A term by term guide to understanding the fundamentals of apartment syndication.
The world of apartment syndication is one of much depth. With an extensive list of involved parties, including the general partner, limited partner(s), investors, property management group, broker, legal team, etc., and an even more extensive list of steps involved, the apartment syndication process is one that is VERY easy to get lost in. My purpose for compiling this list was to provide a solid foundation of knowledge for those interested in this aspect of real estate. These terms will help you navigate through all things apartment syndication, as well as real estate as a whole.
1. An assumption fee a fee that the buyer of a property with an assumable mortgage pays to the lender (usually a bank) for the ability to take over the mortgage, often included in the closing costs. ~1% is common here.
2. A capital account is an account that tracks each owner/partner’s equity in an asset. Calculation: (Partners Equity) = (Contributions) + (Allocations) – (Distributions)
3. Capital expenditures (CapEx) represents the money spent by a company in order to acquire or maintain/extend the useful life of an asset/property. CapEx should not be confused with operating expenses, which are short term expenses required to meet the basic ongoing operational cost of running the property. They are expensed using depreciation over the life of the asset, while operating expenses are fully tax-deductible in the year they are incurred.
4. The capitalization rate (CAP) is a rate of return on a real estate investment property based on the expected income that the property will generate. It is used to estimate the investor’s potential return on their investment. When acquiring a property, a higher CAP is better. When selling, a lower CAP is better. A higher CAP implies a lower price, and vice versa. Calculation: (CAP) = (NOI) / (Total Asset Value).
Example: Assume we buy an apartment for $1M and the annual return is $60K, then the CAP is (60,000) / (1,000,000) = .06, or 6%.
5. Cash flow is the cash generated from the operations of a company. Calculation:(Cash Flow) = (Revenue) – (All Operating Expenses).
Example: Assume your duplex has annual revenue of $36,000. Now assume you have operating expenses of $26,000 (debt service, insurance, CapEx, vacencies, etc), then the cash flow is ($36,000) – ($26,000) = $10,000/yr, or $833/mo.
6. The Cash-on-Cash return (CoC) is a rate of return, often used in real estate transactions, that determines the cash income on, or in proportion to, the cash invested. Calculation: (CoC) = (Annual Cash Flow) / (Total Equity Invested).
Example: Assume you invest $100K into an apartment syndication deal and realize a return of $8K annually, then the CoC is (8,000) / (100,000) = .08, or 8%.
7. The debt service coverage ratio (DSCR) is the multiples of cash flow available to meet annual interest and principal payments on debt. A bank will typically want to see 1.2x – 1.4x here. Anything under 1.0x would imply that there is not enough cash flow to cover debt service. Calculation: (DSCR) = (NOI) / (Total Debt Service).
Example: Assume a NOI of $120,000 and a debt service, or annual note, or $100,000, then the DSCR is (120,000) / (100,000) = 1.2x.
8. Defeasance allows the cancellation of a mortgage upon repayment of the loan through substitution of collateral.
9. The term disposition refers to the sale of an asset (property).
10. Economies of scale (Economies), relative to real estate, is the increased cost advantage associated with the increase in number of units.
Example: Assume an investor is renovating a SFH and needs to purchase a washer and dryer. She goes to Home Depot and purchases a modest set for $700. Now assume another investor is renovating a MFH with 100 units and also needs a washer and dryer for each unit, but his contractor is able negotiate a price of $55,000 for all 100 sets. This equates to $550/set, saving him $150 per. This is the beauty of economies of scale.
11. An equity multiple represents the total cash distributions received from an investment in proportion to the total equity invested. A value less than one implies that the investment loses money, while a value greater than one implies the investment makes money. Calculation: (Equity Multiple) = (Total Cash Distributions) / (Total Equity Invested).
Example: Assume and equity multiple of 2.5x. This implies that for every $1 invested, you receive $2.5 in return (over the life of the investment).
12. The fair market value (FMV) is the selling price (or market value) of a property. Calculation: (FMV) = (NOI) / (CAP).
Example: Assume that a property generates $1M in NOI and that the CAP rate is 6%, then the FMV is (1,000,000) / (.06) = $16,666,666.
13. Forced appreciation is the increase in market value through an increase in NOI, which is forced by an increase in income or a decrease in expenses.
Example: Assume a starting point of $1M NOI and a 6% CAP which equates to a FMV of $16.67M. Now assume income is increased through the addition of covered car ports that bring an additional $100K per year. Our new NOI is $1.1M, and thus the new FMV is (1,100,000) / (.06) = $18,333,333. Appreciation was forced on the asset by driving up NOI.
14. The gross rent multiplier (GRM) is the price of the property in proportion to its potential gross income. The GRM is commonly used to compare potential investments and/or to determine if the listing price of a property is fair. Calculation:(GRM) = (FMV) / (Potential Gross Income).
Example: Assume a property, which is valued at $5M, has potential gross income of $500K, then the GRM is (5,000,000) / (500,000) = 10x.
15. A K-1 tax form allows a company to utilize pass-through taxation, which shifts the income tax liability from the entity earning the income to those who have a beneficial interest in it.
Example: In the case of apartment syndication, the general partner would pass on the tax liability to the limited partners (investors).
16. The internal rate of return (IRR) is the discount rate at which the net present value (NPV) of a set of cash flows equals zero. Simply put, it is the rate at which a real estate investment grows or shrinks. Another way to think of IRR is as a time sensitive compounded annual rate of return; the investment grows/shrinks by X% per year, evenly, over the life of the investment.
17. A metropolitan statistical area (MSA) servers to group counties and cities into specific geographic areas for the purpose of a population census and the compilation of related statistical data.
18. The net operating income (NOI) is the annual income that a property generates after accounting for ALL expenses. NOI does not account for debt services, depreciation or CapEX. Calculation: (NOI) = (Gross Rent) – (Vacancy & Credit Losses) + (Other Income) – (Operating Expenses).
19. The operating expense ratio (OER), or Expense Ratio, is the cost of operating a property in proportion to the income that the property generates. This measure can be used over time in comparison with that of other properties to help determine relative operating efficiency. Calculation: (OER) = (Operating Expenses) / (Gross Income).
Example: Assume a property generates gross income of $100,000 and has operating expenses of $60,000, the OER is (60,000) / (100,000) = .6 or 60%.
20. A preferred return (Pref) is a first claim on profits (promised to investors) until a target return has been achieved. This helps minimize risk to investors and thus makes the investment more attractive.
Example: Assume an individual invests $100K in an apartment syndication deal and also assume that the general partner promised an 8% pref, this means that the investor will receive $8K cash flow annually before the general partner receives any payout (assuming sufficient cash flow).
21. A private placement memorandum (PPM), sometimes referred to the offering memorandum, is a legal document that is provided to prospective investors that details the offering; the description of the company and how it will be managed, the use of proceeds, the risks of the investment, and the subscription terms, among other things.
22. Pro forma is a method by which financial results are calculated. The typical pro forma that one will see in an apartment syndication deal will forecast anticipated results for future years.
23. Used properly, a ratio utility billing system (RUBS) allows for the owner or property manager of a property to divide a utility bill (water, electricity, waste services, etc.), which may otherwise be charged as a whole, among residents based on occupancy factors, square footage, or a combination of both. This can dramatically decrease expenses, driving up NOI.
24. To reposition a property is a strategy in which the owner, or general partner, of a property aims to change the position of the asset in a market through adding value and/or rebranding the property.
25. A return hurdle is the rate of return that, when achieved, triggers a disproportionate profit split. For an example, see #34. Common return hurdles are pref, IRR, and equity multiple.
26. Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. Calculation: (ROE) = (Net Income) / (Shareholder’s Equity).
27. The reversion CAP is the expected CAP rate at the end of an investment (or disposition of a property). It is the benefit that an investor expects to receive at the time of sale.
28. A sensitivity analysis, also referred to as what-if or simulation analysis, is a way to predict a certain outcome given a number of variables. This is often used to show returns in the event of a market downturn (often proving that large, value-add multifamies expose investors to less risk that other traditional investments).
29. A subscription agreement is a legal document provided to investors, by the sponsor, that outlines share/unit price (among other details) and servers for the investor to subscribe (or buy) shares/units in the deal.
30. A syndicate is a team of individuals or companies that pool their resources (time, money, expertise, etc.) in order to accomplish a goal or complete a project that they are unlikely to be able to accomplish or complete on their own.
31. T12 stands for trailing 12 months of what the property actually operated at in terms of income and expenses. This is valuable (most would say absolutely necessary) information to have when underwriting the property.
32. The Promote refers to a ‘bonus’ of sorts used to motivate the sponsor to exceed return expectations and reward them for their work in finding, managing and adding value to the property. It is an extra, disproportionate share of returns rewarded to the sponsor.
Example: Investors receive 100% of profit until a pref of 8% is met, after which investors receive 70% and the sponsor receives 30%. The 30% to the sponsor is the “promote.”
33. The term value-add is used to describe a property that offers the opportunity to increase cash flow or FMV through renovations, rebranding, or increased operational efficiencies.
34. The waterfall structure is a method for splitting profits among partners in a business deal that allows for said profits to follow an uneven distribution. In a waterfall model, payouts change when previously agreed upon return hurdles are met.
Example: An investor is paid 100% of profits until a pref (the return hurdle) of 8% is met, after which profits are split 70/30 between the investor and the general partner.
I hope you’ve found this guide to be beneficial and informative. If you find that there are any critical terms for apartment syndication/commercial real estate that I’ve left out, please comment your thoughts and explanation!