Capitalization & Structuring
The capital structure, sometimes referred to as the ‘cap stack’, refers to how an investment is owned and funded – it describes the amount and hierarchy of all contributed capital. The primary categories are debt and equity, however those can have various subcomponents, down to the individual investors. An investor’s position on the stack determines their repayment priority, with debt being entitled to repayment before equity.
Cost of Capital / Weighted Average Cost of Capital (WACC)
The cost of capital is what an investor is paid to contribute capital to an investment. It can be expressed as a percentage or an absolute dollar amount, and is effectively the investment return required by the capital source (debt or equity).
A lender charges a 2% origination fee and 6% interest rate for a $100K loan that is outstanding for one year. The lender’s profit is $8K ($2K origination fee + $6K interest expense). The investor is required to pay the lender $8K for the $100K loan, therefore the cost of capital is 8%.
cost of capital = total amount paid to capital provider ÷ total capital provided
8% = $8K ÷ $100K
For an operator raising capital to fund a project, it is important that the gross returns generated by the project exceed the cost of capital, otherwise the capital will dilute or even eliminate the operator’s returns.
If the $100K loan mentioned above was used to fund a $125K real estate investment that generated a 20% ROI, there would be $25K in gross profit. The lender is entitled to $8K, leaving $17K for the investor – a 68% Return on Equity. However, if the investment only returned 7%, the gross profit would be $8.75K of which the lender still earns $8K, leaving $750 for the operator – only a 3% Return on Equity.
For investments with multiple parties in the capital stack, the individual cost of capital for each investor is blended to determine the weighted average cost of capital (WACC).
Suppose for the project mentioned above, the operator also raised $15K of equity from a third party investor requiring a 20% return. This would bring the amount of third party capital raised to $115K (87% of which is debt and 13% is equity). Assuming the $10K contributed by the operator was not assigned a cost of capital, the WACC for third party capital raised would be 10%.
WACC = (% of Debt ÷ Cost of Debt) + (% of Equity ÷ Cost of Equity)
10% = (87% ÷ 8%) + (13% ÷ 20%)
Debt is a source of capital used to finance an investment. In real estate, the most common form of debt is a loan, in which the party that originates and holds the loan is referred to as the lender and the party that receives the loan is the borrower. Other types of debt include lines of credit and credit card debt.
Real estate investment loans are often secured by the subject property as collateral, meaning the lender has the right to foreclose and take ownership of the collateral if the borrower defaults under the loan documents. The borrower is obligated to repay the loan, with interest, based on a pre-agreed payment methodology outlined in the loan documents.
Equity represents ownership of an asset (a property, a company, etc.). The percentage of equity owned by an investor is commensurate with their ownership amount in the underlying asset. For instance, owning 50% of the equity in a real estate investment is the same as owning 50% of the subject property.
The total equity in an investment is determined by taking the difference between the market value and the amount of debt on that investment; it is the amount of money available to distribute to owners after debt is repaid. Unlike debt, equity increases or decreases along with the market value of the subject property.
Equity = Market Value – Debt
Example: A property is acquired for $100K, using 75% leverage ($75K of debt). Later, the market value of the property grew to $110K. Therefore, the value of the equity increased from $25K to $35K (+40%).
Cash Equity vs. Non-Cash Equity
Cash equity is the portion of the total equity invested in an asset represented by actual cash contributions. Cash equity typically matches the cash used to acquire a property, but can change over time if there are additional cash contributions, or with certain types of cash distributions classified as a “Return of Capital,” such as a refinance or partial sale.
Non-cash equity is the difference between the total equity and the cash equity in an asset.
Non-Cash Equity = Total Equity – Cash Equity
Example: A property is acquired for $100K, with $75K of debt + $25K of cash. Later, the market value of the property grew to $110K so the total equity value increased by $10K from $25K to $35K. In this scenario, the cash equity is $25K, and the non-cash equity is $10K.
Leverage refers to the use of debt to finance an investment. An investment that includes debt in the capital stack is “levered,” and one that doesn’t is considered “unlevered.” When used as a noun, leverage refers to the ratio of debt to the total cost basis, expressed as a percentage. For example, if an investment property has a $100K total cost basis of which $60K is debt, the leverage is 60%.
Investors use leverage to reduce the amount of cash equity required, and increase potential investment returns. It is important to note that leverage also exacerbates negative results if the returns are below the cost of debt, a situation referred to as “negative leverage.”
As part of determining the optimal capital structure for a particular investment, investors should compare both the unlevered and levered investment returns. This illustrates the benefits of using leverage, which need to be weighed against associated risks.
Foreclosure is the legal mechanism used by a lender to take ownership of a property that has been pledged as collateral for a loan (outlined in the Deed of Trust). A lender may seek to foreclose on the mortgaged property to minimize its financial losses if a borrower defaults on the Loan Documents, typically related to missed debt service payments.
When a foreclosure occurs, the investor typically loses all of its equity in the property – meaning the value of its investment goes to zero.
The foreclosure process is nuanced, and varies by state. Just under half of the states use a “judicial foreclosure” method; the lender must obtain the court’s permission to foreclosure by proving the borrower defaulted. The majority of states use “non-judicial foreclosure” which is typically quicker – as long as there are no lawsuits, it does not go through the courts.
Most lenders seek to sell a foreclosed property as quickly as possible to recover their capital, which is sometimes done through an auction process administered by the courts. However, some lenders might have strategic reasons to continue owning the property after foreclosure. There is a category of lenders whose strategy is “loan-to-own” where foreclosing was part of their original business plan.
Home Equity Line of Credit (HELOC)
A HELOC is a type of loan in which the borrower can withdraw up to a certain limit established by the lender for an established time period (the “term”), where the lender’s collateral is the borrower’s equity in their home – the market value of the home minus any existing mortgages. The lender charges interest on the amount of debt outstanding at any point in time. A HELOC can be a helpful tool for bringing cash to the closing table or making short term investments in certain situations.
For example: You have a home worth $500K that has a $400K mortgage, resulting in $100K of home equity. If the agreed-up HELOC limit with your lender is 80% and the annual interest rate is 5%, you can withdraw up to $75K, for which you would pay $333 per month in interest expense.
$333 = ($80K x 5%) ÷ 12 months
Risks associated with a HELOC are that the borrower’s home, typically their primary residence, is the lender’s collateral – if the loan is not repaid, the lender could force a foreclosure to recover all of the equity in the home. Additionally, a HELOC functions similarly to a credit card, which can make it tempting to use more debt than is responsible.
When applied to real estate investing, an interest rate represents the cost of borrowing investment capital from a financier, typically a lender. Interest rates are expressed as an annualized percentage of the amount borrowed.
If the interest rate on a $100K loan is 6%, the annual interest expense is $6K, or $500 per month until the loan is repaid.
The higher the interest rate, the more perceived risk a lender is associating with loaning its capital. From an academic perspective, if US Treasury Bills (deemed to be “risk free”) are paying 2%, a lender may determine that value-add real estate investments warrant a 4% spread over the risk free rate, which implies they are willing to lend to real estate investors at a 6% interest rate. If the risk free rate increases to 3%, and the lender continues to apply the 4% spread, their interest rate for real estate investors would increase to 7%.
The term “Loan Documents” refers to the collective set of written legal instruments used to create and enforce a loan. The loan documents are signed by the lender and the borrower, as well as the guarantor (if applicable). The primary loan documents include the Loan Agreement, Promissory Note, and Deed of Trust; others may be required depending on the type of loan or what state the property is located in.
Loan Agreements – The Loan Agreement outlines the “business terms,” such as detailing items that require lender approval, how a construction draw process works, the type and amount of required reserves, and generally what the borrower needs to do to stay in compliance with the Loan Documents.
Promissory Note – The Promissory Note, or “Note” for short, describes the conditions under which the lender agrees to make a loan to the borrower, and the borrower promises to repay the loan. The Note is secured by the Deed of Trust as well as the other loan documents.
Deed of Trust – The Deed of Trust, or “Deed” for short, is the legal mechanism by which the lender is granted a “first lien” position, until the loan is repaid. The Deed is recorded “on title” at the local courthouse and provides the lender the right to foreclose and take possession of the property if the borrower defaults on any of the Loan Documents.
Guaranty – The Guarantee is a contract that obligates a guarantor, who is typically an affiliate of the borrower, to fulfill the borrower’s obligations under the Loan Documents in the event the borrower fails to do so
Environmental Indemnity – a stand-alone agreement that remains enforceable after the loan is repaid and protects the lender from environmental-related liabilities stemming from the subject property.
In a business partnership, certain actions may be identified as “major decisions” within the control provisions of the partnership documents. These major decisions are deemed to be important enough that they are made pursuant to a pre-negotiated framework. Sometimes the largest investor is able to unilaterally make major decisions. In other instances, a consensus between the partners might be required.
Examples of major decisions include…
selling the property and for what price
approval of the business plan and annual budget
approval of construction scope/budget and material modifications to the same
financing terms and the decision to refinance
hiring or replacing team members (property manager, general contractor, leasing/sales agent, etc.)
insurance and tax matters
establishing cash reserve requirements
approval of press releases or responding to media inquiries
Appreciation / Depreciation
In real estate, appreciation describes a property’s increase in market value over a specified time period, whereas deprecation refers to a decrease in market value. Appreciation and depreciation can be expressed as either an absolute dollar amount, or as a percentage.
A property is acquired for $100K. If one year later the market value is $105K, the property appreciated by $5K, or 5%. If after five years, the market value has grown to $120K, the cumulative appreciation is $20K, or 20%.
Appreciation % = (Ending Market Value – Beginning Market Value) ÷ Beginning Market Value
5% = ($105K – $100K) ÷ $100K
It can be useful to frame appreciation as an annualized figure – in which the cumulative appreciation is assumed to have occurred evenly over the time period. For instance, the property above appreciated by $4k per year over five years to arrive at a $120K market value.
Annualized Appreciation $ = (Ending Market Value – Beginning Market Value) ÷ # of years
$4K = ($120K – $100K) ÷ 5 years
From a percentage standpoint, the property realized an average annual appreciation of ~3.7%, meaning that if the $100K property increases in value by 3.7% per year (including compounding), it will be worth $120K after 5 years.
Annualized Appreciation % = ((Ending Market Value ÷ Beginning Market Value)^(1 ÷ # of years)) – 1
3.7% = (($120K ÷ $100K)^(1 ÷ 5)) – 1
Return on Equity
Return on Equity is a common financial metric utilized to gauge the overall profitability of an investment as a function of cash equity invested, expressed as a percentage.
Return on Equity = Net Profit ÷ Cash Equity
Example: A property is acquired using $50K of cash equity, and when sold results in $20K of net profit. The resulting Return on Equity for this investment is 40%.
The levered yield is the annualized potential cash flow returns from an investment property, expressed as a percentage. It represents the distributable levered cash flows generated from a rental property, as a percentage of cash equity.
Investors use levered yields to assess the maximum potential cash flow returns of a rental property or portfolio. Additionally, the “spread” between the levered yield and the unlevered yield is indicative of how accretive or dilutive using leverage is to the investment in question.
Levered Yield = (Net Operating Income – Interest Expense) ÷ Cash EquityThe levered yield is usually higher than the cash-on-cash return, since it treats all distributable cash as if it were paid to the investor(s). In reality, this cash is often used to make required principal payments on the loan (amortization), to pay for capital improvements or to fund working capital reserves.
The unlevered yield is the annualized cash flow return from property operations assuming no leverage, expressed as a percentage. It illustrates the annual distributable cash generated from a rental property compared to the total cost basis of the investment, excluding the impact of financing.
Investors use unlevered yields to assess and compare operating fundamentals of investments on an apples to apples basis, independent of financing assumptions which vary based on a variety of factors unrelated to the property itself (capital market conditions , borrower circumstances, etc.). Additionally, the unlevered yield forms the baseline to determine how accretive a particular financing strategy is (or isn’t).
Unlevered Yield = Net Operating Income ÷ Cost Basis (unlevered)
The calculation is similar to the cap rate, which represents the unlevered yield an investor expects to earn after acquiring a rental property.
Underwriting & Reporting
After Repair Value (ARV)
An estimate of the subject property’s market value immediately after a rehabilitation is completed. The ARV is typically determined by evaluating recent comparable property transactions, and may be confirmed with an appraisal.
Closing costs are the cumulative fees and expenses incurred when a property is bought or sold, excluding the price of the property itself. Typical closing costs include (but are not limited to) title insurance and fees, financing fees, transaction fees or commissions, due diligence costs, appraisal fees, and legal expenses.
Real estate investors and appraisers use comparable properties to support a subject property’s estimated market value. Often called “comps” for short, comparable properties share physical and other characteristics with the subject property that would cause them to be valued similarly by a purchaser or renter. An investor may use different comps for the same subject property depending on if they are seeking to validate the purchase price, or the after repair value.
A perfect comp would be located on the same street as the subject property, would be identical in all respects, and publicly marketed for sale or lease immediately prior to the contemplated subject property transaction. Perfect comps are hard to come by, so best practice is to focus on specific features that are proven to be primary drivers of value.
Examples of features used to identify comparable properties:
number of bedrooms and bathrooms
square footage of the home
lot size – how big is the yard?
property condition – is it move-in ready or does it require repairs?
special characteristics – pool, basement, upgraded finishes or landscaping, etc.
proximity to desirable amenities – retail, restaurants, parks, public transportation, etc.
Other considerations involve specifics around the nature and timing of comparable property transactions.
Good comps were subject to a typical marketing process resulting in a negotiated “arm’s-length” transaction, ideally with multiple bidders providing support for the market price. Additionally, the length of time the comp was marketed for sale or lease should be in line with the area’s average “days on market.”
The closer the transaction date of the comp is to the subject property, the stronger the comp. This reduces the risk of macroeconomic conditions causing appreciation or depreciation in the market, which may skew the results.
An asset’s market value is the estimated gross purchase price a buyer (i.e. – “the market”) would pay to acquire the asset in an “arm’s length” transaction. Market value is often validated by an appraisal or broker’s opinion of value completed by an independent third party who conducts a thorough analysis to determine a subject property’s market value using standardized methods.
Net Operating Income (NOI)
The net operating income, commonly called “NOI,” is the amount of cash available for distribution from normal operations of a real estate investment, prior to paying for capital expenditures, financing costs, and non-typical or owner-specific expenses.
Net Operating Income = Effective Gross Income – Operating Expenses
The purchase price is the amount paid by a buyer to acquire a property from a seller, which will be included in a purchase and sale agreement. A seller of a property will describe a buyer’s purchase price as its sale price; they are the same number. The purchase / sale price does not include closing costs or other adjustments.
Payment received for the right to use or occupy a property. Typically, rental income is defined within the terms of a lease agreement. Rental income can be expressed as a whole dollar amount, or as a function of the property’s square footage.
An example: A tenant in a 1,500 square foot single family property signs a 12-month lease at a rate of $2,000 per month, or $1.33 per square foot. The annual rental income for this property is $24,000 per year.