Need to Know Terms for the Real Estate Investor
By Christopher Levarek
“An investment in knowledge always pays the best interest.”
- Benjamin Franklin
Knowledge conquers fear and investing in real estate is no exception. Often time investments in real estate can appear intimidating due to the lack of exposure for the investor in this space. Today we would like to cover some need to know terminology for the passive investor when looking at investing in real estate.
Whether investing in apartment syndication, small multifamily or even single family homes, the following terms are referenced in Joe Fairless’s, “Best Ever Apartment Syndication Book” and are good to understand:
Apartment Syndication: A temporary professional financial services alliance formed for the purpose of handling a large apartment transaction that would be hard or impossible for the entities involved to handle individually, which allows companies to pool their resources and share risks and returns. In regards to apartments, a syndication is typically a partnership between general partners (i.e. the syndicator) and limited partners (i.e. the passive investors) to acquire, manage and sell an apartment community while sharing in the profits.
Accredited Investor: A person that can invest in apartment syndications by satisfying one of the requirements regarding income or net worth. The current requirements to qualify are an annual income of $200,000, or $300,000 for joint income, for the last two years with the expectation of earning the same or higher, or a net worth exceeding $1 million either individually or jointly with a spouse.
Active Investing: The finding, qualifying and closing on an apartment building using one’s own capital and overseeing the business plan through its successful execution.
Breakeven Occupancy: The occupancy rate required to cover all of the expenses of a property.
Capital Expenditures (CapEx): The funds used by a company to acquire, upgrade and maintain a property. Also referred to as CapEx. An expense is considered CapEx when it improves the useful life of a property and is capitalized – spreading the cost of the expenditure over the useful life of the asset. CapEx included both interior and exterior renovations.
Capitalization Rate (Cap Rate): The rate of return based on the income that the property is expected to generate. Also referred to as the cap rate. The cap rate is calculated by dividing the net operating income by the current market value of a property.
Cash Flow: The revenue remaining after paying all expenses. Cash flow is calculated by subtracting the operating expense and debt service from the collected revenue.
Cash-on-Cash Return: The rate of return based on the cash flow and the equity investment. Also referred to as CoC return. Coc return is calculated by dividing the cash flow by the initial equity investment
Debt Service Coverage Ratio (DSCR): The ratio that is a measure of the cash flow available to pay the debt obligation. Also referred to as the DSCR. The DSCR is calculated by dividing the net operating income by the total debt service. A DSCR of 1.0 means that there is enough net operating income to cover 100% of the debt service. Ideally, the DSCR is 1.25 or higher. A property with a DSCR too close to 1.0 is vulnerable, and a minor decline in revenue or minor increase in expenses would result in the inability to service the debt.
Depreciation: A decrease or loss in value due to wear, age or other cause.
Equity Investment: The upfront costs for purchasing a property. For apartment syndications, these costs include the down payment for the mortgage loan, closing costs, financing fees, operating account funding and the fees paid to the general partnership for putting the deal together. Also referred to as the initial cash outlay or the down payment.
General Partner (GP): An owner of a partnership who has unlimited liability. A general partner is usually a managing partner and is active in the day-to-day operations of the business. In apartment syndications, the general partner is also referred to as the sponsor or syndicator and is responsible for managing the entire apartment project.
Gross Rent Multiplier (GRM): The number of years it would take for a property to pay for itself based on the gross potential rent. Also referred to as the GRM. The GRM is calculated by dividing the purchase price by the annual gross potential rent.
Internal Rate of Return (IRR): The rate needed to convert the sum of all future uneven cash flow (cash flow, sales proceeds and principal paydown on the mortgage loan) to equal the equity investment. Also referred to as IRR.
Limited Partner (LP): A partner whose liability is limited to the extent of their share of ownership. Also referred to as the LP. In apartment syndications, the LP is the passive investor who funds a portion of the equity investment.
Loan-to-Value Ratio (LTV): The ratio of the value of the loan amount divided by the apartment’s appraised value.
Market Rent: The rent amount a willing landlord might reasonably expect to receive and a willing tenant might reasonably expect to pay for tenancy, which is based on the rent charged at similar apartment communities in the area. The market rent is typically calculated by conducting a rent comparable analysis.
Net Operating Income (NOI): All the revenue from the property minus the operating expenses. Also referred to as the NOI.
Operating Agreement: A document that outlines the responsibilities and ownership percentages for the general and limited partners in an apartment syndication.
Operating Expenses: The costs of running and maintaining the property and its grounds. For apartment syndications, the operating expense are usually broken into the following categories: payroll, maintenance and repairs, contract services, make ready, advertising/marketing, administrative, utilities, management fees, taxes, insurance and reserves.
Passive Investing: Placing one’s capital into an apartment syndication that is managed in its entirety by a general partner.
Preferred Return: The threshold return that limited partners are offered prior to the general partners receiving payment.
Price Per Unit: The cost per unit of purchasing a property. The price per unit is calculated by dividing the purchase price of the property by the total number of units.
Private Placement Memorandum (PPM): A document that outlines the terms of the investment and the primary risk factors involved with making the investment. Also referred to as the PPM. The PPM typically has four main sections: the introductions (a brief summary of the offering), basic disclosures (general partner information, asset description and risk factors), the legal agreement and the subscription agreement.
Pro-forma: The projected budget with itemized line items for the revenue and expenses for the next 12 months and five years.
Rent Roll: A document or spreadsheet containing detailed information on each of the units at the apartment community, including the unit number, unit type, square footage, tenant name, market rent, actual rent, deposit amount, move-in date, lease-start and lease-end date and the tenant balance.
Sophisticated Investor: A person who is deemed to have sufficient investing experience and knowledge to weigh the risks and merits of an investment opportunity.
Subscription Agreement: A document that is a promise by the LLC that owns the property to sell a specific number of shares to a limited partner at a specified price, and a promise by the limited partner to pay that price.
Underwriting: The process of financially evaluating an apartment community to determine the projected returns and an offer price.
Vacancy Rate: The rate of unoccupied units. The vacancy rate is calculated by dividing the total number of unoccupied units by the total number of units.
Value-Add Property: A stabilized apartment community with an economic occupancy above 85% and has an opportunity to be improved by adding value, which means making improvements to the operations and the physical property through exterior and interior renovations in order to increase the income and/or decrease the expenses.
In Final
Investing as a passive investor in a deal means understanding the terms of the investment thus ensuring your comfort and expected outcomes. Understand the above terms and ask the right questions of the syndicator or general partner in any agreement. Investing should be a partnership of understanding, learning and exciting personal/business development.
Please note the list above is not exhaustive, but more of some of the common unknown/misunderstood terms. To learn more on investing, sign up for monthly newsletter and have investing knowledge brought to you. Invest Smart!