There
are a number of terms bantered about in the real estate investment
world. We've put together a list of some of the most common with brief
definitions.
Gross Potential Income:
This
is a relatively useless calculation but needs to be included. It is the expected
income a property will produce without deductions for vacancy, collections
losses, or miscellaneous income.
Gross Operating Income:
Same
as above but adds in losses due to vacancy and non-payment by a tenant.
Net Operating Income:
Now
we’re getting to the important stuff. The bottom line numbers. Are you making a
profit or loss before taxes. Here we add in operating costs such as management fees,
repairs, insurance, etc.
CAP Rate (AKA Capitalization
Rate)
You hear this term bantered around a lot in the world
of real estate investing. It is a ratio used to estimate the value of income
producing properties. The ratio is determined by dividing the net operating
income by the sales price or value of the property.
If you are buying a rental home you want to see as high a CAP rate as possible and in a marketable area. In the Greater Phoenix area we like to see a CAP rate above 6%. You can find properties with rates as high as 18. These are often in scary areas and/or poorly maintained. You'll want to find a balance between a good CAP rate, location and condition of the property.
Cash Flow: Before and After
Taxes
Obviously, cash flow is an important consideration to the real estate
investor. It represents all the money coming is such as rent, interest on bank
accounts, etc. minus outgoing expenses like operating costs, debt payment and
capital expenditures.
Cash flow should be evaluated as a before tax and an after tax figure. Some investors actually lose money before taxes but show a profit afterwards. A good CPA is essential to evaluating this.
The key factor is evaluating cash flow is to be realistic. Don’t blue sky yourself with unrealistic rents and incomplete operating cost assessments.
Debt Service:
This a fancy
name for a simple thing… the total you pay on loan for the property… make sure
and include any second, third or HELOC’s assigned to the property.
Return on Equity:
This
is a term used more commonly in the stock market and has bearing
on real estate too. Essentially, ROE is the percentage return on
your cash investment. It is generally evaluated on an annual basis and
simply lets you know what kind of return your are getting on your
money.
