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Top 5 Words to Learn Before Investing in Real Estate

Real Estate Investing Words You Must Know

Let’s demystify the top five words you will hear in every conversation about real estate investing. If you’re looking to start investing, follow along. These terms will help you understand the real estate landscape in Nampa, Idaho, and surrounding areas and navigate the complexities of the market more effectively.

1. Appreciation

This is my absolute favorite word in real estate. Simply put, “appreciation” refers to the increase in value of a property over time. But here’s the deal: Like stocks, real estate can go up and down due to market conditions.

For example, a financial crisis in 2008 caused property values to plummet. In 2020, a global pandemic set off one of the most significant appreciation runs in some areas, like Idaho. Today, higher interest rates have caused real estate values to dip.

It goes to show that real estate is not a short-term game. Real money is made by holding onto your property investment over the long term.

National Appreciation Rate

Black Knight reported a national appreciation rate of 3.8% per year. If you average the highs and lows of the typical real estate investment over the last 20 years, you would see an appreciation of almost 4% per year.

An increase of 80% over 20 years isn’t too shabby. But if there is anything I want you to take from this information, real estate is highly local. As they say, “Location, location, location. ” Some real estate areas climb or drop faster than others.

Statistics

I’d be remiss if I did not tell you what happened in the Treasure Valley of Idaho, where I live. I have a couple of charts that I want to share with you. One is for Ada County, where our capital, Boise, is located. The other is for Canyon County, where Nampa is.

A professor at Boise State University put these statistics together for us. She compiles these numbers using the local multiple listing service. This isn’t an in-depth look at today’s real estate market in the Treasure Valley; I will put together videos on that topic later. I want to point out how the market has performed over the last 16 years.

Appreciation in Ada County

Earlier, I mentioned the financial crisis of 2008. From 2007 until about 2011, the Ada County market dropped about 36%. I can attest to this personally. My husband and I purchased a duplex in Boise in 2004 for $178,000. As we stared down the barrel of losing our house, we had that duplex appraised to see if we could sell it. It was only worth $89,000! Needless to say, we did not sell.

Fortunately, in 2012, the market started to rebound, and the trailing averages for the last ten years stand at 13%. More impressively, in the previous five years, it has gone up to 17%.

Appreciation in Canyon County

In Canyon County, the 2008 crash had a more devastating effect, dropping those values by 50%. However, on the rebound, the 10-year trailing average is 17% per year and 20% for the last five years.

2. You Cannot Time the Market

A bit of caution: I saw many newbie investors buy a property while counting on appreciation to make their money in the short term. We saw remarkable appreciation of properties every month. It seemed wise to buy something, hold on to it for a year, and sell it at a profit after it had appreciated.

But here’s another famous saying in real estate: “You cannot time the market.” Some of them got caught in the latest market dip. The recent rate increase was fast, and many newbies found themselves trying to get rid of these properties because they needed to consider other crucial factors to investing. More on that later.

3. Equity

You have likely heard “equity” when purchasing your home or during a refinance. Equity is the difference between the value of your home and what you still owe on it. Equity belongs to you, even though some steps are required to access it.

Although we want to kid ourselves that the house belongs to us, it doesn’t. It belongs to the bank until you pay your debt or mortgage. Here is a quick way to determine a property’s equity. Keep in mind: We are not going down the rabbit hole of transactional fees that happen at the buy or sale of a property, like realtor commissions, title, and lender fees.

Say you paid $300,000 for your rental and borrowed $240,000. The equity of this rental is $300k-$240k=$60,000. This means that if you sold it right after buying it, you would make about $60,000 on that sale, notwithstanding the transaction fees.

You might be looking at that and saying, “Silvia, that’s just plain dumb! Why would I invest in a home if the only thing I get back is my own money?” Hold on a minute!

Now, people buy and sell only sometimes. That’s why I said, “Don’t be the newbie.” But you must know that equity is also something that happens over time.

Some equity can be built quickly, like buying it undervalue (say you pay $280K, and it’s worth $300K). This would give you $20k in instant equity. Or you can spend a couple of months making some nice improvements that make it worth $320k. You update the kitchen or bathrooms, paint the exterior, add new floors, etc.

Still, equity happens over a more extended period for most people. First, you make monthly payments, and a portion of that money is applied to the principal balance of $240k, reducing it by that amount every month.

Second, as the years go by, your property increases in value, widening the gap between the value and what is owed: your equity.

Considering the national appreciation average of 3.8%, at the end of five years, that home has gone up 19%, making your property worth $357,000. Your equity, not including the amount of debt you have paid off, has grown from $60k to $117k.

Equity works the same way for all residential real estate properties. It allows us to leverage a property over and over again. Every time the property appreciates and increases in equity, we can use that equity to purchase another property.

Loan-to-Value (LTV) Ratio

This refinance part brings us to our next term, Loan-to-Value ratios. LTV is the ratio of the loan amount to the appraised value or purchase price of a property. Let’s do some more math.

LTV Ratio = MA/APV

  • MA is the amount you are asking to borrow.
  • APV is the value of the property.

In our previous example, our ratio when we purchased the property looked like this:

$240,000/300,000=0.8 or 80% LTV ratio

LTV is important for two major reasons:

Lower Interest Rate

The lower the LTV, the lower the interest rate a bank will charge you. Lenders look at LTV ratios to determine the amount of risk they are taking by lending to you. It translates to how much skin you have in the game.

If you put down 20% of your own money, you are less likely to default on that payment than if you only came in with 5%. While a lender will take the risk of lending you 95% of the amount needed on a home you will be living in, they are very reluctant to give you more than 80% on something that you will be letting someone else occupy.

Even with the 20% down, an investor who hasn’t done his homework might still default. However, selling a home in a foreclosure with at least 20% equity is better than one with only 5%. Those transaction fees we discussed earlier might eat up 7% immediately.

Higher Equity

Equity and LTV go hand in hand. The more equity you have, the lower your LTV ratio. Hence, if you wanted to access your home’s equity without selling it, you would opt for a refinance to pull that equity out.

Most lending institutions have a limit on what LTV they will accept when it comes to taking equity out of your home. For your residence, you can get what banks call a Home Equity Line of Credit (HELOC). I have seen HELOCs financed for up to 95% LTV.

Investment properties have lower LTVs, around 75%- 80%. With the market tightening, I have heard of some lenders only offering up to 50%. But before you run out and get a HELOC on your house to buy that next rental, know there is some inherent risk in putting your residence on the line.

4. Cash Flow

Unlike equity and LTV, cash flow is specific to investment properties. Every investor dreams of it, and it is the reason for many math calculations!

Cash flow is the income generated from a rental property after deducting all expenses. This includes mortgage payments (on the property and any HELOCs if you used them), property taxes, insurance, and all maintenance and operating costs.

Although I have personally had occasions when my cash flow on a property was 0, I don’t recommend ever purchasing a property with no cash flow. Earlier, I mentioned our duplex, which had dropped in price by half. It meant that virtually any equity we built between 2004 and 2011 had been totally wiped out. The only saving grace for that property was that our tenants at the time were paying enough rent to cover the mortgage. I’ll be honest: If there were repairs or other expenses during that time, we must have covered them out of pocket.

5. Depreciation

Depreciation is also specific to investment property as it relates to real estate. Accounting depreciation, as it is sometimes referred to, is defined by Merriam-Webster’s dictionary as: “to deduct from taxable income a portion of the original cost of a business asset over several years as the value of the asset decreases.”

Leave it to the tax people to flip the meaning of a word from a negative connotation to a positive one. No one ever wants to depreciate the value of a property in real life. I mean, can you imagine? I just finished telling you about the importance of equity and how it relates to the value of a property. Less value = less equity.

But in the tax world, this definition is a crucial perk. When you hear that a wealthy person (picture Trump) only paid a minimal income tax, you might look at your tax return and say, “WTF! How do they do it?” Well, through depreciation.

Real estate is one of the most tax-advantaged investment vehicles out there. The IRS tax code has been carefully written to incentivize specific behavior. In the case of investment real estate, the government wants individuals and companies to take the risk of buying something for someone else to live in. Depending on when you sell, there are no guarantees that you will make money on that rental, nor will you get a great tenant in there that pays for that investment. So, to convince you to do it anyway, they offer you this deduction on your income tax return.

Most properties are depreciated over a set schedule of 27.5 years. If you owned the property for that long, you could deduct your taxable income yearly for those 27.5 years. I looked at my 2021 tax return, and that duplex provided us with a depreciation deduction of $6k. Imagine what could be done if you multiply that by five or ten properties!

When my husband and I started investing, we had no clue what any of these words meant. Still, despite our ignorance, investing in real estate has afforded our family many opportunities. Early on, it allowed us to upgrade our own home with little money down, using equity from our rentals as a down payment. Then, a few years ago, when we moved to Idaho with two kids in tow, we were virtually unemployed.

Twenty years into investing, when real estate sales fell from the face of the earth, our investments allowed our lifestyle to remain unchanged. So, am I happy I learned about these words? Yes, yes, I am!

In Conclusion

Contact us if you need help with a property investment guide or managing, buying, or selling a home. We’d be happy to help.

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