Breaking Down Buzzwords in Real Estate Investing

Quick takeaways

• As with stock and bond investing, commercial and multifamily real estate investing has a language all its own.

• Different terms relate to different aspects of the real estate cycle, including development, investment, property management, asset management, and disposition.

• If you’re a Realberry investor or prospective investor, contact our Investor Relations team for help understanding any buzzwords of interest.

Basis

Basis, or cost basis, generally refers to the value of investment real estate for tax purposes.

Basis can go up if the owner makes improvements to a property such as by replacing the heating, ventilation, and air-conditioning system or installing a new solar-panel covered roof. Or basis can go down, for example, as a result of depreciation deductions, which are tax deductions taken on rental properties of all types as they age.

Basis is essentially the purchase price plus acquisition costs (such as closing costs, broker commissions, and legal fees) at the time an asset is acquired, or the development value after a new construction project is completed. It’s not necessarily the same thing as appraised value or replacement cost [cross-link].

Cap Rate

Cap rate, short for capitalization rate, typically refers to the expected yield on an income-producing property the first year after it is acquired. This is sometimes called a going-in cap rate. Cap rates can also be calculated on a trailing basis, using actual historical NOI from the prior 12 months rather than projections.

Cap rate is an investment metric. It’s calculated by dividing the first year’s projected or actual net operating income, or NOI [cross-link], by the purchase price. It’s analogous to the yield on a bond.

Usually cap rates and prices move in opposite directions at the same time. In other words, as the price of a property goes down, the cap rate goes up. The opposite is usually true as well. It’s analogous to the relationship between the price of a bond and the yield on the bond.

CapEx

CapEx, or capital expenditures, are investments made to a property to physically improve it in a meaningful way. Capital expenses, also known as capital improvements, typically, but not always, add value to a property. Often, tenants will pay more (higher rent) in exchange for capital improvements or after significant capital improvements have been made to a property. However, many capital improvements can be required just to maintain the overall functionality and or competitiveness of the asset, and do not necessarily allow for an increase in rental rates.

Examples include new elevator cabs, new glass curtain walls or windows, and new amenities such as a gym added to an office or multifamily building.

Capital expenditures are in contrast to operating expenses [cross-link], which are generally made to repair or maintain a property.

Loan-to-Value and Loan-to-Cost

Loan-to-value and loan-to-cost are both financial metrics used to gauge how much leverage (debt) is on a property. They are both ratios.

The loan-to-value ratio is the amount of debt on a property divided by the value of the property. The loan-to-cost ratio is the amount of debt on a property divided by the cost of a property.

Mark-to-Market

Mark to market is a general term that can be applied to a range of different financial factors or situations. Generally, it means re-valuing something to reflect current market values or rental rates.

For example, a bank that has a mortgage loan on a property — with the property as collateral — can at any time during the life of the loan mark the property value to market; in other words, re-value the property based on current market conditions. Marking the value of collateral to market in this case could result in the property being revalued lower or higher, with potential implications for the mortgage loan terms.

Another example: After an investor buys a multi-tenant property that is charging below-market rents, the investor-owner could mark the rents to market; in other words, increase the lease rates to reflect what tenants of similar properties are generally paying.

NOI

NOI, or net operating income, is a measure of a commercial or multifamily property’s profitability. Typically calculated on an annual basis, NOI is determined by subtracting a property’s operating expenses from the revenue it generates. In other words, property income minus operating expenses equals NOI. Net operating income does not include income taxes or financing costs such as mortgage interest. These expenses are considered “below the line”

OpEx

OpEx, or operating expenses, are costs incurred to maintain and manage a property on a day-to-day basis but not improve the property per se. This is in contrast to capital expenditures [cross-link], which typically represent improvements including significant modernizations.

For example, the cost to repair a heating, ventilation, and air-conditioning unit would be an operating expense, while the cost to replace the HVAC system would be a capital expenditure.

Other examples of operating expenses are utilities, insurance, elevator maintenance, and landscaping.

Preferred Return (Pref) and Waterfall

Investors in private equity real estate typically get paid before the sponsor of an individual property or fund investment. This is known as a preferred return since the investors receive a share of profits first, before performance incentives are collected by a sponsor.

The term waterfall is often used to describe how performance incentives work in private real estate investing. The waterfall analogy connotes the thresholds at which different payments are made to investors versus sponsors and in what amounts based on achieving performance goals.

Replacement Cost

Replacement cost is the actual cost of rebuilding a property from the ground up. Replacement cost is one way that commercial appraisers value a property. Insurance companies also consider replacement cost when underwriting coverage on a building in the face of damage or loss.

For a variety of different reasons similar to a single-family home, replacement cost may be higher or lower than a sale price, which is driven largely by supply and demand; or the property’s assessed value for tax purposes, which is driven largely by comparable sales.

Spread Compression and Spread Expansion

Spread compression and spread expansion refer to the relationship between a property's cap rate and the investment sponsor's cost of debt. The underlying principle: the higher a sponsor's cost of debt relative to a property's cap rate, the lower the return an investor should expect, and vice versa.

This dynamic is rooted in the broader concept of the cap rate spread, the difference between a property's yield and prevailing borrowing costs. Spread compression typically occurs when debt costs are rising; spread expansion generally occurs when debt costs are declining.

Stabilization

In commercial and multifamily real estate, stabilization generally refers to the point at which a new or underperforming property reaches its steady-state potential in terms of occupancy or rent levels; in other words, the point at which it becomes stable and or operating as would be expected in normal conditions.

Stabilization isn’t the same thing as profitability. A property may in fact become profitable before it stabilizes. (The opposite is true as well.) A good analogy is general health. A stabilized property is essentially a healthy one in simple terms.