It’s All Greek to Me: Common Real Estate Terms Defined
|Copyright 2014 by Virgo Publishing.|
|By: Ben Vestal|
|Posted on: 02/01/2008|
As many of you know, David Letterman presents a nightly top-10 list on his show. I’m always a bit in the dark when Dave does his countdown because I’m so uninformed about pop culture. It occurred to me some people might feel the same way about real estate terminology, and it might be helpful to readers to have a top-10 list of common terms.
Many self-storage owners and buyers may be unfamiliar with the language real estate professionals use frequently throughout the process of buying and selling properties. Brokers sometimes forget to explain the terms they use on a daily basis. Below you’ll find a list of frequently used phrases to help you understand the lingo of real estate transactions. Learn them, and you might even impress a broker or two. Drum roll, please!
10. Cap Rate
The cap rate is the rate of return an investor is willing to accept on an income-producing real estate asset. Because different types and classes of investments can be difficult to compare, a cap rate provides a basis for evaluating the rates of return of unique properties.
Many factors play into the cap rate, most especially interest rate. Some of the other factors are a property’s location, market conditions, quality of construction and historical income, just to name a few.
You can calculate the cap rate by dividing the net operating income (see No. 9) by the purchase price. Or, to calculate a purchase price or value for a facility, you can divide the net operating income rate by the return an investor is seeking.
There are other methods of arriving at a value, such as replacement cost and surveying the market, but cap rates are the gold standard for valuing self-storage. The cap rate is largely a function of the general real estate market and somewhat dependent on the qualities of the facility.
9. Net Operating Income
The net operating income (NOI) is the income from a property or business after operating expenses have been deducted, but before deducting taxes, depreciation and debt service (interest and principal). I believe 90 percent or more of a storage facility’s value is directly related to NOI.
NOI is used to calculate the value of the property by applying a market cap rate or rate of return an investor is looking to achieve to a value or purchase price.
8. Loan to Value
Loan-to-value (LTV) is the relationship of the loan balance to the appraised value of the property. For example, if the appraised value of a property is $1 million and the loan balance is $750,000, the property then has an LTV of 75 percent.
This is not always the true market value or what you feel the value may be, but simply the loan amount divided by the appraised amount. LTV is typically used in the underweighting analysis when you refinance or place a loan on a property. Lenders historically have had limits in the range of 70 percent to 80 percent of the loan to appraised value.
7. 1031 Exchange
Named after its place in the U.S. tax code, a 1031 Exchange (sometimes known as “like kind exchange”) allows for the capital-gains taxes on a transaction to be deferred if the proceeds from the sale are reinvested in a similar or “like kind” asset. These exchanges are typically used in real estate, but people can also apply them to some other big-ticket assets.
The key thing to remember is you are only deferring the taxes, not avoiding them. There are lots of details to consider, so be sure to call your accountant first when considering this type of transaction.
6. Special-Purpose Property
A special-purpose property is a building or property that has limited uses, such as self-storage, churches, theaters and schools. Self-storage is sometimes considered a special-purpose property, meaning the building or property would need major remodeling, rezoning or demolition to be used for an alternate use and, thus, may impede financing with some institutions.
5. Debt-Service Ratio
The ratio between NOI and your annual debt service is known as the debt-service ratio. This is typically the way a lender monitors an asset’s performance.
Lenders generally require a debt-service ratio in the range of 1.1 to 1.5. In some situations, a lender may require a minimum debt-service ratio to be maintained for the life of the loan. For example, if your annual NOI is $100,000 and your annual debt service is $70,000, the debt-service ratio is 1.42.
4. Reverse Leverage
Reverse leverage is when the interest rate on funds borrowed to purchase an asset exceeds the return on investment a buyer will receive. For example, if a cap rate or investor’s targeted return on an investment is 7 percent and the interest rate on the funds borrowed to purchase the investment is 8 percent, this would be considered reverse leverage.
Typically, reverse leverage will deteriorate an investor’s return on equity and is sometimes a deal killer! A period of reverse leverage conditions in the market reduces values in general and has a negative impact on the ability to sell a property.
3. Real Estate Investment Trust
Real estate investment trusts (REITs) are generally publicly traded companies that own, develop or operate commercial properties. They are required by law to distribute 95 percent of the NOI that allows them to avoid paying corporate tax (but you get the taxes). Some well-known self-storage REITs are Public Storage and Extra Space.
2. Defeasance Clause
If you really need to know this term, call a professional. If you’re just curious, read on. Defeasance occurs when you want to terminate a loan early that is not prepayable. It is required that you substitute other collateral (usually a form of U.S. government securities) for the property securing the loan.
The amount of the securities required to be posted must be enough to pay off the principal, interest and fees of the loan. This occurs most often in the event of sale. You still must pay back the loan. Many times, this means posting much more security than the remaining loan balance.
Forbearance is a lender’s decision to delay taking legal action on a delinquent loan at the request of a borrower. In other words, the lender may give you some time to comply with your loan documents before it starts the foreclosure process. This can only take place at the lender’s absolute discretion and is determined on a case-by-case basis.
These definitions are brief and only address the common understanding of the terms, but there are many nuances that may affect the meaning based on the context in which they are used. It’s always best to consult a real estate professional if you have any questions about the terms or details of a transaction.
Ben Vestal is the executive vice president of the Argus Self Storage Sales Network, a real estate brokerage and development company based in Denver. Argus also operates www.selfstorage.com, a marketing medium for industry owners. For more information, call 800.55.STORE.