The Essential Real Estate Glossary

By
Telukunta Sai Kinnera,
The Essential Real Estate Glossary

Real estate, like any other industry, has its jargon. It can be quite confusing, complicated, and misleading if the individuals dealing with the field aren't aware of the vernacular terminology the field holds.

Here's a compilation of few such words that might help you understand this realm of real estate better.

Terms

Realty

Realty is a piece of real land. To put it in simple words, it is the real estate property.

Closing Costs

These are the expenses/fees paid at the closing of the real estate transaction.

Due Diligence

Due diligence is the process of thoroughly examining the financial, operational, legal histories of the property along with deep and stringent inspection of the interior and exterior of the property.

Peer-to-peer (P2P) Lending

It is also known as "social lending" or "crowd-lending."

P2P is a method of lending money to individuals or businesses through online services that match lenders with borrowers.

Dividends

Dividends are the returns that investors earn every month after investing in REITs.

Assessed Value

It is the ascertained monetary worth of a property that helps to estimate the property taxes.

Commercial Real Estate (CRE)

Commercial real estate is property used mainly for business purposes or to provide a workspace. Usually, commercial real estate is leased to tenants to conduct business.

Fixed-rate Mortgage

It is a type of mortgage loan in which there is a fixed interest rate for the loan's whole term period.

Adjustable-rate Mortgage Loan

Also known as variable-rate mortgage/ adjustable-rate mortgage/ tracker mortgage.

It is a mortgage loan in which the interest rate applied to the outstanding balance varies all through the life of a loan.

Realtor

Realtor is a real estate agent who purchases or rents or sells the land and is a member of the National Association of Realtors (NAR).

Balloon Mortgage

It is a loan that has an initial period of low or no monthly payments, and at the end of the tenure, the borrower is required to pay off the full balance in a lump sum.

Contingency

A contingency, in a formal real estate contract, states that certain conditions should be met by either the buyer or the seller to proceed to the next step.

Foreclosure

It is a legal method in which the lender attempts to recover his balance debt amount from a borrower who has ceased to make payments by forcing the sale of the asset that he used as collateral while taking the loan.

Real Estate Owned (REO)

They are the lenders' assets - like the bankers, government agencies, etc. which they have procured at the unsuccessful foreclosure auction.

Lease Rental Discounting

Lease Rental Discounting is a tool to acquire term loans from banks using rental receipts as collateral.

Leverage

It is an investment strategy of using borrowed money (borrowed capital, generally) primarily without having to put your money much.

To leverage a property, you can take loans from banks, money lenders, credit unions, etc. For example, if your property values 20 lakhs, they might provide you an investment of 15 lakhs, and you will have to pay only the remaining five lakhs. Thus, decreasing the amount to be paid from your end and maximizing the returns.

Amortization

  1. Amortization in loan perspective

It is a method of equalizing the monthly mortgage payment by adjusting the proportion of principal to interest all through the life of the loan.

To help you understand the concept better, here's a small explanation of how the adjusting is done: While repaying a loan, although your total payment remains the same each period, you'll be repaying the loan's interest and principal in varying amounts each month. At the beginning of the loan term, the interest costs are at their highest. As time passes, more repayment goes towards your principal, and you pay proportionately less interest each month.

For example, if you take a 20 lakh loan at a 9 percent interest, you'd be paying the minimum principal amount, i.e., some 9 thousand principal amount and maximum interest amount, i.e., some 9 thousand interest, at the starting point summing up to 18,000 per month. But as the term comes to an end, you'd be paying the same 18,000, but the interest would become minimum, i.e., 1-2 thousand and the principal becomes maximum, i.e., 16-17 thousand.

This amortization is done to estimate useful life or the maturity or loan period in the case of a bond or a loan.

  1. Amortization in Intangible Assets Perspective

Amortization is the process of incrementally charging the cost of an asset to expense over its complete expected period of use, which moves the asset from the balance sheet to the income statement. Generally, the assets that can be amortized are patents, goodwill, trademarks, customer lists, motion pictures, franchise agreements, and computer software.

For instance, let's assume that XYZ owns the patent on a piece of technology and that patent lasts for 20 years. If the company spends 20 lakhs to advance the technology, then it would record two lakhs each year for 20 years as an amortization expense on its income statement.

The benefits of amortizing assets are that the company gets to pay less tax and may even post higher profits.

Capital Appreciation

Capital appreciation refers to the increase or appreciation of the investment's value or price, which may include fixed assets, company stocks or bonds, or the land.

It can be understood as follows.

If you buy land at the cost of 15 lakhs, after some 10-15 years, it would no longer be of the same price. It would have touched some 25-30 lakhs of a minimum.

This difference of 10-15 lakhs between the investment and the present value is capital appreciation.

Inflation

It refers to the sudden and unexpected rise in the increase in prices and fall in purchasing power of the currency.

For example, consumer goods' prices are not the same as before per se, 20 years. This explains the increase in prices and the loss of purchasing power of the currency.

Portfolio, Portfolio Diversification and Risk Diversification

A real estate portfolio is a collection of property investments owned by an investor or a group of investors.

In finance and investment planning, portfolio diversification combines a variety of assets to reduce the overall risk of an investment portfolio. So, it is a risk management strategy.

Investing money in different properties to reduce the risk of investing only in one type of investment is known as risk diversification.

Formulae

Principal, Interest and Annual Percentage Nate

The principal is the original sum of money taken as a loan on which the interest is paid regularly.

Interest is the payment made for the use of credit.

When interest is expressed as rate percent on a yearly basis, it is called the Annual percentage rate.

APR-formula

where n = number of years

For instance, if you take a loan of 10 lakhs( principal) for a tenure of 10 years (n) from a financial institution at an interest rate of 10 %, the total interest becomes 1,00,000. On the addition of extra fees and substituting all the mentioned values in the above formula, APR can be calculated as 2.1%.

Equity

Real estate equity is the difference between the fair market value of a property and the amount of debt the owner holds.

Equity-Formula

For example, if you own a property worth 30 lakhs and owe 20 lakhs on loan used to buy the property, then the difference of 10 lakhs is the equity.

Net Present Value

The difference between the values of present cash inflow and current cash outflow over a period of time.

Where:

Rt= net cash flow

t  = time of the cash flow

i  = discount rate

NPV-formula

For instance, you invested in a project 'A' for about ten lakhs today. After investing, you started generating cash flows without any further investment. Assume the IRR to be 8% for this project.

Period Project ‘A’ Cash Flows Discount Rate/Internal Rate of Return(%)
Today - 10 lakhs 8
1st Year 2 lakhs 8
2nd Year 3 lakhs 8
3rd Year 3 lakhs 8
4th Year 3.5 lakhs 8
5th Year 3.5 lakhs 8
Total Cash Flow 15 lakhs -

Substituting all the cash flow, time of cash flow, and internal rate of return values in the NPV formula, the NPV can be obtained as follows:

Period Net Present Value
Today 10,00,000
1st Year 1,85,185
2nd Year 2,57,202
3rd Year 2,38,150
4th Year 2,57,260
5th Year 2,38,204
Total Cash Flow 11,76,001

The above table shows the net present value of  1,76 lakhs at the end of 5 years on the 10 lakhs investment made today.

  • Internal rate of return

It is a discount rate that makes the net present value of all the cash flows from a certain project to zero.

Where:

Cash flows = Cash Flows in the time period

i                  = discount rate

t                 = time period

To understand it better, we can take the example mentioned above itself. If we replace the 8% discount rate with 13.92%, the total cash flows become 10 lakhs, and NPV becomes 0, i.e., no difference between the invested amount and value of the invested amount 5 years down the line.

Note:

Higher the IRR of a project or a financial scheme, the more profitable it is to invest in that.

Debt to Income Ratio (DTI)

It is the percentage of a consumer's monthly gross income that goes into payment of debts.

DTI-formula

For example, if your DTI ratio is 15%, 15% of your monthly gross income goes to debt payments each month, i.e., if 20,000 is your income, 3,000 is your DTI.

Gross Rent Multiplier

It is the ratio between the price of a real estate investment and its annual rental income before its costs, such as property taxes, insurance, and utilities, are accounted for.

GRM-formula

For instance, if a property purchase value is 30 lakhs, and the annual gross income you earn on it is 5 lakhs, the GRM is 6.

Gross rent multiplier is a great way to take a "quick look" at how fast the property will be paid off from the gross rent the investment is generating.

Cash-On-Cash Return

Cash-on-cash return is the ratio of pre-tax annual return to the total amount invested on the property.

cash
cash-on-cash-return-formula

For a better understanding, here is an example.

Let's assume that a company decides to purchase a commercial space for 50 lakhs. The company pays its down payment of 10 lakhs and takes a mortgage of 40 lakhs form the bank. Besides the down payment, the company is required to pay 3 lakhs in various fees. The company decides to give this space on lease.

After a year, the annual return revenue from the property is 5 lakhs. Also, the company has to pay mortgage payments, including interest and principal amount, i.e., 1.5 lakhs.

To calculate the Cash-on-cash return, we need first to determine the annual cash flow.

Annual cash flow = annual rent - mortgage payments

  =    5,00,000  -  2,50,000

=    2,50,000

Then, the next step is to find out the total cash invested, excluding the leverage.

Total cash invested = down payment + fees

  = 50,00,000 + 3,00,000

 = 53,00,000

Cash-on-cash return for first-year can now be calculated from the above formula.

C-O-C return   = 2,50,000 / 53,00,000

  = 0.83 or 83 %

In this way, the cash-on-cash return can be used to get an estimate of what an investor may receive over the life of the investment.

Break-even Ratio

For property, it is the percentage of gross operating income that the property needs for costs to equal expenses.

break-even-ratio-formula

For example, let us assume that a given property has an annual debt service of 10 lakhs, and it's annual operating expenses are 10 lakhs.

Total yearly expenses = 10,00,000 + 10,00,000 = 20,00,000

Now, let’s say this property has a gross income of 30 lakhs.

Break even ratio = Total expenses / gross income

                              = 20,00,000 / 30,00,000

                              = 0.667 or 66.7 %

So, you need roughly 66.7% occupancy to break even and cover your expenses.

  • Net operating income

Net operating income (NOI) is a calculation used to estimate income-generating real estate investments' profitability. It is equal to all revenue generated from the property minus all necessary operating expenses.

Net operating income = Real estate revenue - operating expenses.

For example, if a real estate land yields 10 lakhs and it's operating expenses are 5 lakhs, the NOI is 5 lakhs.

It is used to estimate the capitalization rate, which in turn helps find the property's value. Thus, allowing to compare various properties values before buying or selling.

  • Capitalization rate

Mathematically, the cap rate can be defined as the ratio of net operating value to market value or original capital cost, alternatively.

cap-rate-formula

For example, if a commercial slot's net operating income is 35 lakhs and the market's asset value/ sale price is 10 crores, then the cap rate can be determined and is found to be 0.035 or 3.5%.

In the above example, an all-cash investment of 10 crores would produce an annual return on investment of 3.5%.

Thus, it can be understood that the cap rate gives us an idea about the return on investment and indirectly helps you estimate the property's value.