Frequently Asked Questions (FAQs)
about Real Estate Investing
Commercial & Multifamily
CAP (Capitalization Rate): Percent of cash return in the first year if the property were purchased for cash. The ratio of NOI to purchase price.
NOI (Net Operating Income): Income after vacancy and expenses and before debt service.
Rent Ratio: (monthly rent/purchase price or market value). Should be 1.0% or more for acceptable cash on cash return with a 75-80% loan. Mostly used for rental homes.
Gross Rent Multiplier: (purchase price or asking price / gross rents received from an investment). Mostly used for multifamily (apartment) properties.
Depreciation: Commercial is 39 years linear depreciation, residential (to include multifamily) is 27.5 years. This assumes all physical assets will predictably depreciate to a value of zero after this time and the losses from this offset income on a tax basis. Depreciation is one of the main benefits of investment real estate ownership.
Cash on Cash Return: Percent of cash out of an investment in a year relative to the amount of cash invested. It does not consider the time value of money. It is a very commonly used metric, however, seldom used professionally.
Internal Rate of Return (IRR): The annual rate of return that one receives on investment for all of the capital and cash flows based on the net present value for each when deployed. It is the discount rate such that the sum of today’s investment and future cash flows has a net value of zero. It expresses in the form of an interest rate the value of a given investment in today’s terms. It is the most accurate and one of the most widely used ways of calculating and comparing multiple investments by professionals.
The annual rate of return that one receives on investment for all of the capital and cash flows invested. It does not factor in the net present value of all monies that go into and out of the investment.
The IRR typically is slightly lower than the Average Annual Return because the profits at the end upon sale have a lower net present value than monies that are spent at the beginning of the investment.
Debt Service: Amount of the principal plus interest loan payment per month or annual. The cash flow that services the debt.
NNN: A type of lease in which the tenant is responsible for the taxes, insurance, and maintenance of the building that the tenant leases. Often there is some landlord responsibility (i.e roof and foundation, parking lot, HVAC, etc)
Absolute NNN: Similar to above, however, the tenant receives and pays all bills directly, bypassing the landlord as an intermediary. This is generally the most favorable lease for a landlord.
Gross Lease: Taxes, insurance, and maintenance are the responsibility of the landlord. The tenant is still responsible for their utilities.
- Modified Gross: Similar to above but with a slight modification - the modification is determined through the negotiations between Tenant and Landlord.
Full-Service Lease: The tenant’s rent includes all the same components of a Gross Lease but the Landlord is also responsible for paying the utilities used by Tenant.
- CAP rates.
- Potential for actual vs. virtual returns.
- Potential for appreciation and rent appreciation.
- Population growth & inward migration
- Employment growth
- Cost of living
- Political support of business and development
- Track record
- Ability to qualify for loans
- Access to deal flow
- Ability to negotiate
- Ability to manage investment
Typically single-family assets lead the market cycle and tend to be most closely aligned with the current economic cycle. When the economy dips, single-family prices tend to dip immediately as well. Commercial assets move slower and tend to lag compared to economic changes. In addition, commercial tenants tend to be of higher credit, be more reputable, and are less likely to move or default on a lease, so commercial markets tend to be more stable than single-family.
Trust in syndicator: As an investor, you are a limited partner in a commercial real estate deal. As such, you are fully passive, with all management decisions being made by the syndicator (sponsor). Therefore, trust in a syndicator, and a successful track record, is very important when evaluating a deal.
Risk tolerance Commercial deals tend to run the gamut of risk/reward. Low-risk investments are typically stabilized assets that have conservative leases and tenants in place close to or at full occupancy. These are usually longer hold periods and are sometimes referred to as “mailbox money”, with a secure dividend check every quarter. Other deals are “value add”, which take on more risk to make substantial improvements to a property, typically increasing both occupancy and rents. Development deals also offer attractive returns at higher risk and can encompass land entitlement, construction, and operation of a new facility.
Desire for passive investments: As a limited partner investors take a passive role in the ownership of real estate commercial investments. Sponsors set up full property management, and handle taxes, finances, accounting, and an investor simply receives predetermined profit splits. It also has the advantage of limiting liability to the amount invested due to its passive nature.
Cash flow vs appreciation: Lower-risk deals tend to have more stabilized values but produce cash flow over long terms that help meet investor cash flow goals. Appreciation and value add deals can generate a large profit but take on more risk to attempt those objectives.
- LLC owns property
- Investors own share in the LLC
- Management is a separate LLC that has all liability
- Investors have no liability beyond their investment
- Managers have all responsibility for managing the asset
Syndications allow one to invest only in products that match their investment objectives Funds generally invest in a portfolio of investments that may or may not meet the investor's objectives.
REITs are public securities with broad investment objectives that have the volatility of typical market securities. “Investors” can get in and out at will but have no long-term commitments.
Leverage, more cash to invest elsewhere, not all eggs in one basket, more passive Benefit from the expertise, experience, and ability of the syndicator to qualify for loans, select from many opportunities, vet the deal, and execute the management of the investment for maximum return on investment.
The syndication establishes a corporation that purchases the asset and the investors own shares of the corporation. An LLC corporation manages the asset for the investors.
Only on the net income after all expenses and depreciation. The annual net income reported on a typical K1 already takes advantage of the depreciation shelter of the investment.
Investing with IRA
The answer is yes! The Employee Retirement Income Security Act (ERISA) of 1974 passed the responsibility of retirement saving from the employer to the employee. Created in 1975, IRAs provide individuals a chance to direct where their retirement funds are invested. The IRS code, instead of distinguishing which investments are allowed, identifies which investments are not permitted under these laws. Under both ERISA and IRS Codes, there are only two types of investments excluded: life insurance contracts and collectibles such as works of art, rugs, jewelry, etc. Refer to Internal Revenue Code Section 401 (IRC § 408(a) (3)).
This has been a long-standing myth. Neither the IRS nor the Department of Labor has ever published a list of legal investments. However, there is a list of Prohibited Transactions and Disqualified Persons that deal with what is not permitted. Real estate and other investments are permitted provided you follow the rules.
Yes. You can consolidate:
- Your traditional and SEP IRAs into a single traditional IRA
- A SIMPLE IRA to a traditional IRA after two years
- Multiple Roth IRAs to a single Roth IRA
The unique thing with IRAs and 401(k)s are the tax advantages. Most contributions are either tax deductible as is the case of a Traditional IRA or 401(k), or the distributions are tax free as in the case of a Roth IRA or Roth 401(k). There are no unique rules for self-direction.
You can self-direct the funds by rolling over your account into a traditional IRA or a qualified plan (if you are eligible to have a qualified plan) that permits complete self-direction. Contact your former employer’s plan administrator or benefits department to determine what, if any, special procedures may be required.
If you are still employed, check with your current plan administrator to determine if self-direction is currently allowed within your plan or if this option can be added.
Possibly. If the company has a self-directed 401(k), you may have the ability to self-direct your 401(k) into these types of investments. To be certain, contact your current 401(k) administrator.