Every industry has its share of jargon and acronyms, and real estate is certainly no exception. This can be intimidating to property investing newbies, so we’re breaking down some common real estate investing terms in a reader-friendly glossary.
Check out our list of real estate investment terms every investor should know and add some new lingo to your lexicon. If there’s anything else you’d like to see on this list, Tweet us @Roofstock or drop us a note in the comments section.
Term: Cap Rate
Definition: Capitalization rate, or cap rate for short, is used to measure the annual rate of return on a real estate investment based on the profit that property is expected to generate. Simply put, it’s the ratio between the net operating income (NOI) and purchase price. Cap rate is calculated by dividing net operating income (NOI) in the first year by the property purchase price. (NOI excludes loan costs if you used financing).
Example: Say you purchase a property for $150,000. The expected NOI in the first year is $12,000.
$12,000/$150,000 = 0.08
Cap rate: 8%
Why it matters: Cap rate is one piece of the puzzle to include when evaluating an investment property. Lower-yielding properties tend to be safer investments, while higher-yielding homes typically come with a little more risk. Both types of properties potentially have a place in your rental portfolio—it's just a matter of why you're investing in rental income properties and what you hope to achieve. Are you looking for higher monthly cash flow, more stability, or something in between? In theory, cap rates can signify varying levels of risk. Higher cap rates may correlate to a higher amount of risk in the purchase, and vice versa. At Roofstock, our marketplace features properties with a variety of cap rates that generally range from 3%-12%.
Term: Net Operating Income
Definition: Net operating income (NOI) is a measure of a real estate investment property’s potential to be profitable. It’s calculated by estimating the property’s revenue and subtracting all operating expenses such as repairs, maintenance, property taxes, HOA fees, etc. NOI does not include mortgage payments.
Why it matters: NOI allows you to analyze properties of all different types without looking at financing terms. NOI is also required to calculate cap rate.
Revenue - all reasonably necessary operating expenses = NOI
Term: Cash Flow
Definition: Cash flow is the amount of money you can pocket at the end of each month, after all operating expenses (including loan payments) have been paid. If you spend less money than you earn, your cash flow will be positive. If you spend more money than you earn, your cash flow will be negative.
Rental income - all operating expenses (including loan payments) = Cash flow
Why it matters: Consistent monthly rental income is one of the most appealing reasons to invest in real estate. Ideally, an investment property should be cash-flow positive. This means rent is higher than the monthly mortgage, which provides a steady stream of passive income. This passive income can go toward maintenance expenses, the down payment on another investment property, or a savings account.
Term: Cash-on-Cash Return
Definition: This figure is the ratio of annual pre-tax cash flow to the total amount of cash invested, expressed as a percentage. Cash-on-cash return measures the yearly return in relation to how much money you put down. It doesn’t take into consideration some of the other benefits of rental property ownership, including appreciation, loan paydown, depreciation and other tax benefits. Whereas calculations based on standard ROI take into account the total return on an investment, cash-on-cash return only measures the return on the actual cash invested. It’s the cash you’ve got left after one year, divided by the cash you’ve invested.
Annual pre-tax cash flow / actual cash invested = Cash-on-cash return
Why it matters: Cash-on-cash return is one way to analyze an investment by focusing on returns based on the actual cash invested. It also helps you understand the effects of leverage, and what your cash-on-cash return would look like if using a mortgage loan to finance part of the investment.
Definition: CapEx, or Capital Expenditures, are defined as new purchases or major improvements/renovations that extend the life of a property, such as replacing a roof, adding an extension or finishing the basement. This term also covers equipment and supplies required to make these improvements. Generally these are one-time, major expenses. Think of it this way: Routinely re-painting your rental home after tenants move out is not a capital expenditure. Installing a new furnace is. Tip: All Roofstock Certified investment properties include full inspection reports with estimated turn costs so buyers can be aware of these expenditures up front.
Why it matters: Most parts of a house will eventually need replacing. Though the big-ticket items may only be needed every 20 years, it’s important to know there will come a time where you have to pay $1,200 to replace a bathroom floor, or $4,500-$10,000 to replace the roof. Just remember—these repairs/improvements ultimately extend the overall life and value of your investment property.
Tip: When it comes to taxes, capital expenditures and routine maintenance are deducted differently. While major improvements and upgrades are recovered through depreciation, general fixes or maintenance that keep a rental home in good operating condition are classified as “repairs” and can be written off in a single tax year.
Term: 1031 Exchange
Definition: When you sell an investment property, you’ll likely have to pay some hefty capital gains taxes at the time of the sale. However, under Section 1031 of the U.S. Internal Revenue Code, a taxpayer may defer (pay at a later date) capital gains and related federal income tax liability on the exchange of certain types of property. To put it in layman’s terms, that means you can pay taxes on the income from the sale of a property at a later date if you take that money and put it towards purchasing another property or portfolio of properties of equal or higher value.
“Some of the most astute real estate investors have executed a 1031 exchange for a single-family home in a highly appreciated market such as California in order to purchase a portfolio of rental properties with lower volatility, more affordability and/or better cash flow in another market, which can generate greater returns over time.” - Ted Farry, President of Conatus Real Estate
Why it matters: If you’re primarily investing in single-family rental properties, the 1031 exchange gives you a lot of flexibility to buy and sell assets without having to worry about being taxed at the point of every sale. This gives you more purchasing power to scale your real estate investment portfolio.
Term: HOA fees
Definition: A homeowner's association is an organization that creates and enforces rules for the properties located in a subdivision, community or condominium. Purchasing property within an HOA's jurisdiction means you automatically become a member and are required to pay monthly HOA fees to assist with maintaining and improving properties within the association.
Why it matters: When evaluating rental investment properties for purchase, it’s important to know if there will be HOA fees since these cut into cash flow and may need to be factored into your rental rates. Be sure to ask what the HOA fees cover and how they compare to other HOA fees in the area.
Tip: Roofstock provides property details and financial information upfront for all of the properties listed on its marketplace, including HOA information (when applicable).
Term: Gross Rental Yield
Definition: Gross rental yield is the total income generated by a property, divided by the price paid for the property and associated closing costs. This is what you get before deducting operating costs (maintenance, property management, insurance, HOA fees, etc).
Why it matters: Gross rental yield provides investors with a quick reference for an annualized return on an investment.
Monthly rent x 12 / purchase price and associated closing costs = Gross yield
Definition: Appreciation is an increase in the value of an asset over time. The increase can occur for a number of reasons, including increased demand or weakening supply, or as a result inflation or interest rate fluctuations. This is the opposite of depreciation, which is a decrease in the value of an asset over time.
Why it matters: Like a property’s cap rate, appreciation is an important piece of the puzzle when evaluating the overall appeal of an investment property. As the market value of your rental increases, so does ROI.
Tip: The Roofstock marketplace makes it easy to view expected appreciation over time for any property.
Term: Adjustable Rate Mortgage (ARM)
Definition: An adjustable rate mortgage (ARM) is a mortgage that does not have a fixed interest rate. Rather, an ARM can change monthly throughout the life of the loan based on the benchmark interest rate, which fluctuates based on capital market conditions. The initial interest rate is typically fixed for the first few years and then resets periodically.
Why it matters: As an investor, you need to know what your potential risks are. With an ARM, your monthly mortgage payments could increase or decrease depending on market conditions.
Term: Fixed-Rate Mortgage
Definition: A fixed-rate mortgage is a mortgage loan that has a predefined interest rate for the entire term of the loan that never changes. The monthly payment for a fixed-rate mortgage is the amount that needs to be paid by the borrower every month to ensure the loan is paid off in full with interest at the end of its term.
Why it matters: Fixed-rate mortgages are appealing because monthly mortgage payments stay the same, which makes budgeting and planning for future investments a little easier.
Definition: Equity is the difference between the current market value of the property and the amount that you (the owner) owe on the property’s mortgage. If you were to sell your investment property, the equity would be the money you receive after paying off the mortgage in full. This value can build up over time as the mortgage balance declines and the market value of the property appreciates.
Why it matters: Building home equity is a great strategy for building long-term wealth. At some point you’ll want to tap into your home equity, whether it’s to fund your retirement, upgrade to a different home, help pay for a major life event, etc. The long and short, this number is your friend and you want it to be growing.
Term: Turnkey Property
Definition: A turnkey property is a home or apartment that is completely, or very close to move-in ready.
Why it matters: Turnkey properties are appealing from an investment standpoint since investors can purchase a property and rent it out immediately without making any major repairs. Even if there are some improvements that need to be made at some point, investors can start earning rental income right away as long as the property is move-in ready, It goes without saying: Do your research before buying a property from a turnkey provider. Read reviews, comb through case studies, and look for as much due diligence up front as possible.
>>Related: See how real estate investing gives Roofstock investor Lenny Hu the freedom to choose jobs he likes doing, rather than the jobs that pay him the most.
Term: Capital Gains Tax
Definition: Capital gain or loss is the difference in the value of a property compared to its purchase price. If there is a gain, it is realized after the asset is sold. A short-term capital gain is one year or less; a long-term gain is more than a year. Both must be claimed on your income taxes, but short-term capital gains have a higher tax rate than long-term capital gains.
Why it matters: Understanding how your real estate investments are taxed is important if you’re looking to optimize performance and returns.
>>Relate: Tax Tips For Real Estate Investors
Term: Debt-to-Equity Ratio
Definition: In real estate, debt-to-equity (D/E) ratio is a measure of ownership. This ratio helps you determine how much of your property is actually yours (if you took out a mortgage to finance it) and how much you owe in debt.
Why it matters: This is important because it paints a more holistic picture of your investment. It tells you how much capital you have invested and how much you owe, which gives you a rough idea of how much you’ll walk away with when you decide to sell. It also matters if you’re looking to refinance your investment property or borrow against it with a home equity line of credit, as lenders will consider your debt-to-equity ratio as a measure of creditworthiness.
Definition: Escrow is when an impartial third party holds on to something of value during a transaction. When you make an offer on a property, you will pay a portion of the down payment ahead of time. This payment will be held by an impartial third party in a separate bank account until the contract has been negotiated and the deal has been closed.
Why it matters: Escrow helps remove risk from transactions for both parties. The escrow agent holds the money exchanged in a purchase until all agreed upon conditions between the buyer and seller are met. Once these are completed, escrow funds are released to the seller.
Term: Closing Costs
Definition: Closing costs are the fees paid at the end of a real estate transaction. These fees vary depending on where you live, the property you buy, and the type of loan you choose. There are costs associated with inspections, transfer of title, loan origination fees, etc.
Why it matters: It’s important to budget accordingly for your closing fees so you have enough cash on hand at the time of purchase. Home buyers will typically pay between 2%-5% of the purchase price of the home in closing fees.
Term: Internal Rate of Return (IRR)
Definition: This is a common term you’ll see when browsing real estate investments or crowdfunding websites. The internal rate of return (IRR) is a measurement of a property’s long-term profitability that takes into account the annual net cash flow and the change in equity over time.
Why it matters: IRR is the single best estimate of your asset’s performance over the entire time that you plan to hold it. It allows you to evaluate investments that may have different cash flows or appreciation potential.
Term: Inspection Contingency
Definition: An inspection contingency is a term in the purchase agreement that lets the buyer:
- Hire a home inspector to look at the home
- Receive a report from the inspector on the home’s condition and issues
- Negotiate a sharing of the new costs with the seller or terminate the purchase agreement and get their earnest money deposit back
Why it matters: The inspection contingency contains a termination date which the buyer must adhere to. The buyer must have the inspection completed, review the report and negotiate with the seller on the next steps within this agreed upon timeframe. If the termination date passes and the buyer has not terminated the agreement or come to an agreement with the seller, the buyer must continue based on the terms in the initial purchase agreement.
This is a growing list and we’ll continue to add to it! If you have a term you’d like us to address, be sure to let us know in the comments or Tweet us @Roofstock.