A Helpful Introduction to Beginning Real Estate Investing

Hopefully this article will acquaint anyone who has an interest in real estate investing with some popular and commonly used reports, terms, and rates of return associated with real estate investing.

Reports

APOD - an APOD (an acronym for annual property operating data) gives a snapshot of a rental property’s income, expenses, and cash flow for one year. It is regularly used by analysts as a first-glance look at the financial performance of investment property without including the elements of tax shelter.

Proforma Income Statement – this report provides a useful way for agents and individual investors to evaluate the future cash flow performance of rental properties. It generally includes calculations for tax shelter so investors can evaluate such things as cash flow after taxes, depreciation, tax benefit or loss, and various rates of return on a year-by-year basis for up to any number of years.

Comparable Sales Report – this report surveys what other similar property has recently sold for and helps someone investing in rental property to evaluate whether a seller's asking price is in line with realistic property value.

Terms

Gross Scheduled Income – also known as potential gross income, this is the total annual rental income a property would generate if all the units were occupied and all rent collected. Its purpose is to estimate the maximum potential income the investment real estate would generate without regard to any vacancy or credit losses.

Operating Expenses – these are costs associated with keeping a property in service such as routine maintenance and repair, utilities, property taxes, insurance, and management fees. They do not include the mortgage payment, income taxes owed by the investor resulting from owning the subject investment, or allowances for depreciation.

Net Operating Income – this is the amount of income remaining to pay the mortgage after deductions for vacancy and operating expenses. Think of it this way: If the property was wholly owned and without debt, it would be your cash flow before taxes and depreciation are considered.

IRC 1031 Tax-Deferred Exchange – this federal tax code provides investment property owners with a means to dispose of one real property asset in exchange for another without having to pay taxes in the year of the exchange. The tax obligation is not vanquished, but Section 1031 permits the investor to defer federal tax until an actual sale of the rental property occurs. It is strongly advised that a tax exchange professional be consulted before you sell any investment property.

Depreciation and Recapture Tax - depreciation is a noncash tax shelter deduction in full compliance with the tax code based upon the type of investment property owned (i.e., residential or commercial). On the flip side, however, because the depreciation taken reduces your investment property’s tax basis and effectively increases your tax gain when you later sell the property, the IRS assumes that any gain you make in part may have resulted from the depreciation taken and in turn imposes a recapture tax on the gain attributable to depreciation taken. Always consult your tax adviser before you sell your rental property.

Measures and Rates of Return

Gross Rent Multiplier – this is used to measure the ratio between annual gross rental income and sale price. It is computed by dividing the property's price by its gross scheduled income and is commonly used in real estate investing for simple, rule-of-thumb comparisons to other rental property opportunities. As a buyer, the lower the gross rent multiplier is the better.

Cap Rate – this is by far the most popular financial measurement you will encounter in real estate investing because cap rate (unlike gross rent multiplier) accounts for the property's operating expenses. It is computed by dividing a rental property’s net operating income by its price. As a buyer, the higher the cap rate is the better.

Cash on Cash Return – this is the return on your initial investment based upon the cash flow generated by the property during the first year. It is computed by dividing the first year’s annual cash flow before taxes by the investor’s initial investment.

Internal Rate of Return – this return reveals in mathematical terms what an investor’s initial cash investment will yield based on an expected stream of future cash flows discounted to equal today’s dollars. Because it calculates for time value of money, thereby allowing analysts to take into account both the timing and the scale of cash flows generated by the investment property, it is one of the more popular rates of return used in real estate investing. You will need a financial calculator or appropriate real estate investment software solution to make this and other time value calculations, however.