We have created a glossary of the most commonly used real estate terms and their definitions. This will help you to have a better understanding of the terminology used for your investment process.
1031 Exchange
When you sell an investment property you will likely have to pay some hefty capital gains taxes at the time of the sale. However, under Section 1031 of the U.S. Internal Revenue Code, a taxpayer may defer (pay at a later date), capital gains and related federal income tax liability on the exchange of certain types of property. To put it in layman’s terms, this means you can pay taxes on the income from the sale of a property at a later date if you take that money and put it towards purchasing another property, or portfolio of properties, of equal or higher value.
Adjustable Rate Mortgage (ARM)
An adjustable rate mortgage, (ARM), is a mortgage that does not have a fixed interest rate. Instead, an ARM can change monthly throughout the life of the loan based on the benchmark interest rate, which fluctuates based on capital market conditions. The initial interest rate is typically fixed for the first few years and then resets periodically.
Appreciation
Appreciation is an increase in the value of an asset over time. The increase can occur for a number of reasons including increased demand, weakening supply, inflation, or interest rate fluctuations. This is the opposite of depreciation which is a decrease in the value of an asset over time. Like a property’s cap rate, appreciation is an important piece of the puzzle when evaluating the overall appeal of an investment property. As the market value of your rental increases, so does the ROI.
Cap Rate
Capitalization rate, or cap rate for short, is used to measure the annual rate of return on a real estate investment based on the profit that property is expected to generate. Simply put, it is the ratio between the net operating income (NOI) and the purchase price. Cap rate is calculated by dividing the net operating income (NOI) in the first year, by the property purchase price. (NOI excludes loan costs if you used financing). Cap rate is one piece of the puzzle to take into consideration when evaluating an investment property. It can signify varying levels of risk: lower-yielding properties tend to be safer investments, while higher-yielding properties typically come with a little more risk. Potentially, both types of properties have a place in your portfolio.
Example: Say you purchase a property for $1,000,000. The expected NOI in the first year is $80,000.
$80,000/$1,000,000 = 0.08
Cap rate: 8%
CapEx
CapEx, or capital expenditures, are defined as new purchases or major improvements and renovations that extend the life of a property, such as replacing a roof or repairing a parking lot. This term also covers the equipment and supplies required to make these improvements. Generally these are one-time, major expenses. Most parts of a property will eventually need replacing and though these big-ticket items may only need attending to every 20 years, it is important to know that there will come a time when you will need to replace a bathroom floor, do major repairs to the parking lot, or fix the roof. Just remember—these repairs and improvements ultimately extend the overall life and value of your investment property.
Note: When it comes to taxes, capital expenditures and routine maintenance are deducted differently. While major improvements and upgrades are recovered through depreciation, general fixes or maintenance that keep a rental home in good operating condition are classified as “repairs” and can be written off in a single tax year.
Capital Gains Tax
Capital gain or loss is the difference in value of a property compared to its purchase price. If there is a gain, it is realized after the asset is sold. A short-term capital gain is one year or less while a long-term gain is more than a year, both of which must be claimed on your income taxes. Short-term capital gains have a higher tax rate than long-term capital gains. Understanding how your real estate investments are taxed is important if you are looking to optimize performance and returns.
Cash Flow
Cash flow is the amount of money you can pocket at the end of each month after all operating expenses, including loan payments, have been paid. If you spend less money than you earn, your cash flow will be positive. If you spend more money than you earn, your cash flow will be negative. Consistent monthly rental income is one of the most appealing reasons to invest in real estate. Ideally, an investment property should be cash-flow positive. This means rent is higher than the monthly mortgage, which provides a steady stream of passive income.
Rental income – all operating expenses (including loan payments) = Cash flow
Cash-on-Cash Return
This figure is the ratio of annual pre-tax cash flow to the total amount of cash invested, expressed as a percentage. Cash-on-cash return measures the yearly return in relation to how much money you put down. It does not take into consideration some of the other benefits of rental property ownership, such as appreciation, loan paydown, depreciation, and other tax benefits. Whereas calculations based on standard ROI take into account the total return on an investment, cash-on-cash return only measures the return on the actual cash invested. It is the cash you have left after one year, divided by the cash you have invested.
Annual pre-tax cash flow / actual cash invested = Cash-on-cash return
Closing Costs
Closing costs are the fees paid at the end of a real estate transaction. These fees vary depending on where you live, the property you buy, and the type of loan you choose. There are costs associated with inspections, transfer of title, loan origination fees, etc. It is important to budget accordingly for your closing fees so that you will have enough cash on hand at the time of purchase.
CRE
Commercial real estate (CRE) is income-producing property that falls into the following main categories: land, industrial, retail, office, special use (such as a gas station or government building), and larger multifamily apartment buildings. Both commercial and residential property can generate cash flow and potential appreciation in market value for investors. CRE is usually bought and sold by well-capitalized, sophisticated investors such as private equity firms or hedge funds, making it much more difficult for a smaller investor to compete.
Debt-to-Equity Ratio
In real estate, debt-to-equity (D/E) ratio is a measure of ownership. This ratio helps you determine how much of your property is actually yours, if you took out a mortgage to finance it, and how much you owe in debt. This is important because it paints a more holistic picture of your investment. It tells you how much capital you have invested and how much you owe, which gives you a rough idea of how much you will walk away with when you decide to sell. It also matters if you are looking to refinance your investment property, as lenders will consider your debt-to-equity ratio as a measure of creditworthiness.
Equity
Equity is the difference between the current market value of the property and the amount that you, the owner, owe on the property’s mortgage. If you were to sell your investment property, the equity would be the money you receive after paying off the mortgage in full. This value can build up over time as the mortgage balance declines and the market value of the property appreciates.
Equity Multiple
The equity multiple is defined as the total cash distributions received from an investment, divided by the total equity invested. Essentially, it is how much money an investor could make on their initial investment. An equity multiple less than 1.0x means that you are getting back less cash than you invested. An equity multiple greater than 1.0x means that you are getting back more cash than you invested. For instance, an equity multiple of 2.50x means that for every $1 invested into a CRE project, an investor could be expected to get back $2.50.
Escrow
Escrow is when an impartial third party holds on to something of value during a transaction. When you make an offer on a property, you will pay a portion of the down payment ahead of time. This payment will be held by an impartial third party in a separate bank account until the contract has been negotiated and the deal has been closed. Escrow helps remove risk from the transactions for both parties. The escrow agent holds the money exchanged in a purchase until all agreed-upon conditions between the buyer and seller are met. Once these are completed, escrow funds are released to the seller.
Fixed-Rate Mortgage
A fixed-rate mortgage is a mortgage loan that has a predefined interest rate for a determined amount of time. Fixed-rate mortgages are appealing because monthly mortgage payments stay the same, which makes budgeting and planning for future investments a little easier.
GRI
Gross rental income (GRI) is the amount of money collected in rent plus any additional income such as application fees, parking fees, advance rent, or any expenses paid by the tenant to the landlord that are not required as part of the lease. Security deposits paid by the tenant are not considered to be income. GRI is used by real estate investors to forecast the total amount of income a rental property could generate. When creating a property pro forma, investors begin with the GRI, then make deductions for vacancy, credit loss, and bad debt to help determine how much adjusted gross income the investment will generate before paying the mortgage and normal operating expenses.
GRM
Gross rent multiplier (GRM) is the ratio of the price of a rental property to its gross rental income before expenses. Another way of thinking about GRM is that the ratio represents how many years it would take for an investment to pay for itself based on the gross rental income received. Everything else being equal, the lower the GRM is, the better the investment may be. GRM is a quick way of ranking potential rental property investments before spending time on a deeper analysis. Unlike Cap Rate, which measures the rate of annual return based on net income (excluding the mortgage expense), the GRM is a multiplier that uses gross income.
Example: Say you purchase a property for $1,000,000. The expected NOI in the first year is $80,000.
$80,000/$1,000,000 = 0.08
Cap rate: 8%
HVAC
Heating, Ventilation, and Air Conditioning (HVAC) systems are used to heat and cool a building. Sometimes, HVAC units have integrated heating and cooling systems, while other times the rental property HVAC system consists of a separate unit. The ventilation part of an HVAC system is made up of ductwork that runs through the building. HVAC systems must be kept in proper condition and receive regular maintenance, as it is one of the three most expensive items in a building.
Internal Rate of Return (IRR)
The internal rate of return (IRR) is a measurement of a property’s long-term profitability that takes into account all cash flows and the change in equity over time. IRR is the single best estimate of your asset’s performance over the entire time that you plan to hold it. It allows you to evaluate investments that may have different cash flows or appreciation potential. IRR is the annual rate of growth an investment is expected to generate.
LTV
Loan-to-Value (LTV) is a percentage that measures the total debt or leverage on a property compared to the market value. In most cases, real estate investors will use a conservative LTV of no more than 75% to 80%. A property with an LTV greater than 80% can be described as being over-leveraged, creating the risk of potential negative cash flow due to a larger mortgage payment. In general, the lower the LTV is, the less risk there is of having negative cash flow from a rental property. A low mortgage payment gives an investor the opportunity to set more net cash aside for capital repairs or a period of extended vacancy if the property takes longer to rent than anticipated.
Example: LTV = $3,750,000 loan / $5,000,000 market value = 75% LTV
Net Operating Income
Net operating income (NOI) is a measure of a real estate investment property’s potential to be profitable. NOI is calculated by estimating the property’s revenue and subtracting all operating expenses such as repairs, maintenance, property taxes, fees, etc. It does not include mortgage payments. NOI allows you to analyze all different types of properties without looking at financing terms. It is also required to calculate cap rate.
Revenue – all reasonably necessary operating expenses = NOI
ROI
ROI stands for “return on investment” and it refers to the profit or cost savings that a company makes for the money it invests in any given endeavor (e.g. terminology project).
In simple terms, the ROI is a formula that measures the profitability of an investment. To calculate this, we divide the benefit (also called the return or net gain), by the cost of the investment. The result gives an estimation of the potential benefits that the investment could bring. If the result of the ROI is positive, then the investment can be made; if it is negative, then the company should not invest.
Turnkey Property
A turnkey property is one that is completely, or very close to move-in ready. Turnkey properties are appealing from an investment standpoint since investors can purchase a property and rent it out immediately, without making any major repairs. Even if there are some improvements that need to be made at some point, investors can start earning rental income right away as long as the property is move-in ready.