Common Real Estate Investment Terms
Common Real Estate Investment Terms (and what they mean)
With any type of investment it is important to understand the terminology used so that the investor can appreciate everything there is to know about the investment. One should not be investing in anything without that knowledge. Real estate investment involves large sums of money that can also be highly leveraged which means plenty of risk. That risk can be reduced with a positive earning property. This article provides some key investment terms that real estate investors should know about.
Any real estate investment without positive cash flow is one an investor should walk away from. Unlike actively traded stocks real estate cannot be bought or sold with the click of a few buttons. Instead the act of buying real estate takes time to not only find the right cash flowing property but then to get all the post contract acceptance aspects in line prior to closing. Therefore if an investor makes a wrong decision one cannot simply sell their investment real estate without taking a loss due to the transaction costs involved.
The cash flow from real estate investment needs to not only be positive but large enough that the cash flow can be banked so that a reserve fund can be setup. If one already has a reserve fund setup to cover major expenses (like HVAC, roof, plumbing and more) that is great, but the cash flow is still required otherwise once a major expense does pop up that real estate investment will become a net negative investment. Real estate investors need to go in the mindset that the investment is supposed to be positive based on the cash flow. While appreciation is nice, appreciation does not happen overnight, and it can take some time before the investor can get access to that appreciation.
In order to obtain the cash flow number from the property the investor needs to know all their up-front costs and compare that to the income flowing into the property through rents. Up front costs include insurance, property taxes, property management fees, repairs and more. The total rents being obtained by the rental property needs to be greater than the costs to own the property in order to have positive cash flow. How much positive cash flow the investor needs/wants is an individual goal that each investor should determine for themselves but the greater the cash flow the better. Getting one dollar a month in cash flow is positive but nowhere near enough to give a proper return to the investor for their investment let alone help build up a fund with which to make repairs to the property as the need arises.
Net Operating Income
Net Operating Income or NOI is the total income being produced by investment real estate minus the expenses of operating the building. Things like property management fees, maintenance fees, owner paid utilities are part of the operating expense. Taxes are usually excluded from the operating expense when figuring NOI. NOI is used for calculating other numbers like the Cap Rate and helps the buyer and/or owner know what an income producing real estate investment will earn them over a particular time frame (usually one year).
The Capitalization Rate (also known as cap rate) is a number obtained by dividing the net income of the investment real estate by the purchase price or value of the property. For instance a property with net income of $10,000 that is being sold at $100,000 has a cap rate of 0.1 or 10%. Cap rates are used to compare investment real estate and gauge the return on investment.
Evaluating investment real estate involves more than just comparing the cap rates of different investment properties. Whereas a lower cap rate property may on paper seem like a poorer deal compared to a higher cap rate number the real estate investor needs to dig further into the facts. Is the lower cap rate property under rented, meaning the rents currently being paid by tenants below what can be obtained by charging market rents? Is the property under managed, sometimes the owner manager lets things go whereas a new owner or professional property manager can boost rents by making sure the building is in better shape which attracts quality tenants. Whatever the reason may be it is up to the individual investor to study and analyze their real estate investments to determine where the real value lies.
Cash on Cash Return
Cash on cash return is a measure of how much cash a real estate investor will get back on their initial cash investment and is usually measured on a year time period. Since the cash-on-cash return is an annual measure the number can vary year by year based on the cash put into the investment. The cash-on-cash return is calculated by dividing the total cash investment by the (before tax) annual cash flow. The cash-on-cash return is comparable to the yield percentage for a stock that pays a dividend.
Some investors prefer to focus on cash-on-cash return since it can be used to compare to other types of investments and the yield they might offer. By comparing the numbers the investor is better able to determine where their cash should be invested based on which investment offers the best return with the lowest risk. Diversification of ones investing dollars means spreading out the risk with different asset classes like real estate, stocks, bonds, and more.
When investing in anything it is important to understand the terms that are used to describe how the investment makes money. One should fully understand about cash flows, calculating cap rates, cash on cash returns and more so that a wise investment decision can be made. Relying strictly on appreciation for investment real estate is a sure path towards a negative cash flowing investment property the first time any major repair is needed.
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About the author: The above article “Common Real Estate Investment Terms” was provided by Luxury Real Estate Specialist Paul Sian. Paul can be reached at paul@CinciNKYRealEstate.com or by phone at 513-560-8002. If you’re thinking of selling or buying your investment or commercial business property I would love to share my marketing knowledge and expertise to help you. Contact me today!
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