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Cap Rates, and Classes, and ROI, Oh my...

Real Estate lingo doesn't have to be confusing.

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Perhaps one of the hardest parts of real estate investing for new investors is understanding the terms we use. In this article, we are going to demystify some of the more common terms that you should be familiar with before starting your investment journey.

PROPERTY TERMS

Properties are classified by several different terms. These include property type and class.

PROPERTY TYPES

  • SFR (Single Family Residential) - A single family home.

  • Multifamily - Broadly describes any residential building that has more than one dwelling unit. These can range from duplexes up to 100+ unit high-rises.

  • Mixed Use - Describes a building that has both commercial and residential units in the same building. For instance, a downtown building with a store on ground level and apartments above.

  • Commercial - Any building not used for residential or manufacturing (industrial). Office buildings, retail stores, and strip malls fall into this category.

PROPERTY CLASS

Properties, excluding single family residential,  are also described by their class. A buildings class loosely defines a combination of their quality, location, tenant profile, and investment characteristics.

 While the exact definitions may vary slightly depending on the region or market, generally, commercial properties are divided into three main classes:

 

 

Class A

  • Class A properties are considered the highest quality and most desirable buildings in their market.

  • They are typically newer or recently renovated buildings with modern amenities, high-quality construction, and prime locations in major business districts or affluent areas.

  • Class A properties attract prestigious tenants, such as multinational corporations, high-end retailers, and upscale restaurants.

  • They tend to command the highest rents and have the lowest vacancy rates compared to other classes.

  • Class A properties are often well-maintained and professionally managed.

Class B

  • Class B properties are considered to be of good quality but may be older or require some updates or renovations.

  • They are generally located in decent or desirable areas but may not be as prime as Class A properties.

  • Class B properties may have fewer amenities and slightly lower rents compared to Class A buildings.

  • These properties often attract a diverse range of tenants, including small to mid-sized businesses, startups, and professional services.

  • While Class B properties may offer attractive investment opportunities with potential for value-add strategies, they may also entail more management and maintenance efforts compared to Class A properties.

Class C

  • Class C properties are typically older buildings that may require significant renovations or improvements.

  • They are located in less desirable or transitional areas with lower demand and lower rents.

  • Class C properties often have outdated infrastructure, limited amenities, and may require ongoing maintenance and repairs.

  • These properties tend to attract tenants with lower budgets, such as small businesses, local retailers, or service providers.

  • Class C properties may offer investors the potential for higher yields through repositioning or redevelopment efforts, but they also carry higher risks due to their condition and location.

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FINANCIAL TERMS

As investment sponsors, when we evaluate an opportunity we look at several different financial metrics to decide if the opportunity will make a good deal for our investor team.

Cap Rate

 

Short for "capitalization rate".  It is the expected return on investment on an income producing property, assuming the property was bought for all cash. It is used as a first pass to determine if the asking price on the property is in line with comparable properties of the same class in the same market.

Cap Rates vary by market, but in general Class A properties have the lowest Cap Rates, often in the 1-3% range, and Class C properties have the highest, sometimes exceeding 10%.  This reflects the lower resale value of the Class C property due to the location and condition.

Example

An apartment building purchased for $1,000,000 cash that produces $50,000 of net profits each year after all operational expenses are paid, would have a Cap Rate of 5% ($50,000 profit / $1,000,000 invested).

If comparable apartment buildings in the area had an average Cap Rate of 6%, this building is likely overpriced for the market.

ROI - Return On Investment

 

How much cash your investment will make while it is invested in a deal. This can be calculated as an overall return or an average annual return.

Example

You invest $50,000 in a deal for 3 years. The property produces $2,000 cash flow the first year, $4,500 cash flow the second year, and $14,000 in profit from the sale in the third year.

We can look at your ROI in several ways.

If we look at each year by itself, the annual returns look like this:

We can also add up all of the returns and divide it by the original investment to get the Total Return on Investment.

If we divide the Total Return on Investment by the number of years the original amount was invested we get the Average Annualized Return on your original investment.

When evaluating an investment opportunity, you should consider the Average Annual ROI and decide if the investment will outperform other investments that you could put your money into for the same time period.

Pref

Some deals will offer a Pref or preferred rate of return to their limited partners. A pref is a minimum annual ROI that the sponsor is offering the limited partners on the deal. This return is paid out of the annual profits before any profits are shared with the sponsor or general partners.

Example

XYZ Properties has an opportunity that is offering a 6% Pref to the limited partners. You invest $50,000.

XYZ Properties will owe you a minimum return of 6% ($3,000) each year you invest with them.

If the first year profits are $10,000, XYZ will pay you the pref first from the profits. The remaining profits will be split between the limited partners and general partners according to the terms of the operating agreement for the deal.

Typically, if there are not enough profits to cover the pref, the balance owed will be recorded (accrued) on the limited partners account for future payment when the funds are available. This may happen during the first year of operation while the sponsor is repairing and remodeling the property for better value.

SYNDICATION TERMS

LLC

Limited Liability Company. A legal structure where each owner is a "member" and the extent of their legal and financial liability is limited to the amount of capital they invested in the company.

Operating Agreement

 

An operating agreement is a legal document that outlines the ownership and operating procedures of a limited liability company (LLC).

 

It serves as the governing document for the LLC, detailing how the business will be managed, how profits and losses will be allocated among members, voting rights, responsibilities of members and managers, procedures for adding or removing members, and other important aspects of the LLC's operation.

Private Placement Memorandum

A Private Placement Memorandum (PPM) is a legal document used to raise capital from investors. It provides potential investors with all the necessary information to make an informed decision about whether to invest in the company.

The PPM provides detailed information about the company, its business model, management team, financial projections, risks, and terms of the investment being offered. It typically includes information about the securities being offered, such as shares of stock or membership interests in the company (for LLCs), as well as details about how the investment will be structured, including any potential returns or dividends.


 

 

 

Subscription Agreement

A real estate subscription agreement is a contract between an investor and a real estate investment entity, such as a limited liability company (LLC), through which the investor agrees to invest a certain amount of money in the entity in exchange for an ownership interest or membership units.

The subscription agreement outlines the terms and conditions of the investment, including the amount of the investment, the percentage of ownership or membership units allocated to the investor, any rights or privileges associated with the investment, and the responsibilities of the investor and the real estate entity.

 

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If you would like to learn more about investing in real estate to build wealth using your savings, HELOC, or 401k/IRA funds, feel free to contact us. We would love to talk about investment  strategies and share our experience to help you leverage your resources to achieve financial success.

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