“The beginning of wisdom is the definition of terms.” — Socrates
What do real estate syndication terms mean?
You may be confused by the term cap rate or DSCR or equity multiple.
These terms can be really confusing!
Here at Bronson Equity, we have about $150 million in multifamily real estate.
I’ve spoken with 1,200 investors individually, and there are a lot of questions that come up.
Questions such as:
How do I understand this?
How do I get my head around this?
So I decided to go through some of these different terms at a high level.
After reading this blog, you should know whether a deal is good or if you should pass.
Warren Buffet once said: “Never invest in a business you cannot understand.”
It’s really important to understand whatever you’re invested in.
We’re gonna get into some important numerical terms and how to understand those numbers.
Let’s jump into it!
1. Three Most Important Terms
We’re going to start by talking about the most important things when you’re looking at any deal, particularly any multifamily or real estate deal.
These terms will be very similar in lots of different deals.
Cash-on-Cash
The first is called cash-on-cash or COC.
Every industry has their own acronyms.
What COC means is the paid-as-you-go number.
Let’s use an example:
We have $100,000 to invest.
If something has projected 8% cash-on-cash, we’d expect around $8,000 per year on average for the life of that deal.
Deals we do can typically take 6-12 months or more before cash flow starts.
But if it’s an 8% cash-on-cash average, that means the flow will typically be less on the front end and more on the back end.
AAR/IRR
The next term is the AAR or the IRR.
AAR is the average annual return.
The way they calculate returns can be a little different in real estate.
For example: If you have $100,000 over five years and it becomes $200,000, that’s a $100,000 profit.
You take that over the number of years, which is five years, and get a 20% return.
In my financial background as an investment advisor, you would never do this.
This would actually be a 15% return because you’d be using a 15% compounded annually.
That means you take the total return and divide it up.
If you’re compounding every year versus taking the total return and dividing it by a number, the AAR can appear higher than other return figures such as IRR.
The IRR is the internal rate of return.
It also incorporates the time value of money.
If you refinance a deal, you get your money back sooner.
There are different factors to go into this as well as a big equation.
Math can be a lot of work, but we’ll keep it simple.
Using the same example from before: a 20% AAR could be a 16% IRR.
Remember, every deal is different.
Typically the IRR is a little lower because it values the time value of money versus other metrics.
When you compare deals, the IRR number is usually the one that is most important.
Evaluate that number.
Equity Multiple
The last really important term is equity multiple.
Equity multiple is how much your investment becomes over the life of the investment.
A 2.0 equity multiple would mean a 200% return of your principle.
$100,000 would become $200,000.
The longer the time horizon for your investment, the higher number you’ll expect to see.
Other Numbers
Next, I’ll go over some other important numbers-based terms that will come in handy when you look at a deal.
Cap Rate
Cap rate is defined as income divided by the market value or the net operating income divided by the current market value.
Some people would want something with a really high cap rate.
A few years ago, we used to see cap rates of 8 or 10.
This means for every $100,000 that went in, you’d be $8,000-$10,000 if you bought the property in cash.
That’s crazy!
It’s not important to have the highest cap rate possible.
There are other ways you can increase the overall returns when the cap rate is not as high.
I’ve explained that concept in more depth in other blogs and videos, so make sure to check those out!
Some people who lie with statistics will project a deal to be more favorable than it actually is.
One way that could happen is this:
Let’s say we buy something at a 5% cap rate.
Some groups will say to lower that because cap rates are going down.
They might sell it at a 4.5% cap rate.
Seems like no big deal, right?
It actually dramatically increases the projections on that deal.
We do the reverse.
We’ll buy it at a 4.5% or 5% cap.
Then, we’ll raise it 50 basis points up to a 5% or 5.5% cap.
Doing that means when we sell, it may be less favorable but we need to be conservative in our projections.
Debt Service Coverage Ratio (DSCR)
The next term is debt service coverage ratio, or DSCR.
DSCR is how much income is used to cover the cost of holding a property.
If it’s a 1.0, that means with all the property costs, as well as the loan, it’s basically 100%.
Everything coming in is going out to cover the cost of owning this property.
That means you’re only covering the debt and other expenses you have.
If it’s 1.25 or higher, that’s favorable because it means you have cash flow.
You’re doing more than covering the debt…
You’re covering the expenses and the property.
Some properties initially start out lower than 1.
If rents are below market, there are ways to increase the value or increase rent.
You have to be aware of that going in.
Net Operating Income (NOI)
The last number term I’ll go over here is net operating income.
This is your income after you pay any sort of expenses.
In other words: What are you left with after all expenses are paid?
Other Terms
We talked about some important numbers so far.
There’s also some important terms you need to know before you invest in anything.
These are common terms that have to do with syndication, particularly multifamily or real estate syndication.
Accredited Investor
Accredited investors are investors who have a certain net worth or income.
If they meet those income/net worth qualifications, they are defined as accredited.
It’s not any sort of gold star or certification.
Instead, it allows you to get in on certain investments that may not be available for non-accredited investors.
At the time of this post, they’re talking about increasing the net worth requirement to $5-10 million.
Currently, the net worth requirement for an individual or couple is $1 million dollars outside your primary residence.
It could also be that your income is either $200,000 or $300,000, depending on if you’re single or married.
These are changing definitions; they changed them last year.
You also can take a Series 65 test and become accredited that way.
Sophisticated Investor
A sophisticated investor is not accredited but they have sufficient knowledge to understand an investment such as multifamily syndication.
As a syndicator, we can’t really take money from people who don’t understand how the investment works.
If all they want to do is double their money in the next six months…
That’s not really what we do.
We deal more with long-term investments.
We’re going for base hits and doubles, not doubling money in the next six months.
We have to evaluate how sophisticated someone is.
If somebody understands a handful of these terms and can outline their goals, they can achieve those goals without a lot of effort.
All they need is some knowledge to get started.
If you’re accredited, people assume you have some sophistication built in.
This may not necessarily be true, but that’s how the SCC has defined it.
Agency vs. Bridge Debt
There are two major types of debt used to buy commercial properties:
Agency debt and bridge debt.
The ‘agency’ in agency debt refers to a government agency such as Fannie Mae or Freddie Mac that help sponsor that debt.
They typically help you get long-term fixed debt, which is great for a property.
The downside is that it’s long-term and there are penalties.
If you sell early, or if you need to refinance, sometimes there are penalties.
Bridge debt is typically shorter term, along the lines of 1-5 years.
Some of the benefits include more flexibility and less limits.
They also can have a floating interest rate or interest rates with caps.
Maybe it’s a 3% interest rate at the time of this post, but maybe you can cap it at 3.5% or 4%.
You pay for the ability to do that.
CapEx (Capital Expenditures)
CapEx stands for capital expenditures.
Capital expenditures are things such as repairs on individual units or common areas.
You’re putting in a grilling station or you’re doing a new kitchen in a particular unit.
If somebody asks: What’s the CapEx budget?
What they’re really asking is: How much is being spent to renovate this property during the life of the deal?
General Partner (GP) vs. Limited Partner (LP)
GP stands for general partner.
LP stands for limited partner.
A general partner operates the deal.
They typically have more day-to-day responsibilities to make sure investments perform.
Limited partner doesn’t mean limited in ownership.
The ‘limited’ simply means limited responsibilities.
People invest as LPs because they want to be more passive in their investments.
If someone has a day job, they don’t want to be the one getting calls about a property.
As an LP, your work is on the front end.
You look at the deal and how these terms are defined.
Then you choose if you want to invest and trust the general partners to handle that.
Typically there is an equity split, which means the profits are split a certain way.
For example, let’s say the property starts making money through rents or appreciation.
As those rents come in and after expenses are paid, every dollar would be split.
A common split is 70-30.
70% would go to the limited partners and 30% to the general partners.
If the deal doesn’t make money, then the general partners don’t really make any money.
They’re incentivized to help make the deal perform.
Often general partners actually invest money and become limited partners as well.
They’re also investing their own money into a deal, which is called skin in the game.
The idea of a general partner investing money into a deal as well is a very good sign.
I usually don’t invest unless a general partner puts something into a deal.
This shows they’re heavily invested into that property as well.
The equity split also exists when the property sells.
Letter of Intent (LOI)
The letter of intent is used if we find a new property and want to make an offer.
When we write a letter of intent, we list how much we are willing to pay.
The owners will agree and actually counter sign the letter.
This is not a legally binding contract.
It’s simply saying we’re going to see if we can reach an agreement.
Purchase & Sales Agreement (PSA)
The purchase and sales agreement is typically very detailed.
It goes back and forth between lawyers – redlining, underlining, crossing things out.
The process can take weeks or longer.
When this is signed, the document is a legally binding contract.
We are legally obligated to buy and the seller is obligated to sell.
When people say they’re under contract on a property, it means they have signed a purchase and sales agreement.
They’re important to understand the status of a particular deal.
Private Placement Memorandum (PPM)
A PPM is a private placement memorandum.
It’s the paperwork associated with a multifamily syndication or other syndicated deals.
They’re typically 60 to 120 pages and very detailed.
They include everything about the investment:
What the property looks like, who’s managing it, how people are getting paid, how the company will operate with a limited liability company.
The PPM also covers what could go wrong and the risk factors.
You can even have a lawyer or a consultant take a look for you.
It can be a little bit of a yawn, but it’s important you understand the terms of that contract.
Subscription Agreement (SA)
A subscription agreement is when an investor applies to join a limited partnership.
The agreement goes two ways between the company and the new shareholder.
The SA outlined the predetermined buying and selling price of the exchange.
Basically, it just makes sure everyone is on the same page during a deal.
We’ll go more in-depth on what a limited partner (or LP) is later!
Class A, B, C, D property
A Class A property is typically built in the last 10 years or it’s in the nicest area.
A Class D property is the roughest property in roughest areas.
We typically buy B and C, which are working class apartments.
We do some improvements to make the space better.
Some people as well as REITs love Class A.
I’m much more or a fan of syndication for a number of reasons.
You need to understand the property class of your investment.
This is usually defined by age, but it also can be defined by the neighborhood, the area, and how recently the property has been renovated.
There are many different factors and it’s more loosey goosey.
The only exception is brand new properties, which are typically considered Class A.
Underwriting
Underwriting doesn’t have to do with writing under a table, but instead with how you look at a deal.
How conservative is somebody in a deal and their projections?
Another thing people do in underwriting is rent growth.
At the time of this post, rent growth is going absolutely nuts.
20% per year nationally!
If you start underwriting every single year it’s growing 20%, your numbers will be off the chart.
Nobody’s doing that, right?
Maybe you’re using 2% or 3% annual growth per year in rents, which is considered conservative depending on the market.
The underwriting is how you determine how that deal will perform or how you’re looking at the unknowns.
Value-Add Approach
I talked about this when we went over the role of renovations.
Owners find a problem with a property and spend thousands of dollars per unit trying to fix it.
You try to increase the value so as tenants move out, new tenants move in and pay a higher amount that increases the value of the property.
It’s the same thing that happens in a flip.
You pay a certain amount for a house, you do a bunch of work, and you try to sell it for more.
In multifamily with a value-add approach, we typically do this over a longer period of time.
This time can range from two to six years.
But overall, it’s the same concept.
That was a lot!
Good on you for getting through all of this.
Give yourself a big pat on the back.
Robert Kiyosaki once said that the difference between the rich and the poor are simply the vocabulary they use.
So if you want to increase your financial IQ, what you’re doing here is awesome.
Keep learning, keep digging.
Now I want to hear from you!
What are some lessons you’ve learned as you’ve invested?
What are some terms that have become very important to you from deals you’ve done?
Have you made mistakes you’ve learned from in that process?
Stick your answers below in the comments and let’s have a conversation!
Before you leave, make sure to check out our special report about investing. It compares the stock market to real estate, and it also includes how the pandemic affects your investment future.
If you are interested in investing with us, we are happy to answer any questions that you may have. Join our investment club today and we will be in touch.
Disclaimer: I am not your investment advisor. This is for educational purposes only. I am not giving specific advice on what you can do. I am simply giving my opinions.
