Knowledge of things and knowledge of the words for them grow together. If you do not know the words, you can hardly know the thing."
― Henry Hazlitt
In issue number #2, we went over the first ten multifamily investing terms you need to have a solid foundation either as a passive investor or aspiring syndicator. Now that you have the basics down pat, it's time to step up your multifamily game with the next ten terms that will continue your development into an informed investor or deal maker.
While the first set of words were meant to provide you conceptual understanding, to give you the big picture, with this set of words, we will zoom in a bit and focus more on the nuts and bolts of the business.
Like the last list, there may be disagreement on the inclusion of some words and the omission of others, but short of publishing a real estate dictionary, I had to limit it at some point.
1. Offering Memorandum- Product from a broker that markets a property for sale. Like any property listing, it will highlight the features of the property, such as the number of units, condition, and building materials.
Unlike traditional property listings though, they will often show potential improvements, investment returns, and detailed descriptions of the surrounding area's employment and entertainment.
2. Letter of Intent (LoI)- This is the document that communicates to a broker or seller your intent to place an offer on a property along with the proposed terms. It's important to note that at this stage, the offer is non-binding.
3. Private Placement Memorandum (PPM)- A legal document providing investors all the information required to make an informed decision. It details the investment opportunity, disclaims legal liabilities, and explains the risk of loss.
Because securities lawyers are required to draft PPMs, this can be one of the more expensive administrative aspects of putting together a syndication, costing anywhere between $10,000- $40,000.
4. Underwriting- The financial analysis of a property to determine the appropriate offer price and potential returns. Because there are so many variables and assumptions involved, this is not an exact science.
When underwriting, the best advice is to be conservative to provide a cushion for all the unknowns (like a pandemic, for example). If reviewing a deals underwriting, ask the sponsor what assumptions they used and why.
5. Due Diligence- The process of confirming the information provided by the seller and uncovering any details that may alter your underwriting or assumptions.
I will certainly do an issue on this topic because there are so many components, but examples include verifying occupancy and reported rental income by reviewing the rent rolls and trailing 12 months of income.
Due diligence should also include verifying the physical state of the building by conducting inspections of every unit and potential large capital expenditures like roofs.
6. Capitalization Rate (Cap Rate)- The rate of return that is expected to be generated on a real estate investment property. The formula for this one is relatively simple; Cap Rate= Net Operating Income ÷ Property Market Value.
I think this is a metric that many new passive investors and syndicators get hung up on. I was a victim of this myself. It's important to understand there is not necessarily a "good cap rate."
While a higher cap rate may indicate a higher rate of return, it also indicates a higher level of risk. One investor may be fine with buying a property in a class D war zone that is a 12% cap, whereas the perfect property for a more risk-averse investor may be a new build class A property at a 4% cap.
7. Cash-on-Cash (CoC) Return- This is the rate of return based on the original investment and the cash flow produced. The formula is CoC Return = Annual Pre-Tax Cashflow ÷ Total Cash Invested.
To illustrate, let's assume you have a 100-unit building selling for $10 million. The initial investment by the investors and syndicator will be $2 million, with the bank taking care of the rest. If our NOI after the first year minus the debt service (but not the tax) is $500k. So what is our CoC Return? 500,000 ÷ 2,000,000= .25 or 25%.
This is a vast oversimplification, but any syndicator worth their salt should be able to tell you what the CoC return is on the deal given their assumptions and projections. In most deal presentations, you will also see the projected CoC Return for individual investors based on typical investment amounts ($50k, $100k, etc.)
If you would like to dive deep into Cash-on-Cash return and the multiple variables that can be considered, I recommend checking out Investopedia's explanation.
8. Preferred Return- The threshold return offered to limited partners before general partners receive payment. Just think of this as the syndicator's way of telling investors, "You get paid before I get paid."
A fairly common practice is to offer passive investors a 6-8% preferred return paid monthly or quarterly on their investment. If profits are such that the threshold is met and investors are given their preferred rate of return, then the general partners may receive a pre-determined percentage of the remaining profits.
9. Internal Rate of Return (IRR)- This one can get a bit complicated but stick with me. Essentially, it is the annual rate of growth an investment is expected to generate over time. The keyword there is "expected."
Because IRR is determined based on projected returns over multiple years, the actual returns will most likely differ. So like any metric for the quality of an investment, it shouldn't be taken in isolation.
10. Exit Strategy- This is precisely what it sounds like, the syndicators plan to return back to investors their original capital.
A common exit strategy is to take the business plan to completion and then sell the property at a price high enough to return investor equity and split the remaining profit.
Another common alternative is for the deal sponsors to refinance the property, pulling out cash from the equity that has been built so they can repay investors but hold on to the property.
Conclusion
If you know and understand the first 20 words I've presented, then you will certainly know enough to be dangerous. Like any pursuit of expertise, there is no finish line when it comes to your understanding of multifamily investing. There is always more to learn and new aspects to explore.
Just remember, at a certain point, blogs, books, and podcasts can only teach you so much; beyond that point, experience becomes your most valuable teacher and you need to jump into the fire. (I meant that figuratively, so please don’t jump into actual fire)
There's plenty more to come in future posts, so make sure you click here to subscribe. I'll let you know when new posts are out and provide valuable "pro-tips" associated with that week's topic.
Ready to start passively investing in multifamily real estate and want to see if our opportunities might be a good fit for you? Click here to visit our website to learn more or reach out to me directly at Tim@ZANAinvestments.com.
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