Every area of our lives has specific language that allows us to communicate efficiently and effectively. Real Estate Investing is no different. Here are some of the basic terms you must understand to be a successful investor in real estate.
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After Repair Value (“ARV”): estimated fair market value of the property AFTER repairs have been completed.
Capitalization Rate (“Cap Rate”): most popular method of assessing profitability and return on investment potential assuming the property is purchased CASH and NOT financed. Cap Rate is generally calculated as the ratio between the annual rental income to its current market value.
Example: Cap Rate = Annual Net Operating Income “NOI” / Fair Market Value “FMV”
Comparative Market Analysis (“CMA”): process used to evaluate the fair market value of a property; the maximum price a “buyer” is willing to pay and the minimum price a “seller” is willing to accept.
Depreciation: a reduction in the value of an asset over time specifically related to normal wear and tear as well as the projected useful life of the asset. The reduction in value (on the books), using the straight-line depreciation method, can be stretched across 27.5 years for residential properties and 39 years for commercial properties. The depreciation is calculated on the building value ONLY and does not include the value of the land.
Example: $170,000 Property FMV, $20,000 Land Value, 37% effective tax bracket
Adjusted Gross Income reduction = $150,000 / 27.5 = $5,454.55 per year
Annual Money You Keep & DON’T Pay In Taxes = $5,454.55 x 0.37 = $2,018.18
Debt Service: total cash required to pay back all debt obligations; make monthly PITI payments.
Debt Service Coverage Ratio (“DSCR”): measurement of an assets available cash flow to pay current debt obligations (debt service).
Example: DSCR = Annual Net Operating Income / Total Annual Debt Service
Fair Market Value (“FMV”): a.k.a. Market Value, the maximum price a “buyer” is willing to pay and the minimum price a “seller” is willing to accept.
Gross Rental Income: any and ALL payments received as rent including fees for additional amenities (parking, storage, laundry, etc.).
Gross Rent Multiplier (“GRM”): method used to compare rental investment opportunities.
Example: GRM = Purchase Price (incl. ALL closing costs, repairs,etc.) / Annual Gross Rent
Infinite Return: receiving the benefits of cash flow, depreciation, principal pay down, appreciation, when you no longer have any deployed capital, money invested, in the deal.
Loan to Value (“LTV”): calculated as the ratio between the Loan Amount and the Fair Market Value or Appraised Value. Lenders use this calculation to assess their risk.
Example: LTV = Loan Amount / Fair Market Value
Market Rent: the projected amount of rent that can be expected for the use of a property, in comparison to comparable properties in the same area.
Net Operating Income (“NOI”): amount of income produced by a rental property (does NOT include Debt Service).
Example: NOI = Gross Rental Income - Operating Expenses
Operating Expenses: cost of running and maintaining a property including insurance, taxes, legal fees, utilities, landscaping, cleaning, and repairs.
Percent ARV: ratio used to measure deployed resources
Example: %ARV = ARV / (Purchase Price + Repairs)
PITI: monthly debt payment that includes Principal payment (mortgage), Interest payment (mortgage), Property Tax payment, and Insurance payment.
Principal Paydown: debt service covered by collection of rent, a.k.a. “thank you tenant”. The amount of principal paid down and converted to equity.
Rent Ratio 1% Rule: measures the price of the rental property (including closing costs and repairs) against the gross monthly income it will generate.
Example: Rent Ratio = (Gross Monthly Rent / (Purchase Price + Repairs)) x 100
($1,500 / ($130,000 + $20,000)) x 100 = 1%
Return On Investment (“ROI”): calculated as the ratio between the value of the investment versus the cost of the investment.
Example: ROI = (Net Return / Cost of Investment) x 100
Rule of 72: a simple equation used to estimate how long an investment will take to double at a fixed rate of return. Even though this rule only applies to compound interest, it may still be helpful to estimate simple returns as well.
Vacancy Rate: also known as a holdback expense, is the projected amount or percentage of rental income that will be lost due to unknown/unanticipated vacancies (no renter/tenant = no income).
Value-Add or Air-Equity or Forced Equity: any real estate with significant opportunities to increase fair market value by completing renovations, repairs, or repositioning.
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