Real Estate Investing Terminology 101
Dr. Joel J. Napeñas
10 minute read
Most, when introduced to investing in real estate think about investing in terms of one aspect only, appreciation. Whatever it is your personal home, a piece of land, or a second home, you buy on the hope that ‘one day, this (insert here…. house, land, building) will go up in value and be worth a lot more than it is now.’ However, there are a number of different factors when determining whether your investment will be a good one.
Here we go over the different terms to evaluate an investment. These can and should be applied in properties of all sizes and types, or whether you are buying directly or investing passively in a syndication or fund.
Market appreciation
As mentioned above, this is the measure most go by in handicapping whether their investment or purchase will be a good one. The problem is, it is also the least predictable one, and the one that you have the least control over.
Appreciation is the increase in value of the property over time. Value of things go up based on supply and demand, with decreased supply and increased demand driving up the value of the property. Things that increase demand are:
- attractiveness of the property due to: 1. location (proximity to jobs or amenities) and 2. aesthetics and characteristics of the property
- economic factors such as:
- income growth for buyers and investors due to jobs and increased business activity
- costs of borrowing – lower interest rates make borrowing less expensive therefore making it more accessible to all
With respect to supply, at the time of this writing, there is a general undersupply of housing units for purchase and for rent. In markets where there is an influx of migration to the areas due to the factors mentioned above, supply constraints and increased demand further increase the value of the properties in this manner.
Forced Appreciation
This is where you have control and can increase the value of your property. There are two main ways to do this:
- Make the property more attractive
This is the way that most know how to force appreciation. In the case of your personal home, you decide that you want to renovate your kitchen and bathroom to make it look nicer, and ultimately more attractive to a prospective buyer when the time comes to sell it. This is also the main premise of ‘flippers’ in which they buy a property at a desirable location, make it more attractive, and sell it for a higher price that, hopefully is more than the cost of doing the renovations so they can make a profit.
- Make the property more profitable
If you own a property and it generates income in the form of rent, you want to find ways to make it more profitable by either increasing revenues or decreasing expenses. One main way of increasing revenues is by making the property more attractive and thus increasing rents. A main way to reduce expenses is to decrease utility bills on the property by making it energy efficient or conserving water.
Net operating income (NOI)
This is a calculation of profits that the property makes if you were to purchase the property outright with cash (i.e.: did not take a mortgage on the property). The NOI is calculated by taking the revenues and subtracting all expenses (e.g.: taxes, insurance, maintenance, repairs and improvements) but not including the mortgage. This value is especially important in determining the value of commercial grade properties, which include larger multifamily properties.
Cash on Cash
If a property is generating income during the time of ownership, the income generated is expressed as a cash on cash return.
Cash on cash is the amount of annual income as a percentage of the total investment into the property. This is not to be mistaken with the income as a percentage of the purchase price of the property.
So as an example, let’s say that you purchased a property for $200,000 with a 25% down payment, which had $4000 in closing costs and $16,000 in renovations. Your initial investment in the property is $70,000 ($50,000 down payment + $4000 closing costs + $16,000 renovations). The cash flow is determined by the revenue generated from rents minus all the expenses (e.g.: mortgage payments, insurance, taxes, maintenance, utilities). If the property cash flowed $7000 a year (about $584 a month) you would have a cash on cash return of 10%.
In today’s market (at the time of writing), a good cash on cash return is anything above 6%. If you were to compare this to ownership of a publicly traded equity (e.g.: a stock), this would be a dividend. How many publicly traded stocks you own pay a dividend of greater than 6%?
Cap rate
The Capitalization rate, which is well known as the ‘cap rate’ is the rate of return that is expected to be generated on a real estate investment property if you were to by the property in cash (i.e.: without taking a loan to purchase the property). The cap rate is calculated by dividing a property’s net operating income by the current market value. Therefore, the lower the cap rate, the more expensive the property is, and conversely the higher the cap rate, the lower the value of the property.
For instance, using the example of a $200,000 property, if the net operating income is $10,000, then its cap rate is 5% ($10,000 divided by $200,000).
Two main factors that determine the cap rate are:
- The type of property – Less desirable properties have higher cap rates. So for instance an older property that houses lower income tenants would have a higher cap rate than a brand new luxury apartment building.
- The market conditions – In a hot real estate market, cap rates decrease due to the increased demand for properties and resultant increase valuations of properties. Market conditions can be affected by: the overall economy, the city, and the neighborhood. Cities where there is tremendous demand such as Phoenix or Austin would have lower cap rates than ones where there is less demand, like Detroit or Cleveland.
In the case of stocks, the cap rate can be compared to the price to earnings ratio, by taking its inverse (i.e.: earnings per share divided by the price of each share). With current market cap rates at 5%, this translates to a price to earnings ratio of 20. (For comparison, the price to earnings ratio of Apple at the time of writing is 27.15).
Equity multiple
The equity multiple is the expected or achieved total return on an initial investment. This is calculated by taking the original principal invested and adding the total cash flow generated plus the profits you made on the sale of the property, divided by the amount you initially invested to purchase the property.
So let’s go back to the example of the property mentioned above. You had placed $70,000 total to purchase the $200,000 property, and it generated $7000 of cash annually, and you sold it after 5 years at $318,000. Assuming that the real estate agent takes 6% of commission ($18,000), you made a profit of $100,000 on sale.
Therefore, your total return is the total annual cash flow of $35,000 ($7000 multiplied by 5) plus $100,000 for a total of $135,000. In this case, your equity multiple would be 1.93, which is the achieved total return of $135,000 divided by the initial $70,000 investment. In other words, your total return was 193%, which comprises your original investment (100%) plus the 93% percent return on investment.
So in the case of stocks, if you bought a stock at $5 and sold it at $50, you ‘10x ed’ your investment, which would be the equivalent of an equity multiple of 10.
Average Annual Return (AAR)
The average annual return is the total return you get on your investment over a period of time divided by the number of years. Another term used is the return on investment (ROI).
Using the example above, if you took the 93% return on investment and divided it by the number of years (5 years) then the average annual return is 18.6%.
Internal Rate of Return (IRR)
This is a more complicated measure of return of your investment, which factors in the time preference and value of your investment. Money that is returned earlier on in the investment is worth more than money received later in the investment because it can be used and reinvested to generate greater returns.
Using the example above, let’s say that we had two properties that both generated a total return of $135,000, which included an average annual cash flow of $7000. However what if one property had $7000 consistently in all five years, whereas the other one had no cash flow the first year, but more cash flow in the subsequent years that add up to a total of $35,000 over the five years. While both gave you the same total cash flow and ARR over the 5 years, the one that gave you cash return earlier has a higher IRR than the other one, because your cash flow was in hand earlier on in the investment cycle.
Discussion
Valuation of residential vs. commercial properties
The value of single family and smaller multifamily properties (e.g.: residential properties) are based on market conditions, and are generally not valued based on net operating income and cap rates. Values are based on comparables of similar properties in the area and are at the mercy of market conditions and its fluctuations that are beyond your control. Because of the greater frequency and availability of smaller properties to the retail buyer, there is much more volatility. While one can force appreciation on such a property mostly by improving its aesthetics and characteristics, increasing the NOI does not predictably increase its value.
On the other hand, commercial grade properties (which include larger multifamily properties of greater than 4 units) are valued strictly on the NOI and Cap rates. Therefore one can predictably calculate and raise the value of their property when increasing the NOI.
At the current market cap rates of 5%, for every dollar you raise your NOI in that year, you are increasing the value of the property by $20. Cap rates are at the mercy of general market conditions, however their fluctuations are not as volatile as that of smaller properties. At the height of the global financial crisis of 2008, cap rates for apartments were at a high of 7% compared to the 5% cap rates of today.
Conclusions
Whether you are actively or passively investing, and whether its a single family home, short term rental, a medical office building, or apartment building, knowing the basic terminology of investing in real estate will help you understand the ways in which you can evaluate a prospective investment and its performance.
Having a better understanding will help you make better investing decisions and minimize risks.
Happy investing!
Dr. Napeñas, a practicing academic dental specialist in Oral Medicine, is founder and managing partner of 5DH Partners, a real estate investing firm that educates and helps dentists and other professionals generate passive income and build wealth through investing in real estate.
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