Terms Every Beginner Real Estate Investor Should Know Part 3
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This is part three of my four-part series covering Real Estate Terms and Acronyms.
This is part three of my four-part series covering Real Estate Terms and Acronyms. If you haven’t read Parts 1 and 2 yet, please do so here and here, respectively! You don’t want to skip parts 1 and 2 as part 3 builds on the real estate terms covered in the first two parts. To summarize, I decided to publish a list of real estate terms and metrics explaining how to calculate them. However, the list turned out to be too long to cover in a single article, so I decided to split it in to four shorter, easier to read parts.
In this part, we will cover the most common profitability terms and metrics that you are likely to encounter. Be aware that this section does involve some math, but do not panic yet! I have tried to keep it as simple as possible for you. I have no doubt that with some practice, you will quickly become an expert at calculating these metrics. Ready, set, go, let’s take it slow in to part three…
Real Estate Profitability Terms and Metrics
- Underwriting: This term is most commonly refers to the steps that lenders such as banks perform to evaluate the borrowers loan request and verify the ability to pay. It is most common when dealing with commercial properties. However, as an investor it will be in your best interest to carefully evaluate and verify all the financial details about a property you are considering for an investment. Therefore, underwriting is just as important to a beginner investor as it is to a seasoned investor or a bank.
- 1% Rule: This is a quick rule-of-thumb calculation to determine if a property will yield a monthly positive cash flow or not. In simple terms, it is the total expected gross monthly rent divided by the purchase price (including closing costs). You can use my free 1% calculator to quickly analyze your deals. It has been proven over many years, that unless you are purchasing a property with all cash, if it does not meet the 1% rule, you will not get a monthly positive cash flow. This rule is usually applied to single family residences as well as 2-4 unit properties. Some investors apply this to multifamily properties with 5-10 units to quickly determine if the property is worth looking investigating further.
- Cash-on-Cash Return (CoC): This metric, expressed as a percentage, is a measure of the annual cash return on the amount of cash invested. The cash invested includes the down payment and closing costs when purchasing with a mortgage. If you are making a cash purchase, then all the cash invested should be included. To calculate the cash on cash return, you will divide the net annual cash left over after paying all the expenses, reserves and the mortgage. For example, let’s assume you purchased a house for $100,000 with a 25% down payment and incurred $5,000 in closing costs. Your total cash invested is $30,000. Additionally, let’s assume that your underwriting shows that you expect to have $150 extra cash left over each month. This equals $1,800 for the year. Your CoC return is 1,800/30,000 which equals to 0.06 or 6%. If you purchased this property all cash, your CoC will be 1,800/105,000 which equals 0.017 or 1.7%. You can use my free cash-on-cash calculator to quickly find your rate of return for any property. Many investors require a higher cash on cash return compared to what the banks offer due to the additional risk inherent in real estate investing.
- GOI: Gross Operating Income is simply the total annual income collected from the property. This includes rent and income from other sources, like coin-operated laundry facilities.
- NOI: This metric refers to the Net Operating Income of a property. This is calculated by subtracting your operating expenses from your GOI. Mortgage payments are excluded from the calculation as these are not considered operating expenses. For example, if your annual GOI is $100,000 and you spent $70,000 on management, maintenance, supplies, insurance, taxes, and utilities, your NOI for the year is $30,000 The NOI affects the value of a property. You can raise the NOI by lowering your expenses or increasing your income.
- DCR or DSCR: Debt Coverage Ratio or Debt Service Coverage Ratio is a measure of cash available to service the debt on the property. It answers the question: how much cash is available to make the mortgage payments.
A DSCR of less than 1 would mean a negative cash flow and that there is not enough cash coming in to meeting the operating expenses. Lenders will tell you the minimum ratio that is acceptable; usually this is 1.25. The higher this ratio is, the easier it is to obtain a loan
- Cap Rate: Cap rate also known as capitalization rate is a measure used to compare different real estate investments. It is more often used to compare commercial properties including multifamily properties with 5 or more units. Cap rates vary by city and by areas within cities. It is a ratio calculated by dividing the annual NOI by the cost or value of the property a shown below.
For example, if the price to purchase a building is $1,000,000 and it produces $100,000 in annual net operating income, then: $100,000 / $1,000,000 = 0.10 = 10% cap rate.
The cap rate can be increased by raising the NOI or lowering the purchase price.
- Gross Rent Multiplier (GRM): The Gross Rent Multiplier (GRM) is an easily calculated, multi-faceted metric. First, it can be used to determine the estimated value of a property. While it is not very precise, it is an excellent tool to assess the value of a property without investing too much time. Secondly, this metric also answers the following question: How long will it take before the property “pays for itself?” The result of calculating the GRM is usually returned in the number of years that it will take for the property to pay for itself. You can use my free GRM calculator to analyze your deals. Finally, this metric can also be use to compare multiple properties to determine which one is a better deal. Unlike the cap rate, which requires a lot more detail and time, the GRM is a way to quickly make an apples-to-apples comparison between multiple properties. This metric is different from other metrics because it does not consider the actual net cash flow. Instead, it calculates a ratio of the purchase price of a real estate investment to the expected gross annual rental income. Use this metric alongside the 1% Rule to make your initial determination about whether a property is worth investigating further or not.
As mentioned in the previous parts of this series, I write these articles with the hope that these terms will help you make better decisions and mitigate some of the inherent risks that come with investing in real estate. While these are not all the profitability metrics, if you master the ones listed in this article you will be miles ahead of other investors. As you progress in your passive income journey, you will find that the same metric may be called something different by another investor or company. Therefore, it is important to carefully evaluate each investment and understand how the various metrics are being calculated. I never rely on anyone else’s calculations. This is a good rule of thumb to follow. Always perform your own calculations. You can find additional metrics here.