Real estate investments offer a potentially lucrative way to build a diversified investment portfolio. They frequently serve as a hedge against inflation and fluctuations in the stock market (not to mention bank failures). They often provide tax benefits like pass-through deductions for depreciation, too. Characteristics like these make the asset class a perennial investor favorite.
But physical buildings and land are generally not liquid. You cannot always sell or refinance them quickly or cost-effectively if they are underperforming, or if you want to do something else with your capital.
This makes careful consideration of all the moving pieces in a real estate investment essential. You need to evaluate the potential success of a real estate investment before you get started. Complex real estate terminology used in these projects may make that difficult unless you first learn the “language” of real estate investment.
Some of the critical homework when making a real estate investment is due diligence on the asset class, property location, tenant, any investment partners, and the physical property itself. You will also want to evaluate the prospective financial performance of your property. This includes both the potential income it may generate and the expenses you are likely to incur along the way.
That’s no small task. The technical terms and the ways they interact are complicated enough that professionals study for years to master them. Still, having a strong grip on the most common real estate terminology helps. It’s the key to communicating effectively with the professionals you will need to work with to keep your investment on track. It also better prepares you to push back should things not add up.
The bottom line is that if you want to add a real estate investment to your portfolio, you first need to know the lingo. This includes the investment, property operations, and lending terms that play a central role in sound decision-making.
The following real estate terms are meant to introduce you to common methods for predicting returns, measuring value, and navigating important tax advantages. Terms common to passive real estate investment opportunities are also described here.
1031 exchanges allow investors to defer payment of capital gains, depreciation recapture, and other federal taxes when selling a real estate investment asset by “replacing” the relinquished asset with “like-kind” property. The name “1031” refers to section 1031 of the Internal Revenue Code.
The 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. All real estate is considered “like kind” for 1031 purposes, so farmland can be exchanged for an office building, and a residential property can be exchanged for a commercial one. 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.
Many passive investment opportunities are available only to “accredited investors”. This refers to individuals with a net worth in excess of $1 million (excluding your primary residence) or an annual income exceeding $200,000 (or $300,000 jointly with a spouse). These standards are set by the federal securities industry to help protect individuals who may be unable to bear the risk of loss from getting locked into complex, costly, illiquid investments.
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 offered for sale 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.
The capital stack includes 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.
Cost segregation is an accounting method used to separate out the acquisition cost of the various personal property elements from the cost of the land and structural elements. This allows tax deductions for depreciation to be taken more quickly.
The approach can be helpful because all assets do not depreciate at the same rate. For example, the useful life of personal property you buy along with a building, like an electronic security system, is shorter than that of the structural elements of the building (i.e., the doors and windows).
A Delaware statutory trust is a form of business trust commonly used to accommodate unrelated investors seeking to do 1031 tax-deferred exchanges (see definition above). Investors are beneficiaries of the trust, and receive income from distributable cash flow and capital events (such as the sale of the property) in proportion to their equity investment.
The trust owns the property and a professional real estate company usually manages it. Most DSTs are offered through private placements and are generally available only to accredited investors.
The equity multiple, or multiple on invested capital (“MOIC”), 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. It also can’t provide any indication of how long it will take to achieve a projected return. An EM of 2.0x may seem like a good deal – effectively doubling your money. Getting that return in one or two years, however, is far more profitable than an investment returning an EM of 2.0x over 20 years. For this reason, it is helpful to look at EM along with other metrics, such as IRR, to help you evaluate more holistically the profitability of an investment.
“In-place” cash flow is the operating income generated by the leases and contracts that were in effect at the time you acquired 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, but it may reflect your projections for potential upside in future years.
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.
Multiple on invested capital is a measure comparing the value of the equity investment at a point in time, such as the time of sale, to the equity value at inception. It is also expressed as the equity multiple (“EM”). MOIC does not take time into account, so it is often used in conjunction with other metrics, such as IRR, to help you evaluate the success of your investment.
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 the appreciation you might realize from selling the property. You need to know a property’s NOI to calculate cap rates. Lenders also use NOI to underwrite potential loans for a property, including debt service coverage ratios (DSCR).
Created by the 2017 amendments to the federal tax laws, opportunity zones are designated geographic areas where the state seeks to stimulate economic development. All 50 states have designated opportunity zones.
Investments of capital gains in a Qualified Opportunity Fund (“QOF”) for businesses and developments in a designated Opportunity Zone are eligible for favorable tax treatment, including deferral or forgiveness of certain capital gains tax. The capital gains invested may be from any source, including the sale of securities or real estate. The major benefit of opportunity zone investments is that gains earned in the QOF itself are not subject to capital gains taxation so long as all statutory requirements have been satisfied, including a minimum 10-year investment period.
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 may go toward the following:
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. 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, 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).
ROI is the calculated benefit or proceeds of an investment, divided by its cost. Benefits will include income generated from the property such as rents and fees, as well as appreciation in value. Costs include the costs of acquisition, disposition, operation, improvements, and financing (both debt and equity).
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.
Similar to reserves, working capital refers to funds set aside to cover expenses for the property. Working capital may include an allowance for expenses that are not otherwise specifically provided for in the operating budget, or funds to keep the ownership entity (i.e., the LLC that holds title to the property) in good standing.
You may know how to invest in real estate, but do you know how to maintain the property and increase its value? These real estate terms help you better understand an investor’s obligations related to tenants, rent, and repairs.
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, management fees, or other items that the landlord may pass through to the tenant such as real estate taxes and insurance costs.
Base rent may be reflected as either 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, which are often “pass-throughs” from service providers.
Often a component of rent in leases for space in multi-tenant commercial properties, CAM covers the operating expenses for the common areas of the property. This includes places like lobbies, parking lots, elevators or escalators, lawns and patios, roofs, and hallways. CAM addresses things such as:
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). The tenant must then handle interior maintenance in addition to 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.
Ratio Utility Building System (RUBS) is a method of allocating charges for utility services in a multifamily building based on unit size, number of occupants, and other features of each unit such as number of bathrooms.
A triple-net lease obligates the tenant to handle the payment for and performance of its own property maintenance. The tenant also pays all taxes, insurance, and other operating expenses for the leased premises.
A turnkey investment is a property that does not require any significant repairs, improvements, or leasing before the property can begin generating income for the owner.
Mortgage loans can help real estate investors acquire more valuable real estate than they can pay for with their available cash. It also allows them to leverage returns so that they can profit on “borrowed” dollars. Lenders can add a layer of protection, too. They will conduct their own due diligence on your property before they let you borrow funds. The following terms are important to understand before you borrow money for your real estate project.
Amortization is the spreading of loan payments over a fixed amount of 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, 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 include 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 typically secured by a second/junior mortgage on the property.
In the case of a non-recourse loan, a lender may require the borrower or its principals to provide a limited guaranty for losses arising from specific “bad acts,” such as transferring title to the property without the lender’s prior consent or allowing the borrower entity to become bankrupt. These acts, typically within the borrower’s control, are considered to be “carved out” of the non-recourse nature of the loan, meaning that the lender can pursue the borrower’s unrelated assets in the event of a default.
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.
An escrow is a third-party account in which funds are held pending some specified contingency. The contingency could be a closing, presentation of appropriate paperwork to draw funds under a construction loan, the due date for real estate tax payments, or the commencement of a tenant’s lease.
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.
Note that LTV does not take into account transaction costs such as brokerage commissions, due diligence expenses, and professional fees for the project. It also does not look at working capital and other reserves. To evaluate the amount of a loan in relation to the “all in” acquisition cost, loan to cost (“LTC”) is used.
A mezzanine loan is often for a shorter term (and commands a higher interest rate) than the senior loan on a property. Unlike a bridge loan, 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, 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), or to provide necessary cash in excess of a traditional mortgage loan.
Negative leverage occurs when the interest rate on a mortgage loan exceeds the cash-on-cash yield for the property. Put differently: with negatively leveraged property, the amount you pay in mortgage principal and interest in a given time frame exceeds the net income generated from the property during that same period. Avoiding negative leverage has become an increasing challenge as interest rates have been rising.
In most instances, a lender will require the borrower to sign a personal guaranty of payment of the loan indebtedness. For some commercial properties where the borrower is an established landlord or tenant has strong credit and the lease has a corporate guaranty, the lender may offer a non-recourse loan that looks solely to the property and lease payments to satisfy the mortgage. If a tenant defaults, the lender will not have direct recourse against the personal assets of the borrower for the deficiency.
A short sale occurs when a borrower sells the property for less than the value of the mortgage debt, and the lender agrees in writing to reduce the amount of its lien instead of foreclosing or pursuing the borrower for the deficiency.
Is this real estate terminology list comprehensive? No. It is, however, a good place to start before you dive into due diligence on a prospective property.
By strengthening your understanding of real estate investment terminology, you will know what kinds of financial analysis to do in advance. You will also know how to parse the kinds of reports you receive when investing with other people. Discussions with the legal, financial, and real estate professionals you are working with will get a lot easier to navigate.
Most importantly, you’ll be able to make smarter decisions about what types of allocations are right for you. It might sound cliche, but it’s absolutely true in real estate investing: knowledge is power.
If you’re considering a real estate investment, this vocabulary is the beginning of your required education. Fortunately, Financial Poise offers a number of on-demand webinars to help you along, including:
For more information about our on-demand webinar series, click here.
This is an updated version of an article from April 2020. ©2023. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Tracy Treger is Principal at Syndicated Equities. Tracy 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 of…
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