After successfully completing this topic, you will be able to define important terms related to real estate investment.
Cash flow is the amount of money left over after all cash expenses have been deducted from the cash income of a property. Cash flow is not the same as net income, because net income in a financial statement often includes things like accounts receivable. That’s income, but not cash. Expenses often include reserves for replacements and depreciation. Those expenses are not paid in cash. Cash flow is the most important bottom line item for investors.
Leverage is the use of borrowed funds to increase the investor’s yield. When an investor makes a down payment on real estate, it is called the investor’s equity. Very often investors borrow part of the purchase price.
• Positive leverage results if the percentage rate of return on the investment is greater than the interest rate paid.
• Negative leverage results if the percentage rate of return on the investment is less than the interest rate paid
|Example of positive leverage |
A person pays $100,000 in cash for a property. The property returns $10,000 after all expenses are paid, so the person’s return is 10% ($10,000 ÷$100,000).
If the person borrows $95,000 with a mortgage at 5%, the mortgage payments would be $537 monthly, or $6,444 annually. So, the property would return $3,556 ($10,000 – $6,444). The rate of return has gone from 10% to 71%. How did it get to 71%? Well, the investor now has only $5,000 invested (5% down payment). Divide $3,556 by $5,000 to get .71 or 71%.
Yield is the return on investment from all cash flows (including gain on sale) divided by the investment.
|Example of yield |
A person buys a property for $500,000, pays $100,000 in cash and borrows $400,000. Assume that for the first two years of ownership the property has cash flows of $20,000 and $23,000 respectively. The person sells the property for $625,000 after the second year, and the mortgage balance has been reduced to $390,000. What is the investor’s yield?
The cash flows are as follows: $20,000 year one, $23,000 year two, and $235,000 year three. (sale price of $625,000 – mortgage balance $390,000).
Yield is 278% ($278,000 ÷$100,000).
A capital asset is a significant property, such as homes, cars, investment properties, stocks, bonds, and even collectibles or art. When a capital asset is sold, the investor may have a capital gain or loss. If the asset has been held for 12 months or longer it is considered a long-term gain, and has lower tax rates. A short-term capital gain is property held for less than 12 months.
The basis of a property is the cost of the property plus any capital improvements less depreciation. Basis is deducted from the sale price of the property to calculate the gain on the sale.
Appreciation is the increase in a property’s value over time. Probably the best indicator of appreciation in a city is the Case-Schiller Index. It measures changes in the prices of single-family, detached homes using the repeat-sales method, which compares the sale prices of the same properties over time, rather than simply measuring the median price of homes.
Equity is what the owner owns in a property. It is calculated by subtracting the mortgage balance from the property value. Assume a property is valued at $345,000 and has a mortgage balance of $156,000. The owner’s equity is $189,000 ($345,000 – $156,000).
Liquidity is the ability to sell a property quickly without affecting its market price. For example, if an investor owns 300,000 shares of stock in a small company, a quick sale of the stock could depress the market price the seller is able to get.
Risk is the chance that an investor will lose all or part of the investment. Investors will require higher rates of return for riskier properties.
A tax shelter shields an investor’s income from tax liability. For example, a single-family home is a tax shelter for the owner-occupants because a married couple filing jointly can exclude up to $500,000 in capital gains income.