This column explains some of the financial terminology frequently used in connection with real estate investment, property operations and lending.
1031 exchanges allow investors to defer payment of capital gains, depreciation recapture and other federal taxes when selling an investment asset (including a real estate investment) by “replacing” the relinquished asset with “like-kind” property. The title “1031” refers to section 1031 of the Internal Revenue Code.
In other words, a 1031 exchange allows you to treat the replacement of a property held for investment with another investment property as a continuation of ownership rather than as two unrelated transactions for federal tax purposes. (In order to fully defer gains and recaptured depreciation, the IRS requires that you trade for a property of equal or greater value.)
You may also see these transactions referred to as “like-kind”, “tax-deferred” or “Starker” exchanges. 1031 exchanges may be used for many types of business or investment property in addition to real estate.
A cap rate expresses the sale price of a cash-flowing property based on its net operating income (NOI). Cap rate does not take into account market factors such as replacement cost or price per square foot. The cap rate for a given property equals the annual NOI divided by the value of the property, expressed as a percentage.
For example, a property valued at $1 million with annual NOI of $100,000 has a cap rate of 10%. The lower the cap rate, the more expensive the property.
Read more in Pricing Commercial Real Estate.
The capital stack includes of all of the parties providing funds for the acquisition or improvement of a real estate investment. These parties may include lenders providing debt financing and investors providing equity. The “stack” organizes in order of priority for return of capital.
Cash-on-cash yield measures the cash flow generated by a property from operations (such as leasing). The yield is a percentage equal to the net operating proceeds (after debt service), divided by the equity invested.
If you invest $100,000 in a property and it generates $6,500 in net cash flow after loan payments for the year, then your annual cash-on-cash yield is 6.50%. Note that the yield does not take into account any gains or losses you may realize when you sell the asset, nor does it include any depreciation deductions or other tax benefits you may be entitled to exercise.
The equity multiple measures your investment return compared to the amount of your capital contribution. The EM equals the total net profit you receive from the investment, including cash flow and disposition proceeds, divided by the amount of equity you invested.
Suppose you invest $100,000 and receive $25,000 in net cash flow during your holding period. You then receive an additional $175,000 when you sell the property. In this case, your EM is 2.0x [($25,000 + $175,000)/$100,000].
An EM below 1.0x means you don’t receive back all of your original principal. The EM does not take into account the time-value of your money, nor does it provide any indication of how long it will take to achieve the stated return. An EM of 2.0x may seem like a good deal – effectively doubling your money; however, getting that return in one or two years is very different than an investment returning and EM of 2.0x over 20 years.
“In-place” cash flow is the operating income generated by leases and contracts in effect at the time you acquire the investment property. It does not include prospective income from agreements to be signed in the future, or proceeds from a sale, refinance or return of capital contributions.
For example, the in-place cash flow for an apartment building includes the rental income reflected on the current rent roll, plus non-rent revenues from other sources (such as parking or pet fees). You use in-place cash flow to calculate your real estate investment’s NOI and corresponding cap rate. It does not take into account loan or financing costs, or operating expenses.
The internal rate of return reflects what you can expect a real estate investment opportunity to yield from inception to sale. A property’s IRR takes into account anticipated cash flow, appreciation and the time value of the capital invested.
Traditionally, real estate investors use the IRR to compare potential investment properties. To calculate IRR, you find the discount rate (percentage) that makes the net present value of an investment equal to zero.
Like the equity multiple, IRR does not tell you what your cash flow will look like. Nor does it show how long it will take you to achieve a certain return. However, IRR increases as you earn returns more quickly.
Consider the following examples, all of which have an equity multiple of 2.0x:
|Income Year 1||$5,000||$1,000||$0|
|Income Year 2||$5,000||$2,000||$0|
|Income Year 3||$5,000||$3,000||$0|
|Income Year 4||$5,000||$4,000||$0|
|Income Year 5||$5,000||$5,000||$25,000|
NOI equals the sum of all of the revenues received from a property (i.e., rents and fees) minus the cost of operating expenses (i.e., utility charges, insurance, CAM). A pre-tax figure, NOI does not take into account loan payments, capital expenses or depreciation costs. Accordingly, NOI differs from both the property’s gross revenues and its cash flow. NOI also does not take into account appreciation you might realize from selling the property. You need to know your NOI to calculate cap rates. Lenders also use NOI to underwrite potential loans for a property, including debt service coverage ratios (DSCR).
Preferred, or “pref” equity, refers to an equity investment that receives a return ahead of the owner’s or developer’s investment in the project. Project managers use preferred equity to incentivize outside investors to contribute capital. Such capital might go toward:
making improvements to the property
covering the period between acquisition and stabilization of the property’s income
providing funds in excess of what the owner can contribute or borrow
recapitalizing an existing project
A promote, also called a “carried interest”, allows the sponsor of an investment to receive a disproportionately large share of investment returns (in relation to the size of the sponsor’s investment).
The premise is that the sponsoring party gets “promoted” (treated differently than) other investors with respect to distributions at some point in time. This means that such funds will not disperse to all parties based on their percentage ownership interest. The promote typically occurs at the time of sale or refinance, although promotes of cash flow above some hurdle (such as a percentage return to investors) also occur. Promotes allow deal sponsors to enjoy a greater percentage of the upside in an investment while still providing a return to outside investors.
Investors should look carefully at the investment waterfall to determine whether and to what extent any parties to the transaction get promoted.
“Reserves” refer to funds set aside for future expenses that the investment property’s cash flow cannot readily pay. The property owner or the lender, or both, may hold reserves. Common uses for reserves in commercial investments include capital improvements to the property and re-tenanting costs (such as brokerage fees or new tenant buildouts).
The waterfall describes how cash flow and other proceeds distribute from a real estate investment to investing parties after paying all expenses and debt service. A waterfall may provide for distributions to all parties in proportion to their equity contributions in some circumstances. In other instances, waterfalls are disproportionate, such as where the sponsor’s interest gets promoted.
Base rent is the minimum amount a tenant pays for the use of the premises. It does not include additional charges, such as percentage rent, common area maintenance (CAM) expenses or other items that the landlord may pass through to the tenant. (Common pass-through items include real estate taxes and insurance costs.)
Base rent may show as either as a flat amount (i.e., $5,000.00 per month, $60,000 per annum) or on a per square foot basis. Commercial leases often separate out the base rent from other charges in order to provide for escalations of the base rent over the lease term without affecting these other charges.
Often a component of rent in leases for space in multi-tenant properties, CAM covers the operating expenses for the common areas of the property (i.e., lobbies, parking lots, elevators or escalators, lawns and patios, roofs, and hallways), such as:
maintenance and repair for building systems
cleaning and janitorial services
CAM does not include real estate taxes; you itemize those separately. CAM charges often pass to tenants in proportion to the size of their leased space in the building or property.
Under a double-net lease, the landlord must maintain the roof, building structure and exterior areas (i.e. parking lots), while the tenant must handle interior maintenance, as well as insurance and property taxes.
Some commercial leases provide for the tenant to pay an all-inclusive, fixed amount of rent that does not adjust based on actual operating expenses for the property.
Under such a “gross” lease, the landlord bears the risk that the value of the space plus the cost of actual operating expenses exceeds what the tenant pays in rent. The tenant bears the risk of overpayment if the value or expenses are lower than anticipated. Gross leases afford the parties a degree of predictability about the rental stream during the lease term.
Percentage rent is additional rent a tenant must pay under a lease if it achieves sales in excess of an agreed-upon threshold. These leases require that the tenant provide periodic certifications of its sales to the landlord. Percentage rent provisions are most commonly found in retail leases.
A triple-net lease obligates the tenant to handle payment for and performance of its own property maintenance. The tenant also pays all taxes, insurance and other operating expenses for the leased premises.
Read more in Net, Net, Net: Investment Property Without the Hassle.
Amortization is the spreading of loan payments over a fixed amount time in installments of principal and interest. Some lenders structure commercial loans so that the amortization schedule coincides with the expiration of the loan term. In other words, the ordinary loan payments progressively pay all outstanding principal and interest due—the last scheduled payment completely retires the mortgage debt.
Frequently, however, the loan term is substantially shorter than the amortization period. For example, a loan may have a 25-year amortization schedule, but be payable over a 10-year term. In that case, a the borrower will owe a balloon payment reflecting the outstanding loan balance at maturity.
A short-term loan intended to cover the time frame between two events. These events could the acquisition of a property and the time the investor sells a previously owned asset, obtains permanent financing or raises additional equity. Bridge loans have higher interest rates than longer term loans, and are secured by a second/junior mortgage on the property.
DSCR compares the income generated by the property to the amount due under a loan secured by the property. Lenders use the DSCR to determine whether the asset generates sufficient income to service the debt.
DSCR = net operating income/total loan payments.
The more the DSCR exceeds 1.0, the greater the cash available for loan servicing. A DSCR of 1.0 reflects a break-even point. Commercial loan agreements for operating properties frequently require that DSCR remain above a specified level.
LTV is a leverage ratio. You can calculate LTV by dividing the loan amount by the value of the property (either the purchase/sale price or an appraised value). The higher the LTV, the greater the degree of leverage, and the less equity the owner has in the property.
Read more in Using Leverage in Real Estate Investments.
A mezzanine loan is typically for a shorter term (and commands a higher interest rate) than the senior loan on a property. Unlike a bridge loan—another short-term financing solution with a high interest rate—default under a mezzanine loan may convert the lender’s interest to an equity ownership position in the property.
Mezzanine loans are subordinate to the senior lender (and ahead of equity sources) in the capital stack. Mezzanine financing may be used to make improvements to the property or to cover the period between the time the property is acquired and when its income becomes stabilized (such as during a lease-up period for an apartment building).
Then sign up to receive our weekly Financial Poise newsletter, our take on the most relevant and topical business, financial and legal issues affecting investors and small business owners.
Always Plain English. Always Objective. Always FREE.
Tracy is a Principal at Syndicated Equities where she helps high net worth individuals and family offices to profitably invest in real estate. She also assists investors in identifying appropriate replacement property to complete tax-deferred exchanges under Section 1031 of the Internal Revenue Code. Drawing upon her 20 years of legal experience in the areas…
Accredited Investors: Know Your Online Securities Intermediary
Critical Considerations When Selecting a Private Equity Manager
Can You Get Wealthy Buying Farmland as an Investment?
Super Gains for Superheroes? Check out Investing in Comics
Kenny G Investing in Stuff is Good Entertainment- and Good Business
Beyond the Fringe: The Evolution of Mainstream Alternative Investments
Please log in again. The login page will open in a new window. After logging in you can close it and return to this page.