Did you know that the acronym DSCR stands for Debt Service Coverage Ratio, a crucial metric in real estate investment and financing? It’s just one of many terms that can feel like a foreign language to new investors navigating the US real estate market.
This article aims to demystify these terms, serving as a comprehensive guide for those looking to better understand and utilize the basic language of real estate investment and financing. From types of refinancing to different loans and beyond, we’re breaking down the jargon to help you make informed decisions when you invest.
Real Estate Investing Terms
In the world of real estate investing, understanding key terms can make all the difference. Acronyms and metrics abound, each one carrying significant implications for your investment decisions.
We’ll explain what each one means, giving you the knowledge you need to navigate the investment landscape with confidence.
1% Rule
A rule of thumb in real estate investing which suggests that a rental property should generate monthly rental income equal to or greater than 1% of its purchase price. For example, if a property is purchased for $300,000, then the monthly rental income should be at least $3,000 according to this rule.
50% Rule
Another guideline in real estate investing which indicates that about 50% of the rental income will be spent on operating expenses, excluding mortgage payment. So, if your property generates $3,000 monthly in rental income, you can expect to spend around $1,500 on operating expenses.
Amortization
Refers to the process of paying off a debt, such as a mortgage, over time through regular payments. A portion of each payment goes towards the loan principal, and the remainder goes to interest. Over time, the amount that goes towards principal increases.
Appraised value
The estimated monetary worth of a property as determined by a professional appraiser. For instance, an appraiser might determine that a house’s appraised value is $250,000 based on factors like its size, condition, location, and recent sales of comparable properties.
Asking price
The initial price set by a property seller. Note that the seller’s asking price isn’t necessarily the same as the appraised value or current market value.
Broker
A person who acts as an intermediary between parties to a transaction. In real estate, a broker is a professional who represents sellers or buyers of real estate or real estate properties.
Cap rate (Capitalization Rate)
A metric used in real estate to measure the potential return on an investment. It’s calculated by dividing the net operating income by the current market value of the property. For example, if a property generates $10,000 per year in net operating income and is worth $100,000, the cap rate is 10%.
Capital expenditures (CapEx)
Funds spent by a property owner on major improvements or repairs that extend the useful life of the property which typically must be depreciated over a period of more than one year. Replacing the roof of a rental property or completely re-doing the plumbing system would be considered a capital expenditure. Note that capital expenses are different from operating expenses.
Capital gains
Profits earned from the sale of an investment or real estate. If you bought a property for $300,000 and later sold it for $350,000, your capital gain would be $50,000. Capital gains are taxed at a rate of between 0%, 15%, or 20%, depending on an investor’s taxable net income. A tax deferred exchange can be used to defer the payment of the tax on capital gains.
Cash on cash return
A rate of return often used in real estate transactions that calculates the cash income earned on the cash invested. If you invested $100,000 in cash on a rental property and made $11,000 in profit after expenses in one year, your cash-on-cash return would be 11%.
Cash-out Refinance
A strategy where an investor refinances their property to take equity out of the property in cash. For instance, if you have a property worth $200,000 and owe $100,000 on the mortgage, you could potentially refinance to a new $140,000 loan, pay off the old loan, and keep the extra $40,000.
Closing costs
Fees and expenses paid at the closing of a real estate transaction. They can include title insurance, appraisal fees, and escrow fees. For example, if you’re buying a home, you might pay 2-5% of the purchase price in closing costs.
Cost basis
The original cost or value of the property when it was first acquired, including the purchase price and other acquisition costs such as closing fees, legal fees, recording fees, and any costs related to improvement. It’s essentially the baseline for determining capital gains or losses when the property is sold.
Current market value
The most probable price that a property would sell for in a competitive and open market. A home’s current market value could be determined by looking at recent sales prices of similar homes in the same neighborhood. Note that the current market value and the seller’s asking price may be different.
Debt Service
The cash that is required to cover the repayment of interest and principal on a debt for a particular period. If you have a mortgage, your monthly debt service is what you pay to the bank each month.
Debt Service Coverage Ratio (DSCR)
A measure of the cash flow available to pay current debt obligations. For example, if a property’s annual net operating income is $70,000 and its annual debt service is $50,000, then the DSCR would be 1.4.
Deed
A vital legal document in real estate transactions, signifying the transfer of property ownership. The types of deeds – such as General Warranty, Special Warranty, Quitclaim, Grant, Bargain and Sale, and Deed of Trust or Mortgage – each carry different implications for the buyer’s rights and title protection.
Depreciation
A decrease in the value of an asset over time due to wear and tear, age, or obsolescence. In real estate investing, rental property owners can deduct the cost of a building’s depreciation as a non-cash expense each year to reduce taxable income. The IRS allows a residential investment property to be depreciated over a period of 27.5 years. So, if your home has a cost basis of $200,000 (excluding the land value), you can claim a non-cash depreciation expense of about $7,273 per year to offset your taxable net income.
Due diligence
Refers to the research and analysis of a property before finalizing a transaction. It might include reviewing financial records, checking for any legal issues, and inspecting the property. For instance, before buying a rental property, you might check its repair history and verify the income and expenses provided by the seller.
Earnest money
A a deposit made by a buyer in evidence of good faith when the purchase agreement is signed. If you’re buying a house, you might put 1-2% of the purchase price down as earnest money when you make an offer.
Escrow
Refers to a financial arrangement where a third party holds and regulates the payment of funds required for two parties involved in a given transaction. When buying a home, your earnest money deposit might be held in escrow until the deal is closed.
Fixed-rate mortgage
A type of mortgage where the interest rate doesn’t change over the life of the loan. If you take out a 30-year fixed-rate mortgage at a 6% interest rate, you’ll pay the same interest rate for the entire term of the loan.
Homeowners Association (HOA)
An organization within a residential community that makes and enforces rules for properties and their residents. If you buy a property in an HOA, you’ll be required to pay HOA dues and abide by all the association’s rules.
Internal Rate of Return (IRR)
A metric used in capital budgeting to estimate the profitability of potential investments. The IRR is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. For real estate investors, IRR provides an estimate of the project’s profitability.
Investment property
Real estate property that is purchased with the intention of earning a return on the investment either through rental income, the future resale of the property, or both.
Investment strategy
A strategic approach to investing, designed to achieve specific financial goals or returns. In real estate, this could involve strategies like buy-and-hold, fix-and-flip, or investing in rental properties.
Landlord insurance
An insurance policy that covers a property owner from financial losses connected with rental properties. The policy covers the building, with the option of insuring any contents that belong to the landlord[TB1] . To dig deeper, you can check our article “Securing Your Investment: A Deep Dive Into Property Insurance Options”.
Leverage
The use of borrowed capital to increase the potential return of an investment. In real estate, leverage is often achieved through using mortgage financing to purchase a property.
Limited Liability Company (LLC)
A business structure in the US that protects its owners from personal liability for its debts or liabilities. Real estate investors often create an LLC to buy properties in order to protect their personal assets from any legal issues related to the property[TB2] . To learn more about Legal Structures in the U.S., check out our blog post “Legal Structures Of U.S. Rental Property For Foreign Investors”
Loan-to-Value ratio (LTV)
A financial term used by lenders to express the ratio of a loan to the value of the purchased asset. If you’re buying a home worth $200,000 and your loan amount is $140,000, your LTV would be 70%.
Loan origination fee
A fee charged by a lender to cover the administrative costs of processing a loan application. The fee is often expressed as a percentage of the loan amount. For instance, a 2% origination fee on a $200,000 loan would be $4,000.
Market value
The most probable price that a property would sell for in a competitive and open market reflecting all conditions and restrictions of the agreed upon sale.
Monthly payment
This is what you pay each month for your mortgage. It typically includes principal, interest, taxes, and insurance (PITI).
Multi-family
A type of residential property that contains more than one housing unit. Examples include duplexes, triplexes, and apartment buildings.
Net Operating Income (NOI)
This is a calculation used to analyze the profitability of income-generating real estate investments. NOI equals all revenue from the property, minus all reasonably necessary operating expenses, excluding debt service. For example, if a property generates $100,000 annually in rent and has $40,000 in operating expenses, the NOI would be $60,000[TB3] . To learn more, we have an article on “How To Calculate The Viability Of Investing In Real Estate”.
Operating expenses
The costs associated with running and maintaining a property. These can include property management fees, insurance, maintenance costs, property taxes, utilities, and more.
Pre-Approval
An evaluation by a lender of a potential borrower’s ability to qualify for a mortgage. Getting pre-approved means a lender has agreed to lend you a certain amount of money before you’ve found a home to buy.
Property management
The operation, control, and oversight of real estate. It involves the processes, systems, and manpower required to manage the life cycle of all acquired property including acquisition, control, accountability, responsibility, maintenance, utilization, and disposition.
Property owner
The individual or entity (such as an LLC) that holds legal ownership of a property. This person or entity has the right to sell, lease, and make alterations to the property.
Property taxes
Taxes paid by a homeowner to local governments, often based on the assessed value of the property. For instance, if you own a home with an assessed value of $200,000 and the tax rate in your area is 1.5%, you’ll pay $3,000 in property taxes each year.
Refinancing
The process of replacing an existing mortgage with a new loan. Typically, people refinance their mortgages to reduce their monthly payments, lower their interest rate, refinance for more than you owe to take the difference in cash (Cash-out) or change their loan program from an adjustable-rate mortgage to a fixed-rate mortgage. For more in depth information, head to our article “How A Refinance Loan On Rental Property Can Maximize Your Mortgage”
Renovations
Refers to updating or upgrading an existing building or property. For instance, a homeowner might renovate their kitchen to increase the home’s value.
Return on investment (ROI)
A performance measure used to evaluate the efficiency of an investment or compare the efficiency of a number of different investments. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost.
Tax Deferred Exchange
Also known as a 1031 exchange, this strategy allows an investor to sell a property and reinvest the proceeds in a new property while deferring all capital gain taxes. However, to fully defer paying any tax, the IRS requires that the replacement property must be of equal or greater value, equity, and debt.
Title insurance
Type of insurance that protects real estate owners and lenders against any property loss or damage they might experience because of liens, encumbrances, or defects in the title to the property.
Type of property
Refers to the various categories of real estate, such as residential, commercial, industrial, etc.
Types of loans
There are many types of loans, including fixed-rate mortgages, adjustable-rate mortgages, interest-only loans, and others.
Types of refinancing
This includes rate-and-term refinancing (changing the interest rate or loan term), cash-out refinancing (taking out a new mortgage for more than you owe and taking the difference in cash), and cash-in refinancing (bringing cash to the closing table to lower your mortgage balance).
Underwriting
The process lenders use to assess the creditworthiness or risk of a potential borrower.
In conclusion, gaining a firm grasp of the fundamental terms in US real estate investment and financing is an essential step toward making better informed and successful decisions in the realm of property investment. By unraveling the complexities of various refinancing options, loan types, and other pertinent concepts, this article aims to empower readers with the knowledge necessary to navigate better the intricate landscape of the US Real Estate market. Armed with this newfound understanding, individuals embarking on US Real Estate investment journeys can approach opportunities confidently, with more knowledge to speak the language of the industry and optimize their financial endeavors.
