Investing in real estate is one of the biggest decisions property owners will make. If you’re new to the investment game, you’re probably coming across a lot of words, phrases, and acronyms you’ve never seen before. Or, if you have seen them, you may not be 100% sure what they all mean. Familiarizing yourself with industry “jargon” is crucial to your investment journey as you need to have an in-depth understanding of every word thrown your way to make the best decision possible. Here, we’ve laid out several terms that will allow you to confidently begin investing in rental properties.
Appreciation
Put simply, appreciation is an increase in an asset’s value over time. These increases are affected by a number of factors including changes in supply vs. demand, interest rates, or inflation. Appreciation is important when it comes to analyzing whether to buy (or not buy) a specific property as it helps determine how your return will grow as the value of an investment property increases.
Capitalization Rate
Typically referred to as “cap rate”, this is used to determine your annual return on a property investment based upon the profit you expect the property to generate. This figure is a ratio between your net operating income and the price you paid for the property. For example, if you purchased a property for $200,000 and your expected net income for the year is $15,000, your cap rate would be 7.5% as you divide the expected net income by the purchase price. Keep in mind that cap rate does not take into consideration any loan costs; however, you want your cap rate to be greater than your interest rate on your loan. Does this mean you shouldn’t use this calculation? Not necessarily – it can still be a great tool for evaluating multiple properties when you’re considering which one to purchase.
Cash Flow Before Tax
Cash flow is the pre-tax amount you end up with each month after all operating expenses pertaining to the property have subtracted from gross operating income. You, of course, always aim for a positive cash flow as that means you’ve spent less money on the investment than you’ve earned. To achieve this, the rental payment needs to be higher than your monthly mortgage payment and this will create a steady stream of income for you that can be set aside for future maintenance needs or put towards another investment.
How do you calculate cash flow before tax? Simply subtract your operating expenses, net operating income and annual debt service (your monthly loan payment & interest) from your gross operating income.
Depreciation
Though depreciation may sound like a negative term, it is actually a great benefit for rental property owners as the property is assumed to depreciate over time but in fact will likely appreciate in value. For a real estate investment, depreciation is a tax benefit which allows you to deduct certain expenses from your annual income, thereby reducing your taxable income. It is important to note, that your investment property must meet certain criteria in order for you to be able to take advantage of depreciation: These criteria include:
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