Continuing the series on basic real estate investing terms, here are 3 common terms and some context to help demystify them. It’s important to remember that in this profession, as in others, some concepts have multiple terms that mean the same thing! Terms can vary by location or industry, so if a term you come across isn’t one you understand, consider that you might already know the concept, so do some research. Don’t sell yourself short!
- Vacancy Allowance
- You may recall in a previous post where we defined Gross scheduled income as all the income you could possibly receive from a property in one year. But often, there is some level of vacancy. If there’s none, you still need to plan/save for it. This allowance is expressed as a percentage of your gross scheduled income. Once computed, it is subtracted from the GSI, resulting in Gross Operating Income (GOI). It is worth noting that this figure is also sometimes correctly referred to as vacancy and credit loss. In larger properties like apartment complexes, you need to account for a certain percentage of “credit loss”, meaning bounced checks, uncollected rents, etc.
- Net Operating Income (NOI)
- NOI is arguably the single most important number in the assessment of a rental property. One reason it is so ubiquitous is that it helps asses a property without the variable of the individual purchaser. NOI = Gross Scheduled Income less Vacancy and Operating Expenses. Notice I did not say anything about a mortgage, debt service, or a new roof. I said “operating expenses”, which is a topic for a future post. By finding this number, you can assess the property initially on the grounds of its potential to produce income, whether it’s bought at maximum leverage, or for all cash. If this number is not accurate, your valuation and evaluation of a property will be flawed from the start.
- Cash Flow Before Taxes
- The vast majority of investors do not use cash to buy an entire property. Therefore, there are other figures in the minus column before the returns are all yours, right? Enter debt service and capital expenditures. I will save in depth talks of capital expenditures for a future post, but suffice it to say these are big purchases like a new roof. In a year, the total amount of mortgage payments you owe your lender make up a number called your debt service. You subtract your debt service and any capital expenditures from NOI, and that gives you your cash flow before taxes. It’s that simple!
Hopefully the numbers you end up with at this point are positive and not negative! The calculations in this process up to this point are not difficult, but they require a solid understanding of the definitions of the terms involved. The math is easy! Until next time.