Tag: Real Estate

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. They can also provide tax benefits like pass-through deductions for depreciation. Characteristics like these make real estate a perennial investor favorite.

But investments in physical buildings and land are generally not liquid, and the time required to realize your investment goals can vary based on the nature of the project and the underlying property, the location, and the asset class. You cannot always sell or refinance real estate quickly or cost-effectively if the property is 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.

Why Real Estate Terminology Definitions Matter

Some of the critical homework done by smart investors before making a real estate investment is due diligence.  This involves research on the asset class, property location including the general area and specific submarket, tenant(s) and any lease guarantors, any investment partners, leases, contracts and easements already in place, 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 should begin with a solid working real estate vocabulary. This includes the investment, property operations, and lending terms that play a central role in sound decision-making.

Real Estate Terminology in Investing

1031 Exchange

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 business or investment with other investment property as a continuation of ownership rather than as two unrelated transactions for federal tax purposes. To fully defer taxes on gains and depreciation, the IRS requires that you trade for replacement property of equal or greater value.

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. Fractional interests in real estate, such as tenant in common (TIC) interests, beneficial interests in a Delaware statutory trust (DST), and some oil, gas and mineral rights are also considered ‘like-kind’ for 1031 exchange purposes.  Partnership or membership interests in an entity that owns real estate such as a REIT or LLC are not, however, considered like-kind real estate for 1031 exchange purposes.

Investors seeking to complete a 1031 exchange may not touch the sale proceeds between the time the relinquished property is sold and the time replacement property is acquired.  There are many additional rules and timelines that must be followed; advance consultation and planning with experienced professionals is essential.

You may also see these transactions referred to as ‘like-kind’, ‘tax-deferred,’ or ‘Starker’ exchanges.

Accredited Investor

Many passive investment opportunities are available only to accredited investors. This refers to individuals with a net worth in excess of $1 million (excluding their primary residence) or a consistent 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.

Cap Rate

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, nor does it reflect the costs or benefits of leverage. 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.

Capital Stack

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.

Carried Interest

A carried interest, also called a promote, is a common payment structure used in real estate projects with multiple investors.  The sponsor – the party that sources, underwrites, and manages the project, investors and lenders – may elect to defer all or a portion of its profits from the project until it is sold or certain financial hurdles are met in exchange for receiving a greater share of the upside gains. This structure is intended to compensate the sponsor for its efforts and is typically performance based. The sponsor earns a percentage of the profits after the initial capital contributions and a preferred return (hurdle rate) are returned to the investors. The sponsor’s interest is ‘carried’ on the project’s books until the interest is satisfied or the project is sold.

Cash-on-Cash Yield

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 paying operating expenses and 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.

Composite Return

Investors in income-producing real estate are subject to income tax in the state in which the property is located.  Many states permit the sponsor, manager or general partner of a real estate project with passive investors to file a state tax return on behalf of investors in the project.  When permitted, the composite return saves individual investors the hassle of filing state tax returns for the passive investments.  Note that composite returns are not permitted for certain types of ownership structures such as DSTs, even if the state where the investment property is located permits composite returns.

Cost Segregation

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).

Delaware Statutory Trust (DST)

A Delaware statutory trust is a form of business trust commonly used to accommodate unrelated passive investors, especially those 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. 

Depreciation

Depreciation is a tax treatment that allows the acquisition cost of an asset to be amortized over its useful life.  For example, if a depreciable asset cost $100 and it had a 5-year useful life, the owner would be entitled to a tax deduction of $20 per year for 5 years on account of depreciation.  The IRS publishes guidelines for the useful life of each type of depreciable asset.  These deductions can be significant for investment real estate, and may even entirely shelter the income generated by renting or otherwise operating the real estate.  This is one of the reasons why real estate can be a lucrative form of investment.

Equity Multiple (EM)

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 $175,000 in proceeds 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 the profitability of an investment more holistically.

In-Place Cash Flow

‘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.

Internal Rate of Return (IRR)

The internal rate of return reflects what a real estate investment opportunity yields from inception to sale. Real estate investors use the IRR to compare investment properties that have gone ‘full cycle’, or to predict how a project will perform.

A property’s IRR takes into account cash flow, appreciation, and the time value of the capital invested. 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 (MOIC)

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.

Net Operating Income (NOI)

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).

Opportunity Zones

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 may be 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.  There are many additional rules and qualifications to qualify for the favorable tax treatment, and there is an inherent degree of risk when investing in an economically challenged location; it is important to work with experienced professionals for these types of investments.

Pari Passu

Pari passu indicates that all parties are treated equally in proportion to their share of ownership.  For example, if Partner A owns 20% of an investment, Partner B owns 30% and Partner C owns 50%, a pari passu distribution of $100 would give Partner A $20, Partner B $30 and Partner C $50.

Preferred Equity

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:

• Improvements to the property
• The period between acquisition and stabilization of the property’s income
• Funds in excess of what the owner can contribute or borrow
• Recapitalization of an existing project

Promote

A promote, also called a ‘carried interest,’ allows the sponsor of a real estate or private equity investment to receive a disproportionately large share of investment returns in relation to the size of the sponsor’s investment as incentive-based compensation for the sponsor’s work in organizing and managing the project.

The premise is that the sponsoring party gets ‘promoted’ (treated differently) ahead of other investors with respect to distributions at some point in time, typically after the investors have received an agreed-upon return.

The promote typically occurs at the time of sale or refinance in development projects where cash flow is limited. Projects held for cash flow may also have promotes for distributable cash above some hurdle (such as a percentage return to investors). Promotes incentivize sponsors’ performance by allowing them 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 paperwork and waterfall to determine whether and to what extent any parties to the transaction get promoted.  In a transaction with a promote, funds will not disperse to all parties pari passu based on their percentage ownership interest.

REIT

REIT is an acronym for Real Estate Investment Trust. A REIT is an institutional investment structure for investments in real estate that is purely passive for underlying investors.  A REIT will typically own a pool of assets, and investors may purchase shares of the REIT, which may be publicly traded or privately held. REITs therefore provide a vehicle for investment exposure to a pool of institutional quality real estate. REITs may also offer an opportunity for investment diversification. REIT shares do not, however, pass through all of the tax benefits of real estate ownership, such as depreciation deductions or the ability to do a 1031 exchange, and non-public REITs may have limited liquidity.

Reserves

‘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).

Return on Investment (ROI)

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).

UPREIT

UPREIT is the process through which a property owner can contribute a real estate asset to a REIT on a tax-deferred basis.  The property owner’s interest in the real estate is converted to shares of the REIT corresponding to the value of the property contributed. These transactions may also be referred to as ‘721 contributions’ referencing the section of the Internal Revenue Code that provides for the deferral of taxes when property instead of money is contributed in exchange for an ownership interest.

Waterfall

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.

Working Capital

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.

Real Estate Terminology for Property Operations Evaluation

You may know how to select and acquire real estate, but do you know how to maintain the property and increase its value once you own it? If you are investing passively, can you tell whether the active operator is doing a good job? These real estate terms help you better understand an owner’s obligations related to tenants, rent, and repairs.

Base Rent

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, utility costs, 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.

Common Area Maintenance (CAM)

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:

• Maintenance and repair for building systems
• Cleaning and janitorial services
• Snow removal
• Landscaping
• Electricity, gas, and other utilities
• Water/sewer
• Scavenger
• Security

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.

Double-Net (NN)

Under a double-net lease, the landlord maintains and pays for the roof, building structure, and exterior areas (i.e., parking lots). The lease will specify the parties’ respective responsibility for day-to-day upkeep for these areas, such as annual inspections or snow removal.  The tenant is responsible for payment for and performance of interior maintenance in addition to insurance and property taxes.

Easement

An easement is a legal right to use a property owned by someone else for a specific purpose.  For example, a common type of easement found in commercial real estate is an access easement, which grants the owner of a property – such as the owner of a parcel set back from the road – the right to cross over someone else’s property in a specified area (such as a driveway) for ingress and egress.  Easements are documented in a recorded deed.

Gross Rent

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.

Operating Expenses

Operating expenses are costs, other than debt service and capital expenditures, that are necessary for the maintenance and operation of a property. These include utility charges, property management fees, real estate taxes, property insurance, and maintenance costs.

Percentage Rent

Percentage rent is additional rent a tenant must pay under a lease if it achieves sales in excess of an agreed-upon threshold. Leases with percentage rent require that the tenant provide periodic certifications of its sales to the landlord. Percentage rent provisions are most commonly found in retail leases.

RUBS

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.

Triple-Net (NNN)

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.

Turnkey

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.

Loan-Related Real Estate Terminology

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

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.

Bridge

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 may be secured by a second/junior mortgage on the property.

Carveout Guaranty

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. For this reason, such guaranties are sometimes referred to as ‘bad boy’ carveouts.

Debt Service Coverage Ratio (DSCR)

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.

Deed in Lieu

When a borrower is unable to make payments on a mortgage loan and the lender declares a default, the lender’s formal legal remedy is to foreclose on its mortgage and sell the property. This process can be both costly and time consuming.  A borrower willing to walk away from the property may instead negotiate to voluntarily deed the property back to the lender in exchange for a full or partial release of the mortgage debt. Both parties thereby avoid the expense of a foreclosure proceeding.  A deed in lieu requires the cooperation of both borrower and lender and is usually a last-ditch remedy if a loan modification, refinance with a new lender, or a traditional sale of the property cannot be achieved.

Escrow

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.

Interest-Only (I/O) Period

The payment terms for a mortgage loan typically require the borrower to make monthly payments that include both interest and some portion of the original principal.  Commercial loans may offer an ‘interest only’ period where the borrower is responsible for the interest payments, but the outstanding principal balance is not reduced. Such arrangement can help borrowers by allowing them to retain more of the cash flow generated by the property in the short term, since it is not being paid to the lender right away. This is particularly helpful to borrowers that want to invest heavily in improvements to a property upon acquisition because their monthly loan payments will be lower during the I/O period. However, the borrower is also not building up any equity in the property during this time because the outstanding mortgage balance due remains unchanged.

Loan to Value (LTV)

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.

Mezzanine Financing

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 funds available through a traditional mortgage loan.

Negative Leverage

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.

Non-Recourse Debt

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 where the 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.

Recourse Debt

Recourse mortgage debt is a loan that is secured by both a lien on the property and a guaranty by the property owner.  In the event of a payment default, the lender can look not only to the property but to the other assets of the borrower to satisfy the outstanding indebtedness.  Such assets may include funds unrelated to the real estate investment, such as personal or corporate bank accounts.

Short Sale

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.

Deriving Value from Understanding Real Estate Terminology

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 cliché, but it’s absolutely true in real estate investing: knowledge is power.