Five Finance Related Real Estate Terms You Should Know

In finance, as with most things in life, the details matter. I was reminded of this when I recently sent an email to my financial advisor and mistakenly wrote the number two instead of ten.

Yes, you read that right...

Fortunately, my super-detailed advisor caught my error. I can’t say enough about the importance of having the right people on your team! But you know what? That little mistake made me return to the basics. So here are a few key financial definitions every serious real estate investor should understand:

1. Cash Flow: It’s always about the cash flow.  Investopedia defines cash flow as “a revenue or expense stream that changes a cash account over a given period. Cash inflows usually arise from one of three activities - financing, operations or investing - although this also occurs as a result of donations or gifts in the case of personal finance. Cash outflows result from expenses or investments. This holds true for both business and personal finance.” My working definition of cash flow is “when money flows through your business.” This is a concept that is very important for investors.

For instance, while it’s great to have an investment property with a mortgage due on the 15th, if you don’t have a cash cushion and your tenants pay you on 16th you have a cash flow problem.
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1. Discounting: My understanding of discounting is knowing what the present day value is of your future cash flow. A more technical definition is “the process of determining the present value of a payment or a stream of payments that is to be received in the future. Given the time value of money, a dollar is worth more today than it would be worth tomorrow given its capacity to earn interest. Discounting is the method used to figure out how much these future payments are worth today”.

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1. Internal Rate of Return (IRR):  When you think IRR, think about comparing apples to apples. Our pals at Investopedia define IRR as “the discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. IRR is sometimes referred to as "economic rate of return (ERR)."

Internal Rate of Return helps investors decided between two similarly situated investment options. So, if you’re deciding whether to invest in apartment complex A or apartment complex B, the IRR calculation allows you to determine which property is a better option – at least theoretically.

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1. Net Operating Income (NOI): The Net Operating Income (NOI) is a factor used in determining the value of a piece of real estate. To determine the NOI, you subtract operating expenses from the gross operating income. In practical terms, you subtract your insurance, management fees, utilities, legal expenses, etc. from the gross operating income.

1. Capitalization Rate: I understand the capitalization rate as ultimately telling how long it will take for the asset to repay the cost of capital. This information is presented as a ratio of the cost of the capital against the net operating income. A technical definition, again from Investopedia, is “a rate of return on a real estate investment property based on the expected income that the property will generate.” The calculation is NOI/present value.
   
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A great tool for understanding the basics of finance is this . Of course, you can also just use which is free.

Any other terms we feel are key to know or near mishaps? please feel free to share.