TERMS AND DEFINITIONS: RATES OF RETURNS
Hey guys, it's Kris. Welcome to the third video in our real estate education series in an effort to empower you with the knowledge to go out and evaluate your own real estate opportunities. So, today we're going to focus on the vocabulary of real estate. It seems like real estate has its own alphabet and its own vocabulary. There are a ton of acronyms out there that can be very confusing and we're going to break those down to you in 3 distinct categories. And the first one is going to be rate of return, terms and definitions.
We'll go through those right now. In the second video, we'll split out the income and expenses and what you need to know on the terms and definitions around that. And then third, we'll look at the debt terms and definitions and we'll split out the information on that. And I think what that will do is give you a good understanding, a good base of knowledge to go out and have real estate discussions and when you hear these terminologies, understand how that affects or what that means to the particular project. So let's get started with - the rate of return and the terms and definitions related to that.
So, the first one we're going to start with is total ROI or Return on Investment. You'll hear it referenced, most of the time as ROI which is just an acronym for Return on Investment. And how you define ROI is the gain on investment divided by the original investment amount. So let's make a quick example. Let's assume we buy a house for $100,000. So, that's our original investment amount. So over here I'm going to put $100,000. So we buy a house for $100K and then we need to find out what our gain on investment is.
So, let's assume that we hold that house for 5 years and we sell it for $200,000. So our gain would be what we sold it for in 5 years, minus our original, which is $100,000. So, we've made $100,000. So essentially, that $100,000 divided by the $100,000 of original investment. We've essentially made a 100% ROI which is pretty fantastic. So, the thing that ROI doesn't measure, is the time in which you've earned that return on investment. So, if I said to you as an investor, hey, we made you 100% ROI. You'd say, hey, that's great.
But the next logical question you should ask is, well, how long did it take you to make that for me? An investment that made you 100% ROI over 2 years is a lot different than an investment that made you 100% ROI over 10 years. And we're going to walk through the next step of the ROI discussion here and that's the annual rate of return.
And all the annual rate of return is, is the total return on investment divided by the holding period. So, in our example that we just had - we had our total ROI was - $100,000 and we held it for 5v years. And so, if you do that math: $100,000 divided by 5 is 20%, or in this case 20. And so, our annual ROI would be 20 percent year. Pretty straightforward. The next one - this starts to get into a little bit more complexity.
And all I'd ask you to do - we're going to put a link in this video or a link down below so that you can go read an article on how to compare ROI versus our next term, which is called Internal Rate of Return. Or you'll hear people reference it as IRR. And what IRR is, is essentially a more - it's a way to measure the time that it takes to return the money to you and it takes into the time value of money. And so, money gets distributed in different investments in different times. And that may be, I get some upfront. I may get a chunk of money in year 1 and then I don't get paid again till year 3. Well, your annual ROI would just be an average of that.
So what IRR does is, it's essentially the Rate of Return in which your investment grows or shrinks, but factoring in the time of when you get the moneys back to you. So, it helps you create apples to apples comparisons of different projects that have different return distribution schedules. And that's really what IRR is. For most investors, they look at ROI and annual ROI. But, for some of the more sophisticated investors, IRR is the rate that they look at to understand how their money is being used over time.
And so, I'd encourage you to read that article which will give you a more in-depth view into IRR. In the meantime, we're going to shift to the next rate of return, which is called equity multiple. And all the equity multiple is, is it's just another way to measure the total return paid to an investor. So, the equity in a deal typically is your original investment. And so you're trying to find the multiple where, if you multiply your original investment by that number, that's how much money you make at the end. So let's use our house example again, where our total return after the sale, the total of all returns was $200,000 and our original investment was $100K.
And so, if you divide two by one - everybody knows that math. Is a 2.0 equity multiple. And so what that's saying is: if you bought your house for $100,000. That's your original investment and the equity multiple is a 2.0. It means you can expect to return $200,000 when you're done. And so for you, the investor, it's just an easy way to understand what the performance of that deal is projected to be.
The last one, and this is one you're going to hear in mostly in opportunities where you as a passive investor are looking to participate within a syndication or in a joint venture partnership with another another real estate partner. And really, it's called the preferred return. And, as the name suggests, it just means you, a class of investor, gets their money before anybody else does. And so as investors and syndications, where you'll see this the most - preferred return means you get your money back before someone else does, primarily the sponsor. You don't want the sponsor making money before you do. And when I reference sponsor, Reliant Real Estate is a sponsor. We are a real estate operator and we're sponsoring the investment that you mayyou may be participating in.
So, let's take a look at an example here that I think will give you a good understanding of preferred return. Sometimes people call it as "pref" which is just short for preferred return. So, in our structure, this is a typical structure that you'll see in a real estate syndication. It's an 8% preferred return or pref with a 70/30 split. And so, let's assume that you invest in a Reliant syndication.
We buy a self-storage facility and when you buy that self-storage facility, we give you investor terms. And so, you have 8% preferred return with a 70/30 split. So, I'm just going to write out what that looks like. For easy math, let's say you, as the investor, invest $100,000 with Reliant and at the end of the first year, let's assume the property we buy has $10,000 in profit. So, that $10,000 in profit, we have to distribute that in some way, shape or form. And so, that 8% pref, tells us how to do that. So out of that 10 grand, $8,000 of it goes to you to pay your 8% preferred return. $8,000 is the 8% on your $100,000 investment. So, that pays your 8% pref. The remaining $2,000, that gets split 70/30. In this case, 70% to the investor.
You would walk away with $1,400 and the other $600 goes to, in this case, Reliant or the sponsor. And so what that does is, it means you got your 8% preferred return - your $8,000 and then, you also got your $1,400. So, your total was $9,400. Does that make sense? So I think this is a structure that you want to evaluate with your deals to make sure that our incentives, as an operator, are aligned with you the investor. And in a structure like this, I believe that they are. We have to pay you your preferred return and give you a lion's share of the split before we get to share in the profit.
And I think that's what you want to make sure of, as you look through these investment returns, is - you want to understand how the structure is set up so that it aligns you to the sponsor of the deal. So, that's all we have in the video today. The next video we're going to go through is the income and expenses and we'll walk through some of the key terms and definitions that you need to have to understand that in the context of a real estate investment. Thanks for listening.