085: Apartment Investing Lingo, Talk Like a Pro
APPLE PODCASTS | SPOTIFY
What’s NOI? 🤔
How is CAP Rate calculated?
Why do most lenders require at least 1.25 DSCR?
In current conditions, what’s the common % for an LTC?
What’s one basic rule of thumb when it comes to economic vacancy in our underwriting? 🤔
What’s the difference between AAR and IRR?
Sometimes, in the world of apartment syndication, it can feel like a little bit of a foreign language. Have you ever been new at a company and had no idea what all the acronyms being thrown around meant? What’s a DISC assessment? How about ADR? Does anyone speak this language?
Apartment syndication can be just like that. There’s a lot of insider language and confusing abbreviations, and, let’s face it, MATH. 🤓
We know we often threw a ton of words at you and for some of you, it may have felt like we were speaking a foreign language. And we get it, cause when we were first starting out we were overwhelmed with them too. Trust us, if anyone gets not fully understanding a new language, it’s us!
As your financial BFFs, we’re here to guide you every step of the way. Today, we’re going to go over some apartment-investing linguistics so that you too can speak the language with confidence. Let’s get into it. 👇👇
How can you get more familiar with all these apartment investing terms?
The first and most basic way to get more familiar with some of these terms is simply with time and experiences. Attend investment opportunity webinars and local meet-ups, tune into podcasts, check out Youtube, read apartment syndication books, do the most you can. Get out there and get a little uncomfortable.
Repetition will also help here…just continue to expose yourself and make the unfamiliar more familiar. Pretty soon you will stop feeling like such a newbie!
To help you get there, we’re going to help you get familiar with some of the basic linguistics. We’re so glad you are reading this, and yes, maybe this will help you invest confidently. Let’s get started.
There’s so many terms out there, but here are the key apartment investing terms you should know…
Net Operating Income (NOI) – Cap Rate x Purchase Price
The most important terminology here is NOI! You’ve probably heard of it, but most likely you don’t completely understand what it is. And that’s okay; that’s where we come in!
Why should you care about NOI? Well, the main job of general partners in apartment syndication is to increase the NOI by either increasing income or decreasing expenses. 😌
The truth is that every apartment syndicator has their own version of doing what they think is best to accomplish both. Higher NOI means we are able to maximize our passive investor returns.
Capitalization (CAP) Rate – Net Operating Income (NOI) ÷ Purchase Price
CAP rate is another term you should know – this number is like looking at a photo. It’s a simple snapshot in time of what a multifamily apartment real estate asset’s return is before financing.
Close your eyes for a second 😌 and imagine seeing a picture of yourself looking fondly at your return of investment. Not a financial worry in sight. That’s what your future can and should look like, and you are well on your way to getting there.
With CAP rate, you are calculating the ratio of how long it will take to get your money back in investment on an all-cash purchase. Look, you have done too much work up until this point to not know how much you’re going to make back over time.
Normally when you’re making your deals, the CAP rate is given to you. However, since you’re all calculating queens, (and kings!) you can determine that number for yourself by taking the NOI divided by the value.
This is why we ❤️️ apartment syndication, because unlike single-family homes, multifamily apartments are valued based on the property’s income. So between whatever the building is making, and how many tenants are paying their dues, you’re also making money.
It’s not a fixed price, it can go up and up and up! Do you remember the Pixar movie Up when the house floated into the sky with tons of balloons? This can be you too, but instead of a house, you have multifamily apartments.
But keep in mind that this also means that the property will be assessed based on income numbers, not based on comparative market analysis that is done like with single-family homes. There are more factors involved in how you can generate income on your apartment other than just location. ✨
In the apartment investing world, many would argue that the CAP rate is just as important as the net operating income and even as important as the purchase price itself. Remember, you have no cap.
Gross Potential Rent (GPR)? – Monthly Rent x Number of Units x 12.
You might also have heard of GPR. The GPR is how much income you are going to make if the apartment complex is 100% leased year-round at market rental rates.
👉 Spoiler alert👈 – like anything in apartment syndication, this will require some research on your end so that you know what the going market rental rate is for the area you are investing in. And it will also require a reality check on your part from time to time since we all know that 100% occupancy isn’t very realistic.
Debt Service Coverage Ratio (DSCR) – Net Operating Income (NOI) ÷ Annual Debt Service
Let’s talk next about DSCR, or debt service coverage ratio, which is the formula used to determine the Net Operating Income (NOI) divided by the Total Debt Service. Most lenders require at least a 1.25 DSCR because it’s the number they deem “healthy”. As a rule of thumb, the higher this ratio, the lower the lenders’ risk, and the higher the loan amount. Less risk motivates lenders to lend you more money and vice versa.
To make the math easy on you, that means that for every dollar that gets paid for the mortgage, we keep 25 cents. Ninja 🥷 tip: anything that is lower than 1.25 DSCR is a red flag.
Loan to Cost (LTC) – Loan Amount ÷ Total Cost
What about LTC, or loan to cost?
In today’s market, it is fairly common for an LTC to be around 65% to 75%, sometimes a bit higher, all of which depends on many factors. For example in certain economic climates, you don’t want high leverage. You want to make sure you don’t have to do any major cap ex to add income, so that you can pay off the mortgage.
This goes back to the strategy and business plan put in place to not only maximize profit, but also to minimize risk. A word of caution 👀 : while it may be rational to try to get the highest LTC, because debt is cheap, this may also increase the investor’s exposure. For example, if the General Partner gets a 95% LTC, there’s really no income wiggle room should there be a change in the market.
Economic Vacancy
You know how everyone poses on Instagram in front of neon signs? Picture that, but a little less trendy. Do you remember ever driving by those motel neon signs showing vacancy or no vacancy? Now it’s taking on a whole new meaning. Have you ever seen an apartment complex actually be 100% occupied? Probably not, and that’s completely normal! How many times have you moved over the years? 🧐🧐
It would be unrealistic to expect 100 units to be 100% fully occupied all year round. After all, it’s an apartment complex with, in our case, over 100 families, couples, or individuals. Something to consider as well is that if your complex is 100% occupied 100% of the time, that might mean your rates are too low, and we don’t want that, right?
The concept of economic vacancy is generally defined as a unit not collecting rent. It can be currently physically unoccupied like a model unit or there might be a tenant occupying the unit but they aren’t paying rent. it happens and it’s a part of the calculated risk factor that we love to talk to you guys about. Not to worry, we’ve accounted for this well.
In general, the one basic rule of thumb that we tend to use is around 10% economic vacancy in our underwriting. So many times, we see general partners aggressively put only a 5%-7% economic vacancy rate to win deals.
But you know that The Kitti Sisters like to keep things real and often, that simply isn’t true. We’re not putting our name, or our investment team’s name, on anything that doesn’t sit right with us. And neither should you! 😉😉
Annualized Cash Flow – Net Annual Cash Flow ÷ Equity
What about annualized cash flow?
Annualized cash flow is music to the ears of passive investors. 🤩 Quite simply, it’s the cash flow distribution that you’re projected to receive. This projected cash flow is announced during an investment opportunity. At the time of recording, the typical annualized average cash flow is 5-7% (but keep in mind that this can and does change).
AAR – Total ROI ÷ Years of Investment
Have you ever heard of AAR? No, not AARP, the AAR is a simple equation used to calculate the average amount of money an investment earns each year by dividing years of investment by total ROI.
Let’s take a pause here because we don’t want to freak anyone out with all of this talk about calculations 🧮️ . It’s pretty obvious that math is a part of the deal when it comes to being in the investor world, so we’ll give you some practical examples to help you follow along.
For example, let’s say you invest $100,000 in a syndication that you totally love, has been vetted, and you’re excited to get moving on. Your sponsorship team tells you that the total ROI provided to you is $72,000 over four years.
Seems pretty straightforward, right? M-A-T-H! 🤓🤓
So that means the AAR = $72,000 divided by 4 years = $18,000 average annual return. This is a high-level estimate of what you would earn each year that your money is tied into the multifamily project.
Typically, when presented with an investment opportunity with a syndicator, they will give you an AAR as a percentage. For example, you may be looking at investing $100,000 in a deal that has an estimated 18% annual return.
So, what does that mean for you? Let’s do the math: 18% of $100,000 equals $18,000 a year.
Now, the term “each year” can get a little tricky here, especially if you’re investing for equity growth. In that case, you may not see that $18,000 in your bank account each year. It’s more likely you will get a lump sum payout at the end of the deal lifecycle that adds up to an AAR of $18,000 per year– but all paid at once.
So if the lifecycle is 4 years, that means it’ll be $18,000 times 4, totaling back to your original $72,000.
Of course, each deal and each percentage is different. 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. Nothing to bust out the sledgehammer for, but maybe a fresh coat of paint and some upgraded smart locks.
On the flip side of that, if an apartment needs a little extra TLC, heavier value-add projects should be at 16% or higher. As for apartments that need all new construction, that rate should be above 18% due to the higher risk and lack of cash flow.
AAR is very popular amongst a lot of syndicators, but we prefer the IRR route. 😊😊
IRR – Internal Rate of Return.
Great, so what’s IRR? The IRR still measures the annual return buuuut it’s a lot more complicated equation that offers a deeper dive into the potential returns on investment.
IRR takes inflation 📈 and time ⌛️ of holding into account. Which for us is a major plus. We believe that using AAR alone is too simplistic, leaving out the reality of today’s dollar value and the longevity of the deal.
In this economy, we need all the security we can get as investors. And sometimes it can feel like playing a game where the rules change at every move. Not fun, and completely unpredictable. Using IRR allows investors to truly compare apples to apples. While the math may be more complicated, it’s also more exact so investors can make a more informed decision.
What’s involved in this IRR calculation? A few things. IRR takes into consideration the level of annual distributions for investors, the date that the property will be sold, and the price the property is expected to sell for in order to calculate the total projected return.
All of these factors take into account what AAR does not and because of that, you may actually see that the estimated IRR of a project is lower than the estimated AAR.
What is this complex formula? It does require the same formula as Net Present Value, also known as NPV. This is because the IRR is in fact the discount rate that would make the NPV of an investment equal to zero.
Net Operating Expenses
The last term we want to explore with you in NOE, or net operating expenses. These are expenses that are considered “above the line” which are also commonly referred to as basic operating expenses of your apartment. These are routine, regularly occurring expenses. 👀
Operating expenses include: property insurance, real estate taxes, and property management. For properties of 65 units and up, you will have to hire a property management company.
But don’t forget about other routine expenses, which can include payroll, monthly repairs, maintenance, and utilities. This also includes fun stuff like accounting and legal, eviction fees, and advertising to attract tenants.
We ❤️️ sharing our knowledge with you so much that we’ve put together a list of hundreds of key apartment investing terms, available to you online. All you need to do is go to kittisisters.com/lingo to download them!
GET ME ON THE KITTI FREEDOM CLUB
………..
Rate, Review & Follow!
“I love Cashflow Multipliers.” ◀️ If that sounds like you, please consider >> rating and reviewing our show! This helps us support more people — just like you — move toward the financial futures that they desire. Click here to let us know what you loved most about the episode!
Also, if you haven’t done so already, follow the podcast. We’re sharing the best tips, tricks, and secrets in owning your own time so achieving financial freedom early and permanently becomes easier. Follow now!
Comments +