Speaking the Real Estate Lingo
In my previous blog entitled “The Benefits of Real Estate” I discussed the reasons many people are interested in taking the plunge to become a real estate investor. Maybe you are reading this blog because that person is you! Before you can even think about investing in your first property, you need to know the basic terminologies so you can speak intelligently to the different lending institutions. After all, you are going to be asking them to finance a significant portion of your projects, and it is best to be able to speak their language when applying for a mortgage. Here is a breakdown of some of the basic terminologies:
Potential Rents: This is the amount of rents the building is projected to produce before a vacancy rate is applied.
Gross Rents: The amount of money the property actually produces after a vacancy rate is applied.
Operating Expenses: All operating costs pertaining to a building such as insurance, management fees, repairs, utilities, etc. These do not include your debt service (mortgages and other loans).
Net Operating Income (NOI): This is probably one of the most important terms to understand. A property's net operating income is the dollar amount that is left over after paying all of your expenses. Expenses in this case, do not include your debt service. So if a property produces $100,000 per year in rental income and spends $50,000. The properties Net Operating Income is $50,000. ($100,000 Income-$50,000 Expenses=$50,000 NOI)
Cash Flow: A properties cash flow is the amount of money you are left with after you pay all expenses, and debt service. Using the above example, if you collect $100,000 of rent, and spend $50,000 on expenses, then your debt service is an additional $30,000 on top of that, your cash flow is going to be $20,000. (Income (-) expenses (-) debt service = cash flow). A lot of new investors confuse the terms Net Operating Income, and Cash Flow when they are in fact two different metrics.
Capitalization Rate (CAP Rate): This is a very important metric to pay attention to and it is used to apply values to a building from an income approach. The income approach applies value to a property based on the income it produces, rather than comparable properties that have traded in the same market. To keep it simple, a CAP rate is a market driven multiplier that is derived by industry professionals based on what properties are trading for in comparison to their Net Operating Income. If you have two properties with a net operating income of $100,000 and one sells for $1,000,000 and the other sells for 1,300,000, their CAP rates will be 10% and 7.7% (NOI / Purchase price= CAP rate). So looking at these two examples, if these were the only two data samples to choose from, the average CAP rate for the market would be 8.85%. In a given calendar year, if a 100 properties trade in a market, those data points for those 100 properties will be used to establish a market average. If you know the market average is 8.85% and you are analyzing a property with a net income of $50,000, you could expect a rough property value of 588,000 (50,000 NOI/ .0885 CAP rate=588,000 Approx. Value)
Debt Coverage Ratio (DCR): As we have discussed already, investment properties are typically valued based on the income they produce. Banks and other lending institutions want to know that an income producing property has the ability to cover its debt load. This again, is a ratio based on the properties Net Operating Income. The standard range of an acceptable minimum DCR is somewhere between 1:1-1:25 . The way to interpret this metric is to say for every $1 of annual debt the property carries, the property will produce $1:10-$1:25 of income. Let's say you are looking to purchase a property with a net income of $50,000 and your project annual payments on the loan are going to be $30,000. This particular DCR would be 1:6 which far above the minimum requirement of 1:1-1:25. Let's assume you have the same property with a NOI of $50,000 only this time you are thinking of overpaying and the annual debt service is $50,000. This DCR would be 1:1, below the minimum lending requirements and you will be hard pressed to find a lender that will be willing to lend on your project.
Cash on Cash Return: This one is pretty simple. To derive a property cash on cash, it's pretty simple. This is the amount of actual money you have invested in the project, or in other words your cash basis, in the form of down payments, legal fees, closing costs, etc., compared to the cash flow of the property. If you have $100,000 invested into a project, and your cash flow is $10,000, this would be a 10% cash on cash return. ($10,000 cash flow / $100,000 cash basis=10% Cash on Cash)
Break Even Occupancy: This is an extremely important metric to pay attention to. Your lender, and you, will want to be aware of the occupancy rate needed to cover all expenditures of a property, including debt service, should something take a turn for the worse. Maybe a major employer leaves, and takes a large portion of the renter pool with them. What does the occupancy of your building need to be, to cover its debts and expenses. This ratio is very simple, and important. The formula is ((Total expenses + Annual Debt Service)/Potential Rents)). If you have a property that is producing $100,000 in rental income, spending $50,000 on expenses, and another $30,000 on debts, the break even occupancy would be 80% ((50,000+30,000)/100,000)).
These are the major things investors, appraisers, lenders, and other industry professionals are looking for when they are deciding whether a property is within their “risk profile.” It is important to become familiar with these terms, and understand how they integrate with one another so you can impress, or more importantly, build confidence in your abilities with the industry professionals that are an integral part in helping you get to the finish line and make deals happen.