Real estate investing is a fast paced and continually evolving speciality. The first step to meeting your goals is getting a feel for the playing field. Let’s start with a few key terms and why they matter. (And no, they’re not in alphabetical order! Understanding one term helps you understand the next.)
Net Operating Income.
NOI is a measure of a property’s potential to turn a profit. You estimate your revenue and subtract all operating expenses (e.g. maintenance, repairs, taxes, HOA fees – but not mortgage payments). You need the NOI to figure out the cap rate (below), but it also enables you to evaluate properties with more accuracy.
Cap rate measures the annual rate of return on an investment. It is expressed as the ratio between net operating income and purchase price. Let’s say you purchase a property for $200,000 and expect an NOI of $15,000. You divide $15,000/$200,000 = 0.075. Your cap rate, then, is 7.5%.
Higher cap rates are generally associated with higher levels of risk, while lower cap rates correspond with lower levels of risk. This doesn’t mean you should avoid properties with a higher cap rate: it just means you have to ensure that they fit your strategy (e.g. to boost cash flow while sacrificing a bit of stability).
This is the amount of money you clear at the end of the month after you’ve taken care of operating expenses and loan payments. Positive cash flow is, as you’d expect, when you spend less than you make, while negative cash flow is when you spend more than you make.
Consistent positive cash flow is essential for real estate investors: it provides a steady stream of passive income.
If you took out a mortgage, your D/E allows you to determine how much of your real estate property is yours and how much you still owe in debt. This is a good metric to know because it gives you a more full picture of your investment and what you can reasonably expect to gain if/when you sell. It is also important in that it can help with refinancing or securing a line of credit.
Internal Rate of Return.
The IRR measures the property’s long-term profitability. It encompasses the annual net cash flow and equity changes over time. This gives you an accurate estimate of how your investment will perform over the period of time you hold it.
Capital Gains Tax.
Capital gains influence how your investment is taxed. A gain is an increase in value compared to its purchase price (a loss, therefore, is a decrease in value compared to purchase price) after you sell the asset. This is considered income and you must claim it on your taxes. A short-term capital gain (a year or less) is taxed more heavily than long-term capital gains. Knowing this can influence your investment decisions.
See, you needed to know about capital gains to understand 1031 exchange! When you sell an investment property, you’ll likely have to contend with some significant capital gains taxes. But according to Section 1031 of the US Internal Revenue Code, you can defer this payment if you take that money and use it to purchase another property or properties of equal or higher value.
These real estate investment terms are just the beginning! There is a lot to learn; if you need help, contact the experts at USREEB.