Guide to
INVESTMENT TERMS U S E D I N R E A L E S TAT E
Guide to Real Estate Investment Ter ms
SYN O PS I S This document provides a brief overview of the terms commonly used in Real Estate Investment. Potential investors are encouraged to also read around the subject and seek third party advice to improve their familiarity with the subject. Descriptions have been kept general in nature and do not specifically focus on any individual Private Placement Memorandum from our group of other entities.
DI S CLAI ME R This Guide has been prepared by Luxury Simplified (“LS�) using publicly available information. LS has not independently verified the information contained herein, nor does LS make any representation or warranty, either express or implied, as to the accuracy, completeness or reliability of the information contained in this presentation.
Types of Real Estate Investments
RESIDENTIAL
Residential real estate is the most familiar form of real estate because everyone has purchased a house, rented an apartment, or had some interaction with residential real estate. Tenants of residential properties pay rent to live in the property and owners collect rents as part of the lease agreements. Residential properties include singlefamily homes, multi- family homes, apartment buildings, condominiums, luxury properties, and other variations.
We have seen strategies of purchasing several properties and packages of single family homes. In other words, instead of buying an apartment complex, an investor may buy a portfolio of single family homes and employ a property manager to produce desired gains from the rental income and appreciation.
COMMERCIAL
INDUSTRIAL
While individuals and families are the typical tenants of residential real estate properties, businesses occupy commercial properties though sometimes there may be a mixture of residential and business in the same building. The commercial tenant abides by leases and pay for use of the property, just like any other resident. These leases are more complex than the leases one might have on a condo or apartment and the agreements can vary to include obligations for the tenant to pay for some or all of the following: property taxes, rent, insurance, required maintenance and up-keep, or other expenses that would otherwise be covered by the property owner.
The last type of real estate to cover here is industrial real estate. Industrial properties are used for manufacturing, production, assembly, storage, and related activities. Some large institutional investors own industrial properties and lease the property (usually under long-term agreements) to businesses that will use it for manufacturing and production.
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The goal is always a positive return on investment. Gain can be achieved two ways:
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Equity – i.e. increase in value after completion of renovation or by opportunistic purchase or inflation etc.
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Rental or other operating income, most commonly used to cover holding and operating costs plus a small positive return.
For a real estate property, this is most commonly achieved when the property’s value appreciates. Although the recent bursting of the real estate bubble has made some investors question the idea that real estate investments are a sound long-term investment, traditionally real estate has been a source of steady gains that at least keep pace with inflation and hold tangible value. One simple explanation for why many investors like to hold real estate is that at the end of the day, even if inflation jumps up or the stock market crashes, your property still has some value. If the real estate property does not appreciate or even loses value, there is still an opportunity to notch a return on investment by renting out the property to businesses or residents. In the wake of the financial crisis and real estate meltdown, for example, many investors cushioned the blow to property valuations by renting out properties. This is especially attractive if the property is purchased with a loan and thus the owner will have to make the monthly payments regardless of whether the housing market collapses or the macroeconomic picture changes. Renting out the property or otherwise monetizing the real estate can help the investor meet loan requirements and, ideally, realize returns on the investment. The income and appreciation qualities make real estate a mandatory allocation in many family office portfolios.
Real Estate Investment Str uctures
REAL ESTATE INVESTMENT TRUSTS (REITs) One way of investing at arms length is through what is known as a Real Estate Investment Trust or a REIT. A real estate investment trust (REIT) is an investment company that invests in properties or mortgages and typically provides an income component. REITs trade on exchanges like stocks and bonds, making these securities an easily accessible and liquid avenue for investing in real estate. REITs must pass through a significant portion of their income as a dividend in order to qualify for special tax treatment. Publicly traded REITs normally invest in commercial real estate, such as apartments, hotels, shopping malls, office complexes, and storage units. REITs are a way to invest in real estate without directly investing in private real estate and managing property. The tax benefits of this structure are often the most important aspect for investors considering a REIT compared to other real estate investment structures.
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REAL ESTATE INVESTMENT FIRMS Similar to REITs, a real estate investment group allows an investor to invest their money with a firm that will then use that capital to make investments in real estate, manage properties, and attempt to produce gains for the investor(s).
PRIVATE REAL ESTATE FUNDS There are many different private real estate funds that are structured as a limited liability corporation or limited partnership and investors in the fund commit capital that is deployed to purchase various real estate properties and securities.
INDIVIDUAL PURCHASE Many high-net worth individuals purchase real estate from outside of a pooled fund structure or sophisticated vehicle. These investments are usually taxable, compared to more tax efficient vehicles or tax-exempt entities like government and corporate pension funds, endowments, charitable foundations, etc. Of course, there are many other unique features and characteristics of real estate investments.
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Glossar y of Real Estate Investment Ter ms Accredited Investor A term used by the Securities and Exchange Commission (SEC) under Regulation D to refer to investors who are financially sophisticated and have a reduced need for the protection provided by certain government filings. Accredited investors include individuals, banks, insurance companies, employee benefit plans, and trusts. In order for an individual to qualify as an accredited investor, he or she must accomplish at least one of the following: • • • •
Earn an individual income of more than $200,000 per year, or a joint income of $300,000, in each of the last two years and expect to reasonably maintain the same level of income. Have a net worth exceeding $1 million, either individually or jointly with his or her spouse. Be a general partner, executive officer, director or a related combination thereof for the issuer of a security being offered. An employee benefit plan or a trust can be qualified as accredited investors is total assets are in excess of $5 million.
In a General Solicitation offering (e.g., Reg. D (506) ), additional information will be required to confirm the Investor’s accredited status.
Base Management Fee A Base Management Fee is charged to the fund and paid by investors. This fee should be designed to cover the day-to-day costs of investing in, managing and perhaps ultimately selling real estate. There are a variety of ways that this fee is structured. In some cases, there is a straight fee, say 1 to 2% on commitments to the fund. After the end of the investment period, the fee would normally be based on Net Asset Value (NAV). The investment period is the period in which the fund is acquiring real estate assets and typically would be in the three- to four- year range. Gross Asset Value (GAV) is sometimes also used as a basis of calculation though NAV more often produces stronger alignment between Investor and Sponsor.
Carried Interest Carried interest is also known as “Carry”, “Promote” or “Performance Fee”. Put simply, carried interest is the profit that accrues to the fund Sponsor. It is normal practice for a non-core strategy fund to have a preferred return or hurdle rate over and above which the carried- interest calculation would kick in, hence the term ‘distribution waterfall’. The waterfall gives an increased return to the Sponsor as performance targets are reached, quite often this is a tiered approach, say achieving a IRR tiers of 7.5 and 15% improves the promote from 25 to 40%.
Cash-on-Cash Return A Cash-on-Cash Return (“CoC”) is the expected annual cash return on the Investor’s investment, without compounding. Stabilized investments typically project a CoC of 7% to 12%. Claw-Back Clause: When liquidating an investment fund, if the Investors were distributed less than the agreed Preferred Return, they “claw-back” the missing amount from the carried interest distributed to the fund manager. The claw-back clause is triggered at the very end of the fund.
Debt Service Coverage Ratio (DSCR) DSCR is the wriggle room that a Bank needs to give them comfort that the project can cover its outstanding loan payments. It is based on NET operating income after all operating expenses but before finance costs, divided by those finance costs.
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Due Dilligence An investigation or audit conducted by a registered broker-dealer of a potential investment it will be offering accredited investors. Due diligence serves to confirm all material facts in regards to an investment offering and generally refers to the care a reasonable person should take before entering into an agreement or a transaction with another party.
Electronic Funding Portal An Electronic Funding Portal (“Funding Portal”) is a web-based marketplace that offers investment participations to accredited investors. It also provides secure on-line access to confidential information (e.g., Private Placement Memorandums, Financial Projections, Offering Documents, Videos, etc.) pertaining to the relevant investment opportunity. Some more sophisticated Funding Portals offer an online fulfillment process (e.g., money transfer, escrow accounts, electronic signatures, investor accounts and reports, etc.).
Financial Industry Regulatory Authority (“FINRA”) A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange’s regulation committee. The Financial Industry Regulatory Authority (“FINRA”) is responsible for governing business between brokers, dealers and the investing public.
Fund Fees - Other Sponsor and Fund Fees The chart below sets forth the most commonly agreed-upon types of additional Sponsor and Fund fees, representative ranges, and the frequency of which those fees are charged:
Fee Type
Range
Frequency
Acquisition
1.0% to 3.0% of purchase price of real estate
One-time
Finance
0.5% to 1.5% of indebtedness
One-time
Loan Guaranty
0.5% to 2.0% of guaranteed indebtedness
Annual
Property Management
3.0% to 5.0% of gross collected rents
Recurring
Asset Management
1.0% to 2.0% of gross collected rents, where the Sponsor does not provide property management services
Recurring
Leasing
“Market” based on type of real estate and locale
Paid based on leasing activity
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Fee Type
Range
Frequency
Construction Management
1.0% to 3.0% of total cost of improvements
Paid based on construction activity
Disposition
1.0% to 3.0% of sale price of property, although sometimes this is couched as a brokerage fee, in which case the Sponsor may charge a customary brokerage commission, usually 6.0%, unless a cooperating broker is involved in which case the commission is typically split
One-time
Fund Organization
$50,000 (est.) relating to initial legal, tax and accounting expenses to the formation of the Fund
One-time
Placement Agent
7.0% of the gross proceeds raised
One-time
Escrow
0.45% on the amount of a single distribution with a minimum fee of $600 and a maximum 6-month fee of $3,000. An administrative fee of $150 for each additional escrow distribution that occurs after the first distribution within the first 6-month period.
Paid based on drawdown activity
Transaction Monitoring
1.0% of total gross assets under management. Payable to the Transaction Service Administrator, a fiduciary serving on behalf of the Investors in monitoring activities of the Fund and Sponsor.
Annual recurring
Equity Distribution (Preferred Dividends,Equity Repayment, Profit Distribution)
0.65% per distribution amount. Minimum fee of $150 per distribution and a maximum annual fee of $600.
Paid based on distribution activity
Fund Performance Metrics The Sponsor would most commonly cite the return potential of its Fund (or targeted projects tor investment) in terms of Cash-on-Cash Return (“CoC”), or Internal Rate of Return (“IRR”).
General Solicitation Offerings On July 10th, 2013, the SEC issued new final regulations allowing public advertising and solicitation of Regulation D offers to accredited investors. This exemption is also referred to as a “506©” offering.
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Internal Rate of Return An Internal Rate of Return (“IRR”) is the rate that makes the present value of contributions made by the Investor equal to the present value of distributions received by the Investor. An IRR is a valuable metric because it takes into account all cash flows and the time value of money thereby providing the Investor a benchmark by which it can evaluate competing investments. IRRs typically fall within the 12% to 17% range.
Management Fee A fixed quarterly fee, based on a percentage of the Fund’s assets under management, to cover the Sponsor’s costs of operating the Fund. Example of Fund costs would be: 1) making the opportunity available to the Investors, 2) staff salaries and 3) ongoing legal, accounting, audit, tax matters and other administrative expenses. We would contemplate a minimum fixed annual fee of 2.0%.
Minimum Investment Unit A Minimum Investment Unit (“MIU”) is the smallest dollar amount an investor can make on any one transaction. The MIU is determined by the Issuer and Placement Agent as a function of the overall size of the transaction and the targeted number of investors allowed in the offering.
Net Present Value NPV shows you if your deal is achieving your target return. NPV is the value of all future cash flow from an investment discounted back to a point in time minus the cost to achieve that cash flow. $1.0 today at 10% interest is worth $1.10 in a year. Similarly $1.10 a year from now discounted at 10% will have an NPV of $1.0 today.
Organization and Set-Up Costs This is one of the more straightforward fees. This is where the costs of setting up and structuring the fund are expensed to the fund and ultimately paid by the investors. The organizational costs should not recompense the fund sponsor for the general overhead of set-up costs associated with running the firm. It is normal to have a cap amount stated in the legal documentation, which can vary considerably depending on the complexities associated with the target investor base and the target countries for investment.
Preferred Return Investors typically receive a “Preferred Return,” calculated on the total amount of their capital contribution while held by the Fund. In today’s market, this return can range from 7% to 10% depending on a multitude of factors (e.g., nature of contemplated investments; Sponsor’s size, financial strength and track record, etc.). The Preferred Return is not a guaranteed dividend, and typically accrues until such time as cash distributions are available. The basic premise is that the Investors should receive a minimum return on their capital and the return of their original capital prior to the Sponsor receiving a share of the profits. In other words, the Sponsor is typically playing for the “back-end” pay-off in the profit distribution for their professional skill in selecting and managing the Fund.
Preferred Return “Catch-Up” Once the Preferred Return and original investment is returned to the Investors, the Sponsor typically will receive a profit allocation equal to a portion of the total Preferred Return allocated to the Investors (usually in the same percentage as the Waterfall). The purpose of including a Preferred Return “Catchup” is to allow the Sponsor to have some participation in the Fund’s profits (so long as the Preferred Return has been allocated to the Investors). This feature ensures that the profits resulting from a successful Fund are allocated per the agreed upon Waterfall, and conversely, the profits from a marginally successful Fund will be primarily allocated to Investors rather than the Sponsor.
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Profit Distributions (The “Waterfall”) In private equity investing, distribution waterfall is a method by which the capital gained by the fund is allocated between the Investors and the fund manager. In a real estate investment fund, the fund manager manages the committed capital of the Investors. When distributing the capital back to the Investor, the fund manager will allocate a percentage amount based on a previously agreed Waterfall structure (the “Waterfall”). A waterfall structure can be pictured as a set of buckets or phases. Each bucket contains its own allocation method. When the bucket is full, the capital flows into the next bucket. The first buckets are usually entirely allocated to the Investors, while buckets further away from the source are more advantageous to the fund manager. This structure is designed to encourage the fund manger to maximize the return of the fund. A standard distribution waterfall is defined by difference phases: Recovery, Preferred Return and a Promote. •
Recovery Phase: As long as the capital raised hasn’t been fully returned to the Investor, the whole distributed amount is allocated to the Investors.
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Preferred Return Phase: The Preferred Return is typically a fixed hurdle rate (typically 7% to 10%). The Preferred Return is an IRR that needs to be reached by the Investors before the fund manager gets some return on its invested capital.
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Promote Phase: Above the Preferred Rate phase, every proceeds will be distributed based on the Promote or carried interest (typically 20% to 40%). This means that the fund manager will receive 20% to 40% of the distributed amount, while the Investors will share the remaining 80% to 60%.
Most Waterfalls are calculated on a deal-by-deal basis that calculates IRR hurdle thresholds for each deal. At the end of the fund, a Claw-back provision may be activated if the final IRR calculated at the fund level is below what has been paid to the fund manager (e.g., the fund manager pays-back a portion of its promote distribution at the end of the life of the fund).
Real Estate Investment Fund A special purpose entity (a Limited Partnership or Limited Liability Corporation) established for making equity investments in one or several property investments. The entity is managed by a General Partner or Managing Member (aka as a “Sponsor”). Sponsors can be financial advisors (portfolio manager) or real estate developers (developers). The role of the Sponsor is to select, develop and managed qualified real estate investments.
Registered Broker-Dealer A person or firm in the business of buying and selling securities, operating as both a broker and a dealer, depending on the transaction. The term broker-dealer is used in U.S. securities regulation parlance to describe stock brokerages, because most of them act as both agents and principals. A brokerage acts as a broker (or agent) when it executes orders on behalf of clients, whereas it acts as a dealer (or principal) when it trades for its own account. For example, Turnstone Securities, LLC (“TS”) is a SEC registered broker-dealer (investment bank) which provides placement agent services to middle market companies raising capital via Reg. D private placement offerings.
For LS Group, our partner company providing the service of Registered Broker-Dealer is Turnstone Securities LLC, member FINRA | SIPC.
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Investment Advisory Representative (“IAR”) Personnel that work for investment advisory companies whose main responsibility is to provide investment related advice. According to regulations, IARs can only provide advice on topics on which they have passed the appropriate examinations.
Registered Investment Advisor (“RIA”) An advisor or firm engaged in the investment advisory business and registered either with the Securities and Exchange Commission (SEC) or state securities authorities. A Registered Investment Advisor is defined by The Investment Advisers Act of 1940 as a “person or firm that, for compensation, is engaged in the act of providing advice, making recommendations, issuing reports or furnishing analyses on securities, either directly or through publications.” An investment advisor has a fiduciary duty to his or her clients, which means that he or she has a fundamental obligation to provide suitable investment advice and always act in the clients’ best interests. For example, TS Advisors, LLC (“TSA”) is a California RIA providing transaction monitoring and oversight services.
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