Real Estate Finance Basics: NOI, Cap Rate, Cash Flow, IRR, NPV

Investing in property starts with understanding the numbers. In real estate, key metrics like Net Operating Income (NOI), Cap Rate, Cash Flow, IRR, and NPV help you judge a deal. Think of NOI as the core profit of a property before debt payments. You subtract all normal operating costs (maintenance, insurance, property taxes, management, etc.) from the rent and other income. The result is the NOI – the income that really “hits your pocket” before any loans or taxes.

Cap Rate is an easy way to compare deals. It’s simply NOI divided by the property price. For example, if a building earns P500,000 in NOI and is listed for P10,000,000, the cap rate is 5% (P500k ÷ P10M). A higher cap rate usually means more income relative to price, which often signals a higher yield (but possibly more risk). Use cap rates to see if the asking price makes sense against similar properties.

Cash Flow Modeling and Cash-on-Cash Return

Building a simple cash flow model is essential. Start with rental income and subtract vacancy or credit losses (no building is rented 100% of the time). What’s left is your effective gross income. Then subtract operating expenses to get NOI as above. Next, account for any debt service (principal + interest on a mortgage). The number you get after paying expenses and loan payments is your actual cash flow.

Components of the cash flow template:

• Gross Rental Income: expected rent from tenants.

• Vacancy & Credit Loss: a percentage deducted for empty units or missed rent.

• Operating Expenses: taxes, insurance, utilities, maintenance, management fees, etc.

• Net Operating Income (NOI): Income after vacancy and expenses, before financing.

• Debt Service: Annual mortgage payments (principal + interest).

• Cash Flow: NOI minus debt service.

Once you have cash flow, you can compute the Cash-on-Cash Return. This measures the annual cash flow relative to the actual cash you invested. For instance, if you put P20,000,000 down and get P1,000,000 per year in cash flow, your cash-on-cash return is 5%. It’s a simple way to see how quickly your equity is returning money each year.

IRR, NPV, and the Time Value of Money

Money today is worth more than the same money tomorrow – that’s the core of time value of money. In real estate, we use this idea with Net Present Value (NPV) and Internal Rate of Return (IRR).

• NPV (Net Present Value): This tells you the current value of a series of future cash flows, after accounting for the time value of money. You pick a discount rate (like your cost of capital or required return). Then each year’s expected cash flow is “discounted” back to today’s pesos. If you subtract your initial investment from that sum, the result is NPV. A positive NPV means the deal earns more than your required return; a negative NPV suggests it falls short.

• IRR (Internal Rate of Return): IRR is the discount rate that makes the NPV of your investment zero. In other words, it’s the rate at which the value of all future cash flows (including the eventual sale of the property) equals what you initially put in. If IRR is higher than your target return, the investment looks good.

When modeling, you’ll build a 5- or 10-year forecast of cash flows. This often includes an exit or resale value, which you might estimate using an exit cap rate. For example, if you expect a 6% cap rate on the sale year, and your Year 5 NOI is P600,000, the projected sale price would be P10,000,000 (P600k ÷ 0.06). Then you include that sale price as income in the final year’s cash flow. Plug all yearly cash flows (positive or negative) into a calculator or spreadsheet to get IRR and NPV. Tools like Google Sheets have built-in IRR() and NPV() functions that make this easy.

Financing and Leverage: LTV and DSCR

Few investors pay 100% cash for a property. This is where leverage (using debt) comes in. Two key metrics lenders and investors watch are Loan-to-Value (LTV) and Debt Service Coverage Ratio (DSCR).

• LTV (Loan-to-Value): This ratio compares the loan amount to the property’s value (or purchase price). For example, a P7,000,000 loan on a P10,000,000 property is a 70% LTV. Lenders often cap LTV around 60–70% for commercial deals, meaning buyers must put 30–40% down.

• DSCR (Debt Service Coverage Ratio): This measures how well the property’s income covers the mortgage. It’s calculated as NOI divided by annual debt service. A DSCR of 1.2 means your NOI is 20% higher than the yearly loan payments. Lenders typically look for DSCR above 1.2 (some allow lower if strong overall). A DSCR below 1 means the property doesn’t quite earn enough to cover its debt, which is a red flag.

It’s useful to run numbers both on unleveraged cash-on-cash (NOI/cash outlay) and leveraged IRR. Many investors create a comparison table to see how returns change with different loan terms or higher/lower interest rates. Also, online mortgage calculators can quickly show how changing interest rates, term lengths, or loan amounts affect your annual debt service.

Putting It All Together: Analyzing a Property

The real proof is doing an actual deal analysis. Imagine you pick a building on LoopNet or a similar listing site. Here’s a practical workflow:

1. Check Market Rents: Research similar properties in the area to estimate what rent you can charge. Online listings and rent comp reports help here.

2. Create a Pro Forma: Build a spreadsheet projecting income and expenses for the property. Include your expected rents, a vacancy rate (like 5–10%), and all operating expenses (taxes, insurance, maintenance, management fees, utilities, etc.). This gives you year-by-year NOI.

3. Forecast Cash Flows: Extend the model over 5 (or more) years. Adjust rent growth, expense growth, or other assumptions annually. Include changes in mortgage payments if you plan on an amortizing loan.

4. Calculate Returns: Use your cash flow forecast to compute metrics. First, determine yearly cash flow after debt service. Then use those cash flows to calculate IRR and NPV (with your target discount rate). Check the exit scenario by estimating the sale price using an exit cap rate.

5. Evaluate the Deal: Compare the required purchase price to the value implied by your model. Does the asking price give you a cap rate and IRR that meet your goals? For example, if similar deals have cap rates around 6% and your model at that price shows only a 4% cash-on-cash return, it might be overpriced.

By walking through these steps — from rents to cash flow to IRR — you’re essentially doing due diligence like a pro. If you can pick one real property and correctly build its five-year cash flow model and returns, you’ve mastered the essentials of real estate financial analysis.