The multifamily real estate industry has its own set of terms and jargon that can be complicated for beginners. Understanding these terms is crucial for anyone looking to invest in multifamily properties. Here are some of the most important terms that I encountered in my journey and would like to share them with you to have a better understanding and take advantage of these as and when possible.
Therefore, in this blog, I will define and clarify some of the common terms used frequently in the investing market and are beneficial for beginners.
Crucial Terms to Know
Absorption Rate
It is a metric used to measure the demand for real estate and tells the rate at which units are successfully rented in a specific period. The market rate with an absorption rate at or above 20% is a seller’s market whereas if the absorption rate is below 15%, it is a buyer’s market. In terms of negative absorption rates, the syndicators or operators may reduce the rental price to attract renters. It is a useful metric for investors to know when is the right time to enter the market and helps in making an informed decision about entering the market as they understand the demand for the properties in a specific market. The chance of a profitable investment will thus be higher after knowing the market condition.
Amortization
It is a process of gradually paying off a loan or mortgage over time through monthly payments that cover both principal and interest amount. It helps you differentiate various parts of the loan in detail and reduces the outstanding debt eventually.
Appreciation
It is one of the greatest advantages of multifamily, for passive investors looking for cash flow. It is the increase in the value of a multifamily property over time. It can be caused by various factors, such as market demand, property improvements or renovations, or economic growth in the area. It has a value-add potential that can help passive investors gain high rental income.
Bad Debt
Bad debt represents the portion of rent or lease payments that tenants fail to pay, leading to a financial loss for the property owner. Managing bad debt is crucial for maintaining profitability. The loss will lead to less share of profits among the investors. Thus, it is significant that investors should keep reserve for such times or losses that they might incur so that their strategy of creating wealth should not be hampered by losses suffered and a cushion is provided that will help with the smooth functioning.
Cap Rate (Capitalization Rate)
The cap rate is the most popular measure through which investments are assessed for their return potential and profitability. It is a measure of a property’s potential return on investment (ROI). It’s calculated by dividing the property’s net operating income (NOI) by its present market value. A higher cap rate typically indicates a higher potential return and risk. Ensure that while assessing any investment opportunity it should not be the sole indicator of investment strength as there are other factors as well that impact the investments.
Cash-on-Cash Return (CoC Return)
Cash-on-cash return is a measure of the return on investment for a property, taking into account the actual cash invested by the investor. It’s calculated by dividing the property’s pre-tax cash flow by the initial cash investment. It simply measures the annual return the investor made on the property concerning the amount of mortgage paid in the same year. It is a forecasting tool to set a target for projected returns and expenses.
Debt Service Coverage Ratio (DSCR)
DSCR is a financial metric used to assess a property’s ability to cover its debt payments. It’s calculated by dividing the property’s net operating income by the annual debt service (principal and interest). Many investors in the industry look for a DSCR of about 1.25, however, there is no good DSCR.
Due Diligence
The process of investigating a property before investing, including reviewing financial records, inspecting the property, and researching the market. It is necessary for both investors and property managers to thoroughly investigate each aspect of the property before deciding on investing in an asset. It gives an overview of the potential risk associated with the particular investment.
Return on Investment (ROI)
ROI measures the profitability of an investment. In multifamily real estate, it reflects the total return, including rental income, appreciation, and other gains, relative to the initial investment. It is calculated by comparing the initial price invested in a property with any further costs, to its current value.
Internal Rate of Return (IRR)
IRR is a financial metric used to evaluate the potential profitability of an investment. It considers the time value of money and calculates the annualized rate of return on an investment. The higher IRR usually reflects an attractive investment opportunity.
Conclusion
Investing in multifamily real estate can be a smart way to diversify your investment portfolio and generate passive income. Multifamily properties offer numerous benefits for CRE investors, including stable cash flows, lower vacancy rates, and easier property management. However, it’s essential to conduct thorough research and due diligence on potential markets before making any investment decisions. These terms are just the tip of the iceberg when it comes to the multifamily real estate industry. It’s important to continue learning and researching to fully understand the complexities of this field.