• Randal McLeaird

Multifamily Investing Definitions




Deal Sponsor:


In real estate, sponsors are essentially the backbone of the deal. They’re the reason investors get the chance to invest in an apartment building or mobile home park. Sponsors are the entrepreneur, or partners (also known as general partners,) who will be operating the deal. Sponsors are the ones who keep the deal going. They find the deal, raise the capital, put the financing in place, and hire a management company. They do all the work that keeps the deal alive before, during, and after the purchase.



Asset Management:


Asset management is meant to cultivate market value so ownership can increase its returns, whether it has to do with real estate or any other asset. An asset manager manages assets on behalf of someone else, making important investment decisions that will help the client's portfolio grow. An asset manager also ensures the client's investment doesn't depreciate and that exposure to risk is mitigated. Doing this means watching the market, keeping up to date with research and trends, and staying current with political, financial, and economic news.

Asset managers can also be involved with real estate. These professionals operate with the same principles that an asset manager does in the financial market. They focus on maximizing a property's value for investment purposes—not to be confused with real estate property managers, who handle the day-to-day activities related to a property's operations and physical structure. Source


Acquisition Fee:


An acquisition fee refers to charges and commissions paid for the acquisition or purchase of real property. The sponsor typically spends a significant amount of time sourcing, vetting, traveling to assets, negotiating and completing due diligence and for this, the acquisition fee is charged to help offset some of those costs.


Disposition Fee:


A one-time fee that compensates the sponsor for their efforts in marketing the property or properties.



Defeasance:


Once a commercial real estate loan has been made, it is not uncommon for a lender to pool many loans together and “securitize” them. This means that they create and sell investment securities that are backed by the cash flow produced by the loan payments. These are known as “commercial mortgage backed securities” or “CMBS” for short, and they are a popular product for many institutional investors.

Now, when an investor purchases one of these securities, he or she expects to earn a certain stream of cash flow. But, if a borrower pays off one of the loans that back the securities, this will create a disruption in the cash flow and cause the investor to earn a return that is different than what was expected. There is a penalty for this, and it is outlined in the loan and/or securities agreements.

This penalty, known as “defeasance”, guarantees that the loan’s payments will continue to be met, even after it is paid off and the lender has released their lien on the underlying property. Source


Capitalization Rate:

The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property.

This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor's potential return on their investment in the real estate market.

While the cap rate can be useful for quickly comparing the relative value of similar real estate investments in the market, it should not be used as the sole indicator of an investment’s strength because it does not take into account leverage, the time value of money, and future cash flows from property improvements, among other factors. Source

Catch Up:

A provision included in certain real estate partnership agreements, whereby a special distribution tier is included in the equity waterfall that allows for the general partner (GP) to “catch up” with the limited partner’s (LP) cash flow distributions. The reason for why the general partner’s distributions might lag, or the amount that must be made up with the “catch up” tier, depends on the terms of the partnership structure.


Catch up provisions are most common to structures where the limited partner receives 100% of distributions until it achieves some preferred return requirement, at which point the GP receives 100% of excess cash flow thereafter until some equitable balance between the LP and GP distributions is achieved.

For example, imagine a limited partner contributes 100% of required capital to a real estate venture in return for a 12% preferred return and 50% of all excess cash flows above that threshold. The agreement states that the limited partner will receive 100% of all cash distributions until it has earned a 12% internal rate of return, at which point the GP receives 100% of cash distributions until both partners have received 50% of profit distributions. Once the GP has caught up with the LP, both partners receive any remaining excess cash flow 50/50.

Limited Partner:

A real estate limited partnership (RELP) is a group of investors who pool their money to invest in property purchasing, development, or leasing. It is one of several forms of real estate investment group (REIG). Under its limited partnership (LP) status, a RELP has a general partner who assumes full liability and one or more limited partners who are liable only up to the amount they contribute.

The general partner is usually a corporation, an experienced property manager, or a real estate development firm. The limited partners are outside investors who provide financing in exchange for an investment return.

Under U.S. tax code, partnerships are not taxed. Rather, partnerships do a so-called pass-through, sending all of their income to the partners and reporting on form K-1. Partners receiving a K-1 must individually file their partnership income on Form 1040 if they are an individual or on Form 1120 if they are a corporation.


General Partner:


In commercial real estate investing, a general partner is a person or a team in charge of a real estate deal or private equity fund from its inception on through to the end.

A general partner in commercial real estate might be a real estate development firm, a corporation or a property manager with years of experience. General partners, also referred to as “sponsors” or “GPs,” take an active role in real estate deals. They own the property and they handle all components of the transaction as well as operations.

General partners are responsible for finding investment opportunities through their network and raising capital for deals from outside investors, who are also known as limited partners or LPs.

LPs contribute equity financing in exchange for an investment return.

GPs sign loan guarantees and they execute most decisions about the fund or the deal.


Capital Stack:


The capital stack refers to the layers of capital that go into purchasing and operating a commercial real estate investment. It outlines who will receive income and profits generated by the property and in what order. The capital stack also defines who has the first right to foreclose on the asset as collateral in the event the equity owner defaults on the mortgage.

The capital stack is typically composed of four sections in the following order: common equity, preferred equity, mezzanine debt, and senior debt. Although common equity is listed first in the stack, it holds the lowest priority, meaning common equity lenders are paid last. Senior debt, at the bottom of the capital stack, holds the strongest priority, meaning senior debt lenders are the first to be paid.

While each investment level comes with its own risk and reward, the higher positions in the capital stack typically earn higher returns as a result of their higher levels of risk.


Sources and Uses:

A Sources and Uses is a financial report showing where investment money is coming from and how it is spent. A Sources and Uses can be retrospective or prospective (a forecast).

Sources and Uses usually focus on how an investor is paying for real estate or a major construction project.

Underwriting:

Real estate underwriting is the process of reviewing a loan application to determine the amount of risk involved. The underwriter will look at the borrower’s financial standing and the value of the property at hand to review the potential of the deal.

Demographics:

Demographic factors have a tendency to predict future markets, such as increasing or reducing population. Lets say, If an investor is going to buy a property and he knows that the population is growing in that area, he can be sure that this is a great indicator for future opportunities.

Debt Service Coverage Ratio (DSCR):

Debt Coverage Ratio, or DCR, also known as Debt Service Coverage Ratio (DSCR), is a metric that looks at a property’s income compared to its debt obligations. Properties with a DSCR of more than 1 are considered profitable, while those with a DSCR of less than one are losing money. The DCR/DSCR formula is: Net Operating Income (NOI)/Debt Obligations. Despite the apparent simplicity of the formula, an investor will need to make sure they have the correct numbers in order to calculate an accurate debt coverage ratio for a property.


1031 Exchange:

If you own investment property and are thinking about selling it and buying another property, you should know about the 1031 tax-deferred exchange. This is a procedure that allows the owner of investment property to sell it and buy like-kind property while deferring capital gains tax. A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value.


Offering Memorandum:

An offering memorandum – or OM – is a key legal document used in the private placement of commercial real estate. The OM provides buyers with information about the property and the offering, protects the Sponsor from potential liability, and serves as a tool for winnowing down the pool of bidders.

The offering memorandum describes the objectives of the investment, details some of the potential risks associated with the placement, and the terms and conditions of the commercial real estate private placement. Information in the OM document should include:

  • Building description including property and location overview, demographics, operation and management

  • Summary of the property’s past, present, and potential future return based on different assumptions

  • Pro-forma financial statements including P&L, balance sheet, and investor distribution schedule

  • Management and investment company biographies

  • Participation requirements and confidentiality agreement

Operating Agreement:

A real estate LLC operating agreement template is a basic format to be followed for creating an operating agreement for an LLC involved in the real estate business. An operating agreement is a legally binding document used to set out the internal organization of an LLC and the members’ roles within that LLC. The OA will outline who does what, it will strengthen the ability for the LLC to actually limit liability and help mitigate any disputes.



PPM:

A PPM is a Private Placement Memorandum. It’s a legal document given to all prospective investors in a real estate investment, whether they invest as an LLC or individuals. It’s designed to provide potential investors with full disclosure based on the requirements of the federal securities law.

Net Operating Income (NOI):

NOI in real estate is one of several metrics used by investors to determine how profitable a property is. Most frequently, net operating income is a benchmark used by investors to determine the cash flow and profitability of a potential deal or income-generating property. NOI is a strong indicator of a property’s ongoing revenue, though it does not account for capital expenditures or interest payments. Instead, NOI is used to determine how profitable a property is on its own assuming no debt is in place.


Equity Multiple:

In commercial real estate, the equity multiple is defined as the total cash distributions received from an investment, divided by the total equity invested. Essentially, it’s how much money an investor could make on their initial investment. An equity multiple less than 1.0x means you are getting back less cash than you invested. An equity multiple greater than 1.0x means you are getting back more cash than you invested. For instance, an equity multiple of 2.50x means that for every $1 invested into a CRE project, an investor could be expected to get back $2.50.


Internal Rate of Return (IRR):

The goal of IRR is to provide investors with an expected return based on cash flows that vary over time. An IRR calculation levels those cash flows by expressing a single percentage: the annual rate at which the net present value (NPV) of those cash flows equals zero. Simply put, what your annual return is once the deal is closed and all cash flows have been taken into account over time.

Average Annual Return (AAR):

The average annual return (AAR) is a percentage used when reporting the historical return, such as the three-, five-, and 10-year average returns of a mutual fund. The average annual return is stated net of a fund's operating expense ratio. Additionally, it does not include sales charges, if applicable, or portfolio transaction brokerage commissions.

In its simplest terms, the average annual return (AAR) measures the money made or lost by a mutual fund over a given period. Investors considering a mutual fund investment will often review the AAR and compare it with other similar mutual funds as part of their mutual fund investment strategy.

Typical Types of offerings

506 (b):

First there was Rule 506, under which investors could claim exemption to the requirement of registering securities. Subsequently, in its July 10, 2013, meeting, the U.S. Securities and Exchange Commission (SEC) adopted the new Regulation D, Rule 506(c), authorized by the JOBS Act (Title II). Rule 506(c) went into effect on Sept. 23, 2013. Now the old Rule 506 is known as Rule 506(b).

The original rule was known as Rule 506, but will hereafter be known as Rule 506(b). It is still in effect. In general, under this rule an issuer of securities has a “safe harbor” exemption from registration. That means the issuer doesn’t have to obtain SEC pre-approval of the offering or need a license to sell its own securities, as long as it follows the rules for the exemption.

Rule 506(b) allows an issuer of its own securities to raise an unlimited amount of money from an unlimited number of Accredited Investors and up to 35 Sophisticated Investors.

However, the issuer cannot make any offers or sales of the securities by any means of general advertising or solicitation. To prove they didn’t solicit investors, issuers must be able to demonstrate a pre-existing relationship with an investor. The relationship must pre-date any offer to sell securities.

For issuers relying on Rule 506(b), the investors may self-certify that they are Accredited or Sophisticated. They do that by checking a box on a pre-qualification form provided by the issuer.

506 ( C ) :

The new rule offers promotion opportunities for small issuers who want to raise $1 million to $10 million or more. Under the new Rule 506(c), issuers can advertise to anyone as long as they only accept Accredited Investors in their offerings and comply with the rest of the Rule 506(c) provisions. However, in order to use the Rule 506(c) exemption, the issuer must be able to demonstrate that it took “reasonable steps” to ensure that all investors are Accredited at the time of the investment. The SEC offered some non-exclusive methods to verify Accredited status for natural persons, which include such things as:

  • Verifying income from the past two years’ tax returns and written assertions that the income is expected to continue;

  • Verification of assets by reviewing statement balances from brokerage houses or banks, reviewing tax assessments/third-party appraisals of real estate holdings and verification of liabilities through an investor’s credit report; or

  • Obtaining a written confirmation from a securities broker-dealer, registered investment adviser, licensed attorney or CPA, who attests to have taken reasonable steps to verify the investor’s Accredited status within the past 90 days and that the person is, in fact, Accredited; and there is an exemption for investors who previously invested with an issuer as an Accredited investor.


Accredited investor:

In the U.S., an accredited investor is anyone who meets one of the below criteria:

Individuals who have an income greater than $200,000 in each of the past two years or whose joint income with a spouse is greater than $300,000 for those years, and a reasonable expectation of the same income level in the current year.

Individuals who have an individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the investment (The net worth amount cannot include the value of the person's primary residence.)

Individuals who hold certain certificates, designations, or credentials, such as Series 7, Series 65, and Series 82 licenses.

Individuals who are "knowledgeable employees" of a private fund.

Sophisticated investor:

A sophisticated investor is a classification of investor indicating someone who has sufficient capital, experience and net worth to engage in more advanced types of investment opportunities. Sophisticated investors are investors who have a high net-worth and extensive experience in financial markets. There is no single correct definition of a sophisticated investor, and it varies based on country or circumstance.


Syndicate in real estate:

Real estate syndicators, also referred to as general partners (GPs), are responsible for structuring and operating the real estate syndication. Primary duties of the general partner(s) would consist of:

• Underwriting the deal.

• Completing thorough due diligence on the property

• Arranging the financing.

• Negotiating with the seller.

• Building a business plan.

• Finding investors.

• Raising capital for the transaction.

• Working with the property management team.

• Asset management.

• Handling investor relations.

A real estate syndicator handles everything from finding the property, arranging the transaction and operating the asset upon closing. The syndicator’s role is to execute the business plan and deliver strong returns to the passive investors in the real estate syndication.

Funds vs Syndication

Syndication:

Syndications acquire properties on a deal-by-deal basis, combining capital from multiple investors for each deal. This creates an opportunity for investors to obtain a larger, more stable asset than they could alone.

There’s a few main reasons one may opt for this type of investment:

  1. They’re looking to continue growing in the real estate space, beyond what they may be able to solely accomplish. For example, a property that might be a $10M raise could be attainable by pooling together capital from 10 investors that can contribute $1M of equity each (generating much larger buying power as a group).

  2. To have access to deal flow without the hassle of sourcing each opportunity themselves. The sponsor handles all initial due diligence and can source off market deals through their extensive brokerage network

  3. There’s little work required from the investor’s end; everything from day-to-day operations and property management to quarterly reports are all handled by the sponsor.

Funds:

From the surface, a fund sounds pretty similar to a syndication, but there are a few underlying factors that set the two apart. Contrary to a syndication, in a fund, the money is raised initially and then used to acquire multiple properties. Let’s look at a few advantages of investing in a fund:

  1. Funds create a much more diversified portfolio. Unlike a syndication, you aren’t investing in a single asset, so naturally funds are more diversified. Simultaneously, you’re lowering your risks by spreading capital across multiple assets.

  2. The structure is flexible. Typically, funds are structured as opened (ongoing) or closed (definite date). While closed funds are similar to syndications and give a time range of the length of the deal, open funds allow the investor to join, receive returns and withdraw, according to the sponsor’s terms; therefore, there’s a bit more flexibility with the length of commitment.

  3. Pooled Resources Rather than going out and sourcing multiple properties yourself, a fund allows you to partner with other investors, while utilizing the resources and strategy provided by the fund managers.


Buy box:

In real estate investing, a buy box is an investor’s description of the types of assets they want to buy — and most of the time when investors create a buy box, they’re focusing on different attributes of the assets and markets in which they want to buy.



Difference between AAR and IRR:

IRR and AAR are two commonly used calculations when it comes to multifamily investing. Both measure the investor’s estimated return on investment with a few very specific differences. We recommend focusing on IRR, as it offers a more detailed look at the potential profit. When considering potential investment opportunities, be sure to ask for the IRR and be wary of operators who only offer the AAR. Additionally:

  1. An IRR factors compounding into the calculation whereas an AAR does not take compounding into consideration.

  2. An IRR is time-sensitive. For example, the faster the distribution of returns, the higher the IRR will be when all other factors remain constant. AAR is commonly defined as the arithmetic mean of a series of rates of return.


Cash On Cash:

A cash-on-cash return is a rate of return often used in real estate transactions that calculates the cash income earned on the cash invested in a property. Put simply, cash-on-cash return measures the annual return the investor made on the property in relation to the amount of money invested during the same year.