Property investing comes with its own terminology. In this post we explain some of the common terms which you may come across.
The Cap (Capitalisation) rate % is the net income which a commercial property produces divided by the estimated value of the property over one year. For example, a property valued at $1m which produces net income of $80,000 per year has a Cap rate of 8% (80,000/1,000,000).
The Cap rate is used to broadly compare the prices of commercial properties, and may indicate whether a property is over / under valued. For example, a property with a high Cap Rate may be undervalued as the return is higher than comparable properties and vice versa.
A Certificate of Title is a formal legal document which evidences the ownership, description and encumbrances of a property. A Certificate of Title in Australia is issued by the relevant state government authority.
An Encumbrance on a property is an interest in, or a legal liability which is attached to a property.
The most common form of encumbrance is a security interest (also called a finance charge) which is an interest in the property which arises when a Bank or finance company lends money secured by the property.
Other less common encumbrances are Easements, which mean that a portion of the land may be used by another person who is not the Owner (such as a shared driveway or drainage) and Liens, which is a security interest granted over the property to secure the payment of a debt.
The IRR is the annualised net return on a property project over its life. The calculation of the IRR takes into account the purchase price, income earned, additional expenditures (such as improvements), predicted capital gains, borrowings and interest, and the time value of money (ie Net Present Value).
The purpose of the IRR is to provide a guide regarding a project's overall profitability and to compare the profitability of different projects - a positive IRR indicates that a project is expected to be profitable.
Rental Yield is the income produced by a rental property (generally non commercial) divided by the value of the property. For example, a property valued at $500,000 which produces rental income of $20,000 per year has a rental yield of 4% (ie 20,000 / 500,000).
The rental yield may be expressed as gross (before expenses) or net (after expenses).
A share is a unit of ownership in a company. For example, if you own 2 shares in a company, and there are 100 shares issued, you own 2% (2/100) of the company.
A Preference share is one which has certain rights in addition to other shares issued by the company. The most common Preference share is one which earns a defined rate of interest. For example, a preference share may carry an interest rate of 7%, which means that interest of 7% pa is paid.
A Redeemable Preference share is one which may be redeemed (or bought back) under circumstances, which may be:
In Property projects, Redeemable shares are often used to provide financing during the life of a project, and then redeemed from the proceeds of the sale of the property at the conclusion of the project.
A Trust is a legal entity which is formed by the execution of a Trust Deed. As part of the formation of a Trust, a Trustee is appointed. The Trustee's role is to administer the Trust in accordance with Trust Deed. The Trust Deed defines exactly what the Trust can, and can't, do.
The primary purpose of a Trust is to preserve and maintain the assets that it holds on behalf of its beneficiaries.
Trusts make payments to beneficiaries in the form of distributions. Distributions can be in the nature of capital, or income, or a combination of both.
There are several types of Trusts - Discretionary, Unit, Hybrid and Superannuation Trusts (a type of Hybrid Trust). Each type of Trust operates somewhat differently.
A Unit Trust is a form of Trust in which distributions are determined based on the number of units held by a beneficiary. The total number of units is usually fixed. For example, if you hold 2 units in a Unit Trust which has 100 units, you are entitled to 2% of the Trust distributions.
A Unit Trust has no discretion in making distributions (unlike a Discretionary Trust).
"Any advice provided on this blog is general in nature. Readers are urged to seek their own professional advice before making decisions."