Top Real Estate Investing Terms To Know – Video
Kathy Fettke: Hello everyone. Welcome to Real Wealth Investor Academy, a section on understanding Real Estate Investor Jargon. Let me tell you, when I first got into real estate it was like learning a new language. I totally understand. There’s a lot to try to squeeze into this webinar without totally overwhelming everybody. I’m going to do my best to try to keep it interesting and not too much like reading out of a dictionary, okay? I promise, I’ll do my best.
I wanted to start with commercial lingo. The reason for that is first of all, we certainly have some academy members who are experienced and don’t necessarily need to know the basics, so I thought I’d turn it around and start with the more complicated concepts first and then we’ll move on down the line to more introductory beginner concepts.
We’re going to start with commercial. The capitalization rate, this is one you’re going to hear me talking about a lot which is also known as a cap rate. It’s simply a measure of a property’s performance before considering financing. If you were to go get a loan, you might put down a different down payment than me, you might get a different interest rate than me. A different term, maybe 15-year, maybe 30-year, maybe just a 5-year term. We just can’t really add the financing numbers and expenses into a property’s performance because it’s just going to vary for everybody. The cap rate is a way to get around that. Here is how it works.
You take the net operating income, of an income property, and you divide it by the sale’s price and you have a cap rate. Even though that’s really simple, sometimes it feels a little more complicated.
The Net Operating Income or NOI, is the dollar amount leftover after you’ve collected all your income and paid out all your operating expenses except for the financing again. Net Operating Income again, is all the income that you have leftover after you paid out your expenses.
Gross income minus operating expenses is your net operating income. I hope I’m not being overly simplified here but we’re going to go through a real pro forma in just a little bit but I wanted to explain these. Of course, you can always go back and watch this if you’re brand new to this and your head kind of hurts after a while trying to do the math in your head. You can always listen to this recorded version to refresh.
More commercial terms; Gross income, that’s pretty obvious. It’s all income including rents, laundry, vending machines and late fees. Remember these, these are terms that we use for single family homes these days but these terms are really generated from the commercial world.
Obviously, you’re not going to be collecting money for laundry and vending machines and so forth on a single family home. The idea is all the income that the property generates is your gross income.
Effective gross income is, you just subtract the vacancy from the gross income.
The Vacancy Rate is the number of vacancies divided by the number of units. Again, talking commercial but often times when we’re trying to get a vacancy rate for single-family homes, there’s several ways that people do it. Sometimes when interviewing a property manager, you might want to find out what the vacancy rate is for that property management company. In other words, if they’re managing 500 properties and they have five vacancies then you’d say, number of vacancies, five vacancies, divided by the 500 properties they’re managing and that’s your vacancy rate. Or, you might be able to do a little further research on the area and maybe go to some websites where you’re able to look at the different kind of rents in an area, how many properties in the area are for rent and be able to guess the vacancy rate.
That’s really hard to do though. I would certainly leave that up to the experts and property managers to try to guess the vacancy rate of an area. Generally speaking, vacancy rates when you go online, is usually based on apartment vacancies. Because that’s really much easier to gauge than single-family homes because how do you know that a homeowner hasn’t rented their house out, or now they’re living there, or they are using it as a vacation property.
It’s a lot harder to know. With an apartment, pretty much it’s all rented out, it’s a rental property and you can find out how many are vacant and get the vacancy rate for apartments. That’s basically what you’re going to find online. At RealWealth, we really rely on the property management companies to give us vacancy rates for their companies. All right, moving on.
Operating expenses. That usually include taxes, insurance, utilities, management fees, payroll, landscaping maintenance and supplies but it does not include debt service or interest expense. Again, for the reasons I mentioned before.
Again, we’re taking commercials so hopefully you’re not having to pay all of these fees if you’re investing in single-family homes. Of course, you’ve got taxes and and insurance but you may not be paying all the utilities and again it just depends on the area that you’re in. Sometimes like in California, it’s generally normal practice that a landlord pays for water. Why is that? When I talk landlords and being a landlord, I have wanted to make sure that the tenants don’t skimp on watering the plants. If they feel they have to pay for the water and they don’t want to spend too much, they might not keep the yard up. I think, that’s one of the reasons why we usually cover the water bill. Depending on where you live and whether it’s a condo and what you’re renting out, you may or may not have to cover the garbage and various utilities.
You will have to cover management fees. Payroll, if you have it, if you have a bookkeeper and so forth. Landscaping, again, depends on the contract that you write with your tenant and often we put the landscaping on the tenant to cover but if you’re owning a commercial building or multifamily often that landscaping cost is paid for by the landlord. Maintenance, of course, that is usually the landlord unless you want to triple net lease which we’ll talk about in a little bit. Then supplies, again, that pretty much just applies to the commercial.
Although, there are certain things again that you can work into your contract as a landlord. Again, operating expenses do not include debt service or interest expense because that can vary so much for everybody.
Okay, let’s get on to calculating returns because we have a lot of investors who come into RealWealth and are buying their first property and we’re just assuming that all of these is understood. When we talk about return and cash flow and so forth. I have to remember that Californians really don’t understand cash flow at all. Because it’s usually an appreciation play. Of course, a lot of our members are from all over the world and all over the country.
You may or may not understand cash flow but here it is, it’s operating income minus debt service. That’s the definition of cash flow.
Cash-on-cash return, annual cash flow divided by down payment. This is important to understand and we’re going to go over pro forma in just a moment to explain the cash-on-cash return but basically, it’s just the annual, how quickly you can get your money back on an investment. Here it is, determines how long it takes to get your money back.
Let’s say you’re down payment is $20,000 on a $100,000 home, and you’re financing the rest.
$80,000 is financed by the bank. You’re using $20,000 of your own money and let’s just throw in another $5,000 for closing cost, that’s high but all in you put $25,000, you’ve got a loan for $80,000. How long is it going you take you to get your initial money back so that after that, it’s just money in the bank because you can take the initial money put in and then go buy something else or invest in something else but you’ve got a asset that’s paying you for the rest of your life.
That’s the cash-on-cash return.
ROI, of course that’s just a general return on investment, return divided by cost but that is super, super vague. Be careful when anyone just gives you an ROI because what are they really referring to when it comes to return? For example, I think it’s the next one IRR.
Internal Rate of Return is a little bit more specific in terms of what are we talking about here? It accounts for the time value of money. You could invest your money in a property and tell somebody, “I got a 20% return.” A 20% return on investment, what does that mean? Did you own the property for five years and get 20%, or did you get 20% for a year? Or did you buy it, fix it up and sell it and get 20% in a month?
IRR calculates the time value of money which is very, very valuable. Of course, any of us could make a 20% return if it took us 20 years, that’s 1% a year. My goodness, hopefully we all know how to do that. Better yet, would be to be able to get that 20% return in one year and do that every year. Again, IRR much more useful than ROI.
Again, comparing all of these things let’s say, you were buying $100,000 property with cash. Now, you’ve got $100,000 of your own money as opposed to $20,000 with the down payment as you financed. Your cash-on-cash return is going to be much better where you put less cash in, right? The more you get to know RealWealth and get to know me, you’ll know that I’m a big fan of not using too much of your own cash and really leveraging using more OPM, Other People’s Money.
On this page, debt coverage ratio is the annual net operating income, remember that’s the income after expenses, divided by the annual debt service principal and interest. You’re basically finding out on a debt coverage ratio if you’re going to be negative cash flow or positive cash flow, that’s basically what it comes down to. With adding the debt service in there, are you going to be feeding the property or is the property going to be feeding you? If that debt coverage ratio is less than one, then I wouldn’t buy it because your expenses do not cover income.
Unless you have a bunch of money sitting around to feed the property, you do not want a debt coverage ratio under one but if it’s more than one, you have enough income to cover expenses plus a little extra to put in your pocket. Now, we’re talking. Now, it’s an investment. If you had a debt coverage ratio of one and a half, that means the property generates 50% more income needed to pay all the annual debt and operating expenses. That’s a good deal.
The annual gross rent multiplier. This is just a way for people buying commercial property to just at a glance be able to decide if they want to do further due diligence on a property. It’s not accurate by any means and should not be relied on but it’s a way to quickly say, “Do I want to look at this further or is this a waste of my time.” It’s sales price divided by potential gross income. Example, $100,000 property divided by $10,000 annual rents is a 10% gross rent multiplier.
Moving on. These were a bunch of terms that I had mentioned or that certainly if you were getting a loan you would hear about. I want to make sure that we’ve gone over it.
PMI, this was on the spreadsheet. This is basically Private Mortgage Insurance. It’s usually required by lenders if you’re down payment is less than 20%. Good luck finding an investment property that you can finance with less than 20%. That’s pretty tough to do. Usually, you have to put 20 to 25% down. If you do, my goodness tell me how because like I said I like leverage.
If you’re buying a primary or a second home, a vacation home, oftentimes for a primary you can put just 3.5% down and a vacation home as low as 5%.
There are some really great programs out there to look into. If you have a vacation home, you can rent that out. You just have to stay in it for– it depends on the lender but sometimes it’s two weeks or 10 days, that you have to use that vacation home in order for it to qualify. You can also rent it out. That’s a great loan to get, just 5% down. You would have to pay PMI. That’s the same again if you are getting an FHA loan or if you are getting a loan that was less than 20%, you’d have to pay that. It’s not that cheap, but in my opinion it’s still better than putting all that money down and tying it up with today’s interest rates. I know there’s people who disagree with me on that, but right now is a good time to acquire property. The more you can acquire the better so why tie up so much for property. This window of opportunity is going to be gone before you know it. I can’t emphasize that enough; that people will be looking back and saying, “Oh yes, I bought a property for $45,000.”, and that just will not be possible. We’re going to all regret not buying property in 5 to 10 years, so why put so much down. Again, this is a time to acquire, acquire, acquire.
All right. Loan origination fees. These are also called underwriting fees, admin fees, processing fees and they’re charged by the lender for preparing your loan. It’s basically what your broker makes when you get a loan.
Points, we have a lot of people asking what are points. I don’t know why it’s called points but it’s a one time charge to be negotiated with the lender usually to reduce the interest rate you pay over time. You might go get a loan and they say, “Okay, it’s 3.5% or it’s 5% or it’s whatever the rate is, but if you pay 2 points it will be 4.5% or 4% or whatever.” It often will reduce your interest rate by paying points because you’re basically paying the lender up front for their discount that they’re giving you. It’s in my opinion, a very wise thing to do if you are going to keep the loan for a long time. Believe me, there’s no reason to not keep your loan for a long time because we’re never going to see interest rates like this. In my opinion, don’t get any loans that you would need to refinance out of. I don’t believe in short term loans, not today, because if you buy a property and you get into a short loan and you have to refinance later, you may lose that property because you will not believe how much the payment will change if that rate is at 6% or 8% or 12% or goodness knows what it would be once the government stops subsidizing our interest rates basically.
Don’t get short term loans. Pay the points, lock in a low rate, do not plan to ever get out of that loan. Don’t plan on refinancing, just, in my opinion, put as little money down as you can, get as much loan as you can, get as many loans as you can, get as many properties with as many loans as you can and lock them in today because again, in a few years you are going to have bragging rights. A friend of mine just got 2.5%, I mean that is not going to be available in the future. Pay the points. One point is basically 1% of the loan; so, $100,000 loan, one point is $1,000 that you would pay to reduce the interest rate which overtime is going to pay you back many times over.
Okay. These again we’re kind of going into more basic stuff about loan terms. A HUD-1, this is required by lenders to give you a copy of your HUD-1 Settlement Statement listing all your fees. Same with, I didn’t put it on here but a Good Faith Estimate. This is also required by RESPA, that you receive a Good Faith Estimate showing you all the fees and everything to expect with that loan. If you don’t get that, that lender could be in big, big trouble. Or, if your final HUD-1 does not match your Good Faith Estimate, that lender could be in big, big trouble. This is all to protect the borrower. We know that the government has been very, very active in trying to protect borrowers when it comes to lenders.
Okay, escrow. This is just simply money held by a third party which can be used for a down payment or a bank can use it to pay taxes and insurance. It’s just basically money being held and it’s in a safe place. If your lender says your taxes and insurance will be escrowed, that means that every payment you make a portion goes to taxes and insurance and it’s being held in an escrow account so that the bank doesn’t have to worry about whether those things are being paid. It’s all handled.
Title Insurance. A lot of people ask, “Why do I have to pay this because it’s not really that cheap?” Let me tell you, it’s a lot more expensive to not have it. Most lenders will require a Title Insurance policy which basically just protects both you and the lender from any errors that might happen in the Title search. To make sure that you own that property outright and it’s clear of any liens that existed before you acquired the property. Title Insurance is a must.
Here’s a situation where somebody didn’t get Title Insurance and I understand because it was a difficult situation. They lent money on a project that the borrower defaulted. The person who lent the money had to take the property back. That was the collateral. They took the property back only to find that there were a bunch of liens and they couldn’t sell the property without paying those liens and it was a big mess. Title Insurance would take care of that. Very, very important.
Owner-occupied versus non-owner occupied (OO vs NOO). You’ll probably see this on paperwork and stuff. It’s just basically owner-occupied versus non-owner. Owner occupied is going to be easier to finance, lower interest rate, it’s just banks like it better. They like knowing you’re living in it. Non-owner occupied is basically an investor loan. That means, the borrower doesn’t live in it, they’re renting it out and it’s an investment so the interest rates are usually higher but not that much higher. People are getting loans in the 4% arena and that is increasing cashflow. It’s a great deal so get as many as you can.
Right now if you have good credit and reserves, you can get up to 9 or 10 non-owner occupied loans. A lot of people don’t realize that. Of course, you can qualify for a primary residence and you can qualify for a second home maybe two or three second homes, but you can qualify for up to 10 loans total, some of those being non-owner occupied. The down payment goes up to 25% once you get past four.
More loan terms. PITI, again, getting into some really basic stuff but this is Principal Interest Taxes and Insurance and that’s a mortgage payment that includes all of those things. When you’re looking at your payment, that’s a great question to ask. Is it PITI? Or is it simply the interests and principal? Is it all of it?
Loan to value, again, the percentage of a property’s value that will be mortgaged. An example is $80,000 loan on a $100,000 home is an 80% LTB, 20% equity.
Non-recourse loan. This is important to know if you’re getting any financing for commercial or multi- family or if you are using your IRA to purchase property. You can self-direct your IRA, put your money with the custodian, there’s no penalties or fees for doing so. We have a list of different companies that you can use for self-directed IRAs that have been around forever and are great. They know what they’re doing and have a great track record, and are very compliant.
If you wanted to use that IRA to buy property and get financing, have your IRA get financing.
Let’s say you have a $100,000 in your IRA and you want to buy a $200,000 property, you can do that. You can put $100,000 down and get $100,000 non-recourse loan. That’s what the IRS requires that if you self-direct your IRA and get financing, it has to be non-recourse. Basically that means that, the loan is secured by the collateral which is typically real estate but the borrower is not liable. In the case of a self-directed IRA, if you defaulted for some reason, they couldn’t come after what else is in that IRA, they could only come after the property.
Non-recourse is pretty common for commercial deals, for developers, for larger projects. A lot of times it’s just an agreement between the bank and the borrower that, “Hey, if you default. I’m taking the property. It’s that simple.” For a non-recourse loan, they want to make sure that they’re getting a great property. They want to make sure that there is enough equity in the property should they have to take it back that they will make money. They’re a little bit more diligent in researching what they’re lending on because that’s all they get back, but non-recourse loans are out there. Again, we have a list of lenders who provide them and who will finance your self-directed IRA.
Let’s move on to determining a property’s value. Common term as ARV, which is After Repair Value. This is basically the value of a property after renovation. That’s pretty obvious, I guess. The example would be that if you paid $45,000 for a property and then put $20,000 in repairs, you’ve put $65,000 in but because of everything you did, it’s actually worth about 85,000. That’s your after repair value. Your ARV. You just got 20,000 in earned equity. That’s a beautiful thing.
Comparative Market Analysis. This is CMA. It determines as best it can with the current market value would be by comparing to similar properties recently sold. I got to tell you, you can’t rely on these because properties are all individual and all unique. Just because something down the street sold, it’s going to be different than the one you’re looking at. It might have a different layout, or a different floor plan or just it looks over a park or whatever it is. Different energy, different feel. Whatever it is, it could be just valued differently by the market. It’s hard but pretty much any real estate agent would be happy to give you a CMA. They can just print it out. Their systems do it for them. It’s pretty easy. If you ever wanted to get a CMA, you can call three or four different realtors and they’ll all give you one.
They’ll all be pretty similar because they’re all coming out of the same MLS. The same system that would compare. Now, real estate agent might also put in their opinion as well.
That’s actually what we call a Broker Price Opinion, a BPO. That’s estimating the value of a property by a broker. It’s also based on similar surrounding properties and sales. It also estimates cost of repairs and really important- the broker has to take a picture of the property. They’re going to go and see if it actually exists, which as funny as that may sound, you never know. I have heard plenty of stories where somebody was making an offer on a property that wasn’t there, was burned down or something happened to it. Nobody knew because nobody had been out there. This is the type of thing that happens when you buy tapes or you by site unseen or whatever. CMA wouldn’t do it for you because you need someone to go out and look at it.
A BPO is different than an appraisal because an appraisal has to be done by an appraiser, a licensed appraiser. They have their process for putting together an appraisal. A BPO tends to be a little cheaper. Hedge funds are using them, banks are using them with their REO property to try to gauge the value. They’re doing BPOs. These brokers make maybe 50 bucks to do them. They might do 10 a day. They might do 20 a day. They do them really quick but they are required to go to the property and take a photo, for what that’s worth. I don’t know how they’re really going to estimate the cost of repairs when they’re just taking a photo but somehow they do.
All right. Moving on to rent terms because, let’s say you got the property. Now, what are you going to do with it? Well, triple net lease, otherwise known as an NNN is a lease agreement that designates the lessee tenant as being solely responsible for paying the real estate taxes, insurance, and maintenance.
Those three things, taxes, insurance, and maintenance are the three things that make the NNN. That’s scary if you ask me, man, you better know what you’re doing when you are a tenant signing for a triple net lease because that means you’re paying for all maintenance. What does that mean? If you’re a landlord, hallelujah, you want to have a triple net lease situation with a tenant who has the ability to uphold this because you don’t have to do anything except collect money. That’s why lot of people like commercial real estate because you get the triple net lease often in that kind of deal.
Now, a lease option. I’m sure you have all heard of this. It’s a property owner and tenant who agree that at the end of a specified rental period, the renter has the option of purchasing the property. Often, they’ve already set a price but sometimes not. It’s all up to however you want to structure it. Obviously, it’s better for the tenant to have an agreed upon price because the tenant has the option. Again, the option of purchasing or not purchasing. Today we are seeing prices go up, it would be wonderful if a tenant could set a price based on today’s values and have the option of purchasing at a future date at today’s value which is probably a lot lower than in the future. Again, sometimes there is no agreed upon price and it’s just all right, you get the first option of purchasing this property.
A lease purchase is different in that it binds both parties to the sale. You lease it and then you purchase it and it’s binding, so better know that before going into one of those.
Again going back to the rent terms, I just want to mention that a lease option is a great way to go. Not all states allow it, because a lot of landlords were asking for down payments knowing full well that the tenant could never fulfill the option. They’d never be in a position to buy and if in that timeframe they aren’t able to, then the landlord gets to keep the deposit. States like Texas have said, “No, we can’t do that.” Be careful of that. You can’t just throw together a lease option, you’ve got to make sure that you understand the rules of the state that you’re in.
It is a great way to have a tenant take care of your home if they’re in a lease option. Whether or not they can fulfill in the end.
Okay, exit strategy. Exit strategy is a 1031 exchange, is a great exit. Basically, the IRS allows you to exchange your property for like kind property, which is basically any other property. I mean there’s a few rules around it, but you could exchange single-family homes for a commercial building. You could exchange an apartment for single-family homes. You could do all kinds of things, so like doesn’t mean it’s a white-picket fenced house that you’re changing for another one in the same street. It’s very broad.
For example, my father exchanged an apartment for a bunch of homes for the kids that the kids eventually got to live in and inherit in the future. That was a little tricky, but it could be done. There’s all kinds of things. We’re going to do an entire session on the 1031 exchange so that you know all the rules around that, because that’s really important. What it does is allows you to avoid the 15% to 20% capital gain on the sale of the property by exchanging it.
You can in some cases exchange into a REIT. A REIT is basically Real Estate Investment Trust which is any corporation trust, or trust that acts as an investment in real estate.
Some are publicly traded, some are private but basically you’re buying a share or a unit of the REIT. Those tend to be very passive, so a lot of times landlords will own a bunch of single-family homes and when it comes to retirement they’re like, “You know, I don’t really want to manage homes anymore. I just want to transfer everything into a REIT.” They sell 1031 exchange and put all their money into something that’s totally passive, so that retirement can be real easy and you could play lots of golf.
What you have to be aware of if you did not exchange your property, if you just sold your property and didn’t follow the 1031 exchange rules, you would not only have to pay your capital gain but you would have depreciation recapture. Let me tell you, if you know what this is then your skin probably crawls just thinking about it. It’s an ugly thing that turns into big, big dollars to the IRS. All that depreciation and deductions that you got to take on your property over the years, well if you just sell it and don’t exchange it, you’ve got to pay it all back. It’s not that easy. It’s not like you just get to walk unless you exchange. Do not think that all that writing off that you get to do over the years is just a freebie.