Because I think that an educated investor is the best kind of investor, I wanted to share some of the most important or relevant terms that I believe every real estate investor should know. I encourage you to take a few minutes to become familiar with these terms below, because they are the foundation of interpreting what ultimately what makes a potentially great investment opportunity versus a so-so investment.
1. Cap Rate: This is a commonly used metric in commercial real estate investing, and is short for Capitalization Rate. It essentially indicates the rate of return on a property if the property were purchased for 100% cash, with do debt. This acts as the “multiplier” effect when determining value, and is calculated by dividing the net operating income (NOI) by the property's market value. Sellers want a low Cap Rate (meaning a prospective buyer is willing to accept a lower return on his investment to purchase the property), and of course Buyers want a higher Cap Rate, so that they can enjoy a higher return on their investment. 2. Net Operating Income (NOI): This is the income generated by a property after deducting all operating expenses but before deducting mortgage interest and income taxes. NOI is used to calculate other metrics such as Cap Rate and DSCR. 3. Cash-on-Cash Return: This is another important metric that indicates the cash income generated by the investment compared to the amount of cash invested in the property. This represents the cash that is available to distribute to the ownership group, generally on a monthly or quarterly basis. It is calculated by dividing the annual cash flows from operations by the total cash investment. 4. Debt Service Coverage Ratio (DSCR): This is a ratio that measures the ability of the property to generate enough income to cover its debt payments. It is calculated by dividing the net operating income by the annual debt service. Banks or lenders almost always require a minimum DSCR be met, to help measure whether a property is performing well and can cover its expenses. A common DSCR requirement is 1.25x, meaning that if annual mortgage payments total $100,000 then the annual operating income must be at least $125,000 in order to satisfy the requirement. 5. Internal Rate of Return (IRR): This is a metric used to measure the potential return of an investment over time. It takes into account the time value of money (a dollar today is worth more than a dollar a year from now) and is calculated based on the present value of all expected future cash flows. This is a very common way to measure the projected returns of commercial real estate. It considers the quarterly or annual cash distributions from an investment, along with any projected lump-sum payments received when the property is sold, to calculate a time-weighted return on investment. 6. Operating Expenses: These are the costs associated with operating a commercial property, including property taxes, insurance, maintenance, utilities, and property management fees. 7. Vacancy Rate: There are two types of vacancy to consider when evaluating the net potential income of a property. The first of course is Physical vacancy, which is the percentage of available space in a commercial property that is currently unoccupied. If nobody is living in an apartment unit, then it’s obvious that there will be no rental income for that unit. But the other type of vacancy is called Economic vacancy, and this is a bit more nuanced. This captures the reality that there will always be some sort of bad debts associated with tenants who can’t pay, or perhaps concessions offered to new tenants (eg. The first month is free), or when a tenant’s rent is at a below-market rate (this is called “loss to lease”, see below). 8. Loss to Lease: This refers to the difference between the actual in-place rents at a property and the market rent, or what similar units in the area will rent for. When the actual rent being charged to a tenant is lower than what the market will currently support, then there would be a loss to lease for the difference. For a prospective buyer, a high loss to lease component could signal a great opportunity to increase a property’s value by simply bringing current tenants up to market-rate rents at their next renewal. 9. Leverage: Leverage refers to using borrowed funds to finance a real estate investment. This can help investors increase their potential returns, but it also increases their risk if the investment does not perform as expected. This is sometimes a fine line to walk, and quite often the lender will be the one dictating the amount of leverage you can place on a property. In today’s market, lenders will typically loan 60-75% of a property’s purchase price. 10. Rent Roll: A rent roll is a document that provides details about the rental units in a commercial property, including the unit numbers, the tenants' names, the rental rates, and the lease terms. This document is important for investors to understand the potential rental income and the status of existing leases, and is one of the first seller-supplied documents we look at when beginning to underwrite a potential new deal. It helps us to understand the existing tenant base and make projections of how much rents could increase under new ownership. 11. “T12” financial statements: This stands for the “Trailing 12 months” of financial data, and is another necessary seller-supplied component when underwriting new deals. This income and expense report will give valuable insights into how the current owner or property manager is running the property, and give us clues as to how the property could perform for us going forward. It can highlight obvious rent collection issues or perhaps some operating expenses that seem unnecessarily high, and from here we can begin to determine whether the property has the potential to be a deal worth pursuing or not. 12. Accredited Investor: This is an individual investor who has an annual income of $200,000 or more, a married investor with an annual income of $300,000 or more, or an investor with a net worth of $1,000,000 or more, excluding their primary residence. This distinction is important in real estate syndications, because the Securities and Exchange Commission (SEC) dictates that only accredited investors may participate in some types of private-placement offerings, while in others (see below) only a small number may participate, and within a strict set of guidelines.
13. 506(b) offering: A 506(b) offering is a type of private placement offering that allows a company to raise capital from investors without having to register with the SEC. The offering is made under Rule 506(b) of Regulation D under the Securities Act of 1933. Under a 506(b) offering, a company can offer and sell securities to an unlimited number of accredited investors and up to 35 non-accredited investors with whom a pre-existing relationship is present. However, the company is prohibited from using any general solicitation or advertising to market the offering. This is the most common type of offering for real estate syndications. 14. 506(c) offering: A 506(c) offering is another type of private placement offering that allows a company to raise capital from investors without having to register with the SEC, but it is limited to only accredited investors (see #13 above). The company must take reasonable steps to ensure that all investors are accredited, but in this offering the company is allowed to advertise in any and all manners. This allows the opportunity to potentially raise larger amounts of capital in a shorter amount of time, and is generally preferred for larger syndications or deals.