Once you become a real estate investor, you belong to a world with its own terminology. It can feel overwhelming and confusing at times! Our team at Diversified Investment Strategies is here to help you through 1031 exchanges, and we’re here to make your life as a real estate investor as smooth and simple as possible. Therefore, we’ve picked out a few terms that we’ll define for you, to make your life easier.
IRR – Internal rate of return, IRR, is a metric used in capital budgeting to estimate the profitability of potential investments. It’s a discount rate that makes the net present value, NPV, of cash flow on a particular project equal to zero. NPV is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. This is used to analyze the profitability of an investment. Generally, the higher an investment’s IRR is, the more desirable it is. IRR can help you determine the rate of growth an investment will generate. If the IRR is higher than the RRR, required rate of return, it’s more likely to be a profitable one.
Cap Rate – Capitalization rate, or cap rate, is a concept used in the commercial real estate industry to help estimate the investor’s potential return on investment. It’s the rate of return on a property based on the income the property is expected to generate. To discover the cap rate of a property, you can divide the property’s net operating income, NOI, by the current market value or acquisition cost. You can learn more about cap rates, and interest rates, in this past blog post of ours.
Preferred Return – When you work with a private equity firm, preferred return refers to the threshold return that the limited partners of a private equity fund must receive, prior to the PE firm receiving its carried interest, or “carry.” Typically, PE firms get paid using a 20 and 20 fee structure, with 20 being the percentage of the return in excess that the PE firm gets to keep. The preferred return has traditionally been set to 8-10%, but this is changing with an increase in private equity firms.
Cash-on-Cash Return – This is a rate of return used in real estate transactions to calculate the before-tax cash income earned on the cash invested in a property. These are helpful with investment properties that involve long-term debt borrowing. This causes the actual return on investment to differ from the standard return on investment. Cash-on-cash return only measures the return on the actual cash invested. This can help you analyze the investment’s performance more accurately.
These definitions will get you started! Keep up with our blog for more defined real estate investment terms in the future. We also update you on tips and news about 1031 exchanges, DSTs, REITs and more. If you have any questions, or would like assistance with a 1031 exchange, contact our team at DIS! We are here and ready to help you with all of your investment needs.