Whether you are new to purchasing investment property or you have been buying investment properties for years, it is essential to familiarize yourself with some basic investment terms that are regularly encountered in the world of property investment. Here’s a look at some of the terms you should know.
Cash flow refers to the money that is going in and out of your investment. Your cash flow is determined by subtracting your operating expenses from your gross income. The amount of cash flow you have determines how liquid your investment is over a period of time. This figure helps you determine how well you will be able to pay for the expenses that are associated with your property.
The capitalization rate, or cap rate, is a ratio of your annual net operating income and cost that has been changed to a percentage. This figure shows the relationship between the cost of the property and the income your property generates after paying expenses. With this figure, you can determine the potential percentage return on your investment. For example, if you invest $1 million and the net operating income is $100,000 per year, your cap rate will be 10 percent.
The cash-on-cash return is similar to the cap rate, with the main difference being that you divide the annual before-tax cash flow by the total cash that you have invested. As such, the cash-on-cash return considers the financing that you may have used to obtain the property. The capitalization rate and cash-on-cash return both must be considered when evaluating an investment property.
The gross yield is the amount of money your property is expected to produce. To obtain this figure, you divide your gross income by the cost of your investment. This formula does not consider valuation changes or taxes, but it does provide you with a good benchmark for determining how well your property will perform as an investment.
Depreciation and Appreciation
Depreciation and appreciation refers to the gain or loss of value of your property. Of course, potential appreciation is speculative, which means you can only make your best guess about the future of the property based on the information that is available.
When all is said and done, there is not a secret formula for determining whether or not an investment property will be a good investment. By understanding fees associated with purchasing an investment property, such as taxes and insurance, while examining local market dynamics, you will be better prepared to purchase a successful investment property. By familiarizing yourself with these terms as well as the various costs associated with purchasing an investment property, you will be more likely to obtain a property that will give you a healthy return on investment.
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(all data current as of 7/23/2017)
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