5 Real Estate Investment Terms You Should Know
Real estate investors have their own set of lingo that you will not hear anywhere else in life. If you are thinking of investing in real estate it’s best you familiarize yourself with some of the basic terms. Here are five basic real estate investing terms to get you started.
1. Net Operating Income (NOI)
NOI tells you how much money a property would make you each year if you owned it free and clear (without a mortgage). The formula for NOI is very simple.
NOI= net rental income minus operating expenses.
- Net rental income is the total rent you collect from the property in a year
- Operating expenses includes every expense your property incurs during the year such as maintenance, insurance, property tax, legal costs. It does not include any costs associated with the mortgage.
Why do we care about NOI? on its own NOI is not very useful but it’s critical to understand NOI to understand our second term.
2. Capitalization Rate AKA “Cap Rate”
Cap rates are used to help establish a value for income producing multi-family real estate properties. Like NOI, the formula for a cap rate is relatively simple.
Cap Rate= NOI divided by the sale price of the property
If a small apartment building has $10,000 in NOI and sells for $100,000 its cap rate would be 10%.
Why do we care about Cap rates? Cap rates are useful to help evaluate a potential real estate investment. Using the income approach to value real state investments the value is equal to the NOI divided by the cap rate.
In the above example, the small apartment building had $10,000 in NOI, a Cap rate of 10% and a sale value of $100,000.
But if comparable apartment buildings in the same neighborhood have a cap rate of 8% then this is the Cap rate we use to value the property. Using a cap rate of 8% rather than 10% would value this property at $125,000 (8%/$10,000). Whoever bought the property for $100,000 got the property for $25,000 less than it’s worth.
3. The 1% Rule
The 1% rule is a rule of thumb to help give an idea of whether or not a real estate investment property is likely to provide positive cash flow or not. For a property to meet the 1% rule it needs to generate a monthly income of at least 1% of the purchase price.
For a property listed at $100,000 to meet the 1% rule, it would need to generate at least $1,000 per month in rent.
Why do we care about the 1% Rule? The name of the game in real estate is cash flow. If you want to ensure you make money investing in real estate you will want to ensure that you bring in more in rent then you spend on costs.
While NOI and Cap rates are a much more precise way to value real estate investments they require you to have all of the detailed revenue and expense numbers associated with the property. If you don’t have that information handy, the 1% rule can give you a ballpark estimate if the property is likely to have a positive cash flow.
Put simply, amortization tells you when your mortgage will be paid off given your current interest rate and mortgage payment. If you hear someone say “I have a 25-year amortization” They are saying that their mortgage is scheduled to be paid off in 25 years.
Why do we care about amortization? Who wouldn’t want to know when you will be able to pay your mortgage off? If you want to speed up the time frame for when you own your house free and clear you have one of two options.
The first would be to refinance your mortgage for a lower interest rate (if you can get one) and maintain your current payment.
The second would be increasing your mortgage payments above what you are currently paying (assuming you maintain your current interest rate).
Both of these would increase the amount of principal being paid off the mortgage each month which results in a reduced amortization.
5. After Repair Value (ARV)
The after repair value of a property tells us what the value of the property will be worth after all of the rehab and renovations are complete.
Why do we care about after repair value? There is a reason that savvy real estate investors look for “fixer-uppers”. The price a property (especially single-family properties) will sell for is greatly reduced if it is in rough shape.
Most people want a property that is “move-in ready”. A house that needs a new furnace, a new roof, new windows and hasn’t had a kitchen remodel in 40 years will not be able to sell for as much money as the house next door that looks like it’s straight out of an HGTV show.
If we know (from comparable properties) tho at the ARV of a property is $300,000 and the house would require $50,000 worth of work to realize that ARV, the most we should want to pay for that property is $250,000.
While ARV is an important term for all real estate investors to know, it is most important for house flippers. If a house flipper is incorrect in estimating the ARV of a property or the cost to rehab the property, their profits can go out the window.
A house flipper might buy a property with an ARV of $500,000 for $350,000 if they think the rehab costs are $100,000. This would allow them to sell the property for a $50,000 profit. If the rehab ends up costing $200,000 they would experience a $50,000 loss.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information presented will be accurate. Consult a financial professional before making any major financial decisions.