The Overall Rate of Return (OAR) is a financial metric used in real estate and investments that represents the percentage relationship between the net operating income (NOI) generated by an investment property and its purchase price. It is a critical measure of an investment’s profitability and efficiency.
Calculation of OAR
The OAR is calculated using the following formula:
Where:
- Net Operating Income (NOI): The income generated from the property after deducting operating expenses but before deducting taxes and financing costs.
- Purchase Price of Property: The total acquisition cost of the property.
Example Calculation
Suppose a property generates a net operating income (NOI) of $50,000 annually and was purchased for $500,000. The Overall Rate of Return (OAR) is:
Importance and Applications
Applicability in Real Estate
OAR is particularly useful for investors to quickly evaluate the profitability of a real estate investment. A higher OAR indicates a higher return on investment.
Comparisons
Investors often compare the OAR of different properties to ascertain which investment yields higher returns for a given purchase price. It’s also common to compare the OAR with other investment metrics such as the capitalization rate.
Types of Overall Rate of Return
Gross OAR
This metric considers the gross income generated by the property without accounting for operating expenses.
Net OAR
This is the standard OAR measurement that takes into account the net operating income after deducting operating expenses.
Historical Context
Historically, real estate investors have relied on OAR as a benchmark for assessing the viability of property investments. Over time, variations such as the capitalization rate have also been adopted for more nuanced analyses.
Related Terms
- Capitalization Rate (Cap Rate): Similar to OAR, but it often includes projected future income and expenses, making it a more forward-looking measure.
- Net Operating Income (NOI): A crucial component in calculating OAR, representing the income from a property after operating expenses.
- Return on Investment (ROI): A broader measure of profitability, encompassing income from all sources of an investment.
Frequently Asked Questions (FAQs)
What is a good OAR?
A “good” OAR varies depending on the market, property type, and location. Generally, an OAR of 5-10% is considered favorable.
How does OAR differ from Cap Rate?
While both metrics assess profitability, Cap Rate tends to include considerations for potential future income and expenses, making it more speculative compared to the historical and actual basis of OAR.
Can OAR be negative?
Yes, OAR can be negative if the net operating income is negative, indicating the property is not generating enough income to cover operating expenses.
References
- Brueggeman, W.B., Fisher, J.D. (2011). Real Estate Finance and Investments. McGraw-Hill Education.
- Geltner, D., Miller, N.G., Clayton, J., Eichholtz, P. (2013). Commercial Real Estate Analysis and Investments. Cengage Learning.
Summary
The Overall Rate of Return (OAR) is a fundamental metric in real estate investment, providing a snapshot of a property’s profitability relative to its purchase price based on net operating income. Understanding OAR helps investors make informed decisions, compare potential investments, and gauge the efficiency of their real estate assets.
