Real Estate
Real Estate Investing 101 - Knowing The Terminology
When it comes to real estate investing, it’s very important to know whether this project is right for you, particularly if it’s profitable. As seasoned investors, we want to know every financial metrics about the investment opportunity, such as the NOI and the value-add opportunities. If you are new to real estate investing, you may be unfamiliar with the lingo and it’s perfectly normal when you’re just starting off. Here in this article, we talk about everything you need to know about the basics of real estate investing terminology.
Potential and Effective Rental Income
Potential rental income is the hypothetical amount an investor would receive not considering the potential negative situations associated with rental properties. Which means, the property is rented out 365 days a year and rent is always paid on time.
In reality, there always potential for the unit to be vacant or for someone not paying their rent (credit loss). As such, Effective rental income accounts for these negative situations and uses the following formula:
Effective Rental Income = Potential Rental Income – Vacancy & Credit Loss
In a perfect world, investors always want effective rental income equal to potential rental income. However, it is important to be conservative and plan for negative situations in your models, such as identifying the vacancy potential in your geographic area.
Gross Operating Income
Aside from rental income, there may be other opportunities for you to make additional income. Gross operating income is calculated by adding the effective rental income and all potential income generated by the rental property. Here are some common examples:
- On-premise coin-operated laundry machines
- On-premise vending machines
- Monthly parking permits
- Storage Unit fees
- Late Fees
Net Operating Income
Net Operating Income (NOI) is calculated by subtracting the operating expenses from the gross operating income. As an investor, NOI is a true measure of the profitability of an investment because it includes all kinds of expenses. Operating expenses can include:
- utilities – gas, heat, hydro and water
- insurance
- taxes
- maintenance and repairs
- property management fees
- other services – gardening, garbage and snow removal
In addition, NOI may also include non-cash expenses and income into its calculation. Some examples are:
- depreciation of assets and property
- deferred maintenance on the property
- deferred income
In general, NOI is calculated on an annual basis and therefore, it allows you to compare an investment’s profitability each year.
Cash Flow
Cash flow is a bit different from NOI, although both are good indicators of profitability. Cash flow is calculated using the amount of cash income generated each year and subtracting it by the amount of annual debt service. Debt service typically comes in the form of a mortgage or line of credit, if you’re relying on alternative financing. As such, annual debt service would be the mortgage (principle and interest)/line of credit payment that you would make for the year. Assuming the NOI does not have any non-cash expenses or income, then cash flow can be calculated using the following formula:
Cash Flow = Net Operating Income – Annual Debt service
In summary, cash flow is the amount of cash the real estate investor is putting into their pockets each year.
Capitalization Rate
The capitalization rate (also known as cap rate) is used to indicate the rate of return that is expected to be generated on the investment property. This measure is computed using the following formula
Capitalization Rate = Net Operating Income / Current Value of the Property
Capitalization rate is expressed as a percentage. Capitalization rate can be used to estimate the investor’s potential return on their investment and compare with other real estate investments in their local market. It is important to understand your local market’s capitalization rate, based on the real estate property type and building class. By doing so, real estate investors are able to model and estimate a property’s current value based on the NOI and the expected capitalization rate.
Return On Equity (ROE)
In real estate, you are likely not going to purchase this real estate investment with 100% cash but rather leverage other people’s money to do so. Return on equity (ROE) is a financial metric to determine the return on an investment relative to the real estate investor’s equity in that investment. Although return on investment (ROI) is very similar to ROE, they are fundamentally different, which you can find out more here. ROE is calculated using the following formula.
Return On Equity = Net Income / Investor’s Equity
ROE is expressed as a percentage. Net income is the sum of all the net operating income over a period of time and appreciation in property value. Investor’s equity is how much cash is personally “tied up” with the investment property. It is important to note that investor’s equity changes with time. If you’re leveraging other people’s money, the initial equity is just the down payment. Over time, the equity will increase as you are paying back the lender and more of the investor’s cash becomes “tied up” with the property. ROE can be used to estimate the investor’s potential return on their property and compare with other real estate investments. In addition, ROE can be used to compare your investment to other investment opportunities, such as other businesses, real estate or the stock market.
Leverage Ratio
Leverage ratio is one of several financial measurements that calculate how much capital comes in the form of debt, usually in the form of a mortgage or line of credit. It can also be used to assess the ability of the investor to pay off the debt. In real estate, leverage ratio is calculated using the following formula:
Leverage Ratio = Total Debt / Total Equity
Total Equity is calculated using the total asset (the real estate property itself), and subtracting it by the total debt. Financial institutions may use leverage ratio to determine how leveraged (or high risk) the real estate investor is for the investment and can affect the approval of the mortgage.
Loan-to-value Ratio
The loan-to-value (LTV) ratio is another financial measurement that financial institutions and other lenders use before approving a mortgage, which is a form of debt. In real estate, LTV is calculated using the following formula:
LTV Ratio = Total Debt / Current Value of the Property
Generally, most lenders offer mortgage and home-equity applicants the lowest possible interest rate when the LTV ratio is at or below 80%. When the LTV is above 80%, the individual is considered a higher risk and lenders may charge a higher interest rate as such. In addition, higher-risked individuals may also need to purchase mortgage loan insurance as this protects your lender in case you can’t make your payments.
Debt Service Coverage Ratio
In real estate, debt-service coverage (DSC) ratio is a financial measurement of an investments ability to pay current debt obligations. As such, it uses the following formula
DSC Ratio = Net Operating Income / Annual Debt Service
In general, lenders want to protect themselves by having a certain level of safety margin when lending money to real estate investors. Lenders often require a DSC ratio of 1.2 or higher when considering loan applications for rental property and other real estate ventures. If the economy is growing, lenders may be more forgiving and lower the required lower DSC ratio.
Value-Add Opportunities
Value-add opportunities are methods to increase a real estate investment’s cash flow over time by making improvements to the property. This could include making physical improvements to the asset that will allow for higher rents or lowering operating expenses when ever possible. If executed properly, it can increase the net operating income at the property and can result in the property appreciating in value. Generally, investors require additional financing on their projects to complete the improvements. However, these project bear more risk due to the fact that it is currently not operating at its full potential and requires proper execution for the investor to recoup its original investment.
Formula Cheat Sheet
We know this is a lot of information and there’s certainly a lot of formulas. To help you out, here’s a formula cheat sheet for you to use.
| Total Purchase Price | Cost |
|---|---|
|
Effective Rental Income |
Potential Rental Income - Vacancy & Credit Loss |
|
Net Operating Income |
Gross Operating Income - Operating Expenses |
|
Cash Flow |
Net Operating Income - Annual Debt service |
|
Capitalization Rate |
Net Operating Income / Current Value of the Property |
|
Return On Equity |
Net Income / Investor's Equity |
|
Leverage Ratio |
Total Debt / Total Equity |
|
Loan-To-Value Ratio |
Total Debt/ Current Value of the Property |
|
Debt Service Coverage Ratio |
Net Operating Income / Annual Debt Service |
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