Real Estate Investment Terms You Should Know
Being a first time property investor is not going to be easy, especially if you are unfamiliar with the related jargon there are various ratios and terminology that is used to analyze and assess the property value, its profitability and more.
In this article we are going to look at some of the most commonly used investment terms as well as provide you with the explanations as to what each of these means and how it is calculated. Let’s begin. We are going to start with the easy ones and move onwards to the more complex terms as you read on:
- Real Estate Agent – commonly the real estate investment deal is going to be negotiated with the help of two real estate agents. One of them is going to represent the buyer (buyer agent) and the other will represent the seller (listing agent). Their duty in this process is to represent the best interests of both parties and they will normally be paid by receiving a commission/percentage of the final sale value.
- Letter of Intent – this is basically an informal preliminary agreement between the buyer and the seller to enter into negotiations regarding the sale and also set out some basic terms and conditions. Even though this document does not become binding until a more detailed purchase agreement is negotiated, it is advisable to seek expert opinion before signing the letter of intent.
- Bill of Sale – this is a legal document that the seller provides to the buyer on conclusion of a property sale, which reports that on a specific date, at a specific location, and for a particular sum of money the seller sold the property to a specific buyer.
- Affidavit – by definition this is a declaration made in writing made upon oath before a person authorized to administer oaths, especially for use as evidence in court. In the real estate investment process you may come across an “Affidavit of Title“, which is a document provided by the seller of a piece of property that explicitly states the status of potential legal issues involving the property or the seller. The affidavit is a sworn statement of fact. For example, someone looking to sell a piece of real estate would have to provide an affidavit of title indicating that the property is truly owned by the seller, that the property is not being sold to another party, that there are no liens against the property and that the seller is not in bankruptcy proceedings.
- Non-Compete Clause – this is commonly used in the actual contract and prevents the landlord from leasing any other premises on the development to a direct competitor of yours or another tenant operating the same type of business. This is a useful tool for protecting your investment in the long run.
- Title / Deed – a title is a legal way of saying that you own something, in this case a property. It also means that you have the rights to use this property and make modifications to it. A deed, on the other hand, is actually the legal documents that transfer the title from one person to another.
- Title Insurance – this is basically an insurance policy that protects the title holder from loss arising from defects in the title
- Lease Purchase – this is an abbreviation used for a lease with an option to purchase. This is basically a contractual agreement between the buyer and the seller, which allows the buyer to lease the property (usually involving monthly lease payments/installments) with an option to buy out the property by paying off the remaining balance of the total price after a pre-agreed period of time.
- Inspection – this very common part of the real estate investment process where an expert inspector carefully examines the property for any damage. The results of this inspection will be used in the deal negotiations.
- Appraisal – this is another common activity carried out by a specialist during the property sale negotiations during which the specialist will assess the accurate estimated monetary value for the property. This is commonly something that is required when the purchase involves securing a loan or a mortgage.
- Loan Package – this is an organized group/package of documents that contains all the necessary information based on which a loan will either be approved or denied by a financial institution. The contents will of course depend on the type of a loane but it commonly includes documents such as: loan application, statement of use of funds, statement of net worth, P & L statements, tax returns, statements from various types of banking and investment accounts, property appraisal, letters of explanation, credit report, verification of employment, verification of housing payments, purchase agreement, etc.
FINANCIAL & INVESTMENT ANALYSIS TERMS
Investing in real estate means taking a risk and anyone taking such risk would need to know beforehand if it has the potential to generate profit or in simple words if it is a good investment. Of course there is no way out there to determine this with 100% accuracy; however there are certain tools such as ratios and other investment terms which you need to know, that will assist you in reducing such risk. In this section we are going to look at some of the more common financial & investment terms and formulas that perform this task:
This is a simple formula that will help you calculate the return on the cash invested into one or several properties.
The formula is calculated as follows:
Cash yield = Annual before-tax cash flow of a property / Total cash invested
To give you an example with numbers, imagine that that you have purchased a house for a total amount of EUR 500,000 and rented the property out to a tenant for monthly rental of EUR1,750.
You then also spent an additional EUR 30,000 on modifications of the house. The first step would be to calculate the annual cash flow resulting from renting the house:
EUR 1,750 x 12 months = EUR 21,000.
Let’s now put the numbers into the formula:
Cash yield = 21000 (annual cash inflow) / (500,000 + 30,000)(total cash invested)
Cash yield = 0.04 or if multiplied by 100 – 4%
Capital Gain – this is basically the difference between what you have paid to purchase the property and what you eventually sell it for minus allowable deductible expenses. It could also turn out as a Capital Loss if the figure that you arrive is negative. To calculate the adjusted selling price and the adjusted purchase price. To do so:
a. Take the property purchase price and deduct any qualifying deductibles such as cost of ownership, stamp duty or/and repairs.
b. Take the agreed selling price of the property and deduct any qualifying selling costs such as property listing costs, real estate agent commission etc.
Positive Gearing – gearing is generally a very commonly used ratio which is used to compare equity to borrowed funds. Positive gearing would occur when the gross income generated by the investment is less than the cost of owning and managing the investment, including interest charged on the borrowings.
In terms of property investment see below example to better understand this:
Let’s say that you have purchased a property that brings you USD 1500/ month rental income and you also pay USD 1,200 monthly in property expenses (including mortgage repayments). This in turn would mean that at the end of each month you are left with a net of USD 300 in cash before tax. After tax is deducted you are left with USD 200 (sample). Overall you are left with a positive cash flow both before and after tax, which would mean that you own a positively geared property.
Debt Servicing Ratio (DSR) – this ratio is commonly used by lenders to assess how well the borrower will be able to repay a mortgage. As an investor in real estate you would normally use this ratio to determine how much operating income you will need to use for mortgage repayments. DSR is calculated as follows:
DSR = DEBT / NET OPERATING INCOME
Market Value – this in simple terms is the today’s value of property which is derived by taking into consideration the current market effects on this value. That is, the market value of the subject property is derived by the capitalization rate typical investors have accepted when investing in similar properties. The formula for MV is:
Market Value = Net Operating Income (specific property) / Capitalization Rate (market)
For example if we were to assume that the current average cap rate for similar properties in a specific region/area is 7.1% and we want to determine the property market value based on its estimated net operating income of USD 50,000, the answer would be USD 704,225.
Gross Rent Multiplier (GRM) – if you are an investor, GRM would tell you how much you would have to be paid for each $1 of your estimated annual gross scheduled income. The formula for GRM is:
Gross Rent Multiplier = Property Market Value / Gross Scheduled Income (annual)
For example: If your GSI was estimated to be USD 35,000 and the property market value is USD350,000, the GRM would be equal to USD 10. This in simple words would mean that you as an investor would have to pay USD 10 per every $1 gross scheduled income if you purchased the property at its current market value.
Negative Gearing – this is exactly like the positive gearing, but the net value between equity & borrowing or rental income & property expenses is a negative figure.
Cross-collateralization – this is a term often used when it comes to financing properties. In simple words this means that collateral for one loan is also used as collateral for another loan.
If an individual owns a property which was financed by a loan and intends to purchase another property by obtaining another loan, the bank may elect to place both the new property and the already owned property as collateral for the new loan. This is called cross-collateralization.
Internal Rate of Return (IRR) % – this is basically the annualized net return on a property over its useful life. The calculation of the IRR takes into account the purchase price, income earned, additional expenditures, predicted capital gains, borrowings and interest, and the net present value of money. The purpose of IRR is to provide the investor with the overall estimated profitability of an investment into a particular property and to compare that with other potential investments.
Cap Rate – which is short for capitalization rate, is a ratio of net operating income to property asset value. I.e. if a property was listed for USD 800,000 and generated a net operating income of USD 50,000, the cap rate would be 50,000/800,000 = 0.06 or 6%. Cap Rate is another way of telling the investor what his annual return on investment would be.