Hello Sheldon (and fiancé) ,
Great to hear that you and your fiancé are out of school debt.
Valuations on different types of assets can be tricky. In this case, I believe you are looking at a commercial multifamily property (5+ units). Properties with a lower unit count will be valuated by comparable assets in the marketplace. That said, it is still valid to find suitable return metrics residential properties as well.
I will be honest, I have never seen your version of Net Return used before, but to your note the metric itself is actually quite similar to the Cap Rate calculation. In your case, you mention down payment which to me implies that you are leveraging this property with a bank loan. If that is the case, I would recommend you consider what is called a "Cash-on-Cash Return" or COCR. The equation is as follows,
COCR = Net Income / Initial Investment
The net income here takes the NOI and subtracts the debt service payments from the loan. I also subtract any capital used for reserves. The COCR is not necessarily a valuation metric, but it does help gain an understanding of how the property performs from a cash-flow perspective.
Regarding pure valuation (aka, what price will someone pay for my asset), I believe Cap Rate is more than a back of hand calculation. It is subtle, but the true Cap Rate ultimately represents an aggregate return that investors expect to deploy capital in the marketplace. In other words, if investors bought a property all cash they would expect an X% return on their investment. The X% is the Cap Rate. The trick is discovering the actual Cap Rate in the area you plan to invest. One way to get a feel for this is to look at recent acquisitions that have occurred around your area and try to see the Cap Rate at purchase. Institutions like CBRE and IRR also offer reports of general cap rates in submarkets across the country.
Assuming I have convinced you of the value in Cap Rate, the magic of valuation (at least for a commercial asset) is in the NOI. Lets say that you are investing in an area that is at a 7% CAP (give or take). If you find a property and the owner shows you an operating statement of $100k, it is safe to assume that the property is worth ~$1.43M (NOI/CAP = Value).
Or is it safe to assume? In my experience, once you start examining operating statements you find that the expenses are conveniently low. It is possible that the owner is the best property manager of all time, but more likely they are trying to boost the value of the property. My recommendation to you is to get very good at understanding the dollar value of your marketplace's rents and common expenditures. If you get a very good feel for this information you can avoid some major mistakes and potentially find some great value add opportunities.
Returning to our example, if you vet the property and find that the expenses are actually $20k higher your NOI is actually $80k. Now you just avoided buying a property where you would have lost ~200k out of the gate or you have a way to go back to the owner and attempt to purchase the property at a fair price (~1.14M).
On the other hand, if you know your market very well and see an opportunity to increase rents with a small capital investment then you may be able to achieve a $120k NOI after purchase. In this case, you just raised the properties value to $1.71M and increased your cash flow. These are the investments you are looking for in the market place.
My personal preference is to look at metrics which take the opportunity cost of capital into account such as internal rate of return (IRR), net present value (NPV), or profitability index (PI). These are all very related but can be used to help gain an understanding of how time and market risk affect your judgement on an investment. I would not recommend worrying about these metrics until you have had time to research them enough that you feel comfortable applying them to your analysis. There is good literature online that you can look up to get a better feel for these metrics.
I apologize that was so long (I am a big nerd for this stuff). If I can help explain something more clearly let me know. Go get 'em.
Thanks
Jacob
