What are
real estate investment terms, and what good are they really?
When confronted with terminology that is
unfamiliar we tend to just go with the flow so that people will not view us as
beginners, but that ‘fake it till you make it’ attitude will soon be exposed.
Here are some terms commonly used in real estate investment that you need to
understand.
Real Estate Investment Terms You Need to Know
1. Equity
Home equity is the difference
between your home’s fair market value and the outstanding debt that you have on
the property. The value of your equity increases as a result of two
things, first you steadily pay down the mortgage balance and second the
property’s market value appreciates.
2. Appreciation
This refers to an increase in the value of your property over time. The increase can occur for a number of reasons, including increased demand or weakening supply, or as a result of changes in inflation or interest rates. This is the opposite of depreciation, which is a decrease over time. A home’s appreciation is calculated based on the fair market value of comparable homes for sale in the neighborhood.
3. Cash Flow
Cash flow is the money that you can put in your
pocket at the end of each month after you have paid all the operating expenses
of your property, this includes any loan payments.
If you invest wisely, you will have a positive cash flow as the rent that you receive from tenants each month will outweigh your maintenance and repair expenses as well as loan payments.
4. Net Operating Income (NOI)
Net operating income is income that is
generated annually from an investment property after deduction of property
expenses. Such expenses may include property tax, property management fees, and
utilities.
What is the difference between NOI and cash
flow?
NOI does not include the loan repayments.
To put it simply, NOI is an indicator of how a property is performing.
Net cash flow is an
indicator of how your investment is performing.
5. Cap Rate
Capitalization rate or cap rate is
the ratio of the net operating income produced by an investment property divided
by its current market value. This is a real estate investing term that refers
to the rate of return expected from an investment property.
An example of a cap rate calculation according to propertymetrics.com is…
For example, suppose we know that a property
has an NOI of $100,000 and a value of $1,000,000. Then we can calculate a cap
rate by dividing $100,000 by $1,000,000:
Value = $100,000 / $1,000,000 = 10%
This results in a cap rate of 10%.
6. Pre-Approval Letter
A pre-approval letter is a document
offered by a bank that states the loan amount that the bank is prepared to make
to you, the borrower. It is not a guarantee to lend, but it gives agents and sellers
confidence that you can be granted the funds when they are needed.
7. Hard Money Loan
A hard money loan is an asset-based loan
(secured by real property) issued by private investors or organizations. Hard
money lenders are usually quick to supply the funds but they have higher
interest rates than conventional loans.
8. Debt-to-Income Ratio
This is a means of measuring your personal
finances by lending institutions. It compares your monthly debt with your
monthly gross income. This equation is used to measure your ability to
manage monthly loan repayments.
9. Cash on Cash Return
Cash on cash return is your percentage ratio
of annual cash flow before tax to the total amount of cash you have invested.
This financial metric allows you to assess the cash flow from your income-generating
property.
Here is an example of a ‘cash on cash’ return,
according to Investopedia.
The total purchase price of the property is $1
million. The investor pays $100,000 cash as a down payment and
borrows $900,000 from a bank. Due are closing fees, insurance premiums, and
maintenance costs of $10,000, which the investor also pays out of pocket.
After one year, the investor has paid
$25,000 in loan payments, of which $5,000 is a principal repayment. The
investor decides to sell the property for $1.1 million after one year. This
means the investor’s total cash outflow is $135,000, and after the debt of
$895,000 is repaid, he is left with a cash inflow of $205,000. The investor’s
cash-on-cash return is then: ($205,000 – $135,000) / $135,000 = 51.9%.
10. Rental Property Calculator
A rental property calculator is an
online tool that helps you to determine the return on investment, cash flow,
and cap rate on a rental property. Investors input data about an investment
property such as purchase price, property expenses, and financing. You can use
this tool to evaluate and assess if a rental property is a good
investment before purchase.
Summary
Making sense of real estate investment terms can be a challenge. Every type of industry has its own unique terminology which is useful to those in the know but can be a barrier for those just starting out.
By studying this list you will get a good
initial grasp of some of the most commonly used and commonly misunderstood
terms.