Real Estate Finance and Investment
Core concepts
Master the time value of money: present value, future value, and the discount rate that equates them. Know how to compute net operating income (NOI), the capitalization rate, and the relationship value = NOI ÷ cap rate. Understand leverage: loan-to-value (LTV), debt service coverage ratio (DSCR), and how positive leverage raises equity returns when the cap rate exceeds the mortgage constant. Be fluent in the mortgage payment formula and in amortization - how the interest/principal split shifts over the loan term.
Traps
Questions often confuse cap rate with cash-on-cash return and with the discount rate. Cap rate ignores financing and is a going-in yield on price; cash-on-cash uses pre-tax cash flow over equity invested. Another trap: using gross income instead of NOI in the cap-rate formula, or forgetting to deduct capital reserves. Watch for DSCR computed with principal only rather than full debt service. IRR questions may hinge on reinvestment assumptions; don't assume IRR equals a simple average return.
Worked example
A property produces NOI of $120,000 and sells at a 6% cap rate: value = 120,000 ÷ 0.06 = $2,000,000. If financed at 75% LTV ($1,500,000 debt) at 5% interest, annual debt service on an interest-only basis is $75,000, giving DSCR = 120,000 ÷ 75,000 = 1.60 and pre-tax cash flow of $45,000 on $500,000 equity (9% cash-on-cash).
Rule of thumb
If the cap rate exceeds the loan constant, leverage is positive; if it is below, leverage is negative.