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: Equity

 

 

 

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: 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. 

 

 

 

Term: Internal Rate of Return (IRR)

 

 

 

Definition: This is a common real estate investment term you’ll see when browsing rental properties 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: GRM

 

 

 

Definition: Gross Rent Multiplier (GRM) is the ratio of the price of a rental property to its gross rental income before expenses. Another way of thinking about GRM is that the ratio represents how many years it would take for an investment to pay for itself based on the gross rental income received. Everything else being equal, the lower the GRM is the better the investment may be.

 

 

 

Example:

 

 

  • Market value / Gross rental income = GRM
  • $100,000 market value / $12,000 gross rental income = 8.33

 

 

 

Why it matters: GRM is a quick way of ranking potential rental property investments before spending time on a deeper analysis. Unlike Cap Rate, which measures the rate of annual return based on net income (excluding mortgage expense), the GRM is a multiplier that uses gross income. Investors buying and selling real estate can also use GRM to estimate property value. For example, if the GRM for similar rental properties in the market is 7.5 and the property generates a gross annual rental income of $15,000 then the property value should be $112,500 (GRM of 7.5 x gross annual rental income of $15,000). Or, if a single-family house has an asking price of $100,000 and the market GRM for comparable property is 8.3, the gross annual income from the home should be $12,048 ($100,000 market value / 8.3 GRM).

 

 

 

This article is originally published on Roofstock 

 

 

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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 investment 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.

 

 

 

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.

 

 

 

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.

 

 

 

Term: Appreciation

 

 

 

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.

 

 

 

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: Equity

 

 

 

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: 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. 

 

 

 

Term: Internal Rate of Return (IRR)

 

 

 

Definition: This is a common real estate investment term you’ll see when browsing rental properties 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: GRM

 

 

 

Definition: Gross Rent Multiplier (GRM) is the ratio of the price of a rental property to its gross rental income before expenses. Another way of thinking about GRM is that the ratio represents how many years it would take for an investment to pay for itself based on the gross rental income received. Everything else being equal, the lower the GRM is the better the investment may be.

 

 

 

Example:

 

 

  • Market value / Gross rental income = GRM
  • $100,000 market value / $12,000 gross rental income = 8.33

 

 

 

Why it matters: GRM is a quick way of ranking potential rental property investments before spending time on a deeper analysis. Unlike Cap Rate, which measures the rate of annual return based on net income (excluding mortgage expense), the GRM is a multiplier that uses gross income. Investors buying and selling real estate can also use GRM to estimate property value. For example, if the GRM for similar rental properties in the market is 7.5 and the property generates a gross annual rental income of $15,000 then the property value should be $112,500 (GRM of 7.5 x gross annual rental income of $15,000). Or, if a single-family house has an asking price of $100,000 and the market GRM for comparable property is 8.3, the gross annual income from the home should be $12,048 ($100,000 market value / 8.3 GRM).

 

 

 

This article is originally published on Roofstock