Rental Property Terminology
The purpose of this Glossary is to review the essential terms necessary to evaluate rental property to determine the price a property must be acquired to be deemed a “good deal”.
The following should be regarded as a tutorial of essential rental property terminology rather than a traditional glossary. This is a prerequisite to understanding the terms and math behind the Free Deal Analyzer.
Net Operating Income (NOI) = Gross Operating Income (GOI) – Operating Expenses
Gross Operating Income (GOI) (aka Gross Revenue):
- Gross Rent Income (@100% Occupancy) less Vacancy Costs
- Pet Rent
- Onsite Laundry Machine Income
- Parking Fee Income
- Any Other Income Associated with the Property
Operating Expenses:
- Insurance
- Property Taxes
- Utilities
- Repairs & Maintenance
- Property Management Fees
- Legal/Accounting/Bookkeeping Fees
- Bank or Account Fees
- Rental Unit Registration Fees
- Marketing/Advertising Expenses
- Any Other Expenses Associated with Operating the Property
- Does NOT include Income Taxes, Principal and Interest Mortgage Payments, Capital Expenditures*, Depreciation, and Amortization
Notes:
- *Capital Expenditures (CapEx) are large, long-term expenses such as installing a new roof, furnace, A/C, kitchen or bath remodeling, etc. Although CapEx is technically not a component of Operating Expenses, it is absolutely imperative to consider these expenses when evaluating a property for purchase and also when assessing that properties’ long term operating needs. Failure to so is foolish and may have dire consequences. This is a key factor which separates the winners from the losers in the rental business. Including estimated CapEx when evaluating a property for purchase is just smart investing. For example, if you assess that the roof will have to be replaced within 5 years, and the estimated roof life is 20 years, then include 75% of the cost of a new roof into your renovation costs when evaluating a deal and making an offer on the property.
- When evaluating rental property, use actual vacancy rate if known, otherwise use projected vacancy rate, typically 6-10% of Gross Income, or research local vacancy rates in the area the property is located.
- Same for repairs – preferably use owner’s last 3 years repair data, otherwise estimate repair rate based on condition and age of property, typically 10% of Gross Income is a good starting point.
The #1 mistake first-time rental investors make is overpaying for property.
Annual Cash Flow = Net Operating Income (NOI) – Debt Service
Debt Service = Annual Mortgage Payments
Note: For all cash deals, Annual Cash Flow = NOI
Cash-on-Cash Return (aka Cash Yield) = Annual Cash Flow / Total Cash Investment
Total Cash Investment = Down Payment + Renovation Costs + Any other out-of-pocket costs associated with acquiring the property
Cash-on-Cash Return is the bottom line measurable when evaluating a property. What is a “good deal” or “target” rate of return? Every rental property investor has different expectations just like every stock market investor has different expectations. So you will get a variety of answers to that question. It is also highly dependent on the amount of leverage in the deal. All cash deals give the lowest rate of return, yet the highest Cash Flow. Whereas a leveraged deal provides a higher rate of return, yet lower Cash Flow.
For All Cash Deals, Cash-on-Cash Return Targets are:
Minimum > 10%
Preferred > 15%
Stretch > 20%
For Financed Deals, Cash-on-Cash Return Targets are:
Minimum > 25%
Preferred > 35%
Stretch = Infinite ($0 Invested)
Capitalization Rate (aka Cap Rate) = Net Operating Income (NOI) / Purchase Price
Likewise: Purchase Price = NOI / Cap Rate
Note: For all cash deals, Cap Rate = Cash-on-Cash Return
The Cap Rate is used in commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. Lower cap rates (<5%) generally apply to higher cost of living cities and are perceived as safer / less risky investments (Class A). Higher Cap Rate deals are typically considered higher risk and are in markets further down the Class scale (Class B, C, and D).
To assess and determine the value of commercial real estate, the buyer can research Cap Rates for comparable class and usage property in the area in which the property is located. Once the comparable Cap Rate is known, then due diligence is performed to confirm the owner’s declared NOI (or if discrepancies are found, buyer computes actual NOI) to determine a fair market value offering price (i.e. Purchase Price).
Debt Service Coverage Ratio = Net Operating Income (NOI) / Debt Service
DSCR is used in commercial real estate as a measure of the cash flow available to pay current debt obligations. Lenders use this to assess the properties’ ability to cover mortgage payments. A value of less than 1.0 indicates the property is losing money. A “good” or acceptable DSCR is dependent on the current lending climate and other economic factors; however, a typical target is a minimum of 1.25. Ultimately, the lending institution determines the DSCR acceptance standards.