Property Investing 101: Glossary of Important Terms to Know
Like all specialized fields, real estate investing has its own “lingo.” While some terms may sound familiar, many have slightly different nuances when applied to this particular endeavor. What follows is a partial glossary of terms you’re likely to encounter as an investor in real estate.
Used to estimate the expected rate of return on an investment, this is derived by dividing the net operating income by the current market value. Let’s say a property is worth $5,000,000,000 and it is producing a net operating income of $500,000 annually, its capitalization rate is 10 percent.
A measure of the amount of cash moving through a business. It’s the total mount of money actually received, before considering accounts receivable. In real-estate investing, this is a measure of the solvency of a particular building. Positive cash flow means there’s more money coming into the building than is required to operate it. Negative cash flow means the building is costing more to operate than it generates.
A measure of the rate of return in relation to the cash out of pocket to secure an investment. Let’s say you’re looking to purchase a building generating $25,0000 in net revenues each month and you’ll need a down payment of $250,000 to secure the title. Your cash on cash return would be 10 percent for the first year.
Debt Service Coverage Ratio
A quick way to determine if a property has the ability to manage the debt associated with it. Expressed as the quotient of dividing the net operating income by the total debt service, or the monthly payment that must be made to cover loan payments. A number above one indicates positive cash flow. Let’s say a building generates $500,000 in net operating income, but it has $550,000 in debt payments, this calculates to a ratio of .91, which means it’s losing money.
This is the total amount of income a property generates from all sources before its associated expenses are considered. If your building is generating $500,000 annually from rents, parking fees, vending machines, billboard placement, laundry rooms and the like, its gross income is $500,000.
Gross Income Multiplier
To get a rough idea of the investment potential of a property, divide its sale price by the potential gross annual rental income. If, for example you’re being asked to pay $5,000,000 for building generating $500,000 in annual income. This building’s gross income multiplier is 10. Keep in mind though, other expenses are not taken into consideration in this evaluation, so it should only be used to get a rough idea of the investment potential. Related: The Buy and Hold Blueprint: Qualifying an Investment
The difference between the current market value of a property and the amount of the outstanding mortgage against it represents the equity accrued to the owner. If you have a $5,000,000 mortgage balance and the building is currently valued at $7,000,000, you have $2,000,000 in equity in the building. This grows over time as the mortgage is paid down and the property appreciates in value.
Net Operating Income
A good real estate investment has multiple ways to generate cash flow. In addition to rents, revenue could come from parking fees, laundry machines and service fees. On the other hand, you’ll have to pay for maintenance, insurance, property taxes, utilities and the like.
The difference between what the building makes and what it costs to run is the net operating income.
If a building is producing $1,000,000 in revenues annually and expenses come to $500,000, the building has a net operating income of $500,000. Keep in mind this is a before-tax figure; it also excludes principal and interest payments on loans, capital expenditures, depreciation and amortization.
Earnings derived from investments in which you have no active role in the operation of the investment are considered passive income. If you buy a building, hire a property management company to run it and have no other involvement with the building whatsoever, the funds you receive from the operation of the building are considered passive income.
If your 100-unit property consistently has an average of 10 vacant units, you’re running a vacancy rate of 10 percent. The inverse of this figure is the occupancy rate, which in this example would be 90 percent. In other words, the percentage of all available units unoccupied at a given time is the vacancy rate.
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