Resource for Passive Investors
Important Terminology
Passive Investor resources are courtesy of Joe Fairless. All information and more is available at the link to the right.
An accredited investor is a person that can invest in securities (i.e. invest in an apartment syndication as a limited partner) by satisfying one of the requirements regarding income or net worth. The current requirements to qualify are an annual income of $200,000 or $300,000 for joint income for the last two years with expectation of earning the same or higher or a net worth exceeding $1 million either individually or jointly with a spouse.
An apartment syndication is a temporary professional financial services alliance formed for the purpose of handling a large apartment transaction that would be hard or impossible for the entities involved to handle individually, which allows companies to pool their resources and share risks and returns. In regards to apartments, a syndication is typically a partnership between general partners (i.e. the syndicator) and the limited partners (i.e. the investors) to acquire, manage and sell an apartment community while sharing in the profits.
A sophisticated investor is a person who is deemed to have sufficient investing experience and knowledge to weigh the risks and merits of an investment opportunity.
The general partner (GP) is an owner of a partnership who has unlimited liability. A general partner is also usually a managing partner and active in the day-to-day operations of the business. In apartment syndications, the GP is also referred to as the sponsor or syndicator. The GP is responsible for managing the entire apartment project.
The limited partner (LP) is a partner whose liability is limited to the extent of the partner’s share of ownership. In apartment syndications, the LP is the passive investor and funds a portion of the equity investment.
Capital expenditures, typically referred to as CapEx, are the funds used by a company to acquire, upgrade and maintain an apartment community. An expense is considered to be a capital expenditure when it improves the useful life of an apartment and is capitalized – spreading the cost of the expenditure over the useful life of the asset.
Capital expenditures include both interior and exterior renovations.
Examples of exterior CapEx are repairing or replacing a parking lot, repairing or replacing a roof, repairing, replacing or installing balconies or patios, installing carports, large landscaping projects, rebranding the community, new paint, new siding, repairing or replacing HVAC and renovating a clubhouse.
Examples of interior CapEx are new cabinetry, new countertops, new appliances, new flooring, installing fireplaces, opening up or enclosing a kitchen, new light fixtures, interior paint, plumbing projects, new blinds and new hardware (i.e. door knobs, cabinet handles, outlet covers, faucets, etc.).
Examples of things that wouldn't be considered CapEx are operating expenses, like the costs associated with turning over a unit (i.e. paint, new carpet, cleaning, etc.), ongoing maintenance and repairs, ongoing landscaping costs, payroll to employees, utility expenses, etc.
Operating expenses are the costs of running and maintaining the property and its grounds.
For example,
Payroll
Maintenance
Contract Services
Turn/Make Ready
Advertising
Admin
Utilities
Mgmt Fees
Taxes
Reserves
Insurance
Debt service is the annual mortgage paid to the lender, which includes principal and interest. Principal is the original sum lent and the interest is the charge for the privilege of borrowing the principal amount.
Net operating income (NOI) is all revenue from the property minus operating expenses, excluding capital expenditures and debt service.
Capitalization rate, typically referred to as cap rate, is the rate of return based on the income that the property is expected to generate. The cap rate is calculated by dividing the property’s net operating income (NOI) by the current market value or acquisition cost of a property (cap rate = NOI / Current market value)
Price per unit is the cost of purchasing an apartment community based on the purchase price and the number of units. The price (or cost) per unit is calculated by dividing the purchase price by the number of units.
Cash flow is the revenue remaining after paying all expenses. Cash flow is calculated by subtracting the operating expense and debt service from the collected revenue
Closing costs are the expenses, over and above the price of the property, that buyers and sellers normally incur to complete a real estate transaction.
Examples of closing costs are origination fees, application fees, recording fees, attorney fees, underwriting fees, credit search fees and due diligence fees.
Financing fees are the one-time, upfront fees charged by the lender for providing the debt service. Also referred to as a finance charge. Typically, the financing fees are 1.75% of the purchase price.
The operating account funding is a reserves fund, over and above the price of the property, to cover things like unexpected dips in occupancy, lump sum insurance or tax payments or higher than expected capital expenditures. The operating account fund is typically created by raising extra money from the limited partners.
The equity investment is the upfront costs for purchasing an apartment community, which includes the down payment for a loan, closing costs, financing fees, operating account funding, and the various fees paid to the general partner for putting the deal together. May also be referred to as the initial cash outlay or the down payment
Breakeven occupancy is the occupancy rate required to cover the all of the expenses of an apartment community. The breakeven occupancy rate is calculated by dividing the sum of the operating expenses and debt service by the gross potential income.
For example, a 216-unit apartment community with $1,166,489 in operating expenses, $581,090 in debt service and $2,263,624 in gross potential income has a breakeven occupancy of 77.2%
The physical occupancy rate is the rate of occupied units. The physical occupancy rate is calculated by dividing the total number of occupied units by the total number of units.
The gross rent multiplier (GRM) is the number of years the apartment would take to pay for itself based on the gross potential rent (GPR). The GRM is calculated by dividing the purchase price by the annual GPR.
A rent premium is the increase in rent after performing renovations to the interior or exterior of an apartment community. The rent premium is an assumption made by the general partner during the underwriting process based on the rental rates of similar units in the area or previously renovated units.
The debt service coverage ratio (DSCR) is a ratio that is a measure of the cash flow available to pay the debt obligation. DSCR is calculated by dividing the net operating income by the total debt service. A DSCR of 1.0 means that there is enough net operating income to cover 100% of the debt service. Ideally, the ratio is 1.25 or higher. An apartment with a DSCR too close to 1.0 is vulnerable, and a minor decline in cash flow would result in the inability to service (i.e. pay) the debt.
For example, a 216-unit apartment community with an annual debt service of $581,090 and a NOI of $960,029 has a DSCR of 1.65.
The interest rate is the amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of their funds
An interest-only payment is the monthly payment on a loan where the lender only requires the borrower to pay the interest on the principal as opposed to the typical debt service, which requires the borrower to pay principal plus interest
A bridge loan is a mortgage loan used until a person or company secures permanent financing, which are short-term (6 months to three years with the option to purchase an additional 6 months to two years). They generally have a higher interest rate and are almost exclusively interest-only. Also referred to as interim financing, gap financing or swing loan. The loan is ideal for repositioning an apartment community.
A permanent agency loan is a long-term mortgage loan secured from Fannie Mae or Freddie Mac and is longer-term with lower interest rates compared to bridge loans. Typical loan term lengths are 5, 7 or 10 years amortized over 20 to 30 years
A prepayment penalty is a clause in a mortgage contract stating that a penalty will be assessed if the mortgage is paid down or paid off within a certain period.
A refinance is the replacing of an existing debt obligation with another debt obligation with different terms. In apartment syndication, a distressed or value-add general partner may refinance after increasing the value of a property, using the proceeds to return a portion of the limited partner's equity investment.
Appreciation is an increase in the value of an asset over time. There are two main types of appreciation: natural and forced. Natural appreciation occurs when the market cap rate “naturally” decreases. Forced appreciation occurs when the net operating income is increased (either by increasing the revenue or decreasing the expenses).
Appreciation is one of the factors included in the Three Immutable Laws of Real Estate Investing. Click here to learn more about all three laws and their importance when investing in real estate.
Ration Utility Billing System (RUBS) is a method of calculating a tenant’s utility bill based on occupancy, apartment square footage or a combination of both. Once calculated, the amount is billed back to the resident, which results in an increase in revenue.
Property and neighborhood classes is a ranking system of A, B, C, or D given to a property or a neighborhood based on a variety of factors. These classes tend to be subjective, but the following are good guidelines:
Property Classes
Class A: new construction, command highest rents in the area, high-end amenities
Class B: 10 – 15 years old, well maintained, little deffered maintenance
Class C: built within the last 30 years, shows age, some deferred maintenance
Class D: over 30 years old, no amenity package, low occupancy, needs work
Neighborhood Class
Class A: most affluent neighborhood, expensive homes nearby, maybe have a golf course
Class B: middle class part of town, safe neighborhood
Class C: low-to-moderate income neighborhood
Class D: high crime, very bad neighborhood
Preferred Return: the threshold return that limited partners are offered prior to the general partners receiving payment.
Distributions are the limited partner's portion of the profits, which are sent on a monthly, quarterly or annual basis, at refinance and/or at sale.
The sales proceeds are the profit collected at the sale of the apartment community.
The internal rate of return (IRR) is the rate, expressed as a percentage, needed to convert the sum of all future uneven cash flow (cash flow, sales proceeds and principal pay down) to equal the equity investment. IRR is one of the main factors the passive investor should focus on when qualifying a deal.
The cash-on-cash (CoC) return is the rate of return, expressed as a percentage, based on the cash flow and the equity investment. CoC return is calculated by dividing the cash flow by the initial investment.
Equity Multiplier (EM) is the rate of return based on the total net profit (cash flow plus sales proceeds) and the equity investment. EM is calculated by dividing the sum of the total net profit and the equity investment by the equity investment.
The market rent is the rent amount a willing landlord might reasonably expect to receive, and a willing tenant might reasonably expect to pay for a tenancy, which is based on the rent charged at similar apartment communities in the area. Market rent is typical calculated by performing a rent comparable analysis.
The is the hypothetical amount of revenue if the apartment community was 100% leased year-round at market rental rates.
The gross potential income is the hypothetical amount of revenue if the apartment community was 100% leased year-round at market rates plus all other income.
Loss to lease (LtL) is the revenue lost based on the market rent and the actual rent. LtL is calculated by dividing the gross potential rent minus the actual rent collected by the gross potential rent.
Bad debt is the amount of uncollected money a former tenant owes after move-out.
Concessions are the credits (dollars) given to offset rent, application fees, move-in fees and any other revenue line time, which are generally given to tenants at move-in.
A model unit is a representative apartment unit used as a sales tool to show prospective tenants how the actual unit will appear once occupied.
An employee unit is a unit rented to an employee at a discount or for free
The vacancy rate is the rate of unoccupied units. The vacancy rate is calculated by dividing the total number of unoccupied units by the total number of units.
Vacancy loss is the amount of revenue lost due to unoccupied units.
Effective gross income (EGI) is the true positive cash flow of an apartment community. EGI is calculated by the sum of the gross potential rent and the other income minus the income lost due to vacancy, loss-to-lease, concessions, employee units, model units and bad debt.
The economic occupancy rate is the rate of paying tenants based on the total possible revenue and the actual revenue collected. The economic occupancy rate is calculated by dividing the actual revenue collected by the gross potential income.
The subject property is the apartment the general partner intends on purchasing.
Underwriting is the process of financially evaluating an apartment community to determine the projected returns and an offer price.
A pro-forma is the projected budget of an apartment community with itemized line items for the income and expense for the next 12 months and 5 years, which is an output of the underwriting.
The rent roll is a document or spreadsheet containing detailed information on each of the units at the apartment community, along with a variety of data tables with summarized income.
The is a document or spreadsheet containing detailed information about the revenue and expenses of the apartment community over the last 12 months. Also referred to as a trailing 12-month profit and loss statement or a T12.
The exit strategy is the plan of action for selling the apartment community at the end of the business plan.
The rent comparable analysis is the process of analyzing similar apartment communities in the area to determine market rents of the subject apartment community.
The submarket is a geographic subdivision of a market.
A metropolitan statistical area (MSA) is a geographical region containing a substantial population nucleus, together with adjacent communities having a high degree of economic and social integration with that core, which are determined by the United States Office of Management and Budget (OMB).
The acquisition fee is the upfront fee paid by the new buying partnership entity to the general partner for finding, analyzing, evaluating, financing and closing the investment. Fees range from 0.5% to 5% of the purchase price, depending on the size of the deal.
The asset management fee is an ongoing annual fee from the property operations paid to the general partner for property oversight. Generally, the fee is 2% of the collected income or $250 per unit per year.
The property management fee is an ongoing monthly fee paid to the property management company for managing the day-to-day operations of the property. This fee ranges from 2% to 10% of the total monthly collected revenues of the property, depending on the size of the deal.
The refinancing fee is a fee paid for the work required to refinance the property. At closing of the new loan, a fee of 0.5% to 2% of the total loan amount is paid to the general partner.
The guaranty fee is a fee paid to a loan guarantor at closing. The loan guarantor guarantees the loan. At closing of the loan, a fee of 0.25% to 1% of the principal balance of the mortgage loan is paid to the loan guarantor
The private placement memorandum (PPM) is a document that outlines the terms of the investment and the primary risk factors involved with making the investment. The four main sections are the introduction, which is a brief summary of the offering, the basic disclosures, which includes general partner information, asset description and risk factors, the legal agreement and the subscription agreement
Once the deal is closed, the general partner (GP) should send consistent updates on the status of the deal. You may receive updates once a month, which is what my company does. However, some GPs provide quarterly updates. Others provide annual updates. And some don’t provide updates at all. The best update frequency will depend on your preference.
In regards to the information included in the update, this varies from GP to GP. Our monthly reports include occupancy rates, updates on the number of renovated units, details on our rental premiums and how they compare to our projections, capital expenditure updates, relevant updates on the market and resident events. Each quarter, we provide a link to the apartment’s financial statements, which include the T12 and the rent roll.
Overall, you want to know the status of the business plan and how the rents compare to the projections.
General partners should NEVER guarantee a return. If they do, run! Any return offered, like a preferred return, should be a projection, never a promise.
Ideally, the general partners projected returns exceed the preferred return offered. That way, if they don’t achieve the projected returns, they still distribute the full preferred return. If the actual returns end up being lower than the preferred return, the process is that which was agreed to in the PPM. Generally, the preferred return will accrue until it can be paid with the sales proceeds.
Similar to the question about “what happens if the project fails?”, if the general partner (GP) says there are no risks, they are either lying or inexperienced.
The three risk areas associated with apartments are the deal, the market and the team. Therefore, ask the GP about the risks associated with these three areas and what they are doing to mitigate them.
You should also determine if they are following the Three Immutable Laws of Real Estate Investing, which are the laws that must be followed in order to mitigate risk, especially in a down economy.
Before investing in a deal, the general partner (GP) should provide you with the projected timeline, which includes the hold period and the exit strategy of the project. Generally, that is 5 years, and the GP will require you to keep your capital in the deal until the deal sells.
This varies. But if there is a process for pulling your money out of the deal, it will be outlined in the PPM. The process usually entails you selling your shares to another party with the written consent of the general partner.
Generally, the general partner (GP) will make money via the acquisition fee, ongoing asset management, equity ownership in the deal and whatever else they decide to charge. All of the fees they charge should be listed in the PPM.
After determining which fees they charge, ask them why. They should only charge fees based on the value they provide to the deal. If they can’t explain what value they are providing for each fee, then they shouldn’t be charging that fee.
Click here to learn the seven most common fees the GP may charge.
Ideally, the general partner (GP) has their own funds in the deal because there is an extra level of alignment of interests. If you lose money, the GP loses money. If the GP doesn’t invest in the deal, they aren’t exposed to the same risks as you. Additionally, the GP investing in the deal signals to you that they are confident in the deal and the projected cash-on-cash return and IRR, or whichever return factor they base their investment decision on.
The distribution frequency varies and depends on the preference of the general partner and what their team is capable of doing from an administrative standpoint.
The typical frequencies are monthly, quarterly or annually. My company found that the majority of our investors preferred monthly distributions, so that’s what we decided to do. So, we aim to distribute the preferred returns on a monthly basis and any profit above and beyond the preferred return is distributed every 12 months. Most likely, you will receive a your monthly, quarterly, or annual distribution 30 to 45 days after the end of the period. For example, if you receive monthly distributions, you would receive the distribution for March at the end of April.
Then, you will receive your initial equity investment plus profits from the sales proceeds at the end the sale.
Most general partners (GP) will have a minimum investment. The more experience they GP has and the larger the project, the higher the minimum.
You want to know what the minimum investment is so that you can determine if you are financially capable of investing in the deal.
The maximum amount of money the GP will likely allow you to invest is typically 19% of the total equity investment. Anything greater than 19% and the passive investor is underwritten by the lender, and they usually don't want that happening.
If the syndication is a 506b offering, you don’t need to submit your financials. If it is a 506c offering, you will.