Real Estate Lingo, Defined (Part 1)

April 28, 2021
In this edition of our blog, we will review some fundamental terms and metrics used by commercial real estate professionals. These include:

Pari Passu

Pari Passu is a Latin phrase that literally means “with even step” but translates something like “on equal footing”, “ranking equally” or “moving together”. Pari is the Latin word that eventually produced the English word “Parity”, and Passu means “step”. In real estate, this phrase can have several different meanings depending on context, but in every setting, it ultimately means that two or more investors, lenders, assets, or obligations will be treated equally. In the context of financing or lending, Pari Passu would mean that multiple lenders have equal claims to the assets used to secure a loan. Alternatively, in a commercial real estate investment setting, Pari Passu would mean that investors will receive their pro rata distribution dependent on their respective investment amount. As an example, if one investor puts in 60% of the equity in a deal, and another contributes 40%, then the Pari Passu structure would dictate that profits would be split on equal footing, or 60% to the first investor, and 40% to the latter.

Promote

While the concept of a Promote is critical within a commercial Real Estate private equity opportunity and structuring, Promote is simply a commercial Real Estate industry term to describe the Sponsor, or General Partner’s, disproportionate share of the actual profits realized above one or more agreed upon internal rate of return (IRR) or equity multiple (EM) thresholds. This concept, in many other industries, is often described as a “Carried Interest”.



By this point, alarm bells might be going off in your head, and you could be asking yourself, “Wait a minute…Why should the Sponsor get a Promote on a commercial real estate investment if the limited partner(s) put up the majority of the equity needed for the investment?” That is a great question, that we would answer by discussing the roles and responsibilities of the Sponsor, as well as incentivization’s of all parties involved in the deal. First, and easiest to explain, is that a Promote encourages the Sponsor to source potential commercial real estate acquisition targets, and then identify ways to unlock value for all parties involved in the deal. Further, the Promote rewards the Sponsor for the work that they do for the partnership from acquisition through disposition, including underwriting the deal, negotiating contracts, securing financing, completing due diligence, developing business plans, managing leasing, capital projects, and investor reporting, and finally, disposing of the asset. So in the context of the Sponsor providing all of these services, and incentivizing the Sponsor to deliver excellent returns to investors, the Promote is an incredibly powerful tool.



Below is an example of a commercial real estate waterfall, followed by an explanation of relevant terms:

Ownership Equity Structure 

General Partner / Sponsor 

5% 

Limited Partner 

95% 

Total Equity 

100% 

           

Waterfall 

 

GP 

LP 

IRR 

Preferred Return 

5% 

95% 

8.0% 

Tier 2 

25% 

75% 

12.0% 

Tier 3 

35% 

65% 

 

In this example, the Sponsor would contribute 5% of the equity for the investment opportunity, while the limited partner would contribute the remaining 95%. Returns would be distributed annually on a Pari Passu basis up to 8%, followed by returns being split 75%/25% up to a 12% return, and then everything after that would be distributed 65%/35%. Depending on the specific investment opportunity, these terms can and should vary.

Syndicate

The syndication process is not a new one—it actually stretches back hundreds of years. Syndication is when an investor or company (sometimes known as the “syndicator” or “sponsor”) sources an investment opportunity, and then pools capital with other investors with similar investment objectives in order to buy that commercial real estate asset. In this situation, the investors get the benefits of commercial real estate ownership (think tax benefits, as you own the real estate directly) without having to make a potentially very large purchase on their own. This might open up a whole new world of opportunities for investors who might not have the ability to invest in certain asset classes otherwise. Additionally, this investment opportunity allows the equity investor the ability to pick and choose which investments they will fund. A REIT investor, on the other hand, does not have this same optionality. And finally, the equity investor is not involved in the acquisition or financing of the property, nor are they responsible for day-to-day management of the property.

Crowd Funding

Crowd Funding is Syndication for the modern era. In the 1960’s when the Empire State Building was syndicated to a group of investors, the most likely form of communications from the sponsor to potential investors were the US Postal Service and landline telephones! Today, we are in the midst of a revitalization, through modern electronic means, of the longstanding practice of syndication. Through Crowd Funding, investment sponsors can raise capital from investors through many different modern, innovative means, such as websites, apps, and even by using blockchain (the same technology used in cryptocurrencies). Many people are familiar with Crowd Funding because of websites such as Kickstarter or GoFundMe, but these are not Crowd Funding sites dedicated to Real Estate investing. Some of the biggest Crowd Funding companies that are either completely dedicated to Real Estate funding, or have a heavy Real Estate focus are Crowdstreet, Fundrise, or Yieldstreet. While these are some big names with large marketing budgets and a big web presence, anyone can participate in Crowd Funding a Real Estate deal. Depending on the sponsor, the investor might be on the debt or equity side of a Real Estate investment opportunity.

Net Operating Income

Net Operating Income, or NOI, is a measure of a commercial real estate asset’s profitability, calculated by subtracting all property level operating expenses from all revenues generated by the property. It does not take into consideration capital expenditures, leasing costs, taxes on income generated, or costs of financing (principal or interest). Net Operating Income is one of the fundamental financial metrics in real estate analysis, and appears in several different calculations that help describe a property’s value, including the Cap Rate, Internal Rate of Return (IRR), and Cash on Cash Return (ConC). An example of how Net Operating Income is calculated is found below:

Revenue: 

  • Rental income:  $25,000 
  • Parking income:  $4,000 
  • On site billboard:  $1,000 

Total Revenues:  $30,000 

 

Operating Expenses: 

  • Property Taxes:  $5,000 
  • Property Management Fees:  $2,000 
  • Insurance:  $2,000 
  • Repairs and Maintenance:  $1,000 

Total Operating Expenses:  $10,000 

 

In this example, Net Operating Income for this commercial real estate asset would be calculated as $30,000 less $10,000, or $20,000.   

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