by Matt Faircloth
If you have been in this business for more than 5 minutes, you have heard all the lingo that people use. It seems like some of these terms are not used in any other profession, so if you are new to the business, it can be your first time hearing them. You really can’t “fake it ’til you make it” on this. You need to know what people are talking about so you can comprehend and maybe even contribute to the conversation!
I made a list of 16 real estate investing terms along with my definitions of them. Some, like CAP Rate, are commonly misunderstood. Others are ones you should know but aren’t talked about as much, like a Phase 1 Study. With each term, I will give you MY definition (not the dictionary’s definition) and why it’s important to know the term.
So here we go…
16 Common Real Estate Investing Terms, Defined & Explained
1. REO: Real Estate Owned
By whom, you ask? A bank or other financial institution. Why do they call it “Real Estate Owned?” I don’t know; it confused me too, to be honest! They really should call it BO Real Estate, but that would be confusing, too. All joking aside, this term is used for property that was foreclosed on by a bank that held a mortgage on the property or a tax lien holder that foreclosed.
What you need to know here is that this owner has no emotional connection to the property and is most likely not local so they have not seen its condition. Your biggest advocate to get a good deal will be the real estate agent listing it, in my humble opinion. They are the gatekeeper to the lender and can help (or hurt) your chances to get the deal so be sure to play nice with them!
2. Short Sale
This is a sales transaction where the property sells for less than what is owed to the lenders who hold liens on it. The lenders need to agree to the sell price and have to issue a “Settlement Letter” giving their consent to release their lien for an amount other than what is owed to them. These types of deals can take some time to work through the red tape with the banks and are typically coordinated by a third party.
In my part of the world, the agent listing the house has an attorney deal with the bank. The attorney even negotiates a fee for themselves in the settlement with the bank. Most short sales are handled with real estate agents these days. Right after the crash, when things were like the Wild West in real estate, many wholesalers would negotiate a short sale themselves and then resell the deal to others. I don’t see much of that in NJ, but it may happen elsewhere still. Bottom line, you can get a good deal with a short sale—if you are willing to wait for the bank to come around.
3. BPO: Broker Price Opinion
This is an opinion of the value of a piece of real estate, offered up by a real estate broker or agent. Typically you see a BPO as opposed to a full-fledged appraisal on short sales or REO deals. The BPO is not as thorough as an appraisal. Typically the broker gets a small fee and writes up an opinion of value, which is used to justify the sale. The bank will order this to confirm that the deal is being sold somewhere near market value, minus the repairs. The way you win on this is to get that BPO agent to consider the repairs the property needs. If you can, send them some pictures ahead of time!
4. NOI: Net Operating Income
This is a calculation for rental real estate. Easily explained, this is how much money you would make if you owned the property free and clear of a mortgage. The NOI is calculated on an annual basis and equals the Net Rental Income (total rent for the year minus vacancy), minus the Operating Expenses (this is all costs for maintaining the property, including real estate tax, insurance, maintenance, management, utilities, landscaping, legal, leasing commissions, etc.—everything EXCEPT the mortgage payment.) Sometimes people include “Capital Expenses” as an expense also. More on that later. For larger deals, you want to see a NOI that is between 40 and 50% of the Net Rental Income. The NOI means very little by itself, but it’s used for two very important calculations, explained below.
5. CAP Rate
The Capitalization Rate is NOI divided by the sell price or value of a piece of real estate. It is expressed as a percentage, but most people leave the percent part off when they are talking about it, i.e., “This property is a 10 CAP!” CAP rates are used to compare real estate investment opportunities. The CAP Rate is what your return on investment would be if you owned the property free and clear.
In my humble opinion, this term gets thrown around too often in our business. Some people confuse it with Return on Investment, which is very different. It also gets used on small real estate deals, like single family homes and small multi-unit buildings. I don’t think it is an appropriate way to evaluate these types of deals, and it can be dangerous to do so. A Single Family Home can have a fantastic CAP Rate, as long as it’s rented. If you have one month of vacancy, all those calculations go out the window. This is a way deeper conversation for another day, so let’s stop right there.
6. Debt Service
This is a fancy way to say “mortgage payment.” It’s the money required to “Service the Debt” on the property. It includes the interest on the loan and any pay back of the loan balance (principal reduction, defined below). The NOI minus the Debt Service equals your cash flow.
7. DSCR: Debt Service Coverage Ratio
The DSCR equals the NOI divided by the Debt Service. In simple terms, it is how many times over the property can pay the mortgage payment after expenses are paid out. This number is really only important to lenders. In today’s marketplace, they want to see a DSCR at 1.25 or more. When evaluating a deal, just make sure that your DSCR exceeds your lender’s threshold. Most lenders will be able to tell you what their required number is right off the top of their head!
8. Principal Reduction
We went over this briefly; this is the part of a mortgage payment that goes towards paying back the debt. What makes this a conversation piece is how people view it. When you turn in your tax return at the end of the year, all you are able to claim as an expense when considering your Debt Service is the interest. The Principal Reduction is not an expense, it is repayment of a loan.
Some investors—and many commercial brokers trying to sell deals—will call Principal Reduction to be income. The IRS makes you pay taxes on it, so technically it is income. That being said, I always back it out of my profit calculations because it’s not cash in my pocket NOW. It’s potential future income, and there are a lot of IFs to consider before I get to hold that income in my hand. I do see Principal Reduction as a benefit, but to me it’s a part of long term wealth building.
9. $/SF – Dollars Per Square Foot
This is a great way to evaluate things like construction costs, rents, and sell prices of property. The last two apply somewhat in single family homes, and the all apply in multifamily and commercial deals. Not all properties are the same size, so comparing the cost to rehab, rent, or buy a property based on $/SF allows you to compare one deal to another. It’s also a really good “rule of thumb” to evaluate a deal, as long as the market and property type are the same.
10. Phase 1 Study
If you have only done residential deals, you may not have even heard of this one. A Phase 1 is a study to determine the potential environmental hazards that exist on a property. Things like prior uses, on site storage tanks, asbestos, and lead-based paint are taken into consideration. A lender is the one who will push to have something like this done because they don’t want an environmental issue to arise that will drastically decrease the value of the property they have a loan on.
I have had many Phase 1 studies done. One of them uncovered underground oil tanks that had leaked into the soil around the property, and another found a deposit of lead in the soil that had to be removed. If you do the study before closing, it is the responsibility of the seller to take care of remediating these issues. In my part of the world, you can get an “Environmental Review” done for less than $1,000 and a full-fledged Phase 1 done for around $3,000 depending on the size and complexity of the property. The difference is a Phase 1 considers prior uses of the property. If someone was using the address as a paint factory 75 years ago, you want to know about it. The way I look at it, it’s a very inexpensive way to uncover something that can cost you tons of money in the future.
This is a term used to determine the real estate taxes on a property. The assessment has a relation to the property’s value, but is not the same as the value. Most people think they are the same thing—or close to it. That’s not always the case. It doesn’t fluctuate like the value does, and there are equations that are used to determine the assessment. Every town is different. You can call your local tax office to ask how they calculate it if you are curious. The real estate taxes you pay per year equal the Assessment times the Tax Rate. If your property gets re-assessed, your taxes are going to change. When you appeal your real estate taxes, what you are really doing is appealing the town’s assessment of your property.
I had to throw that one in there. If you are going to stay sane in this business, be sure to “Laugh Out Loud” at least three times a day. Doctor’s orders.
This is a basic one. It stands for Loan to Value. A lender will base the loan they will give you on a percentage of the property’s value. The reason I have this in this conversation is that you need to make sure you know what value they are talking about. Most banks use an appraiser. If you are using a private lender, you could mutually agree on a value based on other sales in the market (also called “Comps” or Comparable Sales). If you are doing repairs on the property, you want to know if they are talking about the value before or after the repairs (sometimes called After Repair Value or ARV). It is a basic term, but it’s one that gets thrown around without clarity sometimes.
14. Personal Guarantee
This is another one that’s very common, a term most people think they understand. It carries a lot of weight, and I take it very seriously. A Personal Guarantee is something that’s offered on a loan. It means that even though a mortgage loan is probably given to an LLC or other business entity, an individual(s) is being asked to pledge their own personal credit and assets to the loan as well. That means that you are putting your personal home, bank accounts, and any other assets you own on the line when you sign one of these. Take these seriously when you sign them!
Most mortgages don’t get paid down evenly over time. Most mortgages are amortized, meaning that each month, a little more of the money you pay goes towards principal and less towards interest. At first the principal portion is not much at all. Over time, the principal side goes up and up, to the point where you build a big snowball of debt pay down each month. If you are a visual person, do a Google search for “Amortization Charts” to see this in graphic form.
16. Capital Expenses and Capital Expense Reserves (Cap Ex)
So this is another one that gets tossed around a lot. Some expenses are applied the moment you have to pay for them, like a maintenance man unclogging a toilet, an electric bill, or property insurance. Larger expenses that are considered to be a contribution to the long term value of the property are called “capital expenses.” It seems frugal but is actually unrealistic for an owner of a single family or small multi to set aside money each month for a potential roof repair or heater replacement 15 years down the road.
For larger real estate, these types of expenses come up more frequently. You need to set aside money each year for things like roof replacements, a new boiler, new windows, repaving parking areas, and common area upgrades. There should be a line item in your expenses for Cap Ex. There are plenty of rules of thumb out there depending on the type of property we are talking about. You will find numbers in $/SF or $/Unit, and they should reflect the cost of these Capital Expenditures in your local area.
So the bottom line on real estate lingo is ASK. Don’t let someone throw out a term when you are evaluating a deal and not ask what they mean by it. There’s nothing wrong with getting more clarity and making sure that you are talking about the same thing.
So which ones did I miss?
Let’s get a conversation going! Thanks for reading!
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This information is intended only for the use of the intended recipient(s) and it may be privileged and confidential. Please note that any views or opinions presented in this post are solely those of the author and do not necessarily represent those of the company. This is reposted information and is not original thought of Ireland Investments or anyone associated with the business.
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