Let’s face it: with any new venture, it’s easy to get lost in the lingo. When I entered the financial services industry after college, training and licensure felt like drinking water from a firehose. Although private real estate concepts were easy to grasp, the terms, acronyms and abbreviations made learning harder than I had expected. Later, I realized the clients we serviced felt the same way. By using this as common ground to educate them, I felt empowered to teach them how to understand these terms and show them how to take an active role in their finances.
The world of private real estate investing can be intimidating and even difficult to evaluate if you are not familiar with the main concepts involved. By gaining a general understanding of how it works, you’ll be equipped to ask the right questions and to make an investment decision, even if you’re working with a financial professional.
With alternative investments, there are specific regulations that you, as an investor, must know and understand. Because of my passion for financial literacy, and the fact that I’m new to private real estate myself, I’d like to outline some of the terms you will most likely hear in your conversations with investment managers and other investors. This is not an exhaustive list but should provide you with a basic understanding of various elements within our industry.
Because private real estate is considered an alternative investment, the SEC requires investor accreditation. An accredited investor refers to an individual or business entity that is financially sophisticated enough to assume certain investment risks. Accredited investors must satisfy income, net worth and/or professional experience.
For example, to be an accredited investor, a person must have had a yearly income of at least $200,000 (or joint income of $300,000, if married) during the last two years, and have a reasonable expectation of having the same or higher income in the current year. One can also be an accredited investor if they have a net worth of more than $1M, excluding primary residence and outstanding debt.
As of 2020, the SEC has expanded the definition to those holding general securities licenses (i.e. Series 7, Series 65 and Series 82), and family offices with at least $5M in assets and “knowledgeable employees” of investments in a private fund. Again, the idea is that the investor has enough financial knowledge to understand the investment and assume a higher level of risk.
Preferred Return (“Pref”)
In private real estate, preferred return refers to the order in which profits are distributed to an investor. Typically outlined in the subscription agreement as a return on investment, this distribution continues until the investor receives the rate of return, as outlined in the agreement. Preferred returns can vary but are generally paid to the investor first.
At MLG Capital, our preferred rate of return is 8% annually. It is the first “tier” of our distribution waterfall structure.
Distribution Waterfall Structure
A distribution waterfall structure refers to the order that capital is paid to investors for any profit or gains achieved by the underlying investments. When one tier of the waterfall has been successfully achieved, any excess funds will move to toward the pay out of the next tier, and so on.
To learn more, my colleague, Jorjio Hopkins, has a great explanation of the benefits of the European Equity Waterfall.
Capitalization Rate (“cap rate”)
Capitalization rate is the expected rate of return generated from a real estate investment. It’s calculated by dividing net operating income (NOI) by property asset value. The solution to the equation is typically expressed as a percentage and used to estimate an investor’s potential return on investment.
IRR (Internal Rate of Return)
IRR is the rate of growth an investment is expected to generate on an annual basis. This percentage includes both appreciation (increase in value) and distributions (dividends) over a specific period of time. IRR is used to help an investment manager, like us, decide whether to go with a project, in addition to other factors that we may discuss in a later blog.
Honestly, my experiences have shown me the value in education. As the quote goes, “Teach a person to fish, he or she will eat for a lifetime.” Private real estate investing can be complex but becoming familiar with these concepts will equip you with the map you need to navigate the ins-and-outs of your investments.
Jade Hendricks is an AVP of Investor Operations at MLG Capital, with a background in Wealth Management and Wealth Education. She’s a financial literacy advocate, gym enthusiast and lover of all things coffee. If you’re an accredited investor, invest with us.