Real estate investing can look a little different for each investor. Your investment approach will be unique to you, based on your specific goals, values and lifestyle. Some investors want to oversee a large portfolio of properties, while some investors may want to own only one rental property. No matter where you are in your investment journey, there are some common terms you’ll need to know.
Whether you’re a new or experienced real estate investor, making sure you have a clear understanding of key investment terms is important. We’re breaking down 5 commonly used investment terms to help you level up your understanding of real estate investing. These terms are used to help you analyze and assess investment opportunities.
In the context of real estate investing, appraisal means the determination of the value of a property. An appraisal is done by a licensed professional who follows a set of predetermined criteria to evaluate the estimated market value of the property.
Appraisers use three main methods: (1) income approach, (2) direct comparison, and (3) cost-up approach.
The direct comparison method involves evaluating factors like location, size, and condition, considering sale prices of similar properties. The income approach uses financial metrics of comparable properties. Lastly, the cost-up approach involves appraising a property’s value based on its construction cost, providing a fundamental perspective on the replacement value of the asset. These methods provide an objective benchmark for the property’s market value, helping buyers and sellers make informed decisions about transactions.
For smaller properties like single-family homes up to four-plexes, the direct comparison method is typically considered primary, complemented by the income approach if applicable. Meanwhile, in the realm of commercial properties, which includes all commercial properties, including those with five or more residential units, the income approach takes precedence as the primary method, supported by the direct comparison method. The cost-up approach is often employed when the other two methods face practical challenges.
In transactions involving lenders, appraisers bear a heightened responsibility, particularly when a reliance letter is utilized. This underscores the critical importance of implementing thorough and accurate appraisal methods to ensure a comprehensive evaluation of property values in real estate transactions.
Net operating income (NOI) is calculated by subtracting the property’s operating expenses from its gross operating income (or gross revenue). NOI is often used as a key financial indicator in determining the profitability of a rental property and ultimately the value of the building.
NOI provides a more accurate picture of the property’s profitability because it focuses on the income generated after accounting for the costs of its operation. To put it simply, NOI helps assess a property’s viability as an investment by considering the potential income stream, as well as its ability to cover operating costs.
Capitalization rate or as it’s more commonly known as, cap rate, is calculated by dividing the property’s NOI by its current market value or acquisition cost. This value is then multiplied by 100 to be expressed as a percentage. The cap rate is a great tool for comparing different investment opportunities because it can be used by investors to assess the potential return on each of the investment properties in question.
As a rule of thumb, a high cap rate indicates the possibility of a higher return on investment. However, it’s important to note that it may also indicate higher risk or lower property value. On the other hand, a lower cap rate can suggest a lower return on investment but could also indicate lower risk or higher property value.
Use of a cap-rate when combined with the NOI will allow you to determine the value of the property.
Debt service refers to the repayment of the principal amount and interest on a loan (usually a mortgage) used to finance the purchase of a property. Debt service is expressed as an annual amount and is calculated based on the terms of the loan — including the interest rate, loan amount, and the term. Debt service represents the payments made over the term of the loan.
Debt service is an important factor to consider to ensure that a property’s NOI is sufficient to cover these payments. When the debt service is high compared to the NOI, it can cause cash flow challenges over time. Ideally, you want your property’s income to exceed your debt service for maximum profitability.
This is a metric often used by lenders to determine how much money they are prepared to lend you for a specific property.
A term you’ll hear often in real estate investing is due diligence. Due diligence means the research or investigation done by investors when considering an investment opportunity. Doing your due diligence can include researching many different factors like the local real estate market, comparable properties, and local regulatory requirements, as well as conducting a thorough financial evaluation or property inspection.
The due diligence process will vary for each investor, depending on the type of real estate investment, the specific features of the property and your specific investment goals. Many investors choose to enlist the help of professionals like an accountant, property inspector or financial advisor during this process.
No matter where you are in your real estate investment journey, knowledge is your biggest asset. Understanding key terms like the ones we’ve explored here will help you gain confidence in assessing investment opportunities and help you make educated investing decisions.
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