GLOSSARY

accelerated depreciation: Annual depreciation calculated in such a way that deductions are higher than average in the earlier years and decrease in each subsequent year. Accelerated methods are not allowed for real property but can be used for other classes of property, such as landscaping equipment or vehicles used in real estate investment management.

active participation: The degree of involvement in managing property, to qualify to deduct net losses for tax purposes. This standard requires ongoing involvement in approving tenants, maintaining properties, and approving rent levels and major expenditures.

adjusted gross income (AGI): Gross income for tax purposes, before deducting tax exemptions and deductions.

adjusted purchase price: The purchase price of property plus closing costs paid by the buyer, inspection fees, prorated expenses, and points paid to lenders.

adjusted sales price: The sale price of property minus the seller’s closing costs, which include real estate commissions, inspection fees, repairs, and prorated expenses.

after-tax cash flow: The amount of net positive or negative cash resulting from a property investment, including the benefit or cost from tax calculations.

allocated expenses: Any expenses that cannot be identified as belonging to a specific property and consequently are spread among two or more investment properties on some basis (such as percentage of gross rent received for each property during the year).

amortization: (1) For a mortgage loan, the reduction over time of the principal due to the lender. The calculated monthly payment is divided between interest (based on the current balance remaining) and principal, which amortizes the loan balance. (2) In tax law, the spreading of an expense over a period of time. Points paid at closing must be amortized each year over the period of repayment of the loan. Prepaid insurance, property taxes, and other expenses are amortized over the months to which the expense applies.

annualization: A return expressed as though an investment had been held for exactly one year. This procedure makes all returns comparable, regardless of how long the property was held.

appraisal: The estimated current market value of property, based on one of several methods. These include the sales or market comparisons, cost, and income methods.

basis: The price of property adjusted up for closing costs and capital improvements and adjusted down for depreciation claimed and for any deferred gain resulting from a 1031 exchange. Basis is used for calculation of capital gains and losses.

cap rate: The capitalization rate, or the return generated by income properties. It compares net operating income to sale prices in order to estimate value based on a comparison with similar properties in the same area.

capital gain or loss: The profit or loss on investment property. Capital gains on property owned for more than one year are taxed at rates below the ordinary rates applied to other income.

capital improvements: Payments for items that add value to real estate and therefore must be depreciated over a recovery period (as opposed to being deducted as an expense in the year paid).

capitalization: Debt (financing provided by lenders) or equity (investor funds) used to purchase properties. Capitalization may be generated directly from lenders or investors, or indirectly through the use of investment vehicles such as real estate investment trusts (REITs), mutual funds, and partnerships.

cash flow: The amount of net cash received or paid each month on a real estate investment. When rent receipts are higher than the sum of mortgage payments, operating expenses, and payments for capital improvements, cash flow is positive. When the sum of payments exceeds rental receipts, cash flow is negative.

cash flow projection: A calculation of near-future cash receipts and cash payments, used to ensure that an investor can afford a particular investment, given debt service, operating expenses, potential vacancies, and repairs.

construction and development REIT: A type of real estate investment trust that specializes in providing financing to builders or developers.

cost method: A method used by appraisers to estimate market value, based on the cost to duplicate the same property on land of comparable or identical value.

debt service: The payments due on a monthly basis to lenders, consisting of principal and interest and, in many instances, impounds taken by the lender for payments of insurance premiums and property taxes.

declining-balance depreciation: A method of calculating annual depreciation in which the depreciation in earlier years is higher than it would be with straight-line rates. Under the tax rules, accelerated depreciation can be used for certain classes of assets (but not for real property).

deferred gain: A gain on real estate on which the tax liability is put off until sale of a replacement property, under a 1031 exchange.

depreciation: (1) In tax law, an annual “recovery” of the investment in real property and other capital assets (but not the value of land). As a noncash expense, depreciation deductions create lower tax liabilities without a corresponding outlay of cash. (2) In appraisal, a calculated annual decline in value resulting from the age, condition, or obsolescence of a property.

discount: A price below full market value. In the real estate market, an offer made and accepted that is below the asked price is discounted, and the percentage of difference between the asked price and the sale price is the discount.

economic life: In appraisal, the adjusted value of property based on its current condition (not its actual construction age), used as a basis for calculating depreciated market value.

economic rent: In appraisal, an assumed market-rate rent used to calculate value using the income method; it can be based on units, rooms, or square feet.

effective age: In appraisal, the age of a property based on its current condition, not its actual year of construction.

effective gross income: The maximum possible rental income from a property, less estimated loss of revenue from vacancies.

effective tax rate: The actual tax rate paid by an individual, based on total taxable income. This rate is used for purposes of assessing the cost or value of investment decisions. It may also be expressed as the rate of tax liability saved or paid on any changes made to the tax due on income as reported.

equity REIT: A real estate investment trust that is designed to assume ownership positions in properties (as opposed to debt positions or leveraged positions). This type of REIT is considered safer than leveraged REIT programs because cash flow requirements exclude debt service.

exchange-traded fund: A mutual fund traded on an exchange and specializing in a specific product or range of sectors, such as the real estate industry. The exchange-traded fund has a fixed portfolio, and shares can be bought or sold on public exchanges.

expense ratio: In appraisal, the relationship between expenses and income, used in the income appraisal method to compare properties to one another.

fair market value: The value of property in today’s market based on the average sales of comparable properties in recent months.

gross rent multiplier: A factor in appraisal under the income method that is used to establish the values of comparable income properties. Averages of comparable income properties are used to estimate the market value of a subject property.

half-year convention: In depreciation, a method of calculating first-year depreciation. It is based on the assumption that all assets acquired were placed into service exactly one-half of the way through the year, so that first-year depreciation is one-half of what it would have been if the asset had been owned for the full year.

highest and best use: In valuing real estate, a principle stating that property tends to appreciate at the most favorable rate when the land and improvements are used in the best way possible, given zoning, size, location, and attributes.

hybrid REIT: A real estate investment trust that has equity and debt positions within its portfolio.

illiquidity: The loss, or lack, of liquidity of an investment; a condition in which cash cannot be taken out of the investment without sale or refinancing, or in which no new buyers are available to purchase the investment units a seller wants to sell.

income method: In appraisal, a method used to calculate the market value of properties based on the level of income that is being or can be generated from a property, given gross rent multipliers for similar properties in the same market.

inventory: Properties available for sale and on the market, calculated in one of two ways: number of properties or months of availability based on typical monthly sales. If 400 homes are currently available and a town’s average monthly sales are 100 homes, inventory can be described as 400 properties or as a four-month supply.

investment risk: A risk that investors take when they place capital into any product, including real estate. Attributes define risk; for example, directly owned real estate is illiquid and leverage requires consistent cash flow, but the investment is insured and directly controlled. In comparing one investment to another, it is important that differences in investment risk be taken into account as part of the analysis.

leverage: Investing with borrowed money, such as the mortgaged portion of investment property. The greater the leverage, the greater the cash flow risk; as a result, degrees of leverage may be used to compare the risk levels of various investment strategies.

like-kind exchange (1031 exchange): A tax provision that allows real estate investors to sell an investment property and replace it with another one. As long as specific rules regarding time and amount are met, the exchange allows the investor to defer the tax liability. The basis in the newly acquired property is reduced by the amount of the deferred gain.

limited partnership: An investment vehicle in which a general partner controls the day-to-day management of properties, and a number of limited partners invest funds. They are “limited” in two respects: They cannot participate in decisions within the partnership, and their maximum risk is limited to their investment capital. Limited partners are not allowed to deduct passive losses but must apply them against passive gains or carry them forward and apply them against future capital gains upon the sale of properties held within the partnership.

liquidity: (1) In risk analysis, the level of availability of cash in an investment program. In directly owned real estate, liquidity is poor because cash can be removed only through sale or additional borrowing. In stocks, liquidity is high because shares can be bought and sold quickly. Liquidity is a means of comparing investments and judging market risk. (2) In market analysis, a description of whether investments can be sold. Real estate and stocks are highly liquid because new buyers are available. In limited partnerships, there is no ready market because few new buyers are interested in paying current value for used partnership units; the only way to dispose of them is by selling them at a deep discount. Also called marketability.

margin of profit: In business, the gross or net profit; in real estate, the net difference between the adjusted purchase price and the final adjusted sale price.

marketability: The ease with which an investment can be bought or sold. Stocks are highly marketable because there is an abundance of buyers and sellers, as well as an exchange mechanism. Real estate properties are less marketable because the completion of a sale takes time and involves review steps. Partnership shares have low marketability because there are few full-price buyers for used partnership shares.

market or sales comparison: In appraisal, a method of calculating current market value based on the current market, or by reviewing recent sales of properties of similar size, condition, and location.

market risk: A risk every investor faces, usually related to the possibility of losing money. In real estate, market risk may refer to price changes, trends in rental demand, or cash flow.

material participation: A requirement for investors who directly own property that includes consistent involvement in tenant decisions, approval of expenses, and maintenance. To be considered materially involved and qualify for deduction of net losses, the individual must also own no less than 10 percent of the property if it is owned jointly with others.

mid-month convention: In depreciation, a method for figuring the first-year deduction. It assumes that assets acquired during any month were placed into service exactly halfway through that month. There are 24 half-months in every year, so the number of half-months determines the amount of first-year depreciation.

modified accelerated cost recovery system: The depreciation method currently used under federal tax rules in which recovery periods and depreciation methods are specified for different classes of capital assets.

modified adjusted gross income: On an individual’s tax return, the adjusted gross income without including many of the normal adjustments allowed under the rules. Modified AGI is used to identify income levels in calculating the maximum deduction allowed for real estate losses.

mortgage-backed securities: Debt-based investments in which secured mortgage loans are placed into a package of debts, and units are sold to individual investors. This is a diversified way for individuals to invest in secured debt without having to lend money directly on a single property or to one individual.

mortgage pool: A collection of individual mortgages bundled together in which individual investors can buy units, like a mutual fund consisting of mortgages rather than stocks or bonds. Mortgage pools are created and managed by federal agencies.

mortgage REIT: A real estate investment trust specializing in lending money to investors, builders, or developers of real estate projects.

negative cash flow: The situation in which monthly expenses and payments are greater than the rental income received from a property.

net breakeven point: The rate of return necessary to break even after the combined effects of inflation and taxes.

net market value: The current market value of a property, after deducting the cost of needed repairs.

occupancy rate: The degree of use of rental property, usually expressed as a percentage of the maximum. For example, a property with four units has a 75 percent occupancy rate when one unit is not occupied. The same situation can also be described by the vacancy rate; the property in this example would have a 25 percent vacancy rate under the conditions described.

passive income or loss: Under federal tax rules, income received or losses incurred by an individual who does not materially participate in the management decisions for the property. Passive losses may not be deducted. They must be applied against passive gains, carried forward to use in future tax years, or used to reduce capital gains when the property is sold.

positive cash flow: The situation in which rental income is greater than the sum of operating expenses, mortgage payments, and other cash outlays.

premium: A price above the asked price. For example, in a seller’s market, there may be a number of buyers bidding for a limited number of properties for sale. When a property’s price closes above the asked price as a result, the difference is a premium, usually expressed as a percentage of the original asked price.

primary residence: An owner-occupied home. For tax purposes, an individual may have only one primary residence. Profits of up to $500,000 may be excluded from taxes when this property is sold. Only one such exclusion is allowed once every two years. For calculating the exclusion, a property must have been used as the primary residence for at least 24 months during the past 60 months.

profitability: In real estate, a measurement of the success of an investment, calculated using one of several methods. Generally, it is the difference between an investment’s sale price and its purchase price, adjusted for closing costs, improvements, and depreciation. Profitability may also be based on cash invested (down payment), in which case cash flow is expressed as a percentage of the cash base; or based on annualized capital gains adjusted for interim cash benefits or costs.

prorations: (1) Expenses shared by buyer and seller; they are divided between the two at closing based on the applicable period each is responsible for (usually the number of days). (2) A partial-month liability for interest on a loan, payable by one side in the transaction to a lender.

ready market: Any market in which buyers and sellers can quickly and efficiently locate one another, agree on a price, and complete a transaction.

real estate cycle: The course of supply and demand, reflecting varying degrees of change in attitudes among buyers and sellers and affecting property values.

real estate investment trust (REIT): An investment vehicle in which investors purchase shares in a trust that is traded on a public stock exchange. The purpose of a REIT is to invest in real estate properties on a specified basis (where properties are identified) or through a blind pool (where a market strategy is spelled out, but the properties themselves are not identified). A REIT may be classified as equity, mortgage, or hybrid, depending on the investment risk level and the REIT’s objective.

recapture: A requirement in tax law that, upon sale of investment property, the sum of depreciation expense is taxed as part of the calculated taxable gain.

recovery period: In depreciation, the number of years over which a capital asset can be depreciated.

replacement value: In appraisal and real estate insurance, the value of property if it were to be replaced in exactly the same condition as today. For example, the quality of workmanship in an older property may be higher than modern standards. Replacement value, as a result, is not the same as current cost or market comparison value.

secondary market: (1) In individual investing, the market for the sale and purchase of existing properties, shares, or units. Stocks have a strong secondary market because shares can be traded easily on the public exchanges, and limited partnerships have a poor secondary market. (2) In the mortgage industry, the collective market for the purchase and bundling of home mortgages. Existing mortgages are sold by lending institutions and formed into mortgage pools. Shares of these pools are then sold to individual investors. This secondary market is operated by several agencies, including the Government National Mortgage Association (GNMA) and the Federal National Mortgage Association (FNMA).

second home: In tax law, a residence used part of the year in conjunction with the primary residence. Individuals are allowed to deduct property taxes and mortgage interest on their primary residence and on one additional property as part of itemized deductions.

secured debt: A debt, such as a mortgage, in which the obligation is secured through equity in some property. In the event of default, the lender has the right to foreclose on the secured property to regain the funds loaned to the property owner or investor.

spread: A calculation used to judge the supply and demand in the current market. It is the difference between average sale prices and average asked prices over a period of time. As the trend in the spread percentage changes, it indicates a corresponding change in market condition.

straight-line depreciation: The basic method of calculating annual depreciation expense, in which the depreciable value of the asset is divided by the number of years in the recovery period. The same amount is deducted each year until the asset’s basis is fully depreciated.

supply and demand: A theory in economics observing that buyers and sellers determine the market value of real estate and other assets. When the number of buyers increases, demand is greater; when the number of sellers increases, supply is greater. In real estate, supply and demand are found in three specific areas: the market value of properties, the supply of and demand for rental units, and financing, expressed as money supply and affected by changing interest rates.

time on the market: The time required for a listed residential property to sell, which is used as an indicator of a market’s strength or weakness. In strong seller’s markets, the average time properties remain on the market is low, and in strong buyer’s markets, the average time on the market increases.

transition: Change in a neighborhood or city in which property values move up or down. In a positive transition, upgrades and improvements tend to raise average property values, and in a downward transition, neglect causes property values to fall.

turnover: An average of the number of times investment capital is replaced over a period of time. The more frequent the turnover, the higher the yield.

useful life: In depreciation, an estimated period of years over which an asset may be used in business or investment before it has to be replaced, sold, or abandoned. Useful life determines the recovery period for the asset.

yield: Any measurement of profitability or cash flow from an investment; often used as an alternative for return. Yield may refer to cash flow as a percentage of cash invested or market value, or to the annualized return upon sale of investment property.