Explaining Real Estate Jargon
So, I’m going to break the jargon all up into five different categories: deal flow, debt, due diligence, financial, and a miscellaneous category. First up within the deal flow category is BOV, or broker opinion of value. That is exactly what it sounds like. It's when a property owner a broker to give his or her opinion of value on the asset. The owner would actually provide the financials and the broker would do a full underwriting of the asset and determine the value of it. Next up is OM, or offering memorandum. That's simply the marketing package that the broker or the seller puts together when marketing the property for sale. It often provides sensitive information that allows potential buyers to evaluate the property. The seller or a broker may ask you to sign a CA or confidentiality agreement, or an NDA, a non-disclosure agreement, which are both the same thing. Basically, both are documents from the seller that says since they giving you financials to evaluate my property, you're only going to talk to your team members about them. You're not going to send them around to the world or there's going to be repercussions. Then you go to an LOI or letter of intent, or MOU memorandum of understanding. Both of those are the same and simply refer to a non-binding agreement that spells out the major terms of an agreement to purchase a property. It’s used prior to having attorneys involved in creating a contract or PSA. Now a PSA is a purchase and sale agreement and that is a binding agreement between a buyer and a seller to complete a transfer of ownership of a property. Most, if not all of the time an EMD is required. That is an earnest money deposit, which is simply the initial deposit you put down in order to execute a contract for purchase, or a PSA. And the last abbreviation within the deal flow category is DD or due diligence. And that simply refers to the time period provided by the PSA that a buyer has to perform various inspections of the property to determine if they want to buy the property. Now we're going to jump into the debt category of abbreviations. First up is the DSCR or debt service coverage ratio. The debt service coverage ratio is a measurement of risk by the lenders who are loaning money. Typically, they want you to have at least 1.3 times more net income in order to service the debt. The equation used to determine that is net operating income divided by annual debt service. So, for example, if we have $567,000 in net income and $354,000 in debt service costs, which is the principal and interest added together, then this particular property has a 1.60 debt coverage ratio. That would probably make a lender feel really good about loaning the money because of the amount left over after all the expenses are paid. Next up is IO, or interest only. Sometimes a lender will quote that they'll give two years of IO and that just means that they're going to give you two years where you can pay just interest only. Next is BPs, or basis points. One basis point is equal to 1/100th of 1%. Sometimes lenders will quote interest rates as a basis point above LIBOR and they’ll say something like we are lending 80 basis points above LIBOR, which means 0.8% above the LIBOR. So of course, next we’ll go over LIBOR. LIBOR it is the London interbank offered rate and is simply a globally accepted rate that is the basis from which lenders lend on top of. LIBOR is simply the rate which banks lend to each other on. Next let’s review non-recourse debt, which is basically just debt that's secured by an asset instead of you personally. If you default the lender doesn't come after you, they take the property. If you hear the words capital stack, that's the debt and the equity that you use to buy a property. If you hear the words MEZ debt or mezzanine debt, that's the debt typically developers get to bridge the gap between a primary mortgage and the balance of the equity needed to do the deal. So, let’s say a developer could only get 80% loan from a primary mortgage and he needs another 20%. Maybe he borrows 10% from a MEZ lender, which usually lends at a higher interest rate because the primary mortgage, in the event of default, is the one that gets paid first and if there's anything left over the MEZ lender gets the balance. Often times there's nothing left so the MEZ lender is left with empty pockets, hence why the interest rate is higher. Then there’s defeasance, which is basically just a prepayment penalty. If a lender lends you money, they expect a certain rate of return over a certain period of time. And if you want to pay it off early, they make you pay a penalty so they can make up for those returns. The last jargon under the debt category is bridge loan. That's just a short-term loan against another property you own that has equity that you can use as collateral to purchase another property. Let’s move on to the due diligence category. You might hear hard costs. Those are simply the material and labor costs that make up the physical asset of a development, the actual buildings. Now soft costs are things like architecture fees, engineering fees, CPAs, attorneys, permits, etc. A CO is a certificate of occupancy and it's just a document that says it's safe to enter into the building and live in it. A TCO is a temporary certificate occupancy, which basically just says there's only minor things left to complete but the building is safe to actually occupy. Now in the financial category you might hear underwriting. When someone says they're underwriting a deal, that means that they're actually doing the financial analysis in consideration of purchasing the property. You will also hear cap rate. Like All. The. Time. And that stands for capitalization rate and it's just the rate of return of a property in a one-year time horizon as if you were to pay cash for the property. To calculate a CAP rate, you take the net operating income divided by the purchase price, times 100. So, if you have $150,000 in net income and the purchase price of the property is $2.7 million, and you use no loan whatsoever, that's a 5.6% cap rate or rate of return for that exact period in time. If you hear the word, proforma, that's just a projection of what one thinks the income and expenses and sale price could be in the future. The abbreviation NOI is net operating income. That is simply the income minus expenses. Then there’s EBITDA, which is earnings before interest, taxes, depreciation, and amortization. And that’s just a fancy accounting term typically used in business, but it's equivalent to the net operating income that we just explained. Next, you might hear COC, which is cash on cash. And that’s just net operating income minus debt. Next up is IRR, or internal rate of return. This is my personal favorite because it gives the true, long-term measure of the performance of a property. Let's assume in year zero, which is right now, you buy a property and put down a deposit of $539, 000. In year 1 it produces $43,000 in cash on cash (remember that’s after expenses and debt). In year 2 it produces $46,000 and in year 3 you sell it and walk away after closing with $1 million dollars in your pocket plus the cash flow. If you were to create a rate of return equation in excel, over that three-year period that would calculate a 27.96 IRR. You typically need to use a spreadsheet, or other similar financial support, in order to do the calculation. Ok, so next is ROI or return on investment, which is just the increase or decrease of value over a set time. Let me explain. The equation for ROI is your current value right now, minus what you bought it for, plus all the renovations you put in into it, divided by what you bought for and all the renovations, times 100. ROI doesn't take into consideration time, though. CAPEX, or capital expenditures, are one-time expenses like roof, air conditioner, floor, appliances. OPEX are operating expenditures like the regular maintenance of the property, lawn and pool, repairs and maintenance, and utilities. If you hear BE ratio, that's break-even ratio. Also, one of my favorite calculations. The break-even ratio is basically a measure of what occupancy you have to be at in order to cover all of your expenses and debt. The last term I’ll discuss under the financial category is GRM, or gross rent multiple. The gross rent multiple is calculated by the sale price divided by the gross annual rents of a property. So, if you have a $10 million dollar property with gross rents of $1.275 million, the gross rent multiple is 7.84. And that means that a property is trading for nearly eight times the gross rents. Now we're in the final miscellaneous category of weird acronyms. The first one up is the weirdest of all – frothy. This is when investors ignore market fundamentals and are pay more than a property is worth. Many would say that today's market is frothy. Now, if you hear syndicate or syndicator that's a group of people who have pulled their money together to invest or buy other assets. If you hear absorption rate that's just the proportion of new construction units that have leased in a certain period of time. So, if a hundred units were being constructed and 40 of them leased that's a 40% absorption rate. Affordable housing is a property in which the tenants are receiving some sort of rent assistance from the government or other organization. A soft market is when supply exceeds demand and, in that scenario, usually a tenant or buyer can get a pretty good deal. We are not in a soft market right now. A turnover rate is the percentage of units that became vacant during the year. So, if you have 10 units and at some point, during 12-month period 4 units moved out that's a 40% turnover rate. If you hear someone say that a property is going into DISPO next year, DISPO stands for disposition, which means someone's going to be selling that property. A JV is a joint venture. That's when two or more people get together and they collaborate on deal. If you hear MSA that stands for metropolitan statistical area, and is defined as an area having at least one urbanized area with a minimum population of 50,000 and are linked by social and economic factors. If you hear T12 or T6 or T3, that refers to the trailing 12 months, or 6 months or 3 months. If you're looking at financials, you want to ask for the T12 which means you want the last 12 months, month by month, of income and expenses. Watch the full video in the link below to see visuals of all these calculations.
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