Below we have provided some common Real Estate Investment terms. We hope that this section will better help you understand some important concepts you may be unfamiliar with.
Common Real Estate Investment Terms
As each investor’s valuation of time is different and subjective in nature, in order for an investment analysis to be accurate for all parties involved, any investment analyses should be done with the assumption that the investment is being made for purposes of establishing passive income and would not significantly differ based on who owns the property.
Gross Potential Income + Other Income – Vacancy – Operating Expenses = NOI
NOI is used extensively and while not difficult to figure, is often miscalculated. NOI does not include mortgage payments, capital improvements, Income Taxes (though it does include property taxes) or administrative expenses arising out of owner preference. It is the net income of the “property”, meaning it should be the same regardless of ownership.
Note: NOI should always include the cost or alternative cost of property management (if owner managed) to calculate actual “net income”. Often owner’s won’t factor their time’s opportunity cost, created and above average “NOI”.
Calculation: Price/Annualized Gross Potential Rents = GRM. The answer is generally a number between 5-15, with the lower usually implying a higher probability of ability to cash flow.
Calculation: NOI/Price = Cap Rate
Note: Cap Rates are only as accurate as the assumptions on income and expenses entered and because of such, results can vary widely by who does the analysis. Often cap rates fail to account for property management costs and deterioration of building systems. Whether a property is owner managed or professionally managed, the cost is either time or money. To be correct, even when self-managing- always account for the alternative cost of management as the only way to compare investments is to compare them as a passive income source.
Cash flow is calculated as
Net Operating Income – Non-Operating Expenses (mortgages, etc.) = Cash Flow
Cash on Cash is calculated as
Cash Flow/Total $ Invested = Cash on Cash
It does not account for principal paid down on a loan or for appreciation on a real property.
The Time Value of Money simply implies that the value of a sum of money changes over time according to factors such as the number of time periods involved (i.e.- your monthly mortgage payment), interest rates and future values. When given this data, we can compound (going forward in time) or discount (going backward in time) to determine to establish values such as loan payments, yield returns on investments, the longevity of income streams, or future and present values of investment options.
The difference between an internal rate of return and a compound rate of return is that an internal rate of return is assuming multiple disbursements (cash flows) that are pulled out at different times throughout the life of the investment. I.e.- if you receive monthly cash flows on real estate, then once you get those back, those funds can no longer be considered invested for compounding purposes.
The internal rate of return is the most comprehensive return however in that it accounts for all cash flows disbursed, principal paid down on the loan and appreciation on the property being analyzed, in other words- all aspects of income derived from the investment. In addition, it can be calculated both pre and after income tax to determine the impact of different tax brackets and savings from the investment in real estate.