Learn The Investment Language Today!
If you are new to the world of real estate or transitioning from another asset class, the language of the real estate investor might as well be foreign. The below list of common terms should be helpful in facilitating your understanding and helping you have meaningful conversations in the industry.
Average Annual Return (AAR): AAR is simply the return on investment measured on an annual basis. This is calculated as the total investment return divided by the number of years the investment was held. For example, if the initial investment is $50 and it earned $100 after five years, AAR would be 10% ($50 ROI divided by five years).
Break-Even Occupancy: calculated as the sum of total operating and debt service divided by the property’s potential growth income, this metric describes the minimum occupancy that a property can handle before its income no longer sufficiently covers debt service and operating expenses.
Cap Rate: the ratio of the net operating income to the price paid (or value, whichever is referenced) for the property. For example the cap rate for a $100,000 property that yields $10,000 annually is 10% ($10,000/$100,000).
Cash on Cash (COC) Return: This metric is simply ratio of additional cash received from the investment in relation to the invested principal; For example, if an investor invests $50 and gets $60 back, the cash on cash return is 20% ($10 additional dollars divided by $50 initial principal).
Cash Flow: the net of monthly or annual income minus expenses (positive cashflow is income; negative cash flow is loss).
Debt Service Coverage Ratio (DSCR): The ratio of a property’s annual net operating income to the annual debt service. Calculated by providing annual NOI by Debt Service. Lenders have minimum DSCR standards; ideal ratio is greater than 1.25.
Debt to Income Ratio: the ratio, often used by banks, of an individual’s monthly debt service to total monthly income. For example, a particular lender that I used wanted to see coverage of 40%, which means that my personal debt could not exceed 40% of my income. The way to improve this metric is lower your debt obligations or increase your income.
Internal Rate of Return (IRR): IRR can be considered the standard metric used by sponsors. The purpose of IRR is similar to that of the Average Annual Return (AAR), but takes into account the the time value of money. This calculation that helps investors compare investments to alternative investments. Many investors use a minimum IRR as their “hurdle” as one of a few benchmarks to determine whether the opportunity supports their investment criteria.
Leverage: Debt; the resource used to acquire assets using funds worth a portion of the assets value, allowing investors to take full control of that asset and hopefully realize minimum returns that justify the use of those initial funds. Leverage creates great wealth building opportunities, recognizing the increased risk with its use.
Loan to Value (LTV): The ratio of the bank’s loan amount to the value of the property being purchased. For example, most banks will offer 75% to 80% LTV for investment properties, meaning they will fund no more than this portion of the purchase price. This also means that one would need to supply either ra 20-25% down payment. In the case of a refinance, the 25% remains in the equity of the house and the cash out will be based on 75% of the value.
Loss to Lease: A concept describing when current rates are lower than market rates for units in areas with similar features, this concept is called loss to lease. To calculate loss to lease, subtract the markets rent value from the current rent of the subject property.
Real Estate Business Terms
Joint Venture: A partnership formed between multiple active investors for a specific business opportunity or venture.
Preferred Returns: an arrangement sometime made in syndications where Limited Partners (LP’s) receive a minimum return as first priority within an agreed upon time basis (monthly, quarterly, annually, etc). For example, if the agreement is a 6% quarterly preferred Return for LP’s, with each distribution from cash flow, preferred returns are paid first to achieve the targeted returns for passive investors.
Sponsor: The party in a syndication that puts together the deal, obtains funding, manages the asset, maintains investor relations and executes the business plan to ensure optimal returns for all investors.
Stabilized Property: A property characterized by high (or stabilized) occupancy, perhaps 90% or greater. These properties pose less risk to buyers and are the end goal state of many value-add projects.
Syndication: The pooling of investor funds to purchase a large asset. Investors expect to receive a target return for their investment through the operations of the asset and after the sale or refinance.
Underwriting: The process of financial analysis to understand the value of the property and worthiness of investment, according to a predetermined investment criteria.
Value-Add Property: A property that allows for investors to force appreciation by increasing the net operating income (and therefore valuation) by a combination of increasing income or reducing expenses. Methods to increase NOI involve interior and exterior updates/remodels, more efficient contract services, new property management team, etc.