Three Key Real Estate Terms to Understand
One of my colleagues, Burdett Streeter, complied some very helpful definitions and examples of common real estate terms. Understanding NOI, LTV, and CAP rate are important terms to understand before investing in real estate.
Net Operating Income (“NOI”):
Net operating income is the property's gross rental income plus any other income, such as late fees, laundry income, or parking income, less any vacancies and rental expenses, such as utilities, management and maintenance. Essentially, NOI is the net cash generated before mortgage payments and taxes.
Loan to Value Ratio (“LTV”):
The Loan-to-Value Ratio is the amount of a secured loan or mortgage divided by the fair market value of the property. For example; if your property is worth $100,000 and you have a mortgage balance of $50,000, the Loan-to-Value ratio on your home would be 50%. The LVR helps you quickly determine what percentage your property leveraged based on the fair market value of the property versus your cost. You can also use the LTV to determine the amount of your equity.
If you have more than one loan secured against your property, you need to add up the outstanding balance of each loan in order to calculate the Loan-to-Value ratio. For example, if your home is worth $100,000 and you have a mortgage balance of $50,000, the Loan-to-Value ratio on your home would be 50% as stated above however, if you also have a second secured loan on your home for $25,000, the Loan-to-Value ratio on your home would be 75% ((50,000+25,000) divided by 100,000).
Capitalization Rate (“Cap Rate”):
The Capitalization Rate is a ratio used to compare properties with different valuations, and to also place a value on a property based on the income it generates. The Cap Rate is computed by taking the net operating income (NOI) and dividing it by the property's fair market value (FMV). The higher the Cap Rate for a property the greater the cash flow return.
Cap Rate - Practical Use #1:
You can use the Cap Rate to value your property. Let's say that your property generates $10,000 of annual net operating income. Your real estate agent tells you that the Capitalization Rate in your area is approximately 4%. That would mean that the approximate fair market value of your property is $250,000 ($10,000 ÷ .04).
Cap Rate - Practical Use #2:
Let's assume that you are looking at investing in two properties. The first property has a projected NOI of $20,000 and an asking price of $500,000. The second property has a NOI of only $10,000 but an asking price of $110,000. Which one would the Cap Rate suggest is a better financial investment? That's right, the second property since the Cap Rate is 9% ($10,000 ÷ $110,000) versus 4% ($20,000 ÷ $500,000). Of course, other factors are also important to consider in the overall buying decision.
Provided by: H. Burdett Streeter II, CFP,CEP,CPhD,MCEP(ret)