Investment Terminology

Accredited Investor

An Accredited Investor is defined by the Securities Act as any natural person whose individual net worth exceeds $1M, excluding the value of their primary residence, or has an annual income in excess of $200,000 ($300,000 with spouse) in each of the two most recent years and who reasonably expects an income in excess of $200,000 ($300,000 with spouse) in the current year.

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These are other definitions of an Accredited Investor that can be found by clicking the following link:

https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/updated-3

 

Cash on Cash (CoC) Return

CoC is an annual rate of return and some refer to it as the cash yield. It is calculated by dividing annual cash distributions made to investors by their invested capital.

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Sponsors often present CoC as an averaged value over an asset’s holding period. Since CoC calculations do not discount future cash distributions to present value, it is a less important measure of investment returns than IRR.

Capital Expenditure (CAPEX)

CAPEX are expenditures made for replacements, upgrades, or major repairs to an income property that are depreciated over their useful life.

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We identify needed replacements, upgrades, and major repairs while underwriting the deal, and then finalize the scope and budget during the due diligence period. We, generally, aim to complete all planned CAPEX items within the first 12-18 months after the deal closes.

Examples of common replacements include roofs and HVAC equipment. Common upgrades are new landscaping, signage, lighting/security systems, flooring, fixtures, and finishes while major repairs are made to parking lots, exteriors, windows/doors, gutters/drainage systems, etc.

Capitalization Rate (cap rate)

The cap rate is calculated by dividing a property’s net operating income (NOI) by its sales price.

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One can estimate a property’s market value by dividing its NOI by an appropriate market cap rate. Most national CRE brokerage firms publish market cap rates in quarterly research reports by submarket, property type, and property class.

We first evaluate a potential acquisition using cap rate analysis, and if it appears attractive, then we proceed to discounted cash flow analysis.

Capital Structure

The capital structure is the proportion of equity and debt in a deal.

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In most CRE deals, 60-80% of the acquisition cost is debt financed. Leverage means that for each dollar of equity placed in a deal, the debt financing brings in an additional two-three dollars.

Capital Stack

The capital stack is a visual representation of all sources of capital used to finance a real estate acquisition.

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Each source of capital has a different priority when it comes to receiving payment from the property’s NOI. These are stacked up from the lowest risk-return (senior debt) to the highest risk-return (common equity) as shown in the graphic below.

Commercial Real Estate (CRE)

CRE is income-producing property used exclusively for business-purposes or multi-family properties containing more than four units.

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CRE properties are generally categorized into four types based upon function, and there exists many subcategories under each type:

1) Office
2) Industrial Use
3) Multi-Family (apartment complexes)
4) Retail

Cost Segregation

Cost segregation is a tax deferral strategy based upon accelerated depreciation. A cost segregation study categorizes a property’s improvements into specific asset classifications with most having shorter depreciation recovery periods as compared to depreciating the property’s improvements as a whole.

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Good candidates for cost segregation are newly acquired or renovated properties valued at over one million dollars that have an expected holding period of at least five years, and numerous asset components eligible for re-classification to depreciation recovery periods of 5, 7, and 15 years. Without cost segregation, all property improvements are depreciated over 39 years.

If we is believe cost segregation will benefit a deal then we will commission an engineering company to evaluate the property and produce a cost segregation study after all planned improvements are made to the property.

Debt Coverage Ratio (DCR)

DCR measures the ability of a property’s net operating income to cover its mortgage payment. DCR is calculated by dividing a property’s NOI by its debt service payment.

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Lenders tend not to approve loans with a DCR less than 1.25. Conservative investors set the DCR minimum at 1.5 as we do at HAPGOOD CAPITAL.

Discounted Cash Flow (DCF) Analysis

Discounted cash flow analysis is a valuation method that seeks to determine the profitability of an investment by forecasting future cash flows and then discounting them back to present value. The method is based upon the principles of compounded interest.

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At HAPGOOD CAPITAL, we develop a DCF model for each deal and then compute internal rates of return (IRRs) for a range of different investment scenarios. Each investment scenario is defined by a unique set of assumptions that defines a distinct level of risk. In addition, we perform sensitivity analysis to see how small changes to key inputs affects IRR. This can reveal the need to collect more data.

Due Diligence

Due diligence is the process of discovery and analysis that starts when the property goes under contract and ends with the acquisition’s closing.

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Due diligence involves verifying the key assumptions in the financial analysis, and in ensuring all tests, appraisals, cost estimates, contractor bids, and inspections are completed and that the results meet the sponsor’s underwriting requirements and those of the lender.

Equity Multiplier (EM)

EM equals the total cash distributions made to investors divided by their invested capital.

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EM is most useful in deals with short holding periods as the cash flows are NOT discounted to present value as in IRR calculations.

Gross Income Multiplier (GIM)

GIM is a common ratio used for comparing values of similar properties using the income approach. GIM is calculated by dividing a property’s sales price by its potential annual gross income.

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Potential Gross Income (PGI)

PGI is the total rental income at 100% occupancy plus all sources of ancillary income.

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Ancillary income comes from laundry rooms, vending machines, application fees, parking, net deposits, and so on.

Internal Rate of Return (IRR)

IRR is the annualized interest rate that makes the present value of all cashflows equal the invested capital in a discounted cash flow model.

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IRR incorporates the financial impact from all sources of cash flow over the holding period of the asset. IRR is the most common rate of return used to evaluate CRE investments. The larger the IRR the higher the return on the investor’s invested capital.

Leverage

Leverage is debt divided by the sum of equity and debt in a deal.

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No leverage means the deal was purchased with all equity and there is no debt service while 100% leverage means the deal was fully debt financed. The amount of leverage in CRE deals normally falls between 50% – 80%.

Loan-to-Value (LTV)

LTV is the ratio of the loan amount (or outstanding principal) to the purchase price (or market value) of a debt-financed CRE deal.

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Most CRE deals are underwritten with the LTV between 60-75%. The risk of loan default increases with higher LTV values.

Net Cash Flow

Net Cash Flow is the net of all cash flows within a business (i.e., from operations, investing, and financing activities) within a specific reporting period.

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Positive net cash flow represents cash flow available for distribution to the investors. A portion of net cash flow may be retained to establish cash reserves as is often required by lenders. Most sponsors have set policies for the amount of cash reserves they hold in a deal.

Net Operating Income (NOI)

NOI is the annual cash flow derived from the operating activities of an income-producing property.

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Since NOI is comprised only of income and expenses related to property operations it is independent of the specific ownership and capital structures used in acquiring the property.

Private Placement Memorandum (PPM)

PPM is a set of legal documents given to potential investors that introduces an investment and discloses everything an investor needs to know to make an informed investment decision.

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The PPM is part of a securities offering process called private placement and the disclosure requirements come from Regulation D of the Securities Act. These documents are prepared by lawyers whom specialize in securities law and in raising private capital.

The individual documents include a subscription agreement, investor questionnaire, operating or limited partnership agreement, and a complete business plan that includes financials, risks factors, market analysis, contingency plans, management fee structures, operating plans, CAPEX plans, and so on.

Return on Investment (ROI)

ROI is the sum of all cash distributions made to an investor divided by their invested capital.

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ROI is best used in deals with short holding periods because the cash flows are NOT discounted to present value as in IRR calculations.

Syndication

A real estate syndication is the pooling of capital from passive investors (or limited partners) to purchase commercial real estate. The deal sponsor (or general partner) sources the deal and has a fiduciary responsibility to define the returns and risks for the investors, and if the deal closes to manage and protect their investment.

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The benefit of syndication is that a group of investors can pool their capital to acquire more and/or bigger properties than they could individually. This provides both greater investment diversification and economies of scale. Furthermore, the sponsor is a professional manager with the expertise, resources, and systems to manage the asset, while the investors (or limited partners) are freed from any active role and their liability is limited to their invested capital. The sponsor collects management fees and can participate in profit-sharing splits if expected returns are realized.

Underwriting

Underwriting is when the deal sponsor evaluates an acquisition target to determine if it is a financially attractive deal and if it aligns well with the sponsor’s investment strategy and management capabilities.

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A successful outcome from the underwriting process is a solid business case that the sponsor presents to investors and lenders in order finance the deal.

As HAPGOOD CAPITAL, we follow a standardized underwriting process. The output from the underwriting process goes into a standardized business case template, which includes property details, market analysis, financial projections, and specific plans to manage and improvement the property.

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