How do you determine if a particular property is a good deal? Any savvy real estate investor will tell you to calculate the asset’s net operating income and cash flow.
But what’s the difference between net operating income (NOI) and cash flow? And does that difference even matter?
Both of those formulas are helpful ways to determine a property’s profitability, but there are important distinctions between the two. And yes, that difference matters if you want to accurately assess a deal! This is where accurate real estate bookkeeping comes into play.
Real estate NOI is the revenue from a commercial or residential property minus recurring operating expenses.
When calculating NOI, be sure to include all revenue the asset provides, such as rent, vending machines, laundry machines, parking fees, and the like.
Then subtract the recurring operating expenses:
Although this formula can help you determine a property’s cap rate, it doesn’t include all cash flow related items. NOI excludes mortgage principal payments, mortgage interest, income taxes, and CapEx (capital expenditures recorded on the balance sheet), which are hefty cash outflows in any deal.
Keep in mind that if your property is reporting on an accrual basis, the income and expenses flowing into NOI represent what was invoiced (e.g. charged to your tenants) and what was entered as bills. They don’t necessarily represent cash receipts and payments (what’s entering and leaving your bank account).
Although excluding these important expenditures is the correct way to calculate NOI, it doesn’t give you the full picture of an asset’s potential profitability and ultimately the cash on cash returns. That’s why it’s important to take cash flow into account as well.
There’s no denying that NOI is both 1) important and 2) the right metric to compare one deal to the next since each real estate investor finances their purchases differently, but it doesn’t show you the month-to-month cash flow you would generate on a deal.
Cash flow lets you analyze how much money is going into and out of your bank account for a given property, and ultimately, how much cash you will be able to distribute to yourself and your investors. It can be positive or negative, depending on how your expenses compare to your income. An investor’s goal, of course, is to find properties that will provide a positive cash flow!
Similar to NOI, cash flow calculates the profit (or loss) of an asset. But instead of only counting recurring or annual expenses, it includes any cost you pay for the property, including:
Figuring out your cash flow will help you determine your cash-on-cash returns—that is, the amount of annual cash flow a property generates relative to the amount of cash (equity) invested in a property. To calculate your cash-on-cash return, simply divide the cash profit by how much money you invested into the property.
You might hear some people use NOI and cash flow interchangeably, but if you want to land great deals as a real estate investor, it’s crucial you understand the difference. Your success depends on it!