Where to Begin
Terminology can be confusing in real estate especially since there are both math and legal concepts intertwined in the terminology. I think that it is best to provide an overview of some of the key words and concepts that you will be dealing with on your real estate investing journey. Included below are terms that are used regularly by real estate investing professionals and terms that you should get comfortable using.
After Debt Cash Flow
The pre-tax cash flow generated by a property after taking all property level and mortgage expenses into consideration (Revenue less Expenses less Debt Payments).
Amortization
A time period that gradually pays down loan principal as part of the mortgage or deed of trust.
Asset
From a real estate perspective, an asset is a physical property that includes land and buildings.
Capitalization Rate (Cap Rate)
The expected unlevered initial annual yield generated from a property. The capitalization rate is calculated by taking the annual Net Operating Income (Revenue less Expenses) divided by the purchase price of the property. Assuming a property generates annual Net Operating Income of $600,000 and an investor is buying a property for $10,000,000, the capitalization rate is equal to 6.00%.
Cash-on-Cash Returns
Cash-on-cash returns are percentage returns an investor will receive pre-tax after paying all expenses including principal and interest on a loan. It is calculated by taking the After Debt Cash Flow generated by a property (revenue less all expenses including mortgage expenses) divided by the cash equity originally invested in the property. For example, if a property generates $1,000,000 of After Debt Cash Flow annually and the investor invested $10,000,000 of cash equity into the property, the cash-on-cash return would be 10% per annum.
Cash Equity
The amount of cash invested in a property when it is acquired.
Crowdfunding
Raising money from a large number of investors who invest smaller amounts of capital typically via platforms on the Internet.
Deal
A specific real estate investment. Lenders also use this term to reference a specific financing assignment.
Debt
An obligation to pay back a lender using real estate as the collateral. Debt is arranged to be repaid over a certain time period with payments based on a fixed- or floating- interest rate that can include amortization or be interest only. Debt is typically structured as a mortgage or deed of trust.
Debt Constant
The annual amount of debt service divided by the original loan amount. The debt constant takes the principal and interest payments into account when calculating the true percentage cost of the debt.
Debt Service Coverage Ratio
The debt service coverage ratio (DSCR), also known as “debt coverage ratio” (DCR), is the ratio of operating income available to debt servicing for interest, principal and lease payments. It is a popular benchmark used in the measurement of an entity’s (person or corporation) ability to produce enough cash to cover its debt (including lease) payments. The higher this ratio is, the easier it is to obtain a loan. The phrase is also used in commercial banking and may be expressed as a minimum ratio that is acceptable to a lender; it may be a loan condition. Breaching a DSCR covenant can, in some circumstances, be an act of default.
Debt Yield
Debt Yield is the metric lender’s use to determine what their unleveraged return would be if they had to foreclose on a borrower. Mathematically, the debt yield is equal to the Net Operating Income (NOI) divided by the Loan Amount.
Deed of Trust
A loan document that acts as the security instrument for a lender, but where legal title to the property is transferred to a trustee. It is an agreement among a lender, a borrower, and a trustee that remains in place until the loan for the particular property is paid off.
Direct Real Estate Investment
An investment in a property where you invest directly in a piece of property by yourself or with a partnership group wherein you maintain control.
Effective Gross Income
Effective gross income is the anticipated income from all operations of the real property after an allowance is made for a vacancy and collection losses. Effective gross income also includes items constituting other income that are not derived from rental income.
Equity Multiple
The return of total cash distributed back to an investor from cash flow, financing proceeds, and sales proceeds over the real estate investment hold period calculated in decimal format. An equity multiple of 1.0x means that you get back your original equity invested, an equity multiple less than 1.0x means that you get back less than your original equity, and an equity multiple greater than 1.0x means that you get back your original equity plus profit.
Equity Syndication
A real estate investment sponsored by a real estate investment company wherein the sponsor raises co-investment money from a group of passive investors to acquire the property.
Four Main Food Groups
A term used by real estate investors and lenders to describe the four primary asset types that they either invest in or lend on, which include multifamily apartments, office, industrial, and retail.
Friends and Family Investment
A real estate investment or real estate investment vehicle where capital is raised from people known to the Managing Member or General Partner.
Funds From Operations
A financial figure used when evaluating Real Estate Investment Trusts (REITs). The figure is used to derive the REIT’s cash flow from operations. Funds From Operations is calculated by adding back depreciation, amortization, and any gains on sale to cash flow, but does not include any cash flows from financing activities.
Hotels
A type of real estate asset that provides temporary accommodations, food and beverage, and other services or amenities typically for travelers or tourists.
Indirect Real Estate Investment
An investment in a property or in the shares/member units of an entity investing in real estate. This investment is typically a passive investment. These investments are managed by someone other than yourself wherein the Managing Member or General Partner of the investment maintains control of the decisions of the property and investment. The investor receives a return on their investment through a Preferred Return and a share of the profits. These deals can be structured as Partnerships, Friends and Family, and/or Reg 506 Crowdfunding.
Industrial
A type of real estate asset that provides warehousing, logistics, manufacturing, and dry and/or cold storage space for businesses.
Internal Rate of Return (IRR)
A financial calculation that evaluates the expected annualized return over a given time period. The calculation includes the initial cash equity invested, ongoing cash flows over the hold period, and the ultimate proceeds upon the asset disposition.
Land
A type of real estate asset that is the typically the unimproved dirt in a particular piece of property.
Lender
An entity or individual that lends money to borrowers.
Leverage Cash-on-Cash Returns
A calculation showing the cash-on-cash returns assuming that a property is financed with debt.
Levered Returns
A calculation showing the Return on Equity (ROE) or Internal Rate of Return (IRR) assuming that a property is financed with debt.
Loan-to-Value Ratio (LTV) Ratio
A financial ratio used by lenders to determine the percentage of debt against the property compared with the total value or purchase price of the property. For example, if a borrower has a $7,000,000 loan against a property worth $10,000,000, then a borrower has a 70% loan-to-value.
Location Classes A, B, C, and D
An arbitrary rating assigned to a specific location by an investor. A-class locations are usually in the best locations with the best demographics and lowest crime statistics.
Mortgage
A loan document that acts as the security instrument for a lender. It is an agreement between a lender and a borrower that remains in place until the loan for the particular property is paid off.
Multifamily
A type of real estate asset that provides residential rental housing in one or more buildings within a particular land area. This type of property can also be called an apartment complex.
Net Operating Income (NOI)
A calculation used by real estate investors to depict the unlevered cash flow from a property. It is calculated by taking the difference of the Revenues generated from the property less the Expenses. The Expenses exclude Mortgage payments, Capital Expenditures, Depreciation, and Amortization. The value of the property is derived by dividing the NOI by the Cap Rate to obtain the property value or purchase price. For example, if a property generates a $600,000 per year NOI and the Cap Rate is 6%, then the property is valued at $10,000,000.
Office
A type of real estate asset that provides workspace for business employees.
Partnerships
A real estate construction wherein two of more entities or individuals join together to own property together.
Preferred Return
A minimum threshold return that investors must receive on their invested capital prior to a Sponsor receiving a split of the cash flow and profits on a given deal.
Promissory Note
A loan document wherein a borrower promises a lender that it will repay the amount borrowed at a certain point under the agreed upon terms.
Property Classes A, B, C, D
An arbitrary rating assigned to a specific property by an investor. A-class properties are usually the newest or most modern properties.
Real Estate Investment Trust (REIT)
Real estate holding companies that are either publicly traded or privately traded wherein investors purchase shares of a company that acquires and manages real property on behalf of its shareholders.
Retail
A type of real estate asset that provides business space for businesses that are typically selling products to consumers.
Return on Investment (ROI)
The return of total cash distributed back to an investor from cash flow, financing proceeds, and sales proceeds over the real estate investment hold period calculated in percentage format. An ROI of 100% means that you get back your original equity invested, an ROI less than 100% means that you get back less than your original equity, and an ROI greater than 100% means that you get back your original equity plus profit.
Self-Directed Retirement Vehicles
A type of retirement account wherein the beneficiary has control over the types of assets that it can acquire including real estate, loans, private equity, commodities, and other alternative assets.
Self-Storage
A type of real estate asset that provides storage space for rent to consumers and/or businesses on a short-term basis.
Single Family Residential
A type of real estate asset that provides housing and can either be a detached or townhouse style dwelling.
Sponsor
An entity or individual that acquires, negotiates, arranges financing, and oversees management of real estate.
Trust Deed Investment
An investment in a loan secured by real estate.
Unlevered Returns A calculation showing the Return on Equity (ROE) or Internal Rate of Return (IRR) assuming that a property is not financed with debt.
Until next time, let’s continue growing our passive cash flow and net worth together!
-Robert