The Newbie’s Real Estate Dictionary: 16 Common Investing Terms, Defined & Explained

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If you have been in this business for more than 5 minutes, you have heard all the lingo that people use. It seems like some of these terms are not used in any other profession, so if you are new to the business, it can be your first time hearing them. You really can’t “fake it ’til you make it” on this. You need to know what people are talking about so you can comprehend and maybe even contribute to the conversation!

I made a list of 16 real estate investing terms along with my definitions of them. Some, like CAP Rate, are commonly misunderstood. Others are ones you should know but aren’t talked about as much, like a Phase 1 Study. With each term, I will give you MY definition (not the dictionary’s definition) and why it’s important to know the term.

So here we go…

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16 Common Real Estate Investing Terms, Defined & Explained

1. REO: Real Estate Owned

By whom, you ask? A bank or other financial institution. Why do they call it “Real Estate Owned?” I don’t know; it confused me too, to be honest! They really should call it BO Real Estate, but that would be confusing, too. All joking aside, this term is used for property that was foreclosed on by a bank that held a mortgage on the property or a tax lien holder that foreclosed.

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!

2. Short Sale

This is a 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.

short sales

Related: Newbies: You NEED to Overcome Your Fear of Asking Questions (& Looking Dumb). Here’s Why.

3. 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!

4. 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.

5. 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.

property-management-team

6. 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.

7. DSCR: Debt Service Coverage Ratio

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!

8. 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.

Related: 6 Easy Ways to Be Taken Seriously As a Newbie Investor

9. $/SF – Dollars Per Square Foot

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.

sell-house

10. 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.

11. 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.

12. LOL

I had to throw that one in there. If you are going to stay sane in this business, be sure to “Laugh Out Loud” at least three times a day. Doctor’s orders.

13. 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.

14. 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!

mobile-home-managers

15. 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.

Related: Real Estate Investing Abbreviations

16. Capital Expenses and Capital Expense Reserves (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.

So which ones did I miss?

Let’s get a conversation going! Thanks for reading!

About Author

Matt Faircloth

In 2005, Matt founded The DeRosa Group along with his wife, Elizabeth. At the time, the two person company owned and managed two assets – a single family home and a duplex. Over the last nine years, they have grown the company to a 12 person team owning and managing over five million dollars in residential and commercial assets throughout the central NJ and Philadelphia area. One of DeRosa’s mantras is “to make money while making a difference.”

42 Comments

  1. don alberts

    Matt, Thank you for clarifying these terms and giving the examples in your words. I do truly appreciate you sharing your expertise with me. Learning through others is only helping me to get where I am going that much quicker. I am in this to make a difference. Have a Great Day. Don

  2. Roy N.

    Matt:

    From a business bookkeeping perspective your mortgage not is along-term liability save for the amount to be paid in the current fiscal year. The interest portion of your mortgage payments are technically an expense, but rarely do you see the small landlord treat them as such.

    • Matt Faircloth

      Hi Roy,

      I have seen most “new” landlords treat the entire mortgage payment as an expense. Although it is a deduction from cash flow, only part of the payment is tax deductible (the interest). The Principal pay down is something much different. It is a snowball that starts off very small at first but rolls over on top and gets larger and larger each year. Seasoned investors see the benefit of getting further down the amortization curve.
      I do have to disagree with you on one thing – a mortgage is a long-term liability, it’s the payment amount or “debt service” that can be looked at as an expense for that year. The mortgage amount should show up on the balance sheet for the property as a long-term liability that gets reduced each month by principal pay down.
      Thoughts?
      Matt

  3. Roy N.

    You are correct that CAP is one of the simplest, yet most misused ratios in real estate. It is also meaningless when you are analysing residential real estate which is priced based upon comparable sales and not by the income the property produces.

    However, I do take exception to
    “The CAP Rate is what your return on investment would be if you owned the property free and clear.”

    IMHO, that is also a misuse of CAP rate. When looking at commercial properties in a given area, the {market} CAP rate (or the CAP calculated on a comparable business that has recently sold) simply tells you what {other} folks are paying for a given level cash flow in that market.

    • Matt Faircloth

      Hey Roy,
      Thanks for your thoughts. You are correct, the true intent of the CAP rate is to compare the property to others in the market that may have different bedroom or unit counts, or even compare different markets altogether. I used the explanation of “what your return would be if you owned the property free and clear” to make sure that our newer investors got the point. I wanted to drive home the point that the CAP rate does not consider your mortgage payment / debt service.
      In essence I was correct that if you did BUY a property free and clear, AKA invest the entire purchase price up front you would receive the entire NOI back each year, making the CAP rate your ROI. That being said, you nailed the purpose of the CAP rate on the head.
      Matt

      • bob bowling

        I’ve got to agree with Roy N. that BP people need to stop thinking of a cap rate as a “return”. All it does is measure the market value of NOI for a one year period.
        An easy example to show how it is not ROI in subsequent years. If two similar properties have $50,000 NOI and the market cap is 10% then these properties NOI should sell for $500,000. Now if building A has a new roof and Building is in year 17 of a 20 year roof how could these properties have the same ROI?

  4. Adam Schneider

    Matt,
    That’s a fantastic summary. I’m sure some people will want to clarify a few semantics regarding the technical definitions but your audience is the new investor and you hit the nail on the head. If you do a Round Two, you might want to cover Lease Purchase vs. Lease Option vs. Seller Finance.
    Adam

  5. Jerry W.

    Very nice article Matt. I enjoyed it. I am still very slow on cap rate. While it is used for real estate with 5 or more units, I am hoping to branch out into 4plexes soon and would like to begin valuing them both ways.

    • Matt Faircloth

      Hey Jerry,
      Thanks for reading. Your strategy is solid – use both means of valuation for a 4 unit. You can even get away with going for a “Dollars per door” look if you don’t see that many 4 units in your trading area. There may be more two and three families. That being said the CAP rate can come into play, and most importantly the “cash on cash” return.

      Matt

      • Deanna Opgenort

        Anyone found a calculation that factors”doors” having a particular value in addition to square footage? — I haven’t come across a formula that covers the fact that my return would be MUCH better off if my 1800 sq ft 3 bed/3ba Single family were (3) 600 ft 1 bedroom units (rent difference would probably be $1650/mos vs $850/mos).

        • Matt Faircloth

          Hey Deanna,
          I would look at it from a $/SF perspective but change the type of property you are using for market data from a SFH to a multi-family. SFH’s typically rent for less than apartments per square foot so your assessment is correct. Lots more factors come into consideration including zoning issues and the cost to add 3 kitchens and living rooms to each unit.
          Matt

  6. Pingback: New to investing – the terms you should know! | Rob Thompson, Realtor

    • Matt Faircloth

      Hi Damien,

      I was stumped on this one too. I did some research on BP and seem to have found the answer – Pre Paid, referring to pre paid interest or points on a mortgage, typically paid at closing.

      The only other real estate reference I could find was “Policy, Planning, and Development” which didn’t seem to apply here.

      Anyone else care to chime in on this one?

      Matt

  7. Dave Oberhauser

    Matt, thanks for the great explanations. I find it it hard to “memorize” the meaning of some of these terms and it is gold to review them from time to time. One that I hear often and have trouble wrapping my head around is “Cash On Cash Return.” You got an easy explanation of that one? Thanks!

    • Matt Faircloth

      Hey Dave,
      Thanks, I’m glad you enjoyed. I find that the only way to keep these things fresh my your head is to use the terms regularly. The more you use them the better.

      Cash on Cash return is a figure to calculate the cash you get back for what you put in. It’s calculated by taking the cash flow (rental income minus vacancy minus expenses minus debt service minus capital expenses) and dividing it by the cash outlay to buy the property. It does not factor in mortgage pay down or appreciation as part of your return. Adding in those two things gives you the Internal Rate of Return (IRR). Make sense?

      Matt

    • Matt Faircloth

      Hi Ricardo,

      Absolutely! Here we go. Cash on Cash Return is a percentage. In essence, it’s a measure of how much of your cash you are getting back each year in return. You start with your Cash Flow (Rent minus vacancy allowance minus expenses minus mortgage payment minus capital expense reserve), which put simply is how much money you have left once all the bills are paid and reserves are set aside. You divide that by the total cash outlay to buy the property which may include money down on purchase, rehab or fit out paid out of pocket, reserves paid out of pocket up front, etc… In essence all the money you paid to invest in the deal.
      The Cash on Cash return does not factor in the gain you get by paying down the principal on the loan (Principal Reduction) or increase in property value over time (Appreciation).
      Make sense? Let me know!
      Matt

    • Matt Faircloth

      Hey Ira,

      Good question. I have to admit that I Googled that term for this definition:

      Gross Rent Multiplier is the ratio of the price of a real estate investment to its annual rental income before accounting for expenses such as property taxes, insurance, utilities, etc

      LOL. I am fine turning myself in. I actaully use the concept of the GRM, but on a monthly basis. Monthy rent / purchase price. People on BP talk about the 1 or 2% rule on that equation, and I find that it is a good rule of thumb if your expenses are in line.

      I hope that helps!

      Matt

      • Ira Ashton

        Yes, thanks! It also makes me feel better that you didn’t know what it was, ha ha! I’ve definitely heard of the 1% and the 2% rules. There are so many different calculations that I tend to get confused on which ones I should be using in my own market. There seem to be a lot of differing opinions on that. Thanks for your quick response.

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