3. BPO: Broker Price Opinion
This is an opinion of the value of a piece of real estate, offered up by a real estate broker or agent. Typically you see a BPO as opposed to a full-fledged appraisal on short sales or REO deals. The BPO is not as thorough as an appraisal. Typically the broker gets a small fee and writes up an opinion of value, which is used to justify the sale. The bank will order this to confirm that the deal is being sold somewhere near market value, minus the repairs. The way you win on this is to get that BPO agent to consider the repairs the property needs. If you can, send them some pictures ahead of time!
4. NOI: Net Operating Income
This is a calculation for rental real estate. Easily explained, this is how much money you would make if you owned the property free and clear of a mortgage. The NOI is calculated on an annual basis and equals the Net Rental Income (total rent for the year minus vacancy), minus the Operating Expenses (this is all costs for maintaining the property, including real estate tax, insurance, maintenance, management, utilities, landscaping, legal, leasing commissions, etc.—everything EXCEPT the mortgage payment.) Sometimes people include “Capital Expenses” as an expense also. More on that later. For larger deals, you want to see a NOI that is between 40 and 50% of the Net Rental Income. The NOI means very little by itself, but it’s used for two very important calculations, explained below.
5. CAP Rate
The Capitalization Rate is NOI divided by the sell price or value of a piece of real estate. It is expressed as a percentage, but most people leave the percent part off when they are talking about it, i.e., “This property is a 10 CAP!” CAP rates are used to compare real estate investment opportunities. The CAP Rate is what your return on investment would be if you owned the property free and clear.
In my humble opinion, this term gets thrown around too often in our business. Some people confuse it with Return on Investment, which is very different. It also gets used on small real estate deals, like single family homes and small multi-unit buildings. I don’t think it is an appropriate way to evaluate these types of deals, and it can be dangerous to do so. A Single Family Home can have a fantastic CAP Rate, as long as it’s rented. If you have one month of vacancy, all those calculations go out the window. This is a way deeper conversation for another day, so let’s stop right there
6. Debt Service
This is a fancy way to say “mortgage payment.” It’s the money required to “Service the Debt” on the property. It includes the interest on the loan and any pay back of the loan balance (principal reduction, defined below). The NOI minus the Debt Service equals your cash flow.
7. DSCR: Debt Service Coverage Ratio
The DSCR equals the NOI divided by the Debt Service. In simple terms, it is how many times over the property can pay the mortgage payment after expenses are paid out. This number is really only important to lenders. In today’s marketplace, they want to see a DSCR at 1.25 or more. When evaluating a deal, just make sure that your DSCR exceeds your lender’s threshold. Most lenders will be able to tell you what their required number is right off the top of their head!
8. Principal Reduction
We went over this briefly; this is the part of a mortgage payment that goes towards paying back the debt. What makes this a conversation piece is how people view it. When you turn in your tax return at the end of the year, all you are able to claim as an expense when considering your Debt Service is the interest. The Principal Reduction is not an expense, it is repayment of a loan.
Some investors—and many commercial brokers trying to sell deals—will call Principal Reduction to be income. The IRS makes you pay taxes on it, so technically it is income. That being said, I always back it out of my profit calculations because it’s not cash in my pocket NOW. It’s potential future income, and there are a lot of IFs to consider before I get to hold that income in my hand. I do see Principal Reduction as a benefit, but to me it’s a part of long term wealth building.
9. $/SF – Dollars Per Square Foot
This is a great way to evaluate things like construction costs, rents, and sell prices of property. The last two apply somewhat in single family homes, and the all apply in multifamily and commercial deals. Not all properties are the same size, so comparing the cost to rehab, rent, or buy a property based on $/SF allows you to compare one deal to another. It’s also a really good “rule of thumb” to evaluate a deal, as long as the market and property type are the same.
10. Phase 1 Study
If you have only done residential deals, you may not have even heard of this one. A Phase 1 is a study to determine the potential environmental hazards that exist on a property. Things like prior uses, on site storage tanks, asbestos, and lead-based paint are taken into consideration. A lender is the one who will push to have something like this done because they don’t want an environmental issue to arise that will drastically decrease the value of the property they have a loan on.
I have had many Phase 1 studies done. One of them uncovered underground oil tanks that had leaked into the soil around the property, and another found a deposit of lead in the soil that had to be removed. If you do the study before closing, it is the responsibility of the seller to take care of remediating these issues. In my part of the world, you can get an “Environmental Review” done for less than $1,000 and a full-fledged Phase 1 done for around $3,000 depending on the size and complexity of the property. The difference is a Phase 1 considers prior uses of the property. If someone was using the address as a paint factory 75 years ago, you want to know about it. The way I look at it, it’s a very inexpensive way to uncover something that can cost you tons of money in the future.
11. Assessment
This is a term used to determine the real estate taxes on a property. The assessment has a relation to the property’s value, but is not the same as the value. Most people think they are the same thing—or close to it. That’s not always the case. It doesn’t fluctuate like the value does, and there are equations that are used to determine the assessment. Every town is different. You can call your local tax office to ask how they calculate it if you are curious. The real estate taxes you pay per year equal the Assessment times the Tax Rate. If your property gets re-assessed, your taxes are going to change. When you appeal your real estate taxes, what you are really doing is appealing the town’s assessment of your property.
12. LOL
I had to throw that one in there. If you are going to stay sane in this business, be sure to “Laugh Out Loud” at least three times a day. Doctor’s orders.
13. LTV
This is a basic one. It stands for Loan to Value. A lender will base the loan they will give you on a percentage of the property’s value. The reason I have this in this conversation is that you need to make sure you know what value they are talking about. Most banks use an appraiser. If you are using a private lender, you could mutually agree on a value based on other sales in the market (also called “Comps” or Comparable Sales). If you are doing repairs on the property, you want to know if they are talking about the value before or after the repairs (sometimes called After Repair Value or ARV). It is a basic term, but it’s one that gets thrown around without clarity sometimes.
