The real estate world is not a simple one. It's filled with specialized terminology, concepts, and formulas that you must understand to make smart investment decisions. If you are just starting as an investor, learning and preparing yourself with updated information on the market is your greatest strategy to get the best out of any commercial real estate deal, and it's worth it.
That's why we are sharing with you the 12 essential real estate terms you need to know and why they are important.
Why do I need to prepare to invest?
Investing has become one of the main - if not the main course of action for people who expect to obtain future financial security. Long gone are the days of just saving up, now you can use your money to grow your wealth. Did you know that in 2007 almost two-thirds of Americans were investing in the stock market? 10 years later, just over 50% were investing in the stock market, while the other half were looking to invest in real estate. This number has only gone up in recent years.
Why? Because real estate is, all things considered, a pretty solid market to invest in. As we’ve mentioned in another one of our blogs, real estate is considered an inflation-hedged asset and is always on demand. Nonetheless, having the awareness that no investment deal is 100% secure and doing your proper research is important. As it is to be familiar with the right terminology.
Don’t worry! Once you learn the basics, it's very easy to continue learning and get all the information you need when investing in real estate.
What terms do I need to know when investing in real estate?
Here are some of the main terms and formulas that you must understand:
This comes from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital taxes when you sell an investment property and allows you to reinvest in other property or properties of similar value, within a limit of time. The transaction is done through a qualified intermediary who holds the funds until the exchange process is done, so the proceeds stay tax-free. As an investor, you probably want a 1031 Exchange if you are looking for a property with better return prospects, want a more manageable property, change from a single unit to a multi-unit, or just avoid depreciation (the loss of value caused by time and use).
An increase in property value is called appreciation, this relies on diverse factors (location, age & condition of the property, supply and demand, interest rates, etc). The appreciation of your property can counterbalance inflation to a certain degree. Choosing wisely when it comes to your property can impact your investment positively. Research what areas in your city are growing and overall real estate trends.
In real estate, capital expenditure, also known as a capital expense, refers to the costs associated with acquiring, upgrading, or repairing a property. You can estimate the CapEx of a property by identifying every expense you are gonna have to cover and then dividing the total cost by the years it's reasonable to expect they will last.
Capital Gains Tax
Thanks to appreciation and other elements of the real estate market, you can usually sell your properties for more money than what you originally paid. This happens because of their increased value. However, this is when you have to be aware of Capital Gains Tax because any gains you made have to be reported to the IRS. There are different ways to calculate your Capital Gain Tax and to get an exemption, so always do a lot of research before selling.
Also known as capitalization rate, this indicates the rate of return expected from an investment in a real estate property. It is calculated by dividing a property's net operating income (NOI) by the current market value. It's a really popular measurement investors use to calculate a real estate investment profitability.
Cash-on-Cash Return (ConC)
Also known as cash yield, this is a useful metric that helps you compare the positive net cash inflow from a property with the amount you invested to obtain it. The formula to calculate is your annual pre-tax cash flow divided by the total cash invested to date.
If you are going to buy a property you need to include the closing costs on your budget. These are processing feeds you pay your lender in exchange for creating your loan. They usually variate between 3% or 6% of the total amount of the loan, which is usually a lot more than most people expect, especially because they don’t include the down payment.
There are many more terms to learn and the real estate world keeps growing and changing! But remember that making informed and well thought out decisions will always bring you much more profit in the long run.
An escrow is a legal arrangement that protects both buyer and seller during real estate transactions. A third party holds the money or property until a particular condition (or conditions) has been met. If you are a property owner, an escrow protects your funds for taxes and insurance, and if you are buying it can protect your deposit, so it's always good to have in mind.
Fixed-Rate Mortgage and Adjustable-Rate Mortgage (ARM):
A fixed-rate mortgage is the traditional kind of mortgage, in which the interest rate is set at the beginning and remains the same during the total duration of the loan. These mortgages have the disadvantage that they can take up to 30 to 40 years to pay and have a higher initial interest rate, however, they are easier to keep on a budget and protect you from sudden raises in the market.
An ARM, also known as variable interest rate, is a loan with interest rates that can variate periodically depending on a specific index. With this kind of mortgage, the initial interest rate is fixed for a period of time and then reset monthly or yearly based on the performance of a specific benchmark. These have the advantage of being quicker to pay off (from 1 to 10 years) and an initial interest rate below the market average, however, fluctuations in the market can make the monthly payments go up unexpectedly.
Gross Rental Yield
As an investor, this is a key term to be aware of. Gross rental yield is the annual rental income received from a property before tax, so it's very useful to determine if a property is being profitable. However, you also need to have in mind the Net Rental Yield, which takes the expenses on the property into account.
If you invest in residential property (like condominiums, apartment buildings, or even some neighborhoods) you may have to pay a monthly fee to its homeowner’s association. The HOAs are organizations created to give maintenance and set up rules to these residential communities. They charge a monthly fee to take care of the communal areas, provide services like garbage disposal, conserve green areas, etc.
Net Operating Income (NOI)
This is a measure that helps investors determine the profitability of property in commercial real estate. NOI is fairly simple to calculate since you are looking for a property’s ability to generate positive returns, you only have to take the Gross operating income (how much income it produces) and subtract from it the Operating expenses (taxes, supplies, maintenance, etc.)