So, you think you want to be a real estate investor? I think that’s great!
I’m an investor and I am passionate about educating people about investing in real estate. After all, it is the lowest risk, highest return investment around (we can talk more about that in a future post).
First, a confession…I was intimidated. For those of you who know me, you probably don’t believe it but when I first started to get interested in real estate investing, I was somewhat intimidated. You see, real estate investing has its own language. A language that sounds similar to, but is different than, the terms used in stock market investing. Seasoned real estate investors sling the terms around easily and it can seem at times like it might be too complicated and it’s easier to just invest in mutual funds. THAT would be a shame, so to help, I’m going to take it one step at a time and discuss a few real estate terms and hopefully simplify the language for you.
A good place to start is “Cap Rate.” Investors use this term a lot and its how they compare the return on investment from one property to the next. Cap rate is short for “Capitalization Rate” and in order to understand it, there are a few other terms we need to define first.
Gross Income – Gross income is pretty much what it sounds like. It’s the total amount of income generated by an investment. In a simple example, if a house rents for $1,000 per month, then the Annual Gross Income is $12,000 per year.
Operating Expenses – This too is pretty much what it sounds like. Operating expenses are things like utilities, property taxes, landscaping, maintenance, repairs, etc. — anything you spend on the property in order to keep it running. It does not include any mortgage payments or interest.
Vacancy – Vacancy is a simple one…it’s just how much you expect to have no one paying rent measured in dollars. In most cases I figure that a property will be vacant for 1 month every 2 years. Or ½ half month per year.
The next number you need to understand is “Net Operating Income” or “NOI.” Net operating income is just a simple formula using the terms we already defined above:
Gross Income – Operating Expenses – Vacancy = Net Operating Income (NOI)
Then finally, we can get the Capitalization Rate (CAP) by dividing the NOI by the value of the property.
CAP = NOI / Value
In a simple example, if you own a house that is valued at $100,000 and rents for $1,000 per month with property taxes of $2,000/year and other expenses of $1,000 per year, then the following would be true.
Gross Income = $12,000
Annual Operating Expenses = $3,000
Vacancy = $500 (1/2 of one months’ income)
So, your Net Operating Income would be:
NOI = $12,000 – $3,000 – $500 = $8,500
And your Cap Rate would be:
CAP = $8,500 / $100,000 = 8.5%
I hope that helps! I’ll plan to post more about investing in real estate in the future.
In the meantime, if you have any questions or want to talk to my team about investing in real estate, please feel free reach out…Helping YOU is what we’re here to do!