10 Commercial Real Estate Terms An Investor Needs to Know
Historically, commercial real estate (CRE) has provided a hedge against inflation. Being insulated from market fluctuations, it provides a mostly stable and consistent rate of return. But like every other investment vehicle, commercial properties carry their own set of risks.
Plus, the designation of property as commercial real estate has implications on how it is financed and taxed. That being so, it’s important to know the ins and outs of the commercial real estate industry before shelling out cash on an investment property.
So, here are some terms every commercial real estate investor should know to get you started.
1. Net Operating Income
Calculated as gross income less operating expenses, the net operating income is used to determine the value of an investment property. Income can include rental income, vacancy loss, and any other income-producing avenues of a property like parking tickets. However, expenses do not include mortgage payments or depreciation; but rather property expenses.
NOI lies at the heart of every commercial real estate transaction. It’s calculated on a “proforma” basis prior to property purchase to help an investor determine what a property is worth now and in the future.
2. Capitalization Rate
The capitalization rate, or cap rate, is a profitability metric used to determine the return on investment for a commercial property. It’s the one calculation that everyone in the industry uses. The cap rate is considered a gold standard across the industry because 1) it provides an indication of the return you can make in an all-cash purchase, and 2) it can be used to discern the better deal between two or more properties.
The most common cap rate formula divides the property’s net operating income (NOI) by its current market value.
3. Equity Multiple
Here’s a metric used to describe the relationship between the cash invested in a property and the amount of money it generates. Put simply, it’s the total cash received from an investment divided by the total cash investment. For instance, if you invested $400,000 in motel real estate and received $500,000 in return, your equity multiple is 1.25x.
An equity multiple of less than 1.0x indicates you’re getting less cashback than the equity you invested.
4. Debt-Service Coverage Ratio (DSCR)
Now, this is a metric mostly used by real estate lenders to determine whether a property will generate enough cash flow for the borrowers to pay the mortgage. The DSCR tells you how much cash is left over and is the primary number lenders will look at to determine if a deal is lendable.
The formula for DCR is equal to your annual NOI divided by your annual debt payment. Although exact numbers vary by property type and lender, most lenders prefer a DSCR of 1.25x or more.
5. Per Square Footage
Per square foot is a term you’ll encounter quite a bit while investing in commercial real estate. Rental rates for office buildings, retail centers, and industrial buildings are typically discussed per square foot. It’s a term that can help you evaluate the value of a commercial property.
6. Types of Leases
There are generally three types of leases in the commercial real estate market:
- Full-service leases – In this case, the tenant pays a flat monthly rental fee, and the property owners cater for all operating expenses.
- Modified gross lease – The tenant pays a base monthly rental fee plus some portion of the operating expenses, which are usually negotiated beforehand as part of the lease agreement.
- Triple net lease (NNN) – In this lease structure, the tenant pays a base monthly rental fee and all of the property’s operating expenses. As such, the burden of rising expenses falls only on the tenant.
7. Cash-On-Cash Return
The cash flow is the amount of money that moves in and out of an investment in a specific period. Cash-on-cash return is a ratio that represents an investor’s annual return on their equity.
In essence,
Cash-on-cash return = Annual cash flow / down payment
8. Capital Stack
The capital stack is the structure of all the capital invested into a property, including both equity and debt. Since it determines how much money, or capital, is supporting an investment, it determines who will receive income or profits generated by a property and in what order the funds will be disbursed.
Additionally, it also determines which of the lenders has the first right to foreclose on the property should the investor default on their debt.
9. Cash-Out Refinance
Just like in residential real estate, a cash-out refinance allows you to use funds from a new loan to pay your existing commercial mortgage. There are many reasons for commercial real estate investors to pursue this course of action, the main one being to reduce interest.
With cash-out refinance, you can take on a loan with a lower interest rate and pass on the cost savings to investors. It also allows you to acquire a property with a short-term loan and spend the first few years improving NOI to a point where it can support a higher, longer-term loan.
10. Building Classification
Commercial property can be classified based on its age, location, income, and more. The classes are as follows:
- Class A – These are properties of the highest quality and in the best locations. As a result, they incur the highest rents and are typically best for investors interested in cash flow stability over price appreciation.
- Class B – They’re older, maybe a bit dated, or have minor issues. Invest in class B properties if you’re looking to do some light value addition renovations and are looking for returns that come from a mix of income and price appreciation.
- Class C – Are in a relatively okay location but require moderate to major locations. They are best left for experienced investors with a high-risk tolerance.
- Class D – These properties are below investment grade and carry way too much risk. For instance, they may be properties in high crime neighborhoods or those requiring major structural renovations.
Bonus Term: Internal Rate of Return
The internal rate of return measures the profitability of a potential investment property. It determines which discount rate makes the present value of future cash flows (typically after-tax) equal to the initial capital investment.
Or, to put it more simply, it’s the lowest acceptable level of return that would justify the investment.
Get Specialized Agency Services with Anthony Maccaroni – He knows all Commercial Real Estate Terms
These terms just scratch the surface of what there is to know about commercial real estate investing. Work with an involved commercial realtor who will show you the ropes and guide you on where to invest your hard-earned cash.
I offer a wide variety of services for commercial real estate investors, from property valuations to comparative reporting. Get in touch so we can get started on your commercial real estate in Pinellas and Clearwater.