Property Valuation and Appraisal Study Guide for the Real Estate License Exam

More About Investment

Financial Sources

No matter what part of the real estate life cycle an investor is in, he or she can almost always find a way to borrow money. However, depending on the source of funding, down payments, interest rates, terms, and conditions will all vary. Common financial sources include traditional banks, insurance companies, private or hard money lenders, and group investors.

Interest Rate

The interest rate is what the borrower pays to use the lender’s money and to compensate the lender for the risk that he or she is taking. A large corporate borrower will likely pay a very low-interest rate, while a beginning real estate investor buying its first fix-and-flip property will pay a much higher rate of interest.

Leverage

Leverage occurs when borrowed money—sometimes called OPM or “other people’s money”—is used to buy real estate with the expectation that the net income and appreciation of the property will be greater than the cost of borrowing.

Amortization

Amortization is the repayment of debt in a fixed amount and on a fixed repayment schedule. Examples of amortized loans include real estate mortgages and car loans.

Prepayment

Sometimes, loans have a penalty for prepayment, which compensates the lender in part for the loss of potential interest income. When a borrower has a loan with a prepayment privilege, that means that the borrower has the “privilege” of paying off the loan early without paying a penalty (or sometimes with paying only a very minimal penalty).

Exculpation

Exculpation occurs when a borrower is able to give the property to the lender without facing any personal liability for a deficiency. The part of a mortgage document that allows a borrower to do this is known as an exculpatory clause.

Assumability

Assumability means a borrower is able to have another party assume its existing mortgage under the same terms and conditions. Once the mortgage is assumed—or transferred—the original borrower is released from any obligations to the lender.

Acceleration Provisions

Also known as a call provision, an acceleration provision or clause allows the lender to call the full amount of the loan due if the borrower does not meet certain loan conditions. For example, commercial real estate properties often require a minimum debt coverage ratio. If there is not enough extra income being generated above and beyond the debt payment and general operating expenses, the lender may call the loan due before the borrower can default or declare bankruptcy.

Subordination

Subordination refers to the order of priorities or claims to collect a debt. For example, a home equity loan is usually subordinated (or listed in second place) to the primary or first mortgage that was used to buy the home.

Property and Investment Variations

One of the unique things about real estate is that every property and every deal is different. There are an almost countless number of variables—or variations—with investment property including tenant quality, online and offline bricks-and-mortar competition, zoning changes and government regulation, and, of course, location.

Location

You’ve probably heard the phrase that real estate is all about location, location, location. What this term is really saying is that no two pieces of real estate are exactly the same. It also means that no two buyers, sellers, or renters will view the same property the same way.

Data Sources

Successful real estate investors know that the more data they have to analyze and compare, the more they will be able to minimize investment risk.

Local Sources

There is a variety of local sources for real estate data, most of which can be obtained for free or very inexpensively. Local sources include: real estate boards and the MLS (multiple listing service), tax assessor offices, credit bureaus, banks, and lending institutions, as well as university research centers.

Property Owner’s Records

In disclosure states property owner information is public record and is usually available online. A property owner’s records may include data and documents such as deeds, leases that are recorded, copies of mortgage instruments, liens, sales history, and property tax information.

Investment Returns

Investment returns are measured in a variety of ways. Some measures consider how much money can be made, while others look at the probability of getting the invested money back. Three factors used when analyzing investment returns are: (1) return on investment, (2) return of investment, and (3) risk of the investment.

Return on Investment

Also known as ROI, the return on investment is expressed as a percentage and shows how much money or profit will be made relative to the cost of the investment. The formula to calculate an ROI is (gain from investment – cost of investment) / cost of investment = return on investment.

Safe rate—Safe rates pay lower returns because they also have the least risk. Treasury bonds and Federal Reserve notes pay the lowest interest because they are guaranteed by the full faith and credit of the U.S. Government.

Liquidity premium—Liquidity means that an asset can quickly and easily be converted into cash for its fair market value. Because real estate is not a liquid investment, investors demand a liquidity premium to compensate them for the additional risk being taken.

Management premium—Also known as a control premium, this represents the additional return an investor expects for actively managing the investment.

Risk premium—This represents the additional return that an investor expects in exchange for accepting more risk, such as building a home “on spec” without a buyer lined up.

Return of Investment

Return of investment means that the investor receives the capital back that it has invested. Real estate investors want to have their capital returned and ideally receive a financial return on that capital.

Risk

Investors who are concerned with the return of their investment generally accept a higher level of risk than do investors who focus on a return on their investment. For example, real estate developers accept a high level of risk in exchange for a higher return of and on their capital invested.

Tax Concerns

Real estate is taxed in a variety of different ways, on local, state, and federal levels. There are numerous tax advantages to investing in real estate. However, investors should also consider the various tax implications of a potential real estate investment when determining whether or not the investment will truly be profitable.

Depreciation and Tax Deductions

Depreciation is a non-cash deduction derived from tax law that assumes that real estate only has a certain useful life. Depreciation can be used to reduce the amount of real cash income that is liable to be taxed. Other cash-based tax deductions include mortgage interest, operating expenses, and capitalized improvements.

Tax-Free Exchanges

Also known as 1031 Exchanges or Starker Exchanges, tax-free exchanges allow a real estate investor to legally defer paying capital gains taxes by using profit from the sale of investment real estate to buy like-kind real estate. There are specific rules to follow, and investors should always enlist the help of a 1031 exchange facilitator.

Solving Problems with Real Estate Math

The real estate exam will require you to use some very basic math to answer questions. The test does not involve a lot of math. In this section, we’ll cover some of the common areas of real estate in which math is used.

Measurement of Length and Area

A common use of math in real estate is to determine the length and area of a parcel of land. The land may be unimproved, a developable parcel that is going to be split, or a subdivided lot in subdivision. The term length refers to how long something is—usually the boundaries—and the term area refers to how much space is contained within the boundaries of the parcel.

Linear Measurement

Linear measurement is the sum of the width and depth (or length) of a lot. If a lot is 100 feet wide and 300 feet deep (forming a perfect rectangle with four sides), then the linear measurement of the lot would be: 100 + 300 + 100 + 300 = 800 feet.

Area Measurement

Area measurement is used to determine the square feet the lot contains. Using our above lot that is a perfect rectangle, we determine the area of the lot by multiplying the width and the depth: 100 x 300 = 30,000 square feet.

Acre

An acre consists of 43,560 square feet. If the lot in our above example measured 100 feet x 435.6 feet, it would be an acre: 100 x 435.6 = 43,560 square feet. As it is, our lot is a little over 2/3rds (.66 or 66%) of an acre: 30,000 / 43,560 = .69 of an acre.

Important Terms

When describing lots or parcels of land, there are four important terms to understand: depth, frontage, lineal distance, and right of way.

Depth—Depth is how far back a parcel goes from the front of the lot. In our example, the lot has a depth of 300 feet.

Frontage, front foot—Frontage refers to the width of the property, usually along a street or access road, or along a lake or river. In our example, the frontage of the lot is 100 feet.

Lineal distance, lineal foot—For real estate purposes, a lineal foot is the same thing as a regular foot. In our example, we could also say the lot has a frontage of 100 lineal feet.

Right-of-way—Right-of-way is when there is an established legal right to pass along a specific route through property that belongs to someone else.