It’s very important to “talk the talk” when investing in real estate to maximize your successes. While you’re likely surrounding yourself with smart, knowledgeable industry advisors, real estate investing remains a “hands on” endeavor. Even if you have an experienced team managing your day-to-day operations and advising on your investments, you still need to understand the key terminology so you can lead this team of smart advisors down the path you want to take.
There are some critical terms that are very important to anyone – including your bank – analyzing the performance of your building. These basic concepts include accounting terminology and performance metrics associated with the building.
Some key terms that you should understand include:
- Net operating income (NOI) – Put simply, your net operating income is your revenue minus your expenses. Brought into the real estate arena, this means your total rent collected (actual collections less vacancies) minus your expenses.
- Vacancies – This refers to your loss of income as a result of having empty units in your building. It’s important to understand what your local and regional vacancy rates are. For example, my office maintained an average vacancy rate of 4% for 2013. So, if you own a 10-unit building with an average rent of $800.00 per month, your vacancy loss for the year would be $3,840.00 (10 units x $800.00/month x 12 months = $96,000.00/year. 4% of $96,000.00 equates to $3,840.00). It’s important to calculate this figure when determining your building’s potential profitability.
- Debt service – Your debt service is essentially your annualized mortgage payments (principal and interest).
- Debt service coverage ratio (DSCR) – This is a very important bank ratio, and all banks will look at this number before awarding any mortgage. The DSCR is the amount of cash left over to pay a mortgage after all expenses have been paid. The bank wants to understand how secure their position is. In other words, they want to know how much money is coming into your building, less the expenses – vs. how much you’ll owe them – to determine whether your project is a wise investment for them. This formula is your net operating income (NOI) over your debt service.
- Cap rate – More formally referred to as your capitalization rate, the cap rate is your overall return on investment by getting involved in a particular building. Its formula is your NOI over your purchase price.
- Cash-on-cash return – This is the return on the amount of cash you put into the investment. Through the power of leverage, you only need a down payment of 20%, so this is the amount of return you’d get on that down payment. The formula is your cash flow divided by your down payment.
In future blogs, we’ll explore additional real estate terminology to help you feel – and sound! – more knowledgeable and confident when discussing all aspects of your real estate investments.