Basic Terms and Concepts

Question 1

Present Value

Answer 1

The cash value today of cash received at some fixed future date. Impossible to predict future value exactly, easier to assess in today’s dollars.

Question 2

Net Present Value

Answer 2

One method for evaluating the financial desirability of a proposed investment by comparing (1) the present value of the income stream expected from the proposed investment, with (2) the minimum return on investment that we, the investor will accept.

Question 3

Discount Rate

Answer 3

Variable used to determine the present value of a future payment. Similar to an interest rate. Consists of (1) basic interest rate, (2) expected rate of inflation, and (3) risk factor

Question 4

Future Value

Answer 4

The value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today.

Question 5

Discounted Cash Flow

Answer 5

The present value of a series of cash payments received at periodic future dates, i.e., the present value of an income stream

Question 6

Internal Rate of Return

Answer 6

The discount rate that makes the present value of all future cash flows (i.e., the income stream) equal to the initial cash investment. The discount rate that will produce a Net Present Value of a series of future cash flows of zero. IRR is the investor’s yield on that investment.

Question 7

Income Stream

Answer 7

The property’s anticipated cash flow. Generated by rent.

Question 8

Cap Rate

Answer 8

Expresses the relationship between income at a particular time and the value of the property at that time.

The discount rate applied to the anticipated profits from investing in the real property. The rate of return that expresses the relationship between one year’s income and its corresponding value.

An estimate of the project’s worth following completion of construction. Determined by looking at recent sales prices and NOIs for comparable buildings/projects in the area. The lower numeric value of the cap rate, the less risky the project, and the more valuable the property.

Question 9

Net Operating Income

Answer 9

Combined revenues, rents etc. from which current operating costs are subtracted. Does not include debt service.

Total annual revenues less total annual operating expenses.

Question 10

Stabilized Property

Answer 10

Property that is already built, with a stable operating and revenue history, and that does not require significant renovation.

Question 11

Cash-on-Cash Return

Answer 11

The estimated annual cash payment from operations to the owner, stated as a percent of the owner’s total investment (cash return / investment). This should equal 8% or more on new developments.

Question 12

Return on Equity

Answer 12

Cash-on-Cash Return is the same. The estimated annual cash payment from operations to the owner, stated as a percent of the owner’s total investment (cash return / investment)

Question 13

Leverage

Answer 13

People will take a loan if it will raise their return on the investment.

Question 14

Debt Coverage Ratio

Answer 14

The lender’s expression of the risk it sees in the development. Higher the DCR, the lower the amount of Annual Debt Service and the lower the original loan.

The amount of cash flow available to meet annual interest and principal payments on debt.

The formula for debt coverage ratio is net operating income divided by debt service. The debt coverage ratio is used in banking to determine a companies ability to generate enough income in its operations to cover the expense of a debt.

Question 15

Annual Debt Service

Answer 15

The total amount of all interest and principal paid on all of the property’s loans throughout the year.

Debt service refers to the periodic payments of principal and interest to the lender made by the entity that owns the development.

Question 16

Loan-to-Value Ratio

Answer 16

Serves to assure the lender that it will recover its principal and accrued but unpaid interest in the event the development fails to generate sufficient NOI to remain current on the loan.

Expresses the ratio of a loan to the value of an asset purchased. The term is commonly used to represent the ratio of the first mortgage lien as a percentage of the total appraised value of real property.

A lending risk assessment ratio that financial institutions and others lenders examine before approving a mortgage. Typically, assessments with high LTV ratios are generally seen as higher risk and, therefore, if the mortgage is accepted, the loan will generally cost the borrower more.

= Loan amount / Value of Property

Question 17

Pro forma

Answer 17

Financial spreadsheet prepared by the developer

Question 18

Soft vs Hard Costs

Answer 18

Hard costs are bricks and mortar costs, such as construction and building materials. Site preparation, building permits, etc.

Soft costs are fees, cost of purchase, appraisal, market study, environmental assessment, accounting, architectural plans, etc

Question 19

Reserves for Replacements

Answer 19

Money set aside as a reserve to replace worn-out capital items, such as replacing roofs. Separate from ordinary maintenance expenditures.

Question 20

After-tax Cash Benefit

Answer 20

The intent is to discover the amount of money that can be deposited in the bank at the end of each year.

A measure of a company’s cash flow after all taxes are paid. It is calculated by taking the net income and adding back in the value of all non-cash expenses, notably amortization and depreciation. Publicly-traded companies with a high cash flow after taxes are in a better position to distribute cash dividends than those with a low cash flow after taxes. In addition to this, it is also used as a measure of general performance and financial health.

Question 21

Developer’s Fee

Answer 21

Compensation to the developer for the time and risk involved to develop the project. It is typically based on the size of the project, the total development cost and the risk associated with the project. A percentage of the project cost, typically 10-15%.

The principal short-term financial reward that the developer receives. Paid by the entity that owns the property. The fee is what remains from the sum of the cash proceeds from the mortgage loan and the sale of equity after all third party expenses relating to the development of the property have been paid.

Question 22

Syndicator

Answer 22

An equity sales specialist. Syndicator will advise him on the sale of the equity and will serve as his agent and implementer of the equity sales process.

a real estate syndicate is simply the pooling of money from numerous investors and organizing these funds as a whole into real estate projects.

Question 23

Accrual Basis Accounting

Answer 23

Accrual accounting is considered to be the standard accounting practice for most companies, with the exception of very small operations. This method provides a more accurate picture of the company’s current condition, but its relative complexity makes it more expensive to implement. This is the opposite of cash accounting, which recognizes transactions only when there is an exchange of cash.

The general idea is that economic events are recognized by matching revenues to expenses (the matching principle) at the time in which the transaction occurs rather than when payment is made (or received). This method allows the current cash inflows/outflows to be combined with future expected cash inflows/outflows to give a more accurate picture of a company’s current financial condition.

Question 24

Cash Basis Accounting

Answer 24

An accounting method where receipts are recorded during the period they are received, and expenses are recorded in the period in which they are actually paid. Cash accounting is one of the two forms of accounting. The other is accrual accounting, where revenue and expenses are recorded when they are incurred. Small businesses often use cash accounting because it is simpler and more straightforward, and it provides a clear picture of how much money the business actually has on hand. Corporations, however, are required to use accrual accounting under generally accepted accounting principles.

A drawback of cash accounting is that it may not provide an accurate picture of liabilities that have been incurred but not yet paid for, so the business might appear to be better off than it really is. At the same time, cash accounting means that a business that has just completed a large job for which it is awaiting payment may appear to be less successful than it really is, because it has expended the materials and labor for the job but not yet reaped the rewards.

Question 25

Depreciation

Answer 25

A decline in value of the property/assets over time.

Straight Line Depreciation: spreads out the cost of an asset equally over its lifetime. Does this by dividing the difference between an asset’s cost and its expected salvage value by the number of years it is expected to be used.

Accelerated Depreciation: allows greater deductions in the earlier years of the life of an asset. The straight-line depreciation method spreads the cost evenly over the life of an asset. On the other hand, a method of accelerated depreciation allows you to deduct far more in the first years after purchase.

Question 26

Passive losses (and rules)

Answer 26

Generally, losses from passive activities that exceed the income from passive activities are disallowed for the current year. Disallowed passive losses are carried forward to the next taxable year. Passive activities include trade or business activities in which you do not “materially participate.” You materially participate in an activity if you are involved in the operation of the activity on a regular, continuous, and substantial basis. In general, rental activities, including rental real estate activities, are also passive activities, even if you do materially participate. However, rental real estate activities in which you materially participate are not passive activities if you qualify as a “real estate professional.”

For tax purposes, rentals generally are passive activities and are subject to the passive loss disallowance rules. See IRC § 469(c)(2). A loss from a passive activity is not currently deductible

As long as a taxpayer participates in management decisions in a bona fide sense, he actively participated in the real estate rental activity. There is no specific hour requirement. However, the taxpayer must be exercising independent judgment and not simply ratifying decisions made by a manager.

Question 27

Capital Gain

Answer 27

The proceeds of sale of a property. Cash paid to seller. And cash paid to lender to repay unpaid principal balance of any non-recourse mortgage.

Question 28

Cost Basis

Answer 28

The original value of an asset for tax purposes (usually the purchase price), adjusted for stock splits, dividends and return of capital distributions. This value is used to determine the capital gain, which is equal to the difference between the asset’s cost basis and the current market value. Also known as “tax basis”.

Question 29

Owning Entity

Answer 29

Tax-related entity of ownership, typically an LLC or LP. Both entities pay no income taxes.

Question 30

Option to Purchase

Answer 30

Landowner sells developer the “right to buy the land” in a 30-day window, or similar time-frame. This time is often used to delay purchase and to allow for feasibility studies and more assessment of project potential.

Question 31

Triple Net Leases (Net Net Net)

Answer 31

Tenant pays taxes, maintenance, utilities and insurance on the property. Tenant thereby acts as the property owner in many practical ways.

Question 32

Certificate of Occupancy

Answer 32

issued by the municipality. Establishes legal occupancy permitted following sound construction, as per the building code.

Question 33

Property Management

Answer 33

Day-to-day details of running a property.

Question 34

Asset Management

Answer 34

Watch over the financial health and transactions of a development project. Manages ownership of the property.

Question 35

Portfolio Management

Answer 35

Thinks like an insurance company, all investments made by the company composes the portfolio.

Question 36

Market Feasibility Study

Answer 36

An assessment of: Site analysis (evaluate the area, amenities, planned changes), economic and demographic context, supply context, balance of supply and demand, and product positioning in terms of offering and pricing

Question 37

Capture Rate

Answer 37

The % of income qualified households that the project must capture to be successful

Question 38

Penetration Rate

Answer 38

The % of income qualified households that this and all other comparable projects will capture

Question 39

Disposition Fee

Answer 39

When it comes time to sell the property, the developer, if still involved with the property, will frequently be paid a fee for effecting its sale. The fee would be paid from the proceeds of sale and can vary widely in amount.

Question 40

Management Fee

Answer 40

If the developer is the property manager for the property - either directly or more usually through a subsidiary company - the developer will be paid an on-going property management fee from the rents. 4-6% of groww rental income is typical.