. This is before maintenance capital expenditures and is before finance and taxes. The buildup to NOI varies depending on how complicated the real estate model is. There can be a rent per square foot multiplied by square feet or a rent per unit multiplied by units. There can also be a unit by unit build up vetted by a historical rent roll.

Then there can be all sorts of other assumptions such as first month free or scheduled rent step-ups. These can all be modeled in Excel fairly easily or ARGUS software, which is a commercial real estate gold standard (it’s not that good).

Modeled Capitalization Rate

This is the industry standard measure for real estate value. Capitalization rate (or cap rate) is simply the net operating income (NOI) of the property versus the purchase price of the property. So for historical real estate investments, a cap rate can be easily calculated by dividing the NOI by the purchase price – which will be available on various real estate databases.

However, an investor needs to know exactly what is feeding into the cap rate. Last twelve months (LTM) cap rate is very different from forward year estimates for cap rate. Commercial real estate brokers are fundamentally marketers and next twelve months (NTM) cap rates that they offer may suggest adjusted operating figures that do not reflect the income that the property will actually generate or otherwise present a best case scenario.

Examples are – the LTM net operating income was $100,000 but with market rents, cutting costs on maintenance capital expenditures, no vacancies and excluding the property management fees the NTM NOI will be $130,000, yielding a far higher cap rate.

Ultimately, the cap rate evaluated from many different angles as a real estate investor – some investors may have a floor cap rate that they are willing to accept (because they are then able to get the appropriate levered returns on the property).

Why is the cap rate so important from an industry perspective? The answer is that it is impossible to figure out the levered, after-tax return of the potential buyer universe. No one can guess each buyer’s potential financing cost, tax situation and what improvements that they have assumed going into the purchase. However, the unlevered, pre-tax cap rate is comparable for all buyers.

The way to appropriately model real estate is to have a rent assumption, vacancy assumption and operating expense assumption that spits out an implied NOI and accordingly an implied cap rate given an assumed property purchase price.

Vacancy Rate Assumption

This is a contra figure that is netted off of the revenue line. This simply implies that a certain amount of units will not be rented out owing to market and timing frictions. Obviously, a neighbourhood with a higher vacancy rate means more risk for the buyer/operator and should accordingly come with a higher cap rate to compensate.

Operating Expense Assumptions

This is all the HVAC, utilities, property tax (not income tax) that are running expenses for the property. A conservative assumption is to have the same % of revenue. For many commercial properties especially in office and retail, there may be a net lease instead of a gross lease where the tenant ends up paying these expenses so the cash flow to the buyer is fairly certain. Obviously, this is a transfer of risk from the owner to the tenant, in which case theoretically the net rent should be lower.

Real Estate Capital Assumptions

Purchase Price Assumption

This is what the investor ultimately pays for the property. Run through a real estate model, this ends up being one of the most important drivers for return – so it is definitely worthwhile to get the best price possible, although remaining cognizant of whether it is a buyers market or a sellers market.

Commercial Real Estate Broker Commission Fee

This is paid for by the seller but if there are plans to exit the real estate investment later this will need to be factored in for the sale or exit price. The larger the value of the real estate the smaller the % fee.

So a residential sale could be 7% for the first $100,000 and then ultimately landing around 2.5-3%. However, keep in mind the agent has to split with the seller’s agent and with their brokerage (and their partner brokers in the sale). A large $1 billion building may have a 1% commission.

Loan-to-Value (LTV) Assumption

This is an extremely key component. Assuming that the investor can secure financing with rates below the cap rate, it is useful to put on as much leverage as possible to improve the final rate of return.

For basic real estate, this is simply a mortgage from the bank. For more advanced capital structures, this can involve a second mortgage at a higher interest rate to minimize the equity cheque.

Interest on Mortgage

The higher the interest, the more money goes to servicing debt than returning cash to the buyer. However, keep in mind that interest is tax-deductible.

Real Estate Cash Flow Measures

Tax Rate and Taxable Income

Self explanatory and depends on available deductions and applicable tax rates of the jurisdiction.

Maintenance Capital Expenditures

This is a sneaky line item that shows up below NOI because it technically does not show up in NOI but is a real cash expense to the buyer. However, maintenance capital expenditures will have tax implications and usually end up deducting taxable income so rough-rough the difference in NOI should not be that material.

Tenant Improvements (TIs)

These are tenant allowances to spend in order to entice them to rent. So for an office building, a new tenant may want allowances that are used to spruce up and make the new locale look glamorous with shiny metallic backdrops and ubiquitous use of their logo.