Commercial Real Estate Terminology
A person can invest in securities by satisfying the income or net worth requirement. A person must have an annual income exceeding $200,000 or $300,000 for joint income, for the last two years with expectation of earning the same or higher income in the current year.
A person is also considered an accredited investor if the net worth exceeds $1 million, either individually or jointly with a spouse (or unwedded partner), excluding the primary residence.
A person is also considered an accredited investor if they have a Series 7, 65, or 82 securities license or other verifiable professional credentials.
Active vs. Passive Investing
Active Investing: The finding, qualifying and closing on a real estate transaction using one’s own capital and overseeing the business plan through its successful execution.
Passive Investing: Placing one’s capital into a real estate syndication that is managed in its entirety by a general partner/syndicator/operator.
Capitalization Rate (Cap Rate)
Capitalization rate is used to estimate the investor’s potential return on his or her investment.
The cap rate is calculated by dividing the property’s net operating income (NOI) by the current market value or acquisition cost of a property (cap rate = NOI / Current market value).
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. There are no clear ranges for a good or bad cap rate, and they largely depend on the context of the property and the market.
When acquiring income property, the higher the capitalization rate (“Cap Rate”), the better. When selling income property, the lower the Cap Rate the better. A higher cap rate implies a lower price, a lower cap rate implies a higher price.
The revenue remaining after paying all expenses. Cash flow is calculated by subtracting the operating expense and debt service from the collected revenue.
Cash On Cash (COC)
The ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage. It is often used to evaluate the cash flow from income-producing assets.
For example, a 200 unit apartment community with a cash flow of $300,000 and an initial investment of $3,500,000 results in a CoC return of 8.6%. (COC = Annual before tax cash flow/total cash invested).
Cost Segregation is a tax planning strategy that accelerates the depreciation schedule of a property. The depreciation is accelerated since the asset is generally held for 5 years. So what does this mean to a real estate investor? Investors get to keep more of their hard-earned money.
According to the IRS, a residential building depreciates in 27.5 years, and a non residential building depreciates in 39 years. Let’s take the example of a residential building. Immediately after acquiring the property, a syndicator or General Partner, will hire a consultant to conduct a cost segregation study, which is an engineer-based study, to break down and reclassify different components of the property. The property is reclassified into 4 groups for tax reporting purposes: personal property assets, real property assets, land improvements and land.
Includes components such as furniture, fixtures, window treatments, cabinets and carpeting. These assets depreciate over a 5 or 7 year schedule.
Includes structural components such as the roof, HVAC, plumbing, and wiring. Real property depreciates over a 27.5 year schedule.
Land improvements could include parking lots, driveways, sidewalks, fencing, retaining walls, and landscaping. These items depreciate over a 15 year schedule.
Land doesn’t depreciate.
The reclassification of the property accelerates the depreciation, which can be deducted against the taxable net operating income in the current tax year. Overall tax liability is reduced, and investors benefit from the immediate increase to cash flow.
The Tax Cuts and Jobs Acts of 2017 (TCJA) provides a boosted tax shelter to real estate investors. TCJA allows for bonus depreciation, which is essentially accelerated depreciation on steroids. Properties acquired after Sept 27, 2017, can depreciate certain 5, 7, and 15 property assets immediately. Bonus depreciation was accelerated from 50% to 100% on certain qualifying assets. This IRS tax tool reduces the tax burden, which translates to more mailbox money to the real estate investor.
BlueDoor Equity does not provide professional tax advice. Please consult with your financial advisor, CPA, and or tax attorney (ideally a professional who specializes in real estate) to review how cost segregation can work for you.
Debt Service Coverage Ratio (DSCR)
A ratio that is a measure of the cash flow available to pay the debt obligation. 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 ratio is 1.25 or higher. An apartment with a DSCR too close to 1.0 is vulnerable, and a minor decline in cash flow would result in the inability to service the debt.
Equity Multiple (EM)
Equity Multiple (EM) is the rate of return based on the total net profit (cash flow plus sales proceeds) and the equity investment. EM is calculated by adding the sum of the total net profit and the gross cash flow and dividing it by the equity investment.
An owner of a partnership who has unlimited liability. A general partner is also usually a managing partner and active in the day-to-day operations of the business. In real estate syndications, the GP is also referred to as the sponsor or syndicator. The GP is responsible for managing the project. BlueDoor Equity would be part of the GP in the investment opportunities.
Rule 506(b) allows a General Partner to raise an unlimited amount of money from an unlimited number of Accredited Investors and up to 35 Sophisticated Investors.
These deals can not be publicly advertised or solicited to the general public. Deals can only be shared with investors who have a substantive pre-existing relationship with BlueDoor Equity. To get started, join the BlueDoor Investor Club. Once we get to know you and your investing goals, we’ll start to share investment opportunities with you.
Rule 506(c) allows a General Partner to broadly solicit and publicly advertise the deal. Investors do not need to have a substantive pre-existing relationship with BlueDoor Equity. However, all investors must be an Accredited Investor.
Internal Rate of Return (IRR)
Internal rate of return (IRR) is the rate, expressed as a percentage, needed to convert the sum of all future uneven cash flow (cash flow, sales proceeds and principal pay down) to equal the equity investment. The IRR on an investment is the “annualized effective compounded return rate” or rate of return that sets the net present value of all cash flows from the investment to zero.
IRR is one of the main factors the passive investor should focus on when qualifying a deal. The timing of when cash flow is received has a significant and direct impact on the calculated return. The IRR calculates the return that accounts for the time value of money. The sooner you receive the cash, the higher the IRR will be.
A very simple example is let’s say that 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 that the return is 50% ($25/50). But since time value of money (two years in this example) impacts return, the IRR is actually only 23.43%. It’s best to use a financial calculator to determine IRR of an investment.
If we had received the $25 cash flow and $50 investment returned all in year 1, then yes, the IRR would be 50%. But because we had to “spread” the cash flow over two years, the return percentage is impacted.
The limited partner is a passive investor in the deal. They have limited liability, and their risk is limited to the amount invested. Limited partners are not listed on the loan, and they are not responsible for any active management of the property. Passive investors are limited partners in our syndication deals.
The “Pref” or preferred return is the percentage given to the limited partners first, before the general partners are paid. For example, if the preferred return is 8%, the first 8% return on an investment will go entirely to the limited partner. The general partner will receive distributions after the limited partners are paid.
Ratio Utility Billing System (RUBS)
In many older multifamily properties, units are not individually metered for utilities, so owners/landlords use RUBS, a method of determining a resident’s utility bill based on factors like unit square footage, the number of people living in a unit, or some combination thereof. RUBS can be an excellent way for landlords to reduce costs without directly increasing rent prices. Once calculated, the amount is billed back to the resident, which results in an increase in revenue.
This shows different scenarios for occupancy and where the breakeven point will be if there is a decline in occupancy or if rents are not as high as projected.
A person who is deemed to have sufficient investing experience and knowledge to weigh the risks and merits of an investment opportunity.
Syndication is the pooling of resources to purchase a large asset, such as an apartment building. The investors are passive, limited partners (LP) and the other partner is the General Partner (GP), also called a sponsor or syndicator. The General Partner is the active partner that finds, analyzes and creates the business plan.
Term relates to the division of returns to the limited and general partners. If the split is 70/30 in favor of the LP, then the limited partner receives 70% and the general partner 30% of revenue after the preferred return is paid. This applies to all distributions or capital events. A waterfall refers to a change in the split if a certain return is achieved, typically measured by IRR. For example, a typical split would be 70/30 then change to 50/50 once the IRR hits 15%. This rewards the sponsor for achieving a higher than expected return.
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