Real Estate Terms You Should Know
Below are common terms and concepts used in commercial real estate.
CAPITALIZATION RATE
The Capitalization Rate or Cap Rate is one of two key variables in the most widely used method for valuing income-producing real estate.
Property Value = Projected 12-month NOI/Capitalization Rate
For example, an office property with a projected NOI of $100,000 would be valued at $1,538,462, using a 6.5% Cap Rate (note the lower the Cap Rate, the higher the value).
The question that often gets asked is “What Cap Rate should I use?” At a conceptual level, the appropriate Cap Rate will depend upon the type of real estate and class and location of the property. For example, a Class A office building located in Manhattan will be valued using a lower Cap Rate than a Class B strip center located in Mesa, Arizona. At the property level, determining the appropriate Capitalization Rate to value a specific property can be more art than science. Investors who are active in a given market or property type will have a good feel for Cap Rates. Those less familiar with the Cap Rates in a given market, can refer to relevant trade publications or consult knowledgeable brokers. For quants, recent sales comps or the Gordon Growth Model Formula may be used to derive a Cap Rate.
CARRIED INTEREST
Carried Interest is the Sponsor’s Promote or Sweat Equity return.
CASH-ON-CASH RETURN
Cash-On-Cash Return is the annual cash generated by a real estate asset, after paying all expenses and debt service over the actual cash equity invested in an asset. For example, if the total cash equity in a deal were $600,000 and the real estate investment generated total rents and other income of $250,000 with associated expenses of $130,000 and debt service of $70,000, the Cash-On-Cash Return for the year would be $50,000/$600,000 or 8.3%. Cash-On-Cash Return is favored by some investors because it is the actual cash return that can be expected each year on their investment.
DISCOUNTED CASH FLOW
Discounted cash flow (DCF) is a method used to determine the value in today’s dollars, so-called Present Value, of a series of future cash flows by taking into consideration the time value of money and riskiness of the cash flows. Under the formula, each future cash flow is discounted to present using a discount rate. The rate used to discount each cash flow is often the same but can be individually specified for each cash flow. Below is a simple DCF example for a five-year series of cash flows.
CF Year 1 - $100,000
CF Year 2 - $105,000
CF Year 3 - $110,000
CF Year 4 - $60,000
CF Year 5 - $1,320,000
Discount Rate: 10%
Present Value = $100,000/(1+.1) + $105,000/(1+.1)2 + $110,000/(1+.1)3 + $60,000/(1+.1)4 + $1,320,000/(1+.1)5
Present Value = $1,120,928
In the DCF calculation, the time value of money and the riskiness of the cash flows are incorporated via the discount rate. The time value of money component simply incorporates the idea that a dollar today is worth more than a dollar in the future and equates to the risk-free cost of capital. The riskiness of the cash flow (the likelihood that a cash flow will be realized) is, in essence, a risk premium that is added to the risk-free rate to determine the discount rate (discount rate = risk-free rate + risk premium).
In the real world of commercial real estate, the discount rate is not necessarily calculated using mathematics. For all but the most sophisticated, the rate used to discount future real estate investment cash flows is based on experience and market realities. As a rule of thumb, core real estate investment cash flows are discounted at a rate of 6% to 10%, core plus at a rate of 10% to 14% rate, value add at a rate of 15% to 20%, and opportunistic and ground up projects at rates of 18% and up.
DUE DILIGENCE
In an acquisition of commercial real estate, Due Diligence refers to the buyer’s investigation of all aspect of the property in order to make an informed purchasing decision. The buyer conducts its Due Diligence not only during the Due Diligence Period but also during the days or months leading up to an offer to purchase.
Done correctly, Due Diligence is wide-ranging and thorough. To ensure nothing is missed, buyers and their teams of professionals typically follow a detailed Due Diligence checklist. In broad strokes, major Due Diligence items include a thorough physical and environmental inspection of the property; Excel modeling of future cash flows and return; and the review of survey and title, including underlying documents, entitlements and zoning, financial and accounting records, legal documents, including leases and vendor contracts, tenants, and any pending litigation.
DUE DILIGENCE PERIOD
With respect to a commercial real estate property acquisition, the Due Diligence Period typically is a specified period of time immediately after a purchase and sale agreement is executed. During this time, the buyer has the right to conduct its Due Diligence and decide whether or not to proceed with the acquisition.
The timing and scope of the Due Diligence Period are negotiated between the buyer and the seller and set forth in the purchase and sale agreement. The Due Diligence Period typically will be between 30 to 90 days. During the Due Diligence Period, the buyer is permitted to walk away from the transaction for any reason and receive a full refund of its earnest money deposit. As a result, the Due Diligence Period is often referred to as the buyer’s “free look period.” Most contracts, however, do provide that the buyer must pay the seller a stipulated nominal amount to have the right to walk away and receive a full refund of the earnest money deposit.
EQUITY MULTIPLE
The Equity Multiple is the total cash an investor can expect to receive over the life of his real estate investment divided by the amount of his investment. For example, an investor who puts $1,500,000 into a real estate investment and expects to receive $140,000 each year for the 5 years he plans to own and operate the property plus the return of his capital along with a profit of $800,000 when he sells the property would have an equity multiple equal to $3,000,000/$1,500,000 or 2X.
EXCEL MODEL
The Excel Model or Excel financial model is a representation of the projected financial performance of a real estate investment formulated in Excel. Creating an Excel financial model, often referred to as the Pro Forma, to evaluate a real estate investment or and development project is standard operating practice in commercial real estate.
EXIT CAP RATE
GOING-IN CAP RATE
Refers the Cap Rate paid at the time an asset is acquired.
Going-In Cap Rate = Projected first-year NOI/Purchase Price.
For example, an investor paying $1,500,000 for a rental property with a projected NOI of $97,000 has a Going-In Cap Rate of 6.47%. Going-in Cap Rates also can be used by developers evaluating new projects. For example, a multifamily development project with a total development cost of $10,000,000 and a projected stabilized NOI of $700,000 would have a Going-In Cap Rate of 7%. If the prevailing Cap Rate for a similar completed and stabilized apartment building was 5%, the developer may believe the project offers potentially attractive return.
INTERNAL RATE OF RETURN
The internal rate of return (IRR) is an estimate of the annualized return investors can expect to receive from their investments. The formula for the internal rate of return takes all of a project’s negative and positive cash flows and calculates the rate of return required to make the Net Present Value of those cash flows equal to zero. An example of an IRR calculation for an office investment is as follows:
Type - All cash purchase of an office building
Purchase Price - $1,000,000
Hold Period - 5 years
CF Year 1 - $100,000
CF Year 2 - $105,000
CF Year 3 - $110,000
CF Year 4 - $60,000
CF Year 5 - $120,000
Net Sales Proceeds Year 5 - $1,200,000
0 = ($1,000,000) + $100,000/(1+r) + $105,000/(1+r)2 + $110,000/(1+r)3 + $60,000/(1+r)4 + $1,320,000/(1+r)5
IRR = 13%
In commercial real estate, an investment’s IRR is one of the most commonly used metrics for evaluating the desirability of the investment. Investors are looking for an IRR that is commensurate with the level of risk involved in an investment. As a rule of thumb, investors look for a 6% to 10% return for core real estate investments, a 10% to 14% return for core plus, 15% to 20% for value add, and 18% plus for opportunistic and ground up projects.
While IRR is widely used in commercial real estate, there are drawbacks.
Investment Rate for Interim Cash Flows – The Internal Rate of Return formula implicitly assumes that all interim cash flows are reinvested at the internal rate of return. For example, in the IRR calculation above, the investor receives cash flow equal to $105,000 in year 2. The IRR calculation assumes that the $105,000 is reinvested at the project IRR of 10%. Where an investor is not able to invest the interim cash flows he receives at the project’s IRR, the IRR calculation overstates the return on the investment. Some analysts address this concern by using a modified internal rate of return (MIRR) which allows the analyst to specify the reinvestment rate. For a more in-depth discussion of this issue click here.
Multiple IRRs. Projects that have cash flows that switch from negative to positive more than once can have more than one solution that satisfies the IRR calculation. In these projects, it is preferable to use a Net Present Value analysis.
For a discussion of calculating IRR using Excel, click here.
LEVERAGE
Leverage refers to the percentage of debt that is used to finance a real estate transaction. Since the cost of equity almost always exceeds the cost of debt (positive leverage) in a real estate investment, the higher the leverage the greater the return to the equity investors. While positive leverage is a strong incentive for deal Sponsors to push Leverage, the higher the Leverage the greater a lender’s repayment risk. As a result, lenders limit the amount of debt they will provide to finance a given real estate investment. For example, Senior Lenders typically are comfortable with leverage in the range of 50% to 70%.
LTC OR LOAN-TO-TOTAL-COST
LTC is a measure of Leverage and refers to the amount of the loan over the total cost of the investment or project.
LTV OR LOAN-TO-TOTAL-VALUE
NOI or NET OPERATING INCOME
Net Operating Income or NOI is a measure of the cash flow before debt service generated by an income producing property. It is equal to total rent and other income minus all necessary and reasonable expenses and replacement reserves*. NOI is one of two variables found in the most commonly used method for valuing income-producing real estate.
Property Value = Projected 12-month NOI/Capitalization Rate
* In this formulation, NOI is net of replacement reserves. Many commentators do not believe replacement reserves should be deducted from NOI. For a good discussion of this topic click here.
NET PRESENT VALUE
Net Present Value (NPV) is a calculation that allows investors to make an apples-to-apples comparison of the amount of money they will need to invest in a project and the cash flow they expect to generate from their investment in a project. If the aggregate value in today’s dollars of the cash flows the investment is expected to generate equals or exceeds the aggregate value in today’s dollars of the amount invested, the project is worthy of investment. When considering among multiple projects, the project with the highest NPV should be chosen.
The NPV of a project is calculated by discounting to the present all outgoing cash flows (investment dollars) and incoming cash flows (cash generated from the investment) at a discount rate. The key to and trickiest part of determining NPV is in choosing the appropriate discount rate. The higher the discount rate the lower the investment’s NPV and therefore the less desirable the investment will appear.
In commercial real estate, the discount rate often used by analysts is the risk-adjusted rate of return required for the type of investment under consideration. The intuition here is that the riskier the project, the higher the discount rate. For example, the discount rate used for a CBD Class A office investment will be far lower than for a suburban office turnaround project. As a rule of thumb, core real estate investments require a 6% to 10% return, core plus a 10% to 14% return, value add, 15% to 20%, and opportunistic and ground up, 18% and up.
A simple example of an NPV analysis for an office investment is as follows:
Type - All cash purchase of an office building
Purchase Price - $1,000,000
Hold Period - 5 years
Discount Rate - 10%
CF Year 1 - $100,000
CF Year 2 - $105,000
CF Year 3 - $110,000
CF Year 4 - $60,000
CF Year 5 - $120,000
Net Sales Proceeds Year 5 - $1,200,000
NPV = ($1,000,000) + $100,000/(1+.1) + $105,000/(1+.1)2 + $110,000/(1+.1)3 + $60,000/(1+.1)4 + $1,320,000/(1+.1)5
NPV = $120,928
PARI PASSU
Pari Passu is a Latin phase and is used in law to denote that two or more parties are on equal footing. In a real estate transaction, Pari Passu is often used to denote that two or more classes of equity investors will be treated the same with respect to a specific deal term. For example, two classes of investors will be paid their Preferred Return Pari Passu.
PREFERRED RETURN
Preferred Return or “Pref” is a specified return that is paid to the equity investors. The Pref is paid from a deal’s cash profits, normally in first position under the Waterfall. Preferred Returns typically range from 8% to 10% of the amount of equity invested. The method of calculating the Preferred Return varies from a simple interest calculation to cumulative interest compounding on a monthly, quarterly, semi-annual or annual basis. The Pref also may be paid Pari Passu or to one class of equity investor ahead of another (i.e., outside investors may be paid their Pref before the Sponsor is paid a Pref on the cash it put into the deal).
PRO FORMA
The Pro Forma is another way of referring to the financial projections or Excel Model created to evaluate/Underwrite a real estate investment or development project.
PROMOTE
The Sponsor’s share of the profits for its Sweat Equity. In a typical commercial real estate deal, the Sponsor is the party that identified the investment opportunity and will have the day-to-day, hands-on responsibility for executing and realizing on the investment plan. The Sponsor also often contributes a small portion of the required cash equity (5% to 20% of the total equity in the transaction). The Sponsor’s equity contribution typically is entitled to the same return paid to the other equity investors. Over and above the return the Sponsor receives on its cash equity contribution, the Sponsor will receive a share of the profits for sourcing and managing the deal, so-called Promote or Sweat Equity return
RETURN HURDLES
Under a deal’s return Waterfall, cash profits first go to pay the Preferred Return and return invested capital; any remaining cash profits are then split between equity investors and the Sponsor to pay its Promote. The terms of the Waterfall often provide that the Sponsor receives a progressively more generous share of the cash profits as certain predetermined return metrics (“Hurdle Rates”) are met. Hurdles Rates normally are based on cash equity investors receive 80% of the cash profits and the Sponsor receives 20%, until the cash investors have received a total IRR of 15%; then 70% of cash profits to the cash investors and 30% to the Sponsor, until the cash investors have received a total IRR of 18%; and thereafter the remaining cash profits will be split 60% to the cash equity investors and 40% to the Sponsor.
SPONSOR
The basic financial structure of a commercial real estate deal involves three parties: 1) the Sponsor; 2) the equity capital partner(s), providing the bulk of the equity; and 3) the lender(s), providing the debt financing. The Sponsor will be an organization in the business of investing and/or developing and operating commercial real estate. The Sponsor will be the party in the deal that initially identified the opportunity; persuaded the equity capital partner(s) and lender(s) to provide financing; and will have the day-to-day, hands-on responsibility for executing and realizing on the investment plan.
SWEAT EQUITY
See Promote
UNDERWRITING
Underwriting in the context of a real estate debt or equity deal refers to a careful and typically detailed evaluation of the transaction’s potential risks and returns. The scope and factors taken into consideration in an underwriting will depend upon the type of investment and the details and uncertainties involved. Some factors commonly considered in an underwriting include the quality and experience of the Sponsor, the state of the relevant real estate market, the viability of the development or investment plan, the financial projections and assumptions, the comparable property analysis, and the appraisal.
WATERFALL
A Waterfall refers to the disbursement of cash profits to the equity investors and to the Sponsor to pay its Promote. Note that the equity investors will include passive equity investors as well as the Sponsor to the extent of the cash the Sponsor actually put into the deal (often ranging from 5% to 20% of the total equity invested).
How the cash profits are to be disbursed will be set forth in deal’s Limited Liability Company or Limited Partnership Agreement. Typically, 100% of the cash profits first go to pay a Preferred Return to the equity investors; then, second, to return the equity investors’ original investment; and third, to be allocated between the equity investors and the deal Sponsor to pay the Sponsor’s Promote. Click here to view a sample Waterfall provision.