Common Investor Terminology

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Accredited investor—An accredited investor is a person or entity who qualifies to invest in real estate syndications by satisfying one of the requirements regarding income or net worth, or who holds certain securities licenses. The current requirements to qualify an an individual are an annual income of $200,000 (or $300,000 for joint income with a spouse or life partner) for the last two years with the expectation of earning the same or higher in the future; a net worth exceeding $1 million, either individually or jointly with a spouse or life partner (not including the value/equity in a primary residence); or by holding one of a specific set of securities licenses. An entity is accredited if its assets exceed $5 million or if each of its equity members qualify individually as accredited investors.

Acquisition fee—The upfront fee paid by the new buying partnership to the general partner for funding, evaluating, financing, and closing the investment. Fees range from 1 to 5% of the purchase price, depending on the size of the deal.

Appreciation—An increase in the value of an asset over time. The two main types of appreciation that are relevant to syndications are natural appreciation and forced appreciation. Natural appreciation occurs when the market cap rate naturally decreases over time, which isn’t always a given. Forced appreciation occurs when the net operating income is increased by either increasing the revenue or decreasing the expenses. Forced appreciation typically occurs by adding value to the asset through renovations and/or operational improvements.

Asset management—The management of one or more investment assets by an institution or an individual on the behalf of others. This includes working to appreciate assets over time while minimizing risk.

Asset management fee—An ongoing fee from the property operations paid to the general partner for property oversight. Generally, the fee is 1 to 5% of the collected income, depending in part on the asset’s size.

Balance Sheet—A statement of the assets, liabilities, and capital of a business or other organization at a particular point in time, detailing the balance of income and expenditure over the preceding period.

Bonus depreciation—A tax incentive that allows a business to immediately deduct a large percentage of the purchase price of eligible assets, such as machinery, rather than write them off over the “useful life” of the asset. Bonus depreciation is also known as the additional first year depreciation deduction.

Capital gains—A rise in the value of a capital asset that gives it a higher value than the purchase price and is not realized until the asset is sold. A capital gain may be short-term (one year or less) or long-term (more than one year) and must be claimed on income tax returns. Short-term capital gains are taxed at ordinary income tax rates, while long-term capital gains are taxed separately.

Capital expenditure (CapEx)—Capital expenditures, or CapEx, are the funds used by a company to acquire, upgrade, and maintain a property. 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 is part of a property’s non-operating expenses. As such, it does not reduce a property’s net operating income or overall value. CapEx includes both interior and exterior upgrades and items such as replacing a parking lot or landscaping renovations.

Capitalization rate (Cap rate)—The rate of return based on the income that the property is expected to generate. The cap rate is calculated by dividing the net operating income by the current market value of a property. For example, a 216-unit multifamily apartment complex purchased for $12.2 million with a net operating income of $960,029 has a cap rate of 7.87%.

Carried interest—Also referred to as sponsorship equity. A share of any profits that the general partners of private equity funds or projects receive as compensation, regardless of whether they contribute any initial funds. Because carried interest acts as a type of performance fee, it acts to motivate the fund’s or project’s overall performance. When used in a preferred return structure, carried interest is only paid from residual funds available above the threshold of the preferred return paid to passive investors.

Cash flow—A property’s revenue remaining after paying all expenses.

Cost segregation—The process of identifying property components that are considered “personal property” or “land improvements” under the federal tax code for tax reporting purposes.

Debt Service Coverage Ratio (DSCR)—The ratio that is a measure of the cash flow available to pay the debt obligation. 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. The lower a property’s DSCR is, the more vulnerable it is—a minor decline in revenue or a minor increase in expenses could result in the inability to service the debt.

Depreciation—Tax depreciation is the depreciation that can be listed as an expense on a tax return for a given reporting period under the applicable tax laws. It is used to reduce the amount of taxable income reported by a business. Depreciation is the gradual charging to expense of a fixed asset’s cost over its useful life.

Distribution—The limited partners’ portion of the profits (i.e., cash flow), which are sent on a monthly or quarterly basis.

Economic occupancy rate—The rate of paying tenants based on the total possible revenue and the actual revenue collected. The economic occupancy is calculated by dividing the effective gross income by the gross potential income.

Effective gross income—The true positive cash flow; also referred to as EGI, total income, or total revenue. EGI is calculated by subtracting the revenue lost due to vacancy, loss to lease, concessions, non-operable units, and bad debt from the gross potential income.

Equity multiple—The rate of return based on the total net profit and the equity investment. The equity multiple is calculated by dividing the sum of the total net profit (cash flow plus sales proceeds) and the equity investment by the equity investment. For example, an equity multiple of 1.0 means the investor gets their initial investment back with no profit, while an equity multiple of 1.9 means the investor gets their initial investment back plus a 90% profit.

Financial independence—A person generally reaches this condition when their passive income or cash flow from non-work sources is equal to their total expenses and is expected to continue at that level or increase. At this point, the person does not “need” employment (i.e., W-2 or 1099 job, or self-employment) income to support themselves, and work becomes a choice, not a necessity. Obviously, this is lifestyle-specific and is a different number for everyone.

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 syndications, the general partner is also referred to as the sponsor or syndicator and is responsible for managing the entire project. It can refer collectively to the sponsorship/management team or to each sponsor/manager individually.

Guarantor—An individual who promises to pay a borrower’s debt in the event that the borrower defaults on the loan obligation. Sponsors/managers typically act as loan guarantors. Additional guarantors who are not sponsors/managers can be used to qualify for a loan; these are commonly (but incorrectly) referred to as key principals (KPs).

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. As a very simple example, let’s say you invest $50. The investment has cash flow of $5 in year 1 and $20 in year 2. At the end of year 2, the investment is liquidated and the $50 is returned. The total profit is $25 ($5 year 1 + $20 year 2). Simple division would say the return is 50% ($25/50). But since the time value of money (two years in this example) impacts return, the IRR is actually only 23.43%. If we had received the $25 cash flow and $50 investment returned all in year 1, the IRR would indeed be 50%. But because we had to “spread” the cash flow over two years, the return percentage is negatively impacted. The timing of when cash flow is received has a significant and direct impact on the calculated return. The sooner you receive the cash, the higher the IRR will be.

Key principal (KP)—Person(s) who control and/or manage the borrower entity or property, are critical to the successful operation and management of the borrower entity and the property, and who may be required to guaranty the loan
(i.e., sponsors/managers). Sometimes used interchangeably (but technically, incorrectly) with “guarantor” to refer to person(s) who help the general partnership team qualify for the loan through their net worth and/or liquidity, but who are not active managers of the project.

Leverage—Leverage refers to the amount of debt used to finance assets. It means using borrowed money to increase an investment’s potential return.

Letter of intent (LOI)—A non-binding agreement created by a buyer with their proposed purchase terms; commonly submitted as an initial purchase offer.

Like-kind (1031) exchange—A tax-deferred transaction that allows for the disposal of an asset and the acquisition of another similar asset without generating a capital gains tax liability from the sale of the first asset. Since these transactions are governed by Section 1031 of the Internal Revenue Code (IRC), these are commonly referred to as 1031 exchanges.

Limited partner (LP)—A partner whose liability is limited to the extend of their share of ownership. In syndications, the passive investors who fund a portion of the equity investment are LPs.

Loan-to-cost ratio (LTC)—The ratio of the value of the total project costs (loan amount plus capital expenditure costs) divided by the asset’s appraised value. A loan characterized by its loan-to-cost ratio, as opposed to loan-to-value ratio, typically means the ability to include planned CapEx funds in the amount to be borrowed through the loan.

Loan-to-value ratio (LTV)—The ratio of the value of the loan amount divided by the asset’s appraised value.

Loss to lease—The revenue lost based on the difference between the market rent and the actual rent.

Market rent—The rent amount a willing owner might reasonably expect to receive and a willing tenant might reasonably expect to pay for tenancy, based on the rent charged at similar properties. The market rent is typically calculated by conducting a rent comparable analysis.

Net operating income (NOI)—The property’s total income minus the operating expenses.

Non-operating expense—An expense incurred by an organization that is unrelated to its core operations. The most common types of non-operating expenses are interest charges and capital expenditures.

Non-operating income—The portion of an organization’s income that is derived from activities not related to its core business operations.

Non-recourse debt—A type of loan secured by collateral (usually property). If the borrower defaults, the issuer can seize the collateral but cannot seek out the borrower for any further compensation, even if the collateral does not cover the full value of the defaulted amount. In general, the borrower does not have personal liability for the loan.

Operating agreement—A document that outlines the responsibilities and ownership percentages for the general and limited partners in the limited liability corporation (LLC) formed for a syndication.

Operating expenses—The costs of running and maintaining the property and its grounds.

Ordinary income—Any type of income earned by an organization or individual that is taxable at ordinary rates. It includes but is not limited to wages, salaries, tips, bonuses, rents, royalties, and interest income from bonds and commissions.

Passive income—Earnings derived from a rental property, limited partnership, or other enterprise in which a person is not actively involved. As with active income, passive income is usually taxable. However, it is often treated differently by the Internal Revenue Service (IRS).

Physical occupancy rate—The proportion of occupied units. The physical occupancy rate is calculated by dividing the total number of occupied units by the total number of units at the property.

Preferred return—The threshold return that limited partners are offered prior to the general partners receiving payment (when this is used as part of the project’s return structure). This is commonly referred to as the “pref.”

Private placement memorandum (PPM)—A document that outlines the terms of the investment and the primary risk factors involved with making the investment. 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 projections of the revenue, expenses, and returns for operating a property.

Profit and loss statement—A document or spreadsheet containing detailed information about a business’s revenue and expenses. Also referred to as a P & L or income statement. When it includes the monthly information over the last 12 months, it is referred to as a trailing 12-month P & L, or a T-12.

Real estate investment trust (REIT)—A REIT is a company that owns, operates, or finances income-generating real estate. Modeled after mutual funds, REITs pool the capital of numerous investors. This makes it possible for individual investors to earn dividends from real estate investments – without having to buy, manage, or finance any properties themselves.

Rent roll—A document or spreadsheet containing detailed information on each of the units in a commercial property. For an apartment community, it may include the unit numbers, unit type, square footage, tenant name, market rent, actual rent, other recurring amounts due, deposit amount, move-in date, lease-start and lease-end dates, and the tenant balance.

Return on investment (ROI)—ROI directly measures the amount of return on a particular investment relative to its cost. To calculate ROI, the investment’s return is divided by the cost of the investment. The result is expressed as a percentage or ratio. Also called total return.

Security—A security is a financial instrument that holds some type of monetary value. Securities can be broadly categorized as either equities or debt. An investment in a real estate syndication is an equity security guided by the regulations—in the United States—of the Securities and Exchange Commission (SEC), as well as applicable state agencies. An equity security represents ownership interest and entitles the holder to some control of the company on a pro rata basis via voting rights.

Sophisticated investor—A person who does not qualify as accredited, but is deemed to have sufficient investing experience and knowledge to be able to weigh the risks and merits of an investment opportunity.

Subscription agreement—A document that is a promise by the LLC purchasing a 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.

Syndication—A temporary professional financial services alliance formed for the purpose of handling a large transaction that would be hard or impossible for the entities involved to handle individually, which allows them to pool their resources and share risks and returns. In regards to real estate, a syndication is typically a partnership between general partners (i.e., the syndicators) and limited partners (i.e., the passive investors) to acquire, manage, and sell a real estate asset while sharing in the profits.

Syndicator—See general partner. Also referred to as sponsor or syndicator.

Total return—See return on investment (ROI).