Terms you need to know as an investor
Real estate investors, brokers, agents, asset managers and industry professionals from financial institutions can often forget that some of the terminology they use is unfamiliar to those outside of the real estate industry.
Here is a three-part series on must-know real estate terms to help you understand and manage your investments with confidence. We unpack 5 terms you need to know that can impact on your investments and finances.
1.Internal Rate of Return (IRR)
This is a common real estate investment term you’ll see when browsing rental properties or crowdfunding websites. The internal rate of return (IRR) is a measurement of a property’s long-term profitability that takes into account annual net cash flow and the change in equity over time.
Why it matters: IRR is the single best estimate of your asset’s performance over the entire time that you plan to hold it. It allows you to evaluate investments that may have different cash flows or appreciation potential.
2. Cash flow
Cash flow is the amount of money you can pocket at the end of each month, after all operating expenses (including loan payments) have been paid. If you spend less money than you earn, your cash flow will be positive. If you spend more money than you earn, your cash flow will be negative.
Rental income – all operating expenses (including loan payments) = Cash flow
2. Net Operating Income (NOI) This is a calculation for rental real estate. Easily explained, this is how much money you would make if you owned the property free and clear of a mortgage. The NOI is calculated on an annual basis and equals the Net Rental Income (total rent for the year minus vacancy), minus the Operating Expenses (this is all costs for maintaining the property, including real estate tax, insurance, maintenance, management, utilities, landscaping, legal, leasing commissions, etc.—everything except the mortgage payment.) Sometimes people include “Capital Expenses” as an expense also. More on that later. For larger deals, you want to see a NOI that is between 40 and 50% of the Net Rental Income. The NOI means very little by itself, but it’s used for two very important calculations, explained below.
3. CAP Rate (Capitalisation rate)
The Capitalization Rate is NOI divided by the sell price or value of a piece of real estate. It is expressed as a percentage, but most people leave the percent part off when they are talking about it, i.e., “This property is a 10 CAP!” CAP rates are used to compare real estate investment opportunities. The CAP Rate is what your return on investment would be if you owned the property free and clear.
4. Cash-on-Cash Return
Definition: This figure is the ratio of annual pre-tax cash flow to the total amount of cash invested, expressed as a percentage. Cash-on-cash return measures the yearly return in relation to how much money you put down. It doesn’t take into consideration some of the other benefits of rental property ownership, including appreciation, loan paydown, depreciation and other tax benefits. Whereas calculations based on standard ROI take into account the total return on an investment, cash-on-cash return only measures the return on the actual cash invested. It’s the cash you’ve got left after one year, divided by the cash you’ve invested. Annual pre-tax cash flow / actual cash invested = Cash-on-cash return
5. Debt Service
This is a fancy way to say “bond or mortgage payment.” It’s the money required to “service the debt” on the property. It includes the interest on the loan and any pay back of the loan balance (principal reduction, defined below). The NOI minus the Debt Service equals your cash flow.
Don’t miss part two in REIM’s next edition