Equity - The difference between what is owed on the property and what the property is worth if you sold it. An example: You owe 80,000 and could sell the property for 100,000. You have 20,000 in equity (though you’d need to consider the costs to sell, too). Equity builds net worth, which is the difference between what your assets are worth and what you owe on them, whether real estate, stocks, businesses, etc.
Loan-to-Value - Banks, private, and hard-money lenders all have rules on how much they will lend you based on what the property’s value is. Most of the time, lenders will loan around 70% loan-to-value. Which is just a little fancier way of saying they’ll loan up to 70% of what the property is worth. 70k for a 100k property, for instance.
Cash Flow - The actual cash profits (monthly, annually, however you calculate) from a rental property. Gross rental income less all expenses (including % for vacancy, maintenance) = cash flow. Cash flow IS the reason you can make smart buys in acquiring rental real estate and retire early.
Return on Investment - There are several ways to calculate Return on Investment, including cash-on-cash, internal rate of return, and more. To put it simply, if you have 100,000 into a fix and flip and take home 125,000 when you sell, you will have made 25,000 on your 100,000, which is a 25% return on investment.
Cash-on-Cash ROI - Is more specific and, we think, a more important number to know for a potential investment. If you take the same fix and flip above and you used 70% Loan-to-Value, you would have had 30k of your own cash into that deal, using 70k from a lender. When you sold, you would have profited 25k. BUT your cash-on-cash ROI was MUCH larger. 25K (profit) / 30k (total cash invested) = 83% CoC ROI. Good stuff!
Gross Income – Usually in reference to rentals in real estate investment – is the Gross Rents (before any expenses are deducted). If your duplex units rent for $900 and $800, your gross rental income is $1700.
Operating Expenses - Are the costs to hold the property. With rental properties, that might mean water, sewer, garbage, landscaping, taxes, insurance, mortgage, HOA, and more. With flips (they’d really be called holding costs), that might be loan payments, utilities, insurance, taxes.
Capital Expenditures (CapEx) - Are improvements to rental property. Things like flooring, new cabinets, fixtures, etc. Not general maintenance. A lot of investors hold 5% of gross rents for CapEx. We don’t, because ours are 100% renovated before we rent them out. We opt for a healthier 7.5% maintenance hold.
Vacancy Rate - Like CapEx or maintenance holds, vacancy rate is a % of the gross rents that you hold aside (or just leave in the rental account) to account for moments of vacancy in your rental property. We basically have 0% vacancy, but we still use 7.5% vacancy, which is slightly less than 1 month a year/unit. It hasn’t happened yet, but it’s a good rule of thumb to help ensure positive cashflow always.
Net Operating Income (NOI) - is Gross Rents less Operating Expenses (NOT INCLUDING MORTGAGE). With investment properties (aka rentals), people use NOI to determine market value. You take NOI divided by capitalization rate (see below, market-dependent) to reach market value for the property.
Capitalization Rate - is the property’s Net Operating Income (NOI) divided by its market value. If the property has an NOI of 10,000/year and the market value is 100,000 – that’d be a 10% capitalization rate (10 years to “make” the value of the property). Capitalization rates vary by location and investment class. If the property is in a more desirable location with more upside, perhaps perceived as more stable, the going cap rate will be lower – maybe 4-5% - meaning folks investing there will expect a full return on their purchase price in 20+ years. Properties in B and C investment areas – like Grays Harbor County, where we live – might experience 8-12% cap rates. A little riskier, a little more work (they say, but so far not so much), but potential for your money to go a lot further, faster.
Debt Coverage Ratio (DCR)- is what banks look at when considering lending on your project. It’s also not a bad criterion to include in your rental property analysis. Net Operating Income (NOI) divided by debt service (principal and interest, mortgage) = DCR
Less than 1 is bad. That means your debt isn’t covered by rents. 1+ is good. You need to be 1.25 or higher (generally) to get good financing.
We use (in order of importance): cash flow/unit, cash-on-cash ROI, and DCR. That makes sure the property a) makes money every month, b) has AT LEAST 25% return on our cash (so in 4 years our cash is out), and c) is financeable.