If you are getting started with property investment, it is vital to understand the typical real estate investing terms and definitions. The real estate industry is notorious for unique terminologies that may intimidate beginner investors. Understanding them makes it easy to interact with other real estate experts and conduct transactions without a hassle. That said, the following is a compilation of real estate investing terms you should know.
Real Estate Investing Terms And Definitions To Know
Table of Contents
- Property Classes
- Fixed-Rate Mortgage vs. Adjustable-Rate Mortgage
- Appreciation vs. Depreciation
- Seller’s Market vs. Buyer’s Market
- Cash Flow
- Cash-on-Cash Return
- Capital Expenditure
- Turnkey Property
- Capital Gain Tax
- 1031 Exchange
- Capitalization Rate
- Debt-to-Equity Ratio
- HOA Fees
- The Bottom Line
Below are the different property classes based on their physical, demographical, geographical characteristics:
- Class A properties: These investment properties are typically newly built (under ten years old), in excellent condition, and have fewer maintenance issues. They are usually high-end properties with modern amenities and premium finishes such as granite countertops and hardwood floors. They are in high demand and subsequently have higher occupancy rates, higher rental rates, and lowest risks.
- Class B properties: These properties are quite similar to Class A properties but are a bit older (between 10 and 25 years old) and often need more maintenance. They are located in good neighborhoods and are still in good condition. Expect moderate-high rental prices, more growth potential, lower risks, and lower cap rate.
- Class C properties: They are over 25 years old, located in less desirable, low-income neighborhoods, require a great deal of rehabilitation, and have lower rental rents. They have lower acquisition costs but carry moderate risks due to the higher renovation needs. They come with a high cap rate, fewer financing options, and are best suited for experienced property investors or property management company.
- Class D properties: They are investments older than 30 years and are in a more neglected state. A considerable amount of repairs is needed to make these properties habitable. Additionally, they are located in undesirable locations often characterized by rampant crime and drug abuse. But they have the lowest acquisition costs and boast the potential to yield the highest price-to-rent ratios. Check out this post on investing in Class C and D properties.
Fixed-Rate Mortgage vs. Adjustable-Rate Mortgage
A fixed-rate mortgage is a mortgage loan with a predefined interest rate that does not change throughout the loan’s life. Monthly payments remain the same, making it easier for property investors to budget and plan their future property investments.
Contrarily, an adjustable-rate mortgage (ARM lacks a fixed interest rate and may change monthly throughout the loan term based on capital market conditions. With an ARM, expect your monthly payments to decrease and increase periodically, and therefore you should know the potential risks before dipping your toes in this loan type. Typically, the initial interest rate is fixed in the first few years, after which they start resetting occasionally.
Appreciation vs. Depreciation
Appreciation is the increase in the recorded value of a property over time. This could occur due to several reasons, including;
- Increasing demand and weakening supply of homes
- Fiscal inflation- leads to an increase in the price of several input items like construction materials, land, statutory construction permits, and labor.
- Downward movement of mortgage interests, meaning more potential homeowners or investors can afford the monthly payments.
- Higher population growth in a neighborhood- results in higher demand for housing.
- Property market drivers- they influence the desirability and convenience of living in a particular area. Think about shopping malls, educational facilities, public transport facilities, and other new infrastructure developments.
The opposite of appreciation is depreciation, which is the decrease in a property’s value over time. Depreciation is often attributed to economic weakness and poor property conditions.
Seller’s Market vs. Buyer’s Market
Like all other markets, the real estate market is subject to cycle variations, depending on factors like consumer confidence, economic conditions, and interest rates.
A seller’s market occurs when the supply of properties cannot meet the demand. There are more buyers than homes for sale, and prices tend to be higher. Homes sell quickly, and sellers have more negotiating power.
A buyer’s market happens when the supply exceeds demand in real estate. There are more homes for sale than buyers, prices tend to be lower, and homes stay on the market longer. Homebuyers enjoy more choices and higher negotiating power. A balanced market occurs when the demand for housing equals the supply.
In property investment, equity refers to the difference between the property’s current value and the amount of mortgage the owner owes to the property. It would be the amount of money you would receive if you sold your property and paid off the mortgage balance in full. Equity increases with the reduction of mortgage balance and appreciation of the property’s market value and is a key strategy for accumulating long-term wealth. You might need to harness your home equity at some point in your life, whether you want to fund a significant investment, upgrade to a different home, or fund your retirement.
LTV is a lending risk assessment that lenders take into account before approving a mortgage. It is a percentage measure of the loan against the property’s appraisal value. Assume you intend to borrow $170,000 to purchase a property valued at $200,000. The loan to value ratio would be:
The lower the LTV ratio, the less the risk of negative cash flow often attributed to massive mortgage payments. Lenders prefer lower LTV (usually a maximum of 75-80%), often offering lower interests to borrowers with larger down payments.
Cash flow is the money a property investor pockets after paying all respective expenses, including loan payments and property maintenance. A positive cash flow occurs when you spend less money than you earn. The vice versa is true for a negative cash flow.
Cash flow is used in income-producing properties such as duplexes, single-family rentals, apartment complexes, and commercial buildings. You can use this passive income to build your savings account or fund a down payment of another property. Learn more about ways to maximizing cash flow for your rental apartments.
Cash-on-Cash Return (CoC)
Cash-on-cash return is the ratio of pre-tax cash to the total cash invested. Unlike the standard ROI calculation, which considers the total return on investment, cash-on-cash return only measures the return on actual cash invested.
CoC compares an investment property’s pre-tax cash inflows and the pre-tax cash outflows. It is a good strategy for analyzing the investment’s performance more accurately. Investors can also use the ratio to predict the future expect cash distribution of property investment.
Capital Expenditure (CapEx)
Capital expenditures are one-time expenses geared towards improving an investment property’s overall lifetime and value. The improvement can include replacing a roof, installing a new furnace, finishing the base. From this definition, you can tell that repainting your rental units after a tenant moves out is not a capital expenditure.
When it comes to taxation, capital expenditures are recovered through depreciation, unlike operating expenses (the regular and predictable expenses), which can be written off in a single tax year.
Net Operating Income (NOI)
Used to evaluate the profitability of income-generating property investment, NOI is a before-tax figure that accounts for all revenue minus reasonably necessary expenses such as maintenance, property taxes, HOA fees, utilities, and repairs. Note that NOI excludes capital expenditures, principal and interest payments on a mortgage, and depreciation.
A turnkey property is a property you can buy and immediately rent out. Investors often acquire such properties from companies that specialize in rehabilitating older properties. Most of these companies also offer property management services, freeing up the time and energy investors need to focus on other important matters.
The extent of work and duration required to bring a property to a move-in ready status often varies from property to property. Typical renovation works may include electrical repairs, fixes to the floor, plumbing repairs, and adding fresh paint to the interior. The umbrella term for these activities is rehabilitation.
Capital Gain Tax
A capital gain or loss is the difference between a property’s value and its purchase price. The gain or loss is realized after selling the home. A capital gain can be short term (for properties sold after less than a year of ownership) or long term (for homes held for more than a year).
A capital gains tax is a levy applicable to growth in the value of investment property. Note that short-term capital gains are taxed as ordinary income. However, the tax rates for long-term capital gains are 0%, 15%, and 20%, depending on the investor’s tax bracket.
A 1031 exchange allows you to defer capital gains tax following a sale of an investment property and reinvest all the proceeds in a similar property of equal or greater value. The tax deferral helps free up more investment capital for the replacement property, allowing you to build your investment portfolio without worrying about paying taxes at the point of every sale.
But bear in mind that a 1031 exchange requires relatively higher minimum investment and holding time. Additionally, the procedure comes with strict timelines, requiring the investor to identify the replacement property within 45 days and acquire it within 180 days.
Used in assessing the annual rate of return on property investment based on the expected profits, capitalization rate/cap rate is the ratio of the net operating income(NOI) generated by the property and the purchase price.
Assume a building worth $1m has the potential to generate $70,000 in NOI. The cap rate, in this case, would be:
($70,000/$1,000,000) x 100% = 7%
A good capitalization rate hovers between 4% and 10%, depending on several factors, including the current real estate market, property’s location, current market, and many more.
Debt-to-Equity Ratio (DER)
The debt to equity ratio in property investment is an ownership metric that compares the debt and equity used to finance the purchase of a home. For instance, if you own a property valued at $500,000 and the balance on the mortgage is $350,000, the difference between the two figures is the amount of equity you have in the property: $150,000. Dividing the mortgage balance by your equity gives you your DER: 2.3. The lower the DER, the better your financial position because you owe less on and own more of the property.
A collapse of the housing market can lead to a negative DER. For instance, if a rental property in Southern California is valued at $200,000 and has a mortgage balance of $230,000, the owner has negative $30,000 equity. This spells doom for investors who buy properties intending to resell at a profit, but it should not be a problem if you can hold on longer until the market recovers.
A homeowner’s association (HOA) creates and enforces regulations for properties within a community or subdivision. When you buy a property located in an HOA’s jurisdiction, you automatically become a member and are required to pay HOA fees. The fees go towards maintaining and improving the properties within the subdivision.
As you evaluate potential investment properties, understand that HOA fees cut into your cash flow, and you may need to factor them into your rental prices. Compare HOA fees in different areas and understand what the fees cover.
In property investment, escrow is a financial agreement in which a property seller and buyer enlist an impartial third party to hold money on their behalf and release the funds only when all predetermined conditions are met.
The third-party, known as the escrow provider, serves as a middleman, ensuring the two parties perform their agreed-upon responsibilities in the transaction.
Real estate escrow opens when a signed agreement is submitted, and an earnest amount of money deposit is paid to the escrow provider. It closes when the title is recorded in the buyer’s name and the purchase money is disbursed to the seller.
RTO is a combination of lease agreement and property purchase agreement. For instance, a tenant might pay $2000 per month with $1,400 the regular rental rate and $600 being credited towards the house’s purchase price indicated in the purchase agreement.
A first-time buyer can leverage RTO to purchase property over time without worrying about huge upfront costs. RTO can also serve as a gradual exit for a real estate owner who wants to sell it. In that case, the investor benefits from monthly cash flow that is higher than the normal rental price until the tenant completes the payments.
The Bottom Line
The above are the typical real estate terms and definitions you will encounter when venturing into property investment. Undoubtedly, there are many more terminologies you will come across as you wade the real estate waters, but you have to start somewhere.
Do you want more time, energy, and peace of mind to focus on other important matters of your life without worrying over your commercial or residential properties? RTI Properties can help with some of the best property management services in Southern California. Call us today at 310-532-9122 or contact us online with any questions about property investment or our property management services.