Rental Real Estate TerminologyThis is a primer on rental real estate terminology, just to familiarize you with the basics. These are key numbers you will need to own. The better you understand them, the quicker you will be able to screen out the not-so-good deals. There is another advantage to knowing these terms. It makes you sound more professional and "in-the-know"! And that can open up doors - at least for starting conversations, if nothing else. Gross Rent Multiplier (GRM)This is the most critical number you need to know when you are looking to buy a rental property. It is calculated as follows:GRM = Total Price Paid including fixing up costs / Annual Gross Rent Generally a GRM under 8 is considered a good deal. I was looking for a property in Worcester recently. The asking price was $300,000 and the property would need another $60,000 to fix up. The expected gross rent was projected to be $5,000 per month or $60,000 per year. So, total price paid would be $360,000. Thus GRM = $360,000 / $60,000 = 6. That is a rather good deal. One related rule of thumb I find useful goes as follows: It's a good deal if the total monthly rent from the property is at least 1% of the total price. In our example, 1% of total price is $3000 and total monthly rent is $5000. Clearly it's a very good deal. Net Operating Income (NOI)As we saw earlier, Operating Expenses are expenses incurred in operating the property. NOI is basically your total rent minus Operating Expenses. This is the money you get in hand before you make your mortgage payment.The property in Worcester had Operating Expenses of about $15,000. Thus NOI would be $45,000 (assuming 100% occupancy). NOI brings us to Cap RateCap rate is NOI divided by the total price, expressed as a percentage. In our example, NOI is $45,000 and total price is $360,000. Thus the Cap Rate is 12.5%. Anything above 10% is considered a good deal, and this is another confirmation that this is one.Cap rate is a key number in real estate terminology, especially when dealing with bigger properties. Debt Service Coverage Ratio (DSCR)Debt service refers to paying off the mortgage. As we saw above, NOI is the money you in hand before making your mortgage payment. DSCR is calculated as NOI divided by mortgage payment. Naturally your mortgage holder wants to make sure that the NOI is more than enough to make that payment. In other words, they require that DSCR be above 1. Banks are usually more strict than that and require DSCR above 1.25 or higher. DepreciationReal estate depreciation is another key number in real estate terminology. It is a field in itself, and the laws governing it are complex. At the root of it, depreciation is a phantom expense created to account for the wear-and-tear of your property.The property value is broken down into two: land value and building (also known as "improvement") value. The land does not depreciate. Current law says that the improvement depreciates to 0 over 29.5 years. (I don't know where these numbers came from, but I am sure there is a long and checkered history behind the whole exercise!) Usually the land is assigned 30% of the value of the property and the rest is considered to be the improvement. Thus in the example above, the building would be deemed to have a value of 70% of $300,000 or $210,000, which would be depreciated in a straight line over 29.5 years. In other words, you will be allowed a phantom expense of $300,000 / 29.5 or $7,119 every year. This allows you to shield that much income from taxes every year! Unfortunately this depreciation keeps reducing your cost basis in the property, and thus you have to pay it back when you sell the property. (There is a way around that as well, the so-called 1031 exchange, but that is way beyond the scope of the current discussion.) Annual Property Operating Data (APOD)This is nothing but a fancy name for a spreadsheet that shows all the incomes and expenses related to a particular property. In my experience APODs are rarely available for smaller (2 to 6 unit) properties.Once you start looking at bigger properties (apartment complexes, commercial properties and the like), more sophisticated real estate terminology - such as APODs & cap rate - becomes standard. Rent rollRent roll is a listing of all the rents received from each tenant through the year.Going ForwardNow you know basic rental real estate terminology. It is not that complicated, but it does take effort on your part to really own it.When I was starting out in rental real estate, I set up a spreadsheet on my computer to run all these numbers. As I would look at various properties, I would type in the numbers and try to understand how the deal might work. This is a very useful exercise and I highly recommend it.
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