Real Estate Investing Terms Flashcards
REO
Real Estate Owned
Property owned by a lender - usually a bank - after an unsuccessful sale at a foreclosure auction. This is common because most of the properties up for sale at these auctions are worth less than the total amount owed to the bank: the minimum bid in most foreclosure auctions equal the outstanding loan amount, the accrued interest and any fees associated with the foreclosure sale.
If the property is real estate owned, the bank will then go through the process of trying to sell the property on its own. It will try to remove some of the liens and other expenses on the home, and then try to sell it on the market. Real estate investors will often go after these properties as banks are not in the business of owning homes and, in some cases, the house can be bought at a discount to its market value.
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!
Short Sale
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.
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!
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.
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.
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.
DSCR
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!
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.
$/SF
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.
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.
Assessment
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.
LTV
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.
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!
Amortization
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.
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.
100% Mortgage
A mortgage loan in which the borrower receives a loan amount equivalent to the total value of the property to be purchased. In this situation, the borrower does not need to make a down payment to secure the loan.
A 100% mortgage gives an individual with little or no cash the opportunity to purchase a house or a similar property. The loan is usually backed up by securities, such as stocks and bonds, currently owned by the borrower. Two significant drawbacks to the 100% mortgage are higher interest rates and the possibility that the borrower’s securities will be liquidated to cover a collateral call.
2-1 Buydown
A type of mortgage with a set of two initial temporary-start interest rates that increase in stair-step fashion until a permanent interest rate is reached. The initial interest rate reductions are either paid for by the borrower in order to help them qualify for a mortgage, or might be paid for by a builder as incentive to purchase a home.
Sometimes the cost of a buydown is calculated and placed in an escrow account where each month a certain amount is paid out equal to the difference in the temporary mortgage payment and what the eventual mortgage payment will be. Other times the cost of the buydown is treated like a traditional mortgage point. A thorough analysis should be conducted by the borrower to ensure that a buydown is economical in either situation.
125% Loan
A loan, usually a mortgage, with an initial loan amount equal to 125% of the initial property value. In other words, a 125% loan has a loan-to-value ratio (LTV ratio) of 125%.
A primary measure of a loan’s risk to a lender is the size of a loan relative to the value (LTV ratio) of the underlying property. A 125% loan is a relatively risky loan as compared to a loan with a LTV ratio of less than 100%, and therefore, according to the risk-based pricing method used by lenders, a loan with a LTV ratio of 125% will carry a higher interest rate than a loan with a LTV ratio of 100% or below.
2/28 ARM
A type of adjustable-rate mortgage that has a two-year fixed interest rate period after which the interest rate on the mortgage begins to float based on an index plus a margin. The index plus the margin in known as the fully indexed interest rate. Often, a 2/28 ARM is designed as a short-term financing vehicle that provides borrowers with time to repair their credit before they refinance into a mortgage with more favorable terms.
In many cases, 2/28-mortgage borrowers fail to recognize the risks associated with such a mortgage. They often don’t recognize how much their monthly payments will increase when the interest rate starts to adjust at a higher rate. It is important to note that there is usually a high probability that the fully indexed interest rate will be substantially higher than the initial two-year fixed interest rate. Once this number adjusts, the borrower’s payments are likely to increase as well.
3-2-1 Buydown
A type of mortgage with a series of three initial temporary-start interest rates that increase in a stair-step fashion until a permanent interest rate is reached. Lenders will charge for the temporary interest rate reductions.
A 3-2-1 buydown is sometimes used as a method to help a borrower with excess cash (but a relatively low income) to qualify for a mortgage. Or, a 3-2-1 buydown mortgage might be offered by a builder as incentive to purchase a home.
Paying for a 3-2-1 buydown is similar to paying points on a mortgage in order to lower the interest rate. However, remember, the interest rate reductions on a 3-2-1 buydown are only temporary. A thorough analysis should be conducted to ensure that the buydown is the best economical choice for your current and future situation.
3/27 ARM
A type of adjustable-rate mortgage (ARM) frequently offered to subprime borrowers. These mortgages are designed as short-term financing vehicles that give borrowers time to repair their credit until they are able to refinance into a mortgage with more favorable terms.
3/27 mortgages have a three-year fixed-interest-rate period after which the interest rate begins to float based on an index plus a margin (known as the fully indexed interest rate). There is a high probability that the fully indexed interest rate will be substantially higher than the initial three-year fixed interest rate; therefore, to avoid payment shock, the intent of 3/27 mortgage borrowers is to be able to refinance the mortgage before the interest rate begins to adjust.
A common mistake many 3/27 mortgage borrowers make is a failure to recognize the risks associated with such a mortgage. Many times they do not recognize how much their monthly payments may increase if the interest rate changes. Even if they plan on refinancing before the interest rate starts to move, they fail to foresee future economic conditions that might make refinancing difficult.
For example, the rate of home price appreciation and home equity play a very important role in a borrower’s ability to refinance at a future date. Many borrowers are too optimistic about the rate of home price appreciation. Additionally, many 3/27 mortgages carry prepayment penalties, which make refinancing very costly.
48-Hour Rule
A requirement that all pooled information regarding to-be-announced transactions on forward mortgage-backed securities (MBS) be communicated to the buyer from the seller before 3 p.m. EST 48 hours prior to the settlement date of the trade. The 48-hour rule is a requirement under the Securities Industry And Financial Markets Association (SIFMA), which is formerly known as the Public Securities Association (PSA) or Bond Market Association.
Assume that the agreed upon settlement date between the buyer and the seller is July 14. The 48-hour rule requires that on July 12 by 3 p.m. EST the seller will have informed the buyer of the exact details of the MBS pooled that will be delivered on July 14. Also known as 48-hour day.
5-1 Hybrid ARM
An adjustable-rate mortgage (ARM) with an initial five-year fixed-interest rate. After this initial five-year period, the interest rate begins to adjust on an annual basis according to an index plus a margin (or, the fully indexed interest rate). The speed and the extent to which the fully indexed interest rate can adjust are usually limited by an interest rate cap structure. There are several different indexes that the fully indexed interest rate might be tied to. While the index is variable, the margin is fixed for the life of the loan.
Also known as a “five-year fixed-period ARM”.
There is little probability that the fully indexed interest rate might be lower than the initial fixed interest rate on a 5-1 ARM. The more likely scenario is that the fully interest rate will be higher, leading to an increase in the monthly payment amount beginning in year six.
Depending on the slope of the yield curve, a 5-1 ARM can have an interest rate advantage over a 30-year fixed-rate mortgage. Most borrowers who choose a 5-1 ARM intend to refinance or move before the expiration of the fixed interest rate period. There is some risk in this scenario, because personal finances or general market conditions might make moving or refinancing difficult, or even impossible, five years in the future.
5-6 Hybrid ARM
An adjustable-rate mortgage with an initial five year fixed interest rate after which the interest rate begins to adjust every six months according to an index plus a margin (or, the fully indexed interest rate). The index is variable while the margin is fixed for the life of the loan. 5-6 ARMs are usually tied to the six-month London Interbank Offered Rate (LIBOR) index.
When shopping for an ARM, the index, the margin and the interest rate cap structure should not be overlooked. In a rising interest rate environment, the longer the time period between interest rate reset dates, the more beneficial it will be for the borrower. So, in this case, a 5-1 ARM would be better than a 5-6 ARM. The opposite would be true in a falling interest rate environment.
Additionally, different indexes behave differently in different interest rate environments. Those with a built-in lag effect, such as the Moving Treasury Average (MTA) Index are more beneficial in a rising interest rate environment than short-term interest rate indexes such as the one-month LIBOR. The interest rate cap structure determines how quickly and to what extent the interest rate can adjust over the life of the mortgage. Different cap structures might be available for certain types of ARMs. Finally, the margin is fixed for the life of the loan, but it can frequently be negotiated with the lender before signing mortgage documents.
80-10-10 Mortgage
A mortgage transaction in which a first and second mortgage are simultaneously originated. The first position lien has an 80% loan-to-value ratio, the second position lien has a 10% loan-to-value ratio and the borrower makes a 10% down payment. 80-10-10 mortgage transactions are piggy-back mortgage transactions, and are frequently used by borrowers to avoid paying private mortgage insurance.
The economics of using a second lien rather than paying private mortgage insurance are driven by home price appreciation. If a borrower expects the value of the home to increase quickly, it might be more economical to pay private mortgage insurance for a period of time until the loan-to-value ratio for a first mortgage falls below the minimum required. At this point, the private mortgage insurance can be eliminated, eliminating the need for a second mortgage in a piggy-back transaction.
Absentee Landlord
An individual or entity that rents or leases real estate to another party, but does not reside on the premises. An absentee landlord could be anyone from a local investor to an overseas conglomerate. Regardless of the size of their operations, absentee landlords generally seek to generate rental income from their holdings. Absentee landlords with substantial holdings usually employ management companies to maintain their properties and collect rental payments.
Absentee landlords are the norm, rather than the exception, for commercial properties. The term “landlord” may indicate that the individual or entity’s real estate holdings are likely to be sizable. An absentee landlord may also have a long-term perspective with regard to real estate investments, with ongoing rental income rather than capital appreciation being the primary investment objective.
Absolute Auction
A type of auction where the sale is awarded to the highest bidder. Absolute auctions do not have a reserve price which sets a minimum required bid for the item to be sold. One type of absolute auction relates to foreclosed properties, where the winning bid acquires the foreclosed property. This is opposed to a lender confirmation auction, where the lender must approve the bid in order to complete the transaction.
An absolute auction can occur in various venues including the foreclosure marketplace, the online marketplace (such as eBay.com) or live auction events. In this type of auction, the highest bidder “wins” the item, whether it is real estate property or any other type of product. Absolute auctions are often implemented where there is an immediate demand to sell an item.
Absorption Rate
The rate at which available homes are sold in a specific real estate market during a given time period. It is calculated by dividing the total number of available homes by the average number of sales per month. The figure shows how many months it will take to exhaust the supply of homes on the market. A high absorption rate may indicate that the supply of available homes will shrink rapidly, increasing the odds that a homeowner will sell a piece of property in a shorter period of time.
For example, suppose that a city has 1,000 homes currently on the market to be sold. If buyers snap up 100 homes per month, the supply of homes will be exhausted in 10 months (1,000 homes divided by 100 homes sold per month). If a homeowner is looking to sell a piece of property, he knows that half of the market will be sold out in five months. This rate does not take in to account additional homes that enter the market. The absorption rate can also be a signal to developers to start building new homes.
