In the world of real estate, you can never be too prepared or have too much information. Here is a list of the 23 top terms that commercial real estate investors should know when they are considering a deal or an investment.
- Capitalization Rate (Cap Rate)
The capitalization rate or the Cap Rate of a property will give you a snapshot of the property’s current profitability at the time of purchase. It is a key formula used in all real estate investment, not just commercial property. To understand this rate, take the net operating income and divide it by the asking price. The percentage outcome is the cap rate. An easy example of this, If you have a property with a net operating income of $100,000 per year and an asking price of 1 million, take $100,000 and divide it by $1 million. The result of this equation is .10 or a 10 percent cap rate.
- Net Operating Income (NOI)
The Net Operating income is likely the first metric you will look at when considering an investment. This will tell you how much income the investment is generating annually.
To get your NOI, take your rental income plus any additional income you may have at the property. Take this total number and subtract any operating expenses, vacancy or credit loss – to find your NOI
This number does not include your loan payments or capital expenditures and is calculated before tax.
- Cash on Cash Return
Your cash on cash return or your “COC” is the same thing as your return on investment or “ROI”. This is a huge metric to know as it is essentially informing you and your investors how fast cash is being returned to you. This is calculated by taking the annual cash flow and dividing it by your down payment.
- Debt Service Coverage Ratio
The Debt-Service Coverage Ratio (DSCR) is a ratio that compares your net operating income to your debt obligations. Typically the higher the ratio, the lower the risk, resulting in more cash flow and a more attractive deal to your lender since you should have more than enough income to cover your expenses. In order to calculate your DSCR, you need to know your current net operating income (all revenues less recurring operating expenses for the property. This is before debt service and any one-time charges.) and what your total debt service (annual debt service payments and other financial obligations like a sinking fund) will be.
Here’s an example of the DSCR formula:
Let’s say we are buying a stabilized 200 Unit multifamily apartment building for $10mm.
We have $700,000 in Net Operating Income.
We are putting down 25% equity, or $2.5mm. So we are borrowing $7.5mm.
Let’s say the terms on that money are a 25-year amortization at a 5% interest rate. Our annual payment will be about $526,000. Of that, the loan payments will be roughly 300k towards the principal and 226k towards the interest payments. Note that we operate with triple net leases in place, where the tenant is covering the insurance, taxes and maintenance in their lease payments. If your property is structured differently, make sure you’re considering all of your debt in your total debt service.
Take your $700,000 in NOI and divide it by your total debt service of $526,000 and your DSCR is: 1.33
- Cash-Out refinance
The cash-out refinance is a tool that commercial real estate syndicators often use. Commercial cash out refi is when you buy a commercial property, increase the NOI and then refinance the loan to pull out the original down payment or your investor’s down payment while keeping the property. If you are able to do this successfully, you will have no money invested in a cash flowing property and have a return that is infinity. That’s the power of the NOI.
- Loan To Value Ratio
The loan to value or LTV is a tool used to consider the risk that a financial institution would be taking on before giving a mortgage to a lender. The higher the risk, the higher the interest rate will be.
You can calculate the LTV by dividing the amount borrowed by the appraised value of the property. Keep in mind that the appraisals are usually done by the lender. For easy numbers, if you buy a 1 million dollar property and put $250,000 (25%), the $750,000 loan you would need to take out would be a 75% loan to value mortgage.
- Real Estate Investment Trust (REIT)
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. Because REITs are companies, investors can purchase shares in them, providing exposure to the income and profits produced by the underlying real estate assets. For a company to qualify as a REIT, they must meet the requirements outlined in the IRS code, including:
- Invest at least 75% of total assets in real estate
- Derive at least 75% of gross income from rents on real property, interest on mortgages financing real property or from sales of real estate
- Pay at least 90% of taxable income in the form of shareholder dividends annually
- Be an entity that is taxable as a corporation
- Be managed by a board of directors or trustees
- Have a minimum of 100 shareholders
- Have no more than 50% of shares held by five or fewer individuals
- Building Classification
Commercial buildings are broken into three classes. Where each class ends and another begins is a bit of a grey area.
Class A Building: Class A Buildings are the highest quality, in the best locations with the highest rents. These are usually the most expensive buildings that are purchased by institutional buyers and funds.
Class B Building: Class B Buildings are a bit older, but usually still in good shape and will attract average, working class tenants. A lot of times these buildings will be purchased by value add investors who are working to bring update them and bring them back to their class a status.
Class C Building: Class C buildings typically have low to middle-income tenants in them and are in need of a decent amount of work. A lot of apartment investors go with class C because it offers them the best possible returns without the high cost of entry. These can be in challenging neighborhoods and they may need a lot of maintenance, but if well kept they will generally have a low vacancy rate.
Class D (and below) Building: Anything that is below a C will be called a D or various other terms. These properties need a considerable amount of work and will sometimes not be habitable upon purchase. These can be very opportunistic, but you need to be an experienced operator who knows what they are doing to take on this type of project.
As you get into commercial real estate investment, lease agreements and the lease terms that go with them will be a driving force for your NOI. Let’s look quickly at three core types of leases:
- Full Service Lease: The tenant pays a flat fee and the property owner covers everything else including insurance, taxes, repairs, and utilities.
- Triple Net Lease (NNN): The tenant pays for everything. Insurance, property taxes, and cam fees. This option typically gives the tenant a lower base rent and is attractive to owners as they are mostly passive in this arrangement.
- Modified Gross Lease: The tenant and property owner split certain expenses.
- Common Area Maintenance Fees
CAM Fees include the costs of operating the common areas at a commercial property. Maintenance of shared areas: hallways, elevators, stairways, lobbies, public restrooms, parking lots, sidewalks etc.
You will need to know how the CAM fee is calculated per tenant. Most times property owners will split based on the square footage that a tenant is purchasing relative to the total amount of usable square footage or rentable square footage.
- Tenant Improvements
Tenant Improvements is when the tenant alters the property to better fit their use. If signing a multi-year lease, a tenant will often look for a concession so that they can spend capital to improve the property upon moving in. This is often a point of negotiation with the tenant and the landlord. Sometimes it will be more cost-effective to handle the tenant improvements rather than provide a concession
You will want to have counter-offers for all these improvements, so you know if what the tenant suggests as Rent Concessions is not overly expensive for you.
In some cases, you may be better off doing Tenant Improvements yourself and flipping the rent toward a higher number, rather than accepting a rent reduction because of Tenant Improvements that the tenant would do.
- Equity Multiple
As a tool, Equity Multiple is used to measure an investment’s return as multiple of the original investment. It is calculated as an investment’s total cash flows divided by the original investment. For example, a project that returns $150,000 on an investment of $100,000 has an Equity Multiple of 1.5X.
- Hold Period
The hold period is the amount of time that a property is going to be held for an investment period before it is either sold or refinanced.
- General Partner
The general partner (GP) is the operating side of a commercial real estate syndication. There can be several GP’s in a deal. They will handle all of the day to day activities inside of a real estate investment.
- Limited Partner
A limited partner (LP) is the passive side of a real estate syndication. They bring capital to the table but are not responsible for any of the day to day activities.
- Downside Protection
Downside protection is preventative measures used by the general partners in an investment to prevent a decrease in the value of the investment. There are several ways to achieve this, but it is common for investors to have a plan to protect the investment should undesirable circumstances arise.
- Investing Entity
An investing entity is the channel used to make an investment in a commercial real estate offering. At First National Realty Partners, we have an LLC for each investment.
- Market Value
Market value is the price that an asset can command if placed on the public market. Market value in CRE can be impacted by the location of the property, demand for that type of asset and updates that the property had recieved.
- Commercial Real Estate Broker
A commercial real estate broker is a licensed professional who helps clients buy, sell or lease properties. They are intermediaries between buyers and sellers. A good CRE broker will be where most of your deals come from as you grow your CRE business.
- Core Deal
A core deal is generally considered the safest type of deal with the least risk. Class A buildings that are stabilized and fully leased. These real estate investments do not usually appreciate significantly and provide reliable cash flow for several years.
- Core Plus Deal
A core plus deal is similar to a core deal, but will require some additional leverage to increase the NOI at the investment. These, once stabilized, will generally have a higher rate of return than a core deal, but do come with more risk attached. A good example of a core plus deal is a fully leased office space that needs small updates to a small portion of the square feet of the space to bring in additional rent once the leases renew at the office building.
- Value-add Deal
Value-added transactions are all about transforming a piece of real estate from its current state and re-positioning it into a state of significantly higher property value. Value-added players such as ourselves actively look for assets that may have operating, physical, or financing issues.
We acquire these properties at discounts to intrinsic value, correct the issues, increase net operating income, and cash flow to unlock the true value of the asset. Finally, we execute a clear and defined exit strategy and dispose of or refinance the asset at the NEW higher price point.
- Opportunistic Deal
Opportunistic deals are the riskiest of all deals because of the amount of heavy rehabilitation or ground-up development that is needed. While opportunistic investment properties have the highest return, they should be approached by those who have a good handle on how to execute, otherwise, they may be in for a loss. Sponsors for these projects typically employ the use of high leverage and are often subject to less favorable debt terms and higher interest rates than more stabilized properties.
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