Buying real estate has long been attractive to the investment community. Offering a stable return on investment (ROI) and diversity in your portfolio, real estate holdings allow you to own a tangible asset that, in a good real estate market, will appreciate over time. (In layman’s terms, a “tangible asset” is an investment you can actually touch; a great resource for when the zombie apocalypse goes down.)
Don’t get us wrong; playing the stock market is a noble (albeit risky) game, and those who understand its ins-and-outs are likely to make truckloads of cash. The thing is, the stock market isn’t as stable or predictable as real estate investments; trading can be volatile at times. Not the type who’s always panic-button ready? Real estate investments may be the way to go.
Statistics show that between 1977 and 2007, almost 80% of the total U.S. real estate return was derived from income flows. Sounds legit, right? Before you call up your favorite real estate group (Ahem, hello. It’s us.), we’re sharing a few real estate investment terms that you should know and understand.
There are many factors considered when we calculate the value of real estate: appraisal value of the land and structures, checking what comparable properties are going for, and any current rental income being made on the property.
The latter method is where capitalization rate (cap rate) comes into play. By examining the actual income generated by the real estate, and then deducting operating expenses, you arrive at a net operating income (NOI).
Once you determine the NOI, you divide the NOI by the price of the property, and boom: The resulting number is your cap rate.
Net Annual Income
The million dollar question the IRS asks you annually: How much money did you make last year? Your net annual income is that number.
Net annual income is found by subtracting your expenses from the money you made. Expenses for real estate investments are most often taxes, insurance, management fees, HOA fees (if applicable), maintenance and repairs, and property management fees.
While gross income and gross ROI are important, investors are typically more concerned with net annual income on their investments.
Alright, now you know how much you made on your real estate investment last year. So, what’s the rate of return on the money you’ve invested? This calculation is known as your cash-on-cash return, dividing your net annual income by the total amount of your investment.
For example, if you paid $50,000 for your real estate investment and it produced $5,000 in net annual income, your investment would be producing a 10% cash-on-cash return. (*Double fist bumps.*)
Gross Annual Return
Say you want a quick snapshot of the financial health of your real estate investment. Divide the total income by the total amount invested. This number gives you your gross annual return.
Your gross annual return differs from your net annual income, in that it doesn’t factor in your annual expenses on the real estate. Factors such as taxes, insurance, HOA fees, management fees, and even the type of tenant or the age of the property all play into your net annual income.