| Everyday people, like you and I, can become apartment investors. In fact, all you really need is a mini-course in some of the most important lingo, insider terms, and phrases. With some knowledge, patience, and grit, you’ll be on your way to becoming a confident investor pronto! Have you wondered what’s NOI, the cap rate formula, and why lenders require a minimal 1.25 DSCR or the typical leverage expected in today’s market? When it comes to real estate, there are a lot of terms that can be confusing for someone who’s just getting started. Yet don’t worry – we’re here to help! How do I get to learn the apartment investing lingo better? The more you expose yourself to real estate investing, the more familiar you’ll become with the jargon. Attend investment opportunity webinars and local meet-ups, tune into podcasts, check out YouTube videos, and read apartment syndication books. The more you familiarize yourself with the terms, the less like a newbie you’ll feel. Repetition is key here – keep exposing yourself to new real estate information and concepts. Before you know it, you’ll feel more confident! Here are some of the most important things you should know (NOI) Net Operating Income This is one of the most important numbers to focus on when evaluating an apartment building for investment purposes. It represents the income that’s left over after all expenses (including taxes, insurance, and repairs) have been paid. If you’re an investor in real estate, you know that NOI (net operating income) is important. Yet why? Simply put, the main job of real estate syndicators is to increase the NOI by either increasing income and/or decreasing expenses. The higher the NOI, the more passive investors are able to earn. So if you’re looking to invest in real estate, be sure to ask about the syndicator’s plans for increasing NOI. With a good plan in place, you can maximize your rate of return on your investment. Cap(italization) Rate The cap rate is a measure of how much return on investment you can expect from an apartment building. It’s calculated by dividing the NOI by the purchase price of the property. Simply put, the cap rate is a glimpse in time of what a multifamily apartment real estate asset’s return is before financing. In other words, when you’re considering an investment in real estate, one of the key things to look at is the CAP rate. This ratio tells you how long it will take to get your money back if you were to purchase the property outright with cash. The higher the CAP rate, the shorter the amount of time it will take to recoup your investment. For example, if a property has a CAP rate of 10%, that means it will take 10 years to get your money back. Of course, there are other factors to consider when making an investment decision. But if you’re looking at properties with similar characteristics, the CAP rate can be a helpful way to compare them. When you’re armed with this information, you can make a more informed decision about which property is the right investment for you. When it comes to real estate investing, apartment syndication can be a great option. Unlike single-family homes, multifamily apartments are valued based on the property’s income. So if the building is generating income and tenants are paying their rent, you’re also making income. But it’s important to keep in mind that the way income is generated from an apartment property is different than with a single-family home. For one, location is just one of many factors when it comes to generating income from an apartment. Other considerations include the overall condition of the property, the amenities offered, and more. The CAP rate is a measure of how much income an apartment generates in relation to its purchase price, and it’s something that savvy investors always keep in mind. (GPR) Gross Potential Rent If you’re looking to invest in an apartment complex, you’ve probably heard of the term GPR. The GPR is the Gross Potential Rent that you could potentially earn if the complex was 100% leased year-round at market rental rates. Of course, achieving 100% occupancy is rarely realistic, so it’s important to do your research and have a clear understanding of what the typical market rental rate is for the area you’re investing in. This will help you set realistic expectations. (DSCR) Debt Service Coverage Ratio This is a measure of a property’s ability to service its debt obligations (i.e. make payments on its mortgage). A property with a DSCR of 1.0 or higher is generally considered to be a good investment, as it has enough income to cover its debt obligations. And most lenders require a minimum DSR of 1.25. What this means is that for every dollar you pay towards your mortgage, you should have at least 25 cents left over. This may not seem like a lot, but it’s enough to cover other debts and expenses. Anything lower than 1.25 DSCR is considered risky by lenders and they may be less likely to lend you money. So, if you’re thinking about real estate investing, make sure you’re the investment that you’re considering has a good debt service coverage ratio. When it comes to securing a loan for your apartment/syndication, you may be wondering what the best option is in terms of loan-to-cost (LTC). In today’s market, it is typical for an LTC to be between 65% to 75%. However, this can vary depending on a number of factors, including the current economic conditions. In particular economic climates, low leverage is better than higher. Also having minimal major capex (capital expenditures) is important, so that you can pay down the mortgage on the property. Having a sound, business plan and a strategy in place will help you minimize risk while maximizing profit. A word of caution: While it may be tempting to try to get the highest LTC possible, this may not always be the best option for your business. Ultimately, it’s important to weigh all of your options and make the best decision for your particular investment. For example, if a sponsorship group was to obtain a 88% LTC because the debt was inexpensive, beware because a high LTC can also increase your exposure, especially if the market conditions were to shift. Economic Vacancy It’s rare for an apartment complex to be 100% occupied. In fact, it’s quite normal for there to be some turnover. After all, people move around frequently, and there are usually more than 100 families, couples, or individuals living in one complex. So don’t be surprised if you see some vacancy signs up at your local apartment complex. It’s just a natural part of life! If your complex is constantly renting at full capacity, it could mean that your rates are too low. You don’t want that! Keep your rates competitive to ensure you’re making a profit. It’s estimated that 5-6% of all rental units are vacant at any given time. Most of these units are vacant because the owner is between tenants, but some units are vacant because the owner can’t find a tenant or because the unit is in poor condition. Whatever the reason for the vacancy, it’s important to remember that vacancy is a normal part of owning rental property. It’s not something to be worried about, but it is something to be prepared for with calculated risks. The term economic vacancy is basically defined as a unit not collecting rent. This can be due to a variety of reasons, such as the unit being unoccupied, the owner not being able to find a tenant, or the owner being unable to afford the rent. (A discussion on strategies to mitigate these factors and risks is for another article/episode on another day). Whether it’s a model unit that’s never been lived in, or a tenant who’s stopped paying rent, vacancy is a typical part of business operations and accounted for accordingly. In our underwriting, the one general best practice that we tend to use is around 10% economic vacancy. Some general partners aggressively enter only a 5%-7% economic vacancy rate in their underwriting to win deals. Yet, investors focused on their fiduciary duty like myself know that there’s a likelihood of a minimal of 10% economic vacancy, when acquiring a new property. Our reputation, our investment, and our investors are important to us. That’s why we commit to conservative underwriting on each deal. Annualized Cashflow The annualized cash flow is basically the projected distributions YOU the investor, can expect to receive. Currently, the typical annualized average cash flow is 5-7%. However, it’s important to keep in mind that this number can change over time. Yet if you’re looking for a steady stream of income, annualized cash flow can be a helpful metric to consider closely. Cash on cash return: This is another important metric to focus on when evaluating an investment property. It represents the annual return you can expect to receive based on the amount of cash you have invested in the property. AAR% or IRR% The Average Annual Return (AAR) is a simple equation used to calculate the average amount of money an investment earns each year, and can be a helpful tool in making decisions about where to place your money. To calculate AAR, you simply divide the total ROI (return on investment) by the number of years you have invested. So, for example, if you invest $100,000 in a syndication that has a total ROI of $72,000 over four years, your AAR would be $18,000, or 18% annual return. While math formulas may not be everyone’s favorite thing to do, understanding AAR is crucial for anyone looking to make smart investment decisions with a syndicator who uses AAR. And luckily, it’s not as complicated as it might seem at first. By using AAR to evaluate potential investments, you can ensure that you’re putting your money in the right place – and earning a healthy return on your investment. As we know, the real estate market is constantly changing. So what are we to look for in today’s market? 14-15% or higher is generally considered a good AAR for a stabilized property needing light, cosmetic upgrades i.e. a fresh coat of paint. In contrast, if an apartment needs a little extra renovation, heavier value-add projects should be at 16% or greater. Of course, each deal and each percentage is different. But as a general rule of thumb, these are the numbers you should be looking at when considering an investment property. Internal Rate of Return (IRR) is what we prefer to use in our underwriting and calculations. So what is IRR? It’s a more complicated equation that measures annual return, incorporating inflation and time of holding the property, into account. This is a huge benefit for us, as it provides a more realistic view of potential returns on investment. In today’s economy, we need all the confidence and safeguards we can get as investors, especially in the midst of global macroeconomic uncertainty. That’s why using AAR alone is too simplistic – it doesn’t incorporate these important factors into consideration. IRR provides a deeper dive into the potential returns on investment, giving us the security and peace of mind, we need in today’s economic climate. Applying IRR lets investors to really have a better comparison of deals. Even though the formula is complex, it’s also more accurate so investors can make better investment judgments. To calculate the IRR of a project, you need to consider the degree of annual distributions for investors, the anticipated disposition date of the property, and the anticipated price the property is likely to sell at. All of these points factor in what AAR does not. Because of this, you may actually notice that the expected IRR of a project is less than the expected AAR. To calculate IRR, you need to use the same formula as Net Present Value, also known as NPV. This is because IRR is in fact the discount rate. By incorporating all of these factors into account, you can get a more accurate picture of your potential return on investment. (NOE) Net Operating Expenses As property owners, we’re responsible for making sure your apartment building runs smoothly on a day-to-day basis. That means covering all the necessary “above the Line” operating expenses, like property insurance, real estate taxes, and utilities. If your building has 65 units or more, the sponsorship team has to hire a professional property management company to help with the day-to-day operations. Yet even if the building is smaller, the landlord needs to budget for regular monthly repairs and maintenance. Operating expenses can be a big line item in the budget, yet they’re essential to keeping your apartment running smoothly. So make sure your syndicator has planned accordingly and set aside enough reserves each month to cover expenses. Other regular expenses can include salaries, routine repairs, maintenance, and utilities; plus accounting, legal, eviction fees, and marketing to appeal to tenants.In conclusion, at its core, apartment investing is all about creating value through real estate ownership. This can be done through a variety of means, such as increasing rental income, reducing operating expenses, or adding value to the property through renovations or other improvements. We’ve crafted a glossary of apartment investing terms, available to you online. Simply visit https://kelsiemansray.com/terminology/! To learn more specifically about NOI, you can also click here. If you are interested in future investment opportunities, click here. By Kelsie Mans-Ray KMR Multifamily Acquisitions / Syndicator  NOTE: This information is of a general, educational nature and may not be construed as tax, financial, or legal advice pertaining to a specific offering, exemption or situation. |
An Investor’s Guide to Profits – ROI, IRR & CoC
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