Check out my list of real estate investment terms every investor should know and add some new lingo to your investor vocabulary.
Term: Cap Rate
Definition: Capitalization rate, or cap rate for short, is used to measure the annual rate of return on a real estate investment based on the profit that property is expected to generate. Simply put, it’s the ratio between the net operating income (NOI) and purchase price. Cap rate is calculated by dividing net operating income (NOI) in the first year by the property purchase price. (NOI excludes loan costs if you used financing).
Example: Say you purchase a property for $150,000. The expected NOI in the first year is $12,000.
$12,000/$150,000 = 0.08
Cap rate: 8%
Why it matters: Cap rate is one piece of the puzzle to include when evaluating an investment property. Lower-yielding properties tend to be safer investments, while higher-yielding homes typically come with a little more risk. Both types of properties potentially have a place in your rental portfolio—it’s just a matter of why you’re investing in rental income properties and what you hope to achieve. Are you looking for higher monthly cash flow, more stability, or something in between? In theory, cap rates can signify varying levels of risk. Higher cap rates may correlate to a higher amount of risk in the purchase, and vice versa.
Term: Net Operating Income
Definition: Net operating income (NOI) is a measure of a real estate investment property’s potential to be profitable. It’s calculated by estimating the property’s revenue and subtracting all operating expenses such as repairs, maintenance, property taxes, HOA fees, etc. NOI does not include mortgage payments.
Why it matters: NOI allows you to analyze properties of all different types without looking at financing terms. NOI is also required to calculate cap rate.
Revenue (minus) all reasonably necessary operating expenses = NOI
Term: Cash Flow
Definition: 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 (minus) all operating expenses (including loan payments) = Cash flow
Why it matters: Consistent monthly rental income is one of the most appealing reasons to invest in real estate. Ideally, an investment property should be cash-flow positive. This means rent is higher than the monthly mortgage, which provides a steady stream of passive income. This passive income can go toward maintenance expenses, the down payment on another investment property, or a savings account.
Term: 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. 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
Why it matters: Cash-on-cash return is one way to analyze an investment by focusing on returns based on the actual cash invested. It also helps you understand the effects of leverage, and what your cash-on-cash return would look like if using a mortgage loan to finance part of the investment.
Definition: CapEx, or Capital Expenditures, are defined as new purchases or major improvements/renovations that extend the life of a property, such as replacing a roof, adding an extension or finishing the basement. This term also covers equipment and supplies required to make these improvements. Generally these are one-time, major expenses. Think of it this way: Routinely re-painting your rental home after tenants move out is not a capital expenditure. Installing a new furnace is.
Why it matters: Most parts of a house will eventually need replacing. Though the big-ticket items may only be needed every 20 years, it’s important to know there will come a time where you have to pay $1,200 to replace a bathroom floor, or $4,500-$10,000 to replace the roof. Just remember—these repairs/improvements ultimately extend the overall life and value of your investment property.
Term: 1031 Exchange
Definition: When you sell an investment property, you’ll likely have to pay some hefty capital gains taxes at the time of the sale. However, under Section 1031 of the U.S. Internal Revenue Code, a taxpayer may defer (pay at a later date) capital gains and related federal income tax liability on the exchange of certain types of property. To put it in layman’s terms, that means you can pay taxes on the income from the sale of a property at a later date if you take that money and put it towards purchasing another property or portfolio of properties of equal or higher value.
Why it matters: If you’re primarily investing in single-family rental properties, the 1031 exchange gives you a lot of flexibility to buy and sell assets without having to worry about being taxed at the point of every sale. This gives you more purchasing power to scale your real estate investment portfolio.
Term: HOA fees
Definition: A homeowner’s association is an organization that creates and enforces rules for the properties located in a subdivision, community or condominium. Purchasing property within an HOA’s jurisdiction means you automatically become a member and are required to pay monthly HOA fees to assist with maintaining and improving properties within the association.
Why it matters: When evaluating rental investment properties for purchase, it’s important to know if there will be HOA fees since these cut into cash flow and may need to be factored into your rental rates. Be sure to ask what the HOA fees cover and how they compare to other HOA fees in the area.
Term: Gross Rental Yield
Definition: Gross rental yield is the total income generated by a property, divided by the price paid for the property and associated closing costs. This is what you get before deducting operating costs (maintenance, property management, insurance, HOA fees, etc).
Why it matters: Gross rental yield provides investors with a quick reference for an annualized return on an investment.
Monthly rent x 12 / purchase price and associated closing costs = Gross yield
Definition: Appreciation is an increase in the value of an asset over time. The increase can occur for a number of reasons, including increased demand or weakening supply, or as a result of inflation or interest rate fluctuations. This is the opposite of depreciation, which is a decrease in the value of an asset over time.
Why it matters: Like a property’s cap rate, appreciation is an important piece of the puzzle when evaluating the overall appeal of an investment property. As the market value of your rental increases, so does ROI.
Term: Adjustable Rate Mortgage (ARM)
Definition: An adjustable rate mortgage (ARM) is a mortgage that does not have a fixed interest rate. Rather, an ARM can change monthly throughout the life of the loan based on the benchmark interest rate, which fluctuates based on capital market conditions. The initial interest rate is typically fixed for the first few years and then resets periodically.
Why it matters: As an investor, you need to know what your potential risks are. With an ARM, your monthly mortgage payments could increase or decrease depending on market conditions.
Term: Fixed-Rate Mortgage
Definition: A fixed-rate mortgage is a mortgage loan that has a predefined interest rate for the entire term of the loan that never changes. The monthly payment for a fixed-rate mortgage is the amount to be paid every month to ensure the loan is paid off in full with interest at the end of its term.
Why it matters: Fixed-rate mortgages are appealing because monthly mortgage payments stay the same, which makes budgeting and planning for future investments a little easier.
Definition: Equity is the difference between the current market value of the property and the amount that you (the owner) owe on the property’s mortgage. If you were to sell your investment property, the equity would be the money you receive after paying off the mortgage in full. This value can build up over time as the mortgage balance declines and the market value of the property appreciates.
Why it matters: Building home equity is a great strategy for building long-term wealth. At some point you’ll want to tap into your home equity, whether it’s to fund your retirement, upgrade to a different home, help pay for a major life event, etc. The long and short, this number is your friend and you want it to be growing.
Term: Turnkey Property
Definition: A turnkey property is a home or apartment that is completely, or very close to move-in ready.
Why it matters: Turnkey properties are appealing from an investment standpoint since investors can purchase a property and rent it out immediately without making any major repairs. Even if there are some improvements needed, investors can start earning rental income right away. As long as the property is move-in ready, it goes without saying: Do your research before buying a property from a turnkey provider.
Term: Capital Gains Tax
Definition: Capital gain or loss is the difference in the value of a property compared to its purchase price. If there is a gain, it is realized after the asset is sold. A short-term capital gain is one year or less; a long-term gain is more than a year. Both must be claimed on your income taxes, but short-term capital gains have a higher tax rate than long-term capital gains.
Why it matters: Understanding how your real estate investments are taxed is important if you’re looking to optimize performance and returns.
Term: Debt-to-Equity Ratio
Definition: In real estate, debt-to-equity (D/E) ratio is a measure of ownership. This ratio helps you determine how much of your property is actually yours (if you took out a mortgage to finance it) and how much you owe in debt.
Why it matters: This is important because it paints a more holistic picture of your investment. It tells you how much capital you have invested and how much you owe. This gives you a rough idea of how much you’ll walk away with when you decide to sell.
Term: Escrow & Title
Definition: Escrow and Title is when an impartial third party holds on to something of value during a transaction. When you make an offer on a property, you will pay a portion of the down payment ahead of time. This payment will be held by an impartial third party in a separate bank account until the contract has been negotiated and the deal has been closed. Escrow holds the money and transacts the closing and ensures all conditions have been met. They also record the title into the new buyer’s name and ensure it is free and clear of liens. Title Insurance protects the Buyer from the Seller’s old encumbrances or liens held against the property. It ensures a clean transference of the property.
Why it matters: Escrow helps remove risk from transactions for both parties. The escrow agent holds the money exchanged. They do this until all agreed upon conditions between the buyer and seller are met. Once these are completed, escrow funds are released to the seller.
Term: Closing Costs
Definition: Closing costs are the fees paid at the end of a real estate transaction. These fees vary depending on where you live, the property you buy, and the type of loan you choose. There are costs associated with inspections, transfer of title, loan origination fees, etc.
Why it matters: It’s important to budget accordingly for your closing fees so you have enough cash on hand at the time of purchase. Home buyers will typically pay between 2%-5% of the purchase price of the home in closing fees.
Term: Internal Rate of Return (IRR)
Definition: 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 the 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.
Term: Inspection Contingency
Definition: An inspection contingency is a term in the purchase agreement that lets the buyer:
- Hire a home inspector to look at the home
- Receive a report from the inspector on the home’s condition and issues
- Negotiate a sharing of the new costs with the seller or terminate the purchase agreement and get their earnest money deposit back
Why it matters: The inspection contingency contains a termination date which the buyer must adhere to. The buyer must have the inspection completed, review the report and negotiate with the seller. All of this must be agreed upon during the timeframe outlined in the contract. If the termination date passes and the buyer has not terminated the agreement or come to an agreement with the seller, the buyer must continue based on the terms in the initial purchase agreement.
Term: One Percent Rule!
Definition: The one percent rule is a guideline frequently referenced by real estate investors when evaluating potential property purchases. The monthly rent should be equal to or greater than one percent of the total purchase price of an investment property.
Why it matters: Why does the One Percent Rule matter? Because you want your earnings to cover the price in a reasonable timeframe. Like 16 years, instead of 33.
Term: The 20% rule
Definition: Buy at 20% below market prices.
Why it matters: That way, you have “instant equity,” and it allows for things like market correction or economic factors. All things that can reduce property values. If you have to get out of a property sooner than planned, you won’t lose money on the sell. The old adage, “The money is made at the buy” is a smart general rule.
Term: The 50% Rule for Expenses
Definition: One of the most valuable “tools” to a real estate investor is known as the 50% rule. This means that for a real estate investment the non-mortgage expenses usually averages to about 50% of the rent.
Why it matters: A four-plex that brings in $2,000 per month. Assume over the long run, this property costs $1000 per month in vacancies, maintenance, and other charges (not counting the mortgage.)
Estimate your monthly cash flow by taking the amount of money you have left (NOI), & subtract the monthly mortgage payment.
Term: Unit Mix
Definition: Unit mix is simply the different number of bedroom apartments in a property.
Why it matters: A quick easy way to define the investment. Try to acquire a unit mix with a favorable number of two-bedroom units in relation to one-bedrooms. The ideal ratio is (2) two-bedroom units to (1) one-bedroom unit. For example, on a 100-unit property, 66 two-bedrooms and 34 one-bedrooms.