Real estate investors have their own language. The uninitiated may miss the pure delight of buying a sweet rental home with a 14% CAP rate or when the NOI is a positive number.
In this post we will take a look at some of the common terms used when evaluating the income potential of an investment home, condo, or multifamily unit. This is not a compete list of terms... we'd put you to sleep if we did that. However, you should come away with a bit more knowledge than the average person. In future posts we will add to the list with transactional terms and more. Enjoy.
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,
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 in the 6-8 range. However, you can find units with rates as high as 12. These are often in scary areas and/or poorly maintained.
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 figure and an after tax figure. Some investors actually lose money on the before tax figures but show a profit after taxes. A good CPA is essential for 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 most commonly in the stock market and has some bearing
on real estate as well. 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.
