There are a ton of terms thrown around in the real estate investment world. Many of these are often confusing because they are used in a variety of ways and often wrong. Which means it is even more important to understand the actual definitions and functions. This is the third of a three part series defining real estate investment terms and functions you should know as you analyze possible purchases.
This third entry into understanding real estate investments, looks into terms related to financing and general terms about the strength of an investment relative to our goals. For example, when we use leverage we expect our tenants to pay our mortgage for us, therefore building equity in our property. Below a list of important real estate terms necessary to understand both financing and strength:
Liquidity: Refers to the ability to convert an asset (Real Estate, Bonds, Baseball Cards, etc…) into cash quickly with little discount to the value of the investment. Different types of investments vary in how fast they can be converted into cash at their full value. Real Estate is less liquid than stocks, for example, but more liquid than art.
Marketability: Refers to the time it would take to sell an asset with certainty of the price. The time it takes to sell the asset depends on the activity in the market for that asset and the economic forces of supply and demand.
Risk: Refers to the uncertainty associated with the expected, or hoped for, performance of an investment. As a rule, the higher the expected return, the more risk associated with the investment. Risk refers to the possibility of loss, and how comfortable you may be with that loss.
Equity Build Up: Measures the real return accrued on each additional amortized year of mortgage. As debt is paid down, equity increases. So, with every mortgage payment, a little bit of equity is created, and over time the cumulative effect leads us to outright ownership.
Appreciation: Refers to an increase in the value of an asset over time. The increase can occur for a number of reasons, including increased demand or weakening supply, or as a result inflation or interest rate fluctuations.
Amortization: Refers to the way an asset is paid for over time. Mortgages don’t get paid down evenly over time, they are amortized, meaning that each month, a little more of the money you pay goes towards principal and less towards interest. This can be considered forced savings, since a portion of each mortgage payment reduces the principal owned and increases equity for the investor.
Equity: Refers to the difference between the market value of a property and the amount owed on the mortgage. In other words, it is what you own. For example if you have a property worth $100,000, and owe $40,000, your equity is $60,000. Selling that property today, means you keep $60,000, and the rest goes to pay the debt. Equity builds up gradually over time, as the mortgage balance falls and the market value appreciates.
These general terms help you look at your investments, whether real estate or others, in a more critical way. Going beyond just ratios, but into the dynamics of owning investments, and specifically real estate. Since real estate is an investment that can be financed, equity build up is extremely important and a component that is not considered often enough. Likewise, the way mortgages are amortized plus how appreciation works, give us insight that goes beyond just rates of return.
Hopefully, these definitions and explanations help you look at investing in general, and real estate particularly, in a different light. Understanding what is meant in each case gives you more confidence as you decide to invest.