Real estate is one of the most lucrative and rewarding investment opportunities around. It is truly the best path forward for investors of all levels, whether you have $10,000 or $10 million. However, knowing the terminology is one barrier newer investors feel when learning about real estate. Over the years, financial analysts, accountants, investors, and all others in the real estate industry, have developed a comprehensive suite of real estate terms to describe deals and give prospective investors an idea of the project. To invest confidently, prospective investors need to know and understand these terms.
Fortunately, there are not too many to learn. Here are the top nine crucial real estate terms you need to know to read a prospectus confidently and accurately.
1. One of the Top Real Estate Terms: Cash Flow
Cash flow is one of the most critical real estate terms to understand. Effectively, it is the net income generated from a property after deducting all expenses such as mortgage payments, taxes, insurance, and maintenance.
Analyzing cash flow is vital when assessing investment properties because it reflects their ability to generate a steady income stream. A property with a more significant prospective cash flow has a much higher likelihood of developing a sizable, steady passive income stream. Conversely, a property with minimal cash flow (or, worse, a negative cash flow) will constantly require loans or other investors to remain solvent.
No matter what investment you make in real estate, ensure it has a plan to achieve positive cash flow.
2. Cap Rate (Capitalization Rate)
The cap rate is a metric used to determine the potential return on a real estate investment. Investors calculate this metric by dividing the net operating income (NOI) by the property’s market value or purchase price.
The cap rate helps investors compare different investment opportunities and understand the relationship between risk and return. For example, suppose a property costs $1 million and generates a $100,000 net operating income. The cap rate is 10% ($100,000 / $1 million = 0.10 * 100% = 10%). Further, suppose there’s another investment with a cap rate of 20% on a $1 million property. That means it generates $200k of income.
Which is the better investment? At first glance, the investment with the higher cap rate is better. It generates more rent with the same property value. Generally, the higher the cap rate, the better the investment.
3. Cash on Cash Return in Real Estate
The cash-on-cash return is a financial metric that measures the cash income generated by an investment relative to the cash invested. In real estate, investors calculate this by dividing the yearly pre-tax cash flow by the total cash investment.
Here is an example best illustrates the cash-on-cash return concept. Suppose you invest $500,000 on a $5 million property that will generate a $100k pre-tax cash flow (you get a loan for $4.5 million from the bank). The cash-on-cash return is 20%. Suppose you must invest $1 million because the bank requires 20% down. The cash-on-cash rate drops to 10% now because we’re still getting $100k but on $1 million invested instead of $500k.
Indeed, this metric helps investors determine the effectiveness of their investment and is especially useful for comparing investments with varying degrees of leverage. It compares what cash flow you can expect from the amount you invest (your actual cash risk).
What’s a good Cash on Cash Return? Find out here.
4. Real Estate Equity
Equity refers to the difference between the market value of a property and any outstanding mortgage or loan balance. As a property owner pays off the mortgage and the property appreciates, the equity increases, providing the investor with increased net worth and potential profit upon sale.
Most real estate investments will have some form of mortgage, so understanding the equity in a building and who owns that equity is vital to know whether an investment is worth it. Will the investment make interest-only payments and not build equity? Will it build substantial equity with a shorter-term loan or minimal equity with a long, drawn-out 30-year loan?
These questions can help answer whether an investment will have substantial capital at the end or whether most of the income from the investment will come from rents instead. Find out what a good Debt to Equity Ratio is.
5. Another One of the Top Real Estate Investment Terms: Passive Income
Passive income refers to the earnings generated without the need for direct involvement or active work on the part of the investor. Rental income from real estate investments is an example of passive income, as the investor does not actively participate in the property’s day-to-day operations.
Generally speaking, all real estate investing aims to maximize passive income. Real estate is one of the rare investment opportunities that can create substantial passive income with comparatively minimal capital investment. Learn more about How to Earn Passive Income through Real Estate Investing.
6. ROI (Return on Investment)
ROI is a financial metric used to evaluate the efficiency of an investment. You can calculate ROI by dividing the net profit generated by an investment by the initial cost of the investment. A higher ROI indicates a more profitable investment overall.
For example, suppose you have an investment that generates $10,000 net income annually from an initial $100,000. In that case, that’s a much more profitable investment at 10% ROI than one that produces the same amount of money but from an initial investment of $1 million. The latter investment has an annual ROI of just 1%.
While there are other factors, generally, a higher ROI indicates a better investment overall. Find out how an Asset Manager can increase ROI.
7. NOI (Net Operating Income)
Net Operating Income is a property’s total income, excluding reasonable operating expenses. NOI is crucial in determining a property’s profitability and potential cash flow. Calculating NOI is simple: subtract all reasonable operating expenses from a property’s revenue. Reasonable costs include running and maintaining the building, including premiums, utilities, property taxes, and repairs. This calculation excludes capital expenditures.
Net Operating Income is essential in real estate because it lets lenders forecast cash flows. The NOI helps lenders determine if a property is profitable, and if it is, they use NOI to determine how large of a loan they are willing to make.
8. Real Estate Syndication
A real estate syndication is a legal entity that allows investors to pool resources to acquire and manage a property collectively. A syndication can participate in more extensive and more lucrative investment opportunities than they could individually. A syndication, for example, might pool 100 investors with $50,000 each to form a formidable pool of $5 million to put as a down payment on a multifamily property. That’s far more than any single investor could do with $50,000 (in many parts of the country, $50,000 would barely be a down payment on a single-family home, much less a multifamily building).
Syndication also provides a way to have legal protection from risks. Limited partners (i.e., the syndication’s investors) do not have any liability in the venture. Unlike a landlord, an investor in a syndication needn’t worry about lawsuits or personal liability for a property – the corporate structure of the syndication handles all that for them. All the investor has to do is sit back and collect the passive income (which can be 8%+ per year). Check out this video to learn the basics of real estate syndication.
9. Portfolio Management
Lastly, portfolio management refers to the ongoing process of strategically managing and optimizing an investor’s real estate investment portfolio. Typically, portfolio management involves selecting investments, monitoring performance, adjusting allocations, and managing risk to achieve specific investment objectives.
Any portfolio, whether real estate or something else, should have periodic reviews to ensure it is diversified and meets the investment criteria and objectives.
Check out Disrupt’s portfolio!
As Your Knowledge Grows, You Can Invest with Confidence
Like any other industry, real estate has its own jargon. Fortunately, the terms in real estate tend not to be too complicated overall. Many of these concepts are acronyms and shorthand, and once you learn them, you’ll be able to read any prospectus and compare different investment opportunities. With these nine real estate terms, you’ll start to understand what these opportunities are offering, and you can then invest with confidence.
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