“You don't have to be a mathematician to have a feel for numbers.” - John Nash
Whether you are already operating a rental property or looking to invest in one, you need to know what your property’s cash flow potential is. Three key figures to look at to assess your current cash flow are your property’s Cap Rate, Cash on Cash Return on Investment (CoC ROI) and the Debt to Cash Ratio (DCR).
We are going to take the example of a traditional 1 bedroom apartment rental property in Lakeside Tower C in IMPZ, Dubai. We will go through the process of generating these metrics step by step so you can easily repeat the same calculation for your property of interest.
A little bit about our sample investment:
Building: Lakeside Tower C
Beds: 1 bedroom
Size : 680 Sq Ft
Purchase Price: 600,000 AED*
Total Service Charges: 12 AED/ Sq Ft
Expected Rent: 50,000 AED/year
* The purchase price in our case excludes all closing costs (property registration fees, mortgage valuation fees, processing fees, registration fees, agent fees, and other relevant fees).
Step 1: Calculate your Annual Gross Income
This is the total income you will be generating from your investment. This is mostly the rental income produced. Now in case you were creative and re-purposed your property as a holiday home or an employee rental, you might be able to maximize this income significantly.
Example: If we are planning on operating our apartment the whole year long, then our annual gross income in our case is simply equal to the expected rent of 50,000 AED
Step 2: Calculate your Annual Vacancy Costs:
This is the money value of the total number of days that your property will be vacant, in other words: not generating revenue. Operating your property as a traditional rental with a year-long tenant will lower your vacancy rate. While choosing to rent out your property as a holiday home using Airbnb for instance will most likely mean a much higher vacancy rate as there will be days that you will be looking for a new tenant to move in.
Example: If we will spend around a month looking to find a tenant to move in and occupy our apartment, then our vacancy will be the opportunity cost of having our apartment unoccupied for 30 days. Vacancy = 30 days/365 days x 50,000 AED/year = 4,110 AED
Step 3: Calculate your Annual Total Operating Expenses:
As a landlord you will have to manage your own property but also you will need to contribute to maintain your building’s common areas ( gym, swimming pool, building equipment, building facades, air-conditioning units, elevators, chillers, water tanks, fire pumps).
Even if you choose to manage the property yourself and not go with a property management firm, you will still have to take into account the money value of your time. Property management companies usually take around 5-8% of your rental income to manage and operate your asset.
As for your common area service charges. You will have to chip in every year by an amount agreed upon by your building’s owners’ association. Each landlord will have to pay a unit cost on an AED per Sq Ft basis. This means the larger the unit you own as a landlord, the larger the service charges you will need to pay.
The building’s service charges will most likely depend on the company your building’s owner association ends up choosing to take care of the following:
You will also need to contribute money to your building’s Sinking Fund. A sinking fund is a reserve fund set up to cover capital investment/expenditures, such as replacing assets in common areas. In Dubai expect to place anywhere between 2%-10% of the total charge fees into the sinking fund. The older the building, the bigger the sinking fund bill should be as assets start to deteriorate.
Additionally you might have to pay extra costs like parking costs in certain cases.
Service charges are agreed upon by the building’s owners’ association so you do have a say in them through democratically electing the building committee and through expressing any concerns to the committee members.
Example: The apartment we own is a 680 Sq Ft unit located in a building where the total service charge fee is 12 AED/Sq Ft, then the annual service charge fees or total operating expenses will be: Total Operating Expenses = 680 Sq Ft x 12 AED/sqft = 8,160 AED.
Step 4: Calculate Your Net Operating Income (NOI)
Your net operating income is what you take home after paying all operating expenses, property taxes and discounting vacancy days.
NOI = Gross Income - Vacancy - Expenses
Example: Let’s do the annual NOI calculation for our 1 bedroom apartment. We previously calculated our gross income as 50,000 AED, our vacancy costs as 4,110 AED, and our total operating expenses as 8,160 AED.
The NOI therefore will be NOI = 50,000 AED - 4,110 AED - 8,160 AED = 37,730 AED.
Step 5: Calculate the Capitalization Rate (Cap Rate):
After going through the above four steps, we can now calculate our property’s purchase cap rate.
The property’s purchase cap rate is the ratio of the net operating income to the purchase price. The cap rate is a metric that is completely independent of the buyer and the details of the financing. It is always a great exercise to benchmark your property’s purchase cap rate to the median market cap rate. It is a quick way to evaluate how big or small the cash flow you are currently producing is compared to the market.
Cap Rate = NOI/Price
If we had purchased the property for 600,000 AED and our NOI is 37,730 AED then our cap rate calculation is simple:
Purchase Cap Rate = 37,730 / 600,000 = 6.28 %
A 6.28% cap rate is lower than the median cap rate you could readily get in certain communities in the Dubai market, so overall this is our first negative indicator.
Step 6: Calculate Your Annual Debt Payment:
The mortgage amount is based on the loan to value ratio (LTV) that you end up agreeing on with the bank. The mortgage is then amortized over a long term (in the UAE the usual maximum term is 25 years) at a certain interest rate (around 4%).
Mortgage payments are amortized. This means that early on, most of the payment goes towards repaying the interest on the loan, and later on the payments mostly go towards making principal payments on the loan.
To calculate your debt payment, here is the formula you will need:
Debt Payment = Debt First Year * (i * (1+i)loan term)(1+i)loan term-1
Example: In our case, let’s assume you took out a loan with a 75% LTV, amortized over 20 years for an annual interest rate of 4%.
You will need to be making monthly payments to your lender (bank) so in this case you will need to be making a total of 20*12 = 240 payments [your loan term = 240 months], your monthly interest rate will be 4/12 = 0.33% per month
Debt First Year = ( LTV Ratio / 100) * Purchase Price = 75/100 * 600,000 = 450,000 AED
i = loan interest / 100 = 4/100 = 0.0033
Debt Payment = 450,000 AED * (0.0033 * (1+0.0033)240)(1+0.0033)240-1= 2,727 AED/month
This will amount to an annual payment of 2,727 AED/month * 12months/year = 32,724 AED/year
Step 7: Calculate Your Free Cash Flow
The free cash flow is defined as the net operating income minus any debt payment. In case you chose to pay for your investment fully in cash then your cash flow is equal to your NOI.
Free Cash Flow = NOI - Debt Payment
Example: The free cash flow is simply our NOI which is 37,730 AED minus our Debt Payment which is 33,112 AED. Free Cash Flow = 37,730 AED - 32,724 AED. = 5,006 AED
Step 8: Calculate The Cash on Cash ROI (CoC ROI)
The cash on cash return on investment is the ratio of your free cash flow to the equity you invested. The cash on cash ROI depends on how you, as a buyer, chose to finance your investment. The larger of a loan you take, the smaller your free cash flow, but also the smaller your initial equity.
CoC ROI = Free Cash Flow / Equity
Where Equity = Initial Down Payment + Closing Costs
Example: In the case of our 1 bedroom apartment:
Our initial equity = Initial Down Payment + Closing Costs
Initial Down Payment = 25/100 * 600,000 = 150,000 AED
Closing Costs = 7/100 *600,000 = 42,000 AED (closing costs for a ready property are around 7% in Dubai)
Equity = 150,000 AED + 42,000 AED = 192,000 AED
This makes our first year cash on cash ROI = 5,006 AED / 192,000 AED = 2.6%
As a note some banks in Dubai cover 25% of the closing costs in the mortgage, this will slightly improve our cash on cash ROI but overall our CoC ROI is still lower than the median CoC ROI you can find in the Dubai Market.
Step 9: Calculate the Debt Coverage Ratio (DCR)
To calculate DCR, take the NOI and divide it by the annual debt. A property that achieves a 1.2 DCR is simply generating 20% more income than the payment of the debt. DCR = NOI / Debt Payment
The DCR is a basic, yet effective indicator that shows how leveraged you are. The closer the DCR is to 1, the riskier the investment is, since any unexpected expense, or shortcoming in terms of rental income and you will dip into the negative, having to dig deep into your own cash to make your bank payments.
Example: In our case our NOI is 37,730 AED, and our Debt Payment is estimated around 32,724 AED. Then our DCR is equal to 37,730 AED/ 32,724 AED = 1.15
Step 10: Assessing Your Cash Flow
Now that you have calculated our 3 key metrics (Cap Rate, Coc ROI, and DCR), lets take a step back and evaluate these numbers.
It is clear that from a cashflow perspective that this investment is not performing so well. Here are three general recommendations you should keep in mind when investing in a rental property for cash flow in the Dubai Real Estate market:
In our case you will have to negotiate the price down from 600,000 to at least 470,000 AED , or you will have to get creative and increase your rental income from 50,000 to 62,000 AED to make this an attractive rental property investment.