Financial analysis of income property: cash flow, returns, and leverage

Follow the property's money

Potential gross income is income at full occupancy and collection. Subtract vacancy and collection losses, then add other income to obtain effective gross income. Subtract operating expenses, such as property taxes, insurance, management, and routine repairs, to find net operating income, or NOI. NOI excludes debt service, owner income taxes, and depreciation. Capital improvements are handled separately from routine operating expenses.

From property income to investor cash

Debt service includes both principal and interest payments. Before-tax cash flow equals NOI minus debt service and any separately stated capital expenditures or reserve contributions. Follow the problem's reserve convention and do not subtract the same cost twice. Depreciation is a noncash tax deduction; principal repayment uses cash and reduces debt. Neither belongs in NOI.

Suppose effective gross income is $100,000 and operating expenses are $40,000. NOI is $60,000. With $36,000 annual debt service and no other cash adjustments, before-tax cash flow is $24,000.

Choose the correct denominator

A capitalization rate measures annual NOI relative to property value or price. At a $750,000 price, $60,000 divided by $750,000 equals 8%. Cash-on-cash return measures annual before-tax cash flow relative to initial cash invested. With $200,000 invested, $24,000 divided by $200,000 equals 12%. Include the down payment and other stated cash acquisition costs in that investment. Cash-on-cash return does not include unrealized appreciation or loan principal reduction.

Debt-service coverage ratio, or DSCR, equals NOI divided by annual debt service. Here, $60,000 divided by $36,000 is about 1.67. A ratio of 1.00 means NOI just covers debt service; below 1.00 means it falls short, before other cash needs.

Leverage changes equity outcomes

Leverage means using borrowed money. With interest-only debt and no other costs, borrowing at a rate below the property's income yield increases the cash return on equity; borrowing above that yield decreases it. With amortizing debt, use actual debt service to evaluate cash return rather than comparing the interest rate alone with the capitalization rate.

Borrowing also magnifies percentage gains and losses on equity when property value changes. Appreciation and principal reduction can build equity without producing spendable operating cash. Analyze cash flow, equity changes, and sale proceeds separately before combining them into a defined total return.

These are before-tax measures; an investor's after-tax result depends on applicable deductions, limitations, and individual circumstances.