Real estate investors may prefer to buy an established property that’s leased to tenants. In those situations, you can project revenues from rents as well as expenses for maintenance, taxes, and insurance. If the property’s income exceeds outflow, you’ll have net operating income (NOI).
The ratio of NOI to the purchase price is called the "cap rate," which is the expected return to an all-cash investor. Today, cap rates around 5% can be found in many areas. At that rate, a fair purchase price would be 20 times NOI: you might pay $200,000 for a property with NOI of $10,000.
Ideally, you’ll invest with a relatively small down payment and borrow the rest of the purchase price. Say you buy that $200,000 property with $40,000 down and a 6%, $160,000 mortgage. After paying $9,600 in interest (6% of $160,000), your cash flow would be slightly positive because your $10,000 in NOI would cover the interest payments. If the property appreciates by, say, 10%, to $220,000 in a few years, you’d have a $20,000 gain on a $40,000 investment, thanks to your use of borrowed money.
