5 Essential Financial Terms Every Single-Family Real Estate Investor Should Know
These basic metrics are key to calculating your potential for success.
Don't invest in real estate without understanding key details like the cash flow, cap rate and gross yield of the property.(iStockPhoto)
When it comes to handling your real estate investments, the words from U.S. businessman Peter Lynch consistently ring true: “Know what you own, and know why you own it.”
The internet and big data have been critical in making that sentiment a reality. It may have been nearly two decades in the making, but no stone has been left unturned when it comes to how these two technologies have transformed real estate and real estate investing. So much of what you need to know — which used to take many hours and resources to cull and analyze — is now at the touch of a keystroke.
Whether you’re buying your first investment property or your 50th, understanding the critical areas of research that seasoned investors use every day can help you make a more sound financial decision.
Here is where you should start. The truth is that a real estate investment is only as good as the numbers you’ve crunched. The good news is that there are websites that can do a lot of the heavy lifting for you. It’s also important to remember that there are a lot of nuances to real estate investing.
For example: Investors looking to invest in single-family properties in California should be more focused on home price appreciation potential than yield, since prices have increased faster in California than in most states. Markets in the Midwest, on the other hand, tend to offer low appreciation potential but great yields.
Investors should ask themselves if they're looking for an annuity – an investment that steadily pays out over time – a quick pop in value or a market that straddles both yield and appreciation.
Answering fundamental questions like these will help you decide which measure of return on investment matters most to you and, in turn, which market is right for you. But before you can even start to evaluate what you want from your investment, you need to know these five essential real estate financial terms.
Cash flow. In its most basic definition, this is the money going into and out of a business – and your investment is your business. Cash flow shows how liquid, or flush, your investment is during a given period and, therefore, helps you determine if you will be able to pay the expenses associated with owning the property.
Cash flow = gross income – operating expenses
Capitalization (or cap) rate. The cap rate is a ratio converted into a percentage showing the relationship between the cost of property and the income the property produces after expenses. It’s how you calculate the potential percentage return on your investment. A commonly used example: If you invest $1 million and the net operating income is $100,000 annually, then the cap rate on this investment is 10 percent.
Capitalization rate = annual net operating income / cost
Cash-on-cash return. This is a similar calculation to cap rate, but you divide the annual before-tax cash flow by the total cash invested. The important thing to note is that the cash-on-cash return takes into account the financing that may have been leveraged to secure the property. Both cap rate and cash-on-cash are important equations when evaluating an investment property.
Gross yield. Yield is a fancy way of saying how much money your property will produce, and is calculated by dividing the total annual projected gross income by the total current property price. This calculation doesn’t take into account valuation changes or taxes, but it gives you a good benchmark for how your property will perform.
Gross yield = gross income / cost of investment
Depreciation and appreciation. Examining how a property’s value has increased or decreased is not only imperative but fundamental to the investing process. This, however, is last on the list for good reason. You should never look at valuation in a vacuum without the other data points. Basing an investment decision on potential appreciation is speculative in nature and carries with it a higher amount of risk than investing on in-place income.
The truth is that nobody has the secret formula for successfully investing in real estate, but brushing up on your financial literacy, digging deep into local market dynamics and understanding property-specific fees, such as taxes and insurance, can give you an advantage in the real estate game.
Additionally, today’s investor has access to unprecedented technology, data and tools to make easier and more informed buying decisions, so why not use them to your advantage?