Key Definitions, Concepts and Terms
Below are some common terms used throughout the commercial real estate industry. It's important to familiarize yourself with the key concepts as you embark on your passive investing journey.
Real Estate Syndication:
A real estate syndication is an aggregation of capital from multiple participants or investors to invest jointly in real estate opportunity(s). It is a transactional contract between a sponsor and a group of investors, where investors earn a share of profits or returns. Real estate syndication is a way for investors to pool their financial and intellectual resources to invest in properties and projects much bigger than they could afford or manage on their own. In years past, only the wealthiest and most connected individuals could participate in real estate syndications. However, with the emergence of real estate definitions crowdfunding platforms, as well as individual syndications these investments are now more accessible to high income professionals with disposable income.
Sponsor or General Partner:
The sponsor is the owner or developer of the asset; the party who raises the funds and is responsible for purchasing the asset. The sponsor contacts brokers, sources the deal, obtains financing with the lender. In addition, the sponsor or a hired party maintains the day-to-day operations of the property and execution of the business plan. The sponsor typically forms an LLC for which the syndication is placed, and they take on any personal liability associated with the property through that LLC. It is desirable to see that a sponsor invests a portion of their own capital in the deal to show a commitment to that deal in investing alongside limited partners. This is called “Sponsor Skin in the Game” for investment terms.
Investor or Limited Partner (LP):
Investors or limited partners invest their money in the transaction. A limited partner is just that in that they are limited in their role in the investment other than investing their own investment terms. They contribute a large percentage of the upfront invested capital in syndication deals. A limited partner has no day-to-day involvement in the asset, and their liability is limited to their invested amount in the deal. However, they do have a responsibility to vet the syndication and all of its components before investing to better ascertain suitability. In exchange for their contributions, investors receive a membership or ownership in the company and a preferred return on their real estate definitions.
Accredited investor:
A person or a legal entity who is allowed to participate in investment terms not registered with the U.S. Securities and Exchange Commission. An individual accredited investor is anyone who either earned income of more than $200,000 (or $300,000 together with a spouse) in each of the last two years and reasonably expects to earn the same for the current year, or has a net worth over $1 million, either individually or together with a spouse (excluding the value of a primary residence). (NerdWallet.com)
Passive Investing:
Passive income investing is the practice of buying investments that produce residual income or cash flow without having to actively work on or in the investment. You as the investor are a passive, silent participant with the intention of earning a positive return monthly, quarterly, or at the end of the investment. Passive investment terms, especially in real estate, isn’t necessarily passive. You must understand what you are investing in and dedicate time and effort conducting due diligence on the process of investing in that avenue of real estate, as well as researching and vetting the sponsor, market and deal. There is upfront work involved in any type of real estate investing, even when the income earned is “passive.” The ultimate goal is to find an investment that, once funded, requires minimal time and effort to maintain while earning you a positive return and residual income on an ongoing basis.
Operating Agreement:
the LLC Operating Agreement or LP Partnership Agreement are vital documents when looking at real estate syndications. They set forth the rights of both the Sponsor and Investors and should be read and understood. This includes rights to distributions, voting rights, and the Sponsor’s rights to fees for managing the investment. This is related to legal rights of the limited partner and should be carefully reviewed in detail prior to investing and may consider the help of legal counsel in doing so, especially in terms of real estate definitions.
PPM (Private Placement or Offering Memorandum):
A legal document that states the objectives, risks, and terms of an investment. This document includes items such as a company’s financial statements, management biographies, and a detailed description of the business operations.
The PPM/OM serves to provide buyers with information on the offering and to protect the sellers from the liability associated with selling unregistered securities, particularly in terms of investment terms.
Investment Summary / Executive Summary:
This is a document that is used often in an illustrative form to outline some of the key metrics and business plan of the particular deal that is being offered, especially regarding investment terms. Such as business plan, sponsor experience and track records in some cases, return profile for limited partners, general partner fees, rental comps, and job and employment metrics associated with the location of the property.
Profit Split:
This is often outlined in the investment summary of PPM (Private Placement Memorandum) as to how the profits or proceeds from the property are split amongst limited and general partners, particularly concerning investment terms. In many cases, this consists of a preferred return to limited partners, followed by a waterfall structure that outlines how profits are split above a particular return often using IRR metric. Some deals do not have a preferred return or waterfall structure, but instead are simply a profit split such as 80/20 or 75/25 (Limited Partner/General Partner).
Preferred Return (Pref):
Preferred return indicates a contractual entitlement to distributions of profit, particularly in terms of investment terms. The priority of this distribution is maintained until a predetermined threshold rate of return has been met. Once met, profit distributions are made to any other subordinate stakeholders in the project. (EquityMultiple.com)
Internal Rate of Return (IRR):
A metric used to measure the potential return of an investment, especially in terms of investment terms. The IRR is the rate of growth investment is expected to generate annually which takes into consideration the time value of money. Therefore, the IRR will change based on the projected hold time of the deal.
Partition IRR:
a more advanced way to examine the IRR return which is used to break down the portion of the IRR return that comes from cash flow vs a projected liquidation event of the deal, particularly in terms of investment terms. The importance of this metric is to help assess the level of investment risk. This relates to the cash flow portion of the return as a more predictable parameter to gauge the viability of the property to produce returns. Often properties that are more cash flow oriented may have less overall upside, but also less risk.
Equity multiple:
the total cash distributions received from an investment, divided by the total equity invested, especially in terms of financial terms. 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. (Crowdstreet.com)
Average annual return:
a rate of return metric that is calculated by taking the total profit received and dividing it by the original amount invested and then dividing that by the number of years an investment was held, especially in terms of investment terms.
Waterfall Structure:
Simply stated, a waterfall describes the way cash available for distribution and profits in a project cascades through a series of calculations to make payments to the sponsor and their investors in a pre-arranged hierarchical fashion, particularly in terms of investment terms. The most common tools used to define how revenue and profit splits are made include the preferred return and the internal rate of return. There then may exist hurdles based upon performance metrics such as IRR, at which point the LP/GP Split may change. This tier structure is called an IRR Hurdle, at which a certain project IRR point the proportional share of profits will be adjusted.
Cash-on-cash return:
a percentage that measures the pre-tax cash flow relative to the money invested in an asset, particularly in financial terms. It is calculated by taking the net operating income and dividing it by the total cash investment. (BiggerPockets.com)
Break-even occupancy ratio:
; the sum of all operating expenses and debt service, divided by the total potential rental income, a crucial metric in real estate definitions. This tells you what percentage of the property must be leased in order to cover all expenses and debt service obligations. This ratio refers to the economic occupancy and not the physical occupancy. (PropertyMetrics.com)
Property Expense Ratio:
a measurement of the cost to operate a piece of property, compared to the income brought in by the property, essential in real estate definitions. It is calculated by dividing a property’s operating expense (minus depreciation) by its gross operating income. (Investopedia.com)
Cost segregation study:
a tax strategy that allows real estate owners to utilize accelerated depreciation deductions to increase cash flow and reduce the federal and state income taxes they pay on their rental income, a crucial aspect of real estate definitions. (TheRealEstateCPA.com)
LTV (Loan-To-Value):
an often used ratio in mortgage lending to determine the amount necessary to put as a down-payment on a property compared to the value of that property at the time of sale, a significant aspect of real estate definitions.
Loan to Cost (LTC):
Similar to loan to value but it also takes into consideration the loan amount to the overall cost of the property valuation in addition to the planned capital expenditure based on a value-add plan, an important aspect of real estate definitions.
NOI (Net Operating Income):
a calculation used to analyze the profitability of income-generating real estate investments. NOI equals all revenue from the property, minus all reasonably necessary operating expenses. This number is based on property cash flow and excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization. When this metric is used in other industries, it is referred to as “EBIT”, which stands for “earnings before interest and taxes”. This concept is crucial in understanding real estate definitions and investment terms.
Depreciation:
an important tool for rental property owners that allows them to deduct the costs from taxes of buying and improving a property over its useful life, and thus lowers their taxable income in the process. This concept is vital in understanding investment terms.
Due diligence:
the use of reasonable care in an investigation of the relevant facts, assumptions, parties, conditions, and subject matter pertinent to a transaction. In a real estate transaction, due diligence would include an investigation into the ability of the parties involved to conclude the transaction, confirmation of the market and financial assumptions underwriting the property, an investigation into the condition of the subject property, and the fitness or regulatory restrictions applicable to the subject property’s intended use. This underscores the importance of understanding real estate definitions.
Value-add Real Estate:
a property that requires some improvements in order to increase its value. Such investment properties can be rundown due to the owners lacking the finances to make improvements or just sheer neglect. Investors can buy such distressed or value-added properties at a price below market value and make structural, physical, and operational improvements. This will help attract new tenants, reduce vacancy rates, and generate higher rents. This strategy involves understanding real estate definitions to assess potential returns accurately.
NOI (Net Operating Income):
a calculation used to analyze the profitability of income-generating real estate investments. NOI equals all revenue from the property, minus all reasonably necessary operating expenses. This number is based on property cash flow and excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization. When this metric is used in other industries, it is referred to as “EBIT”, which stands for “earnings before interest and taxes”. Understanding financial terms is crucial for accurate analysis
Sponsor Fees:
Sponsors do a fair amount of work to put a deal together, manage a deal throughout its life cycle, and execute a business plan to produce a favorable outcome for stakeholders. So, it is no surprise that they should want to get paid for those efforts. For real estate projects, sponsors have two primary compensation methods:
a profits interest or “promote” fees.
Much like other investment metrics, the way the fees are structured can help to paint a picture of the overall project. In this article, we discuss the difference between fees and profit interests as well as the differences and justifications for investment terms typical to commercial real estate investments.
1) a profits interest or “promote”
2) fees.
Much like other investment metrics, the way the fees are structured can help to paint a picture of the overall project. In this article, we discuss the difference between fees and profit interests as well as the differences and justifications for fees typical to commercial real estate investments. (crowdstreet.com)
Acquisition / Disposition Fee:
These fees, an essential real estate definition, relate specifically to the purchase and sale of property or land. It is usually a one-time transaction fee that is collected after the purchase or sale and may come in addition to or in lieu of a third-party broker commission, depending upon whether the sponsor has in-house broker capabilities. Acquisition fee often helps to cover the costs associated with finding and evaluating potential assets. Sponsors often underwrite and pursue dozens of potential property candidates for each actual acquisition, so the spirit of this fee is to help the sponsor to defray sunk costs on all the properties it did not acquire (known as “dead deal” costs). The logic behind an acquisition fee is that investors should want to incentivize a sponsor to acquire the best deals and not the first deal that lands in its lap. Disposition fees, when assessed, are often viewed as the other half of sharing deal costs. Market acquisition and disposition fees vary and can be up to 2% of the purchase or sale price. (crowdstreet.com)
Property Management Fee:
Sponsors may do their own in-house property management, a significant real estate definition, meaning they oversee day-to-day operations, maintenance, leasing, and upkeep of a building or property. Having in-house property management is another way of showing vertical integration. Of course, many sponsors prefer to contract these responsibilities to 3rd-party firms. Market rates for property management fees range from 3% – 4% of gross revenues, typically paid based on monthly net collections of the property. (crowdstreet.com)
Asset Management Fee:
The asset management fee is most closely associated with general investment term management costs. Much as the property manager executes the day-to-day operations at the property level, the asset manager oversees operations and makes decisions regarding the asset itself, such as choosing a property manager, determining and adjusting the asset strategy, making key decisions on leasing and capital expenditures, reviewing and approving property-level expenditures above a certain threshold (typically $1,000), reviewing monthly accounting reports, and making recommendations to an investment committee on when to sell or refinance. Asset management fees are usually assessed monthly or quarterly during the investment period and are either a fixed amount or a percentage of the equity raised or a fixed percentage of gross revenues. Market rates average about 1 – 2% of gross revenues or equity annually. (crowdstreet.com)
Construction Management Fee:
Sponsors may charge construction fees if there is significant renovation or ground-up construction as part of an investment term business plan. This is typically confined to ground up construction real estate definitions opportunities. (crowdstreet.com)
Financial Independence:
To accumulate enough retirement savings to maintain your current expenses and quality of life, if you were to withdraw 4% annually, a sound financial term strategy is essential.
Financial Freedom:
The point at which your “Passive Income” sources by themselves cover your monthly or annual expenses in their entirety is a significant financial term known as financial independence.
Side Hustle:
A way to make income that is ancillary or secondary to your primary source of income is known as a financial term, and it can be an active or passive endeavor.
If you're looking to invest passively in real estate syndications and have been evaluating opportunities from sponsors, go ahead and try out our AI-powered LP Deal Analyzer tool. New registered users received two free deals!
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