Real estate investing can be the best decision you ever make. But—depending on what you end up investing in—it can also be the worst.
Sound real estate investing starts with education and knowing the terms you’re likely to encounter as you begin this process. This article outlines the top real estate investing terms that comprise the lingo you’re sure to encounter as you begin the real estate investing process.
Top real estate investing terms
- 1031 exchange
- 2% rule
- 70% rule
- Building classification
- Capital upgrade
- Capitalization rate
- Capital gains
- Cash flow
- Certificate of occupancy
- Cosmetic renovations
- Closing costs
- Debt coverage ratio
- Estoppel certificate
- Fair market value
- Gross building area
- Lease agreement
- Loan-to-value (LTV)
- Net lease
- Operating expenses
- Parking ratio
- Property management
- Real estate investment trust
- Real property
- Rental property
- Right of first refusal
- Security deposit
- Vacancy rate
1. A 1031 exchange
A 1031 exchange enables you to swap properties of equal or lesser value with another investor.
For example, suppose you have a single-family or multi-family house. A 1031 exchange could allow you to swap your investment with another property owner and receive another like property or portfolio of smaller properties in return.
Typically, 1031 exchanges are completed to strategically avoid expiring depreciation tax credits. In addition, a 1031 exchange can potentially let you defer capital gains taxes on the sale of a property for life.
2. The 2% rule
When you’re planning to rent to tenants, it’s critical to assess the potential return on your investment. One way to accomplish this is to use the 2% rule.
This rule says that you should strive for a purchase price where the rent roll equals 2% of the total cost.
By following this rule, you could avoid putting too much into a down payment and mortgage payments—which could cause you to wind up in a situation where the amount you collect in rent isn’t enough to cover your monthly expenses.
3. The 70% rule
Another way to determine if a property is a good investment is to use the 70% rule.
The 70% rule states that an investor should pay 70% of the after repair value (ARV) of a property minus improvements and repairs.
Don’t confuse the 70% rule with the rule of 70, which is a separate investing rule that determines the number of years an investment takes to double. These are two different calculations.
A real estate abatement is a tax break provided by a local or state government.
This type of tax break can reduce your property taxes for a specific period of time—or even give your property permanent benefits.
You’ll still have to pay taxes on your property, but an abatement can reduce the overall amount that you have to pay.
Abatements are often distributed to properties to attract buyers to specific areas. You commonly see this in neighborhood restoration and rehabilitation projects or in areas where municipalities are trying to attract new companies and encourage development.
All properties are different and therefore require valuation assessments. This process is an appraisal, and its purpose is to determine a fair value for a house during a real estate transaction.
Appraisals are almost always required when working with a lender who is providing a mortgage loan. Even if you’re buying a house in cash, it’s still a good idea to complete an independent appraisal to make sure you get a fair deal.
Not sure where to start with appraisals? Ask your real estate broker for some advice.
6. Building classification
In the United States, commercial real estate properties are categorized as class A, B, and C properties.
- Class A properties are the highest quality buildings in the best locations.
- Class B properties are a step below class A but still in good condition and in desirable locations.
- Class C properties usually need significant repair and might be located in less than desirable locations.
When buying real estate, the trick is to look ahead and determine a building’s future class rating. For example, you may be able to get a C building that could turn into a B rating through repairs and changing market conditions. However, an A building may degrade to class B status within a few years.
Commercial real estate isn’t all about the aesthetic appearance. Investors may have to make structural considerations and provide custom features for tenants (e.g., new walls, doors, and lighting).
The project scope is typically up to the organization leasing the space. When a tenant negotiates specific improvements to a commercial real estate lease, it’s called a buildout. Often, a landlord provides an improvement allowance to help cover the cost of any improvements needed to transform a space into a polished environment.
8. Capital upgrade
When you buy a real estate investment, your main goal should be to increase its value to generate a profit. One strategy involves capital upgrades.
A capital upgrade is a type of investment that increases the value of an income property. For example, this may include putting a fence on your property or removing a swimming pool if necessary.
Always talk with a real estate agent or lender before you make a capital expenditure to determine whether the investment will increase the value of the property or whether you would be better off avoiding it. If you guess, you could make the wrong decision and decrease your investment’s value.
Not every real estate investor is flush with cash—many need to secure financing to pay for capital upgrades. If you find yourself in such a position, make sure to shop interest rates to get the best deal.
9. Capitalization rate
The capitalization rate, or cap rate, is a measurement that compares real estate investments to determine ROI. Basically, you take the net income the property should produce and divide it by its current market value.
The rule of thumb is that a high cap rate indicates higher risk, while a low cap rate means lower risk. Use these metrics to avoid making suboptimal real estate investment decisions.
10. Capital gains
Any profit that you make from selling real estate is a capital gain, which boosts your gross income for the tax year.
It’s important to note that there is a difference between short-term and long-term capital gains. If you hold a property for less than a year, you’ll pay a short-term capital gains tax as ordinary income. If you hold the property for more than a year, you’ll pay based on your tax bracket.
A tax professional can help you minimize the amount you pay in capital gains taxes.
11. Cash flow
Cash flow is the difference between a property’s income and operational expenses as well as its debts. In other words, it’s the amount of profit that a property generates after removing other expenses.
It’s critical to analyze a property before buying to determine its internal rate of return (IRR) and potential cash flow so that you don’t get stuck with an investment constantly operating in the red.
12. Certificate of occupancy
A certificate of occupancy is a document issued by a local government. This document states that a building is in compliance with local regulations and fit to house a tenant.
Certificate of occupancy requirements tends to vary from place to place. You can also have a temporary certificate of occupancy that only applies for a limited period of time.
13. Cosmetic renovations
Cosmetic renovations include small interior or exterior real estate upgrades that don’t have any lasting structural impact on the house. This may include painting, landscaping, or pulling up rugs.
You don’t need to consult with a real estate agent when making cosmetic renovations. But if something feels like a large-scale overhaul—like replacing a staircase—it’s probably worth getting an expert opinion to protect your investment.
14. Closing costs
Buying a piece of real estate may require working with a lender to secure financing and dealing with closing costs.
These costs arise at the very end of a sale after everything is complete, including inspections, appraisals, and negotiations. Closing costs—which include title insurance, attorney’s fees, mortgage origination fees, and more—can amount to 5% to 10% of the sale price of the property.
Usually, the buyer has the option to either pay the closing costs off with a lump-sum payment or roll the payments into the mortgage.
Depreciation is one of the top reasons investors get into real estate. It’s a great perk, and if you maximize it, you can save a lot of money.
The basic idea is properties decline in value over time. For example, you may need to replace the windows, doors, or toilets in an apartment complex from time to time, which can be expensive.
The IRS lets you write off depreciation credits for 27 ½ years. So, as the structure degrades in value, you’re allowed to keep pumping money back into the property.
At the same time, the overall value of a property can appreciate in value even when the building itself is depreciating.
16. Debt coverage ratio
When deciding to issue a loan for a commercial property, a lender looks at the debt coverage ratio (DCR), which is the property’s income versus its debt obligations.
The basic formula for calculating DCR is net operating income (NOI) divided by debt obligations. A property with a DCR reading of more than one is most likely profitable and more likely to gain approval for a loan.
An escrow is an arrangement where a third party secures funds to make payments on the owner’s behalf.
After you close a loan on a property, the lender collects money and puts it into an escrow account. Then the lender pays local taxes and insurance at the appropriate time.
It’s important to check in and see exactly how much is in your escrow account each month so that you don’t fall short.
If you have excess in escrow at the end of the year, the lender typically reimburses you by sending a check in the mail.
18. Estoppel certificate
When applying for a loan on your investment property, or when attempting to sell it, you might have to ask your tenants to sign an estoppel certificate.
An estoppel certificate is an agreement that indicates the current state and conditions of a lease and the relationship between the landlord and tenant. This document may be necessary for demonstrating steady cash flow on a property. It protects the lender and helps the investor secure a loan or a sale.
19. Fair market value
Fair market value refers to the price that a property is likely to sell for on the open market.
Determine fair market value based on the recent sale price of a property or by hiring a third-party expert for an appraisal.
Fair market value is often used for tax purposes. For example, local property taxes typically depend on a property’s fair market value.
In addition, fair market value sometimes comes up in court settlements and legal arrangements.
20. Gross building area
There are many measurements to consider when buying commercial real estate. One of the most important measurements is gross building area, which is the total floor area, including below-grade space. It’s measured from the exterior walls and windows and includes all vertical penetrations. Basement space is also included in this calculation.
All real estate transactions should go through an inspection in order to identify any potential areas that require improvement.
An inspection may lead to the discovery of mold or an asbestos issue. It could also reveal critical structural, electrical, or plumbing issues.
An inspection primarily serves the buyer, giving them negotiating leverage. It also potentially gives the buyer a legal way out of an agreement after putting a down payment on a property.
HVAC stands for heating, ventilation, and air conditioning: all the necessities for thermal comfort. Almost all real estate buildings have HVAC systems in some form or another.
It’s a good idea to bring in an HVAC specialist to review a system before making a purchase. This is not something you want to deal with after a transaction, as it could result in costly repairs or upgrades. HVAC is a critical need in real estate; no property is safe without it.
23. Lease Agreement
A lease agreement is a formal arrangement between a landlord and tenant that outlines the terms of their deal.
This document typically outlines how long a tenant can hold a space before they have to renew and the terms and conditions of what they can do while occupying the space. It also determines how much the tenant must pay during that time frame to secure the space.
24. Loan-to-value (LTV)
Another key metric a lender considers when determining whether to issue a loan is loan-to-value (LTV). This is something all potential borrowers should keep in mind when applying.
LTV determines how large a down payment an investor needs to put down on a property.
To calculate LTV, divide the amount borrowed by the appraised property value. An ideal loan-to-value ratio should not exceed 80%.
25. Net lease
In a net lease, the lessee pays more than just rent. They will also cover some or all of the insurance fees, taxes, and maintenance.
In a gross lease, the tenant usually only pays for rental fees, leaving the landlord to cover the rent.
Net leases are commonly applied in commercial real estate agreements.
26. Operating expenses
As the name suggests, operating expenses refer to the costs associated with operating and maintaining a property. This may include repairs, maintenance, utilities, taxes, and insurance, among other expenses.
As a landlord, you can define what constitutes operating expenses within reason. If something is costing you money to keep a building going, it most likely falls under this category.
Operating expenses are typically tax-deductible. However, it’s a good idea to consult with a tax professional before making any declarations to protect yourself.
27. Parking ratio
If there’s one thing you don’t want to overlook when buying real estate, it’s parking, especially if you’re buying office or retail space in a shared building or lot. If people can’t park, you could have a real problem on your hands.
To determine a parking ratio, divide the total rentable square footage of a building by the building’s total number of parking spaces. You typically need about five spaces per 1,000 square feet.
The amount of parking you need is largely based on what type of operation you’re running. Some facilities may require more parking spaces than others.
28. Property management
If you’re like most people, you probably don’t have the time or patience to manage your own property. Making repairs, collecting payments, and dealing with tenants takes a ton of time and exposes you to a considerable amount of risk.
Instead, many real estate investors hire turnkey property management companies to take care of their spaces. A property management company essentially serves as a buffer between the landlord and the tenant. It can be expensive, but it’s typically worth the money.
29. Real estate investment trust
You don’t have to invest directly in a property when putting your money into real estate. Also, you can invest in a real estate investment trust (REIT), which is a company that owns and operates real estate.
You can buy REITs through brokerage firms, just like purchasing stocks. They are generally much easier to obtain than physical real estate because you don’t have to come up with a hefty amount of money to get started. They’re also less risky.
Word to the wise: Watch out for fees when buying REITs.
30. Real property
Real property is a term that describes land and any physical structures attached to it. This may include buildings, lighting fixtures, towers, plumbing, and things of that nature.
When property isn’t affixed to land, it’s called personal property. At the same time, property can also be digital or intellectual and devoid of any particular form or structure. For example, an idea or plan can be intellectual property.
31. Rental property
A rental property is a type of investment property you purchase with the intention of leasing it to renters on a short-term or long-term basis.
A rental property can produce a healthy cash flow if you can get a quality place in a valuable market.
One thing to keep in mind: If you need a loan to finance your real estate investment, the Federal Housing Administration (FHA) is unlikely to help. Typically, the FHA only gives loans for houses that will serve as primary residences.
32. Right of first refusal
A right of refusal agreement gives a company or individual the right to enter a business transaction before another party.
For example, you may lease a space to a tenant whose business depends on that particular location, potentially putting that business in jeopardy if you decide to sell the property. In this case, the tenant may request a right of first refusal, giving them the right to purchase it outright if the owner decides to sell—unless they decline the option.
On the one hand, this can increase the chances of a quick sale for the owner. It can also potentially improve tenant relations, as it’s a nice gesture to make. However, the downside is that it could limit what the seller could receive for a property in an open market. A right of first refusal is typically a binding agreement.
33. Security deposit
A security deposit is a payment a tenant makes to a landlord to secure a lease arrangement.
Once a tenant makes a security deposit on a property, the landlord must take the property off the market. Yet, a security deposit does not complete an agreement. In most cases, the buyer and seller still have to go through formal inspections, appraisals, and the closing process.
A tenant is someone who signs a lease to rent real estate space in a house, condominium, or commercial environment. Tenants can be short-term or long-term, staying there as long as you agree.
Tenants are required to abide by the rules outlined in their lease agreement. However, each state has specific rules governing how landlords can treat tenants. It’s critical to understand your state’s tenant protection laws before allowing someone to rent your space.
35. Vacancy rate
Vacancy rate refers to the total number of available units in an unoccupied property at a specific point in time. For example, if an office building is only 50% full, it has a 50% vacancy rate.
It’s a good idea to analyze the vacancy rate in a building whenever you’re buying space and to look at historical vacancy rates.
You should also look into whether you’ll be responsible for paying for vacancies in your building. In some cases, owners need to come up with the difference for vacant properties.
Frequently Asked Questions
Does real estate produce a strong cash return?
It largely depends on the type of real estate you own. Some properties produce a strong cash return, while others can be very expensive and unprofitable.
Research your target property as much as possible before buying so that you have a clear understanding of its potential profitability.
Are homeowners real estate investors?
There’s a big difference between owning a home and investing in real estate. A real estate investment property is one that is acquired with the sole intention of producing revenue.
That said, you can still generate revenue from your home by using a site like Airbnb and renting out your space. But it’s still going to be a residential property, not an investment property.
Do I need a property manager?
You should strongly consider hiring a property manager if you’re looking into a real estate investment. A property manager can be expensive. But hiring one can also protect you from having to deal with tenants.
Generally speaking, a property manager makes it much easier to be a landlord.
What is passive income?
Passive income is money that flows in on a monthly basis, which requires little to no work. For example, rental income is considered passive income.
What is foreclosure?
Foreclosure happens when an owner stops making loan payments to a lender. When this happens, the property first becomes distressed, and the bank performs due diligence to collect its money. If the owner stops paying entirely, the bank forecloses the property, puts it on the real estate market for resale, and starts working with other realtors and listing services.
If no one buys the foreclosed property, it becomes real-estate owned (REO), which signifies the property is owned by a bank or lender and not an individual or entity.
Should I refinance a property?
It could make sense to refinance a property partway through a loan. You may be able to walk away with a repayment plan that has lower interest payments. Talk with your lender to see if this makes sense for your unique circumstances.
The Bottom Line
Real estate investing is complicated. You could spend a lifetime studying real estate and still discover things that surprise you.
If you’re thinking about becoming a real estate investor, start by learning these basic terms and build from there. When in doubt, ask a friend or mentor who has more experience than you for advice .
At the end of the day, real estate can drastically improve your net worth, but only if you find a property with a strong rate of return. Only by exploring the market can you see what’s out there. Your real estate empire awaits.
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