Like any industry, there are special terms you may not know. Below are some of the more frequently used ones.
Capitalization Rate (Cap Rate)
The Cap Rate is used to indicate the rate of return that is expected to be generated on a real estate investment property before taking into account financing. It allows for a apple-to-apple comparision of different properties.
It's calculated by dividing net operating income by the property's asset value and is expressed as a percentage.
While the Cap Rate can be useful for quickly comparing the relative value of similar real estate investments in the market, it should not be used as the sole indicator of an investment’s strength because it does not take into account leverage, the time value of money, and future cash flows from property improvements, among other factors.
Cash-On-Cash Return (CoC)
Cash-on-Cash return gives you the ratio of your investment return relative to the amount of cash you put into the deal. Say you invested $10k in to something and it returned to you $700 per year. This would be a 7% Cash on Cash return. With real estate, one key thing to realize is that as rents increase - as long as there are no more cash infusions - typically the cash on cash return increases year-over-year. Additionally, in real estate leverage is typically used which propels the cash on cash return in later years of the investment.
Internal Rate of Return (IRR)
The Internal Rate of Return can often get confused with the return on investment and cash on cash because over the period of one year, all these percentages are the same. IRR specifically takes the time value of money and calculates what the average return is over a period of time.
Say you put that $10k in and made 7% per year for 5 years and compounded it each year. That equates to a 7% IRR for those 5 years preculded that your $10k was returned to you at the end of the period. When looking at real estate we know that very seldomly does an asset perfectly return an exact percentage and typically the asset grows in value over the time period. This calculation can take that expected growth and growth in cash flows combined into one metric to look at the investment.
Return on Investment (ROI)
Return on Investment is often used as a rudementary understanding of the profitability of the investment. The problem is that it often does not take time into effect. For instance, if you held an investment for 10 years and received $700 per year your return on investment would be 170%. This figure sounds good, but may not be indicative of a good investment because it did not take into account how much time was allotted to the investment.
Yield and Value Add
Yield and Value Add are a couple of terms that refer to the type of investment and the strategy behind it.
Typically, Yield strategies are looking for a safe, secure asset that will produce a very predictable return. When we sell our assets they are typically very stable and someone looking for a yield play, with not a lot of maintenence, will be our buyer. Learn more
The Value Add strategy, which we actively look for, allows us to improve the asset in a way that produces a higher return for the work we put into the asset. The reason that these often work well is because of bank loan leverage. If we're able to increase rents by 10-20% by only putting in 5% of the asset price there is an inherent gain in value, especially when we are leveraged four-to-one on the financing. The most typical ways to add value to an asset is through construction upgrades and reduction of costs. Learn more