Like any industry, commercial real estate (CRE) investment has its own jargon and vernacular. For new participants, hearing some of the common commercial real estate terms that are common in the industry can be intimidating and make real estate investing seem inaccessible. But, to fully understand the risk/return profile of an investment opportunity, there are 25 commercial real estate terms that every investor should know and understand.
1. Capitalization Rate (Cap Rate)
The Capitalization Rate or “Cap Rate” is commonly used in two ways: (1) it provides an indication of the return that an investor can expect in an all cash purchase; and (2) it can be used to compare the price of one property to another.
The cap rate is calculated as Net Operating Income divided by the property’s asking price and the result is expressed as a percentage. For example, a multifamily property with $100,000 in Net Operating Income and an asking price of $1 million has a cap rate of ($100,000 / $1 Million) 10%. Put another way, if an investor purchased this property with $1 million in cash and earned $100,000 in the first year, they would earn a return of 10%.
2. Net Operating Income (NOI)
Unlike residential real estate, which is valued on comparable sales, commercial real estate is valued based on the amount of “Net Operating Income” or “NOI” that a property produces.
Net Operating Income is calculated as a property’s Gross Potential Rent; less operating expenses and it is expressed as a dollar figure. For example, if a property produces $250,000 in Gross Potential Rent and has $150,000 in operating expenses, the resulting Net Operating Income is $100,000. To estimate value, a Cap Rate can be applied to NOI. For example, if a 10% Cap Rate is applied to $100,000 in NOI, the resulting value estimate is ($100,000 / 10%) $1,000,000.
3. Cash on Cash Return
A property’s Cash on Cash return or “CoC” represents a real estate investor’s annual return on the amount of cash invested into a property.
The formula for calculating Cash on Cash Return is Cash Received / Total Cash Invested on an annual basis and it is expressed as a percentage. For example, if an individual invests $100,000 into a property that returns $10,000 in year 1, the CoC return for that year is ($10,000/$100,000) 10%.
4. Debt Service Coverage Ratio
The Debt Service Coverage Ratio or “DSCR” is a metric used to describe the relationship between a property’s Net Operating Income and loan payments.
The formula for calculating DSCR is Net Operating Income / Debt Service and it is expressed as a decimal. But, it is important to note the time frame used to calculate DSCR must be the same for each variable. If Net Operating Income is an annual figure, Debt Service must also be an annual figure. For example, if a property produces $100,000 in Net Operating Income and has annual debt service of $75,000, the resulting DSCR is ($100,000 / $75,000) 1.33.
To obtain debt on a property, many lenders require a minimum Debt Service Coverage Ratio as part of the requirements for approval. Although the exact number varies by property type and lender, 1.25x is a general guideline and target that many investors aim for.
5. Cash-Out Refinance
Simply, the real estate term “refinance” means the act of obtaining a new loan to replace an old one. Commercial real estate professionals may do this for a variety of reasons, but the most common is to reduce interest expense. For example, if a property owner’s current loan has an interest rate of 5%, but they can obtain new debt with an interest rate of 4%, they may refinance and pass the cost savings on to investors.
In a “cash out refinance,” the new loan has a higher balance than the old loan. Continuing the example above, assume the loan with the 5% interest rate has a balance of $250,000 and the loan with the 4% interest rate has a new balance of $400,000. The proceeds from the new loan are used to pay off the old loan ($250,000) and the difference ($150,000) is the “cash out” and can be used to distribute to investors or renovate the property.
One debt strategy that many individuals use is to acquire a investment property with a short term loan and spend the first few years of ownership improving the property and adding value. In doing so, they also improve Net Operating Income to a point where it can support a higher loan amount. Once stabilized, they will do a cash out refinance and use the cash proceeds to distribute to investors.
6. Loan To Value Ratio
A property’s Loan to Value or “LTV” ratio is exactly what it sounds like. It is the ratio of the loan amount to property value and it is commonly used to gauge how much debt is placed – or can be placed – on a commercial real estate asset.
The formula for calculating LTV is Loan Amount / Property Value where the loan amount is the balance of the debt on the property and the value is an appraised value. For example, if a property has a loan balance of $1,000,000 and a value of $1,500,000, the resulting LTV ($1,000,000 / $1,500,000) is 66.66%.
Banks and lenders may set maximum LTV requirements in potential transactions, which can allow an investor to make an assumption about how much debt they can place on a property. The exact requirements vary by lender and property type, but 75% LTV can be used as a general guideline. For example, if a property has a known value of $1,000,000, then it would be safe for an investor to assume that the maximum amount of debt that could be placed on it is ~$750,000. From a risk perspective, LTV should not exceed ~80% unless there are mitigating factors like a credit tenant or a long term lease.
7. 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, and the tax benefits that go along with them, they must meet the following IRS requirements:
- 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 and have a minimum of 100 shareholders
- Have no more than 50% of shares held by five or fewer individuals
REITs can be publicly traded, meaning that their shares can be bought and sold on common stock exchanges. Or, they may be privately traded, meaning that the shares trade hands between private companies and/or individuals. In addition, they can invest in the asset class of their choice, including apartment buildings, office buildings, industrial buildings, or retail buildings. Some may even invest in residential property like single-family homes.
8. Building Classification
A building’s “classification” is shorthand for a description of its location, amenities, finishes, and potential risk. Generally, commercial real estate assets are placed into one of four “classes.” It should be noted that the delineations between classes are not exact and for properties on the browser between two classes, one investor may see it one way, and another may classify it differently. But, in general, the classes are as follows:
- Class A: Class A properties have the highest quality, best locations, most luxurious finishes, and the highest rents. As a result, these properties tend to attract a stable tenant base, which means they are the least risky and most expensive. Class A buyers are those who prioritize cash flow stability over price appreciation and typically include institutional investors like REITs, hedge funds, and private equity firms.
- Class B: Class B properties are slightly older and may be a bit dated. They are in good, not great locations and may have minor to moderate deferred maintenance. As a result, they tend to attract tenants of average credit quality. Class B buyers may purchase these properties with a “light” value add strategy which includes minor renovations and cosmetic changes. As a result, their returns may come from a mix of income and price appreciation.
- Class C: Class C properties are likely dated, require moderate to major renovations and have a fair location. They tend to attract fair tenants who may not have the financial resources for a Class B property, and as a result cash flows may be more variable and collection expenses may be higher. However, for investors with a high degree of operational expertise and an elevated risk tolerance, they may find significant value in the purchase and reposition of a Class C property. In this case, returns would come from some income and a high degree of price appreciation.
- Class D: Class D properties are below investment grade and come with a high degree of risk. They are likely in poor locations that may be affected by crime or other safety issues and require a significant amount of deferred maintenance, structural issues, or remediation to be brought up to market standards. Class D tenants have high credit default risk and represent a classic boom/bust scenario.
A lease is a contractual agreement between a property owner and business in which the owner agrees to “lease” space to a business in return for a monthly payment. The income generated from monthly lease payments is used to fund operating expenses and debt service. If there are any funds remaining, they are available to be distributed to investors. Broadly, there are three types of leases that are popular in commercial properties and their differences relate to who is responsible for payment of the property’s operating expenses:
- Full Service Lease: In a “full service” lease, the tenant pays a flat monthly rental fee and the property owner is responsible for all operating expenses including insurance, taxes, repairs, and utilities. This structure is simple for the tenant, but places the burden of rising operating expenses on the owner.
- Modified Gross Lease: In a “modified gross lease” the tenant pays a base monthly rental amount plus some portion of the property’s operating expenses that are related to the percentage of the building’s space that they occupy. Specific responsibility for operating expenses between the owner and the tenant are negotiated as part of the lease agreement.
- Triple Net Lease (NNN): In a triple net lease structure, the tenant pays a base monthly rental amount and all of the property’s operating expenses. NNN leased properties are popular with investors seeking passive income because the tenant manages the property on their own and the burden of rising expenses falls on them.
10. Common Area Maintenance Fees
Common Area Maintenance or “CAM” Fees are supplemental fees charged on top of a tenant’s base rent and used to pay for the operating expenses associated with common areas like the parking lot, elevators, stairways, lobbies, public restrooms, and sidewalks.
In most cases, a tenant’s lease will specify exactly how the CAM charges are calculated, but they are typically in proportion to the overall percentage of space a tenant leases. For example, if they lease 20% of the space, they may be responsible for 20% of the CAM charges.
11. Tenant Improvements
Tenant improvements are alterations made to a leased space for the purpose of customizing it to the needs of the tenant. Often, as an incentive for leasing their space, a property owner will offer the tenant a per square foot allowance for tenant improvements. In some cases, if the tenant is a large one and the lease has a long term, the tenant improvement allowances can be significant. For example, the tenant improvement allowance for a Walgreens Drug Store on a 25 year lease could be hundreds of thousands of dollars.
12. Equity Multiple
The Equity Multiple is a return metric used to describe the relationship between the cash invested in a property and the cash received from it.
The formula for calculating the Equity Multiple is Total Cash Received / Total Cash Invested and it is expressed as a decimal. For example, if an individual invests $200,000 in a property and receives $400,000 in return, the resulting Equity Multiple is 2.0x.
13. Internal Rate of Return (IRR)
The Internal Rate of Return is another return metric that provides an investor with a property’s annual compound rate of return. Mathematically, it is the discount rate that sets the Net Present Value of all future cash flows equal to zero.
Depreciation is an accounting concept that allows a commercial property owner to “expense” a portion of the property’s value each year to account for its physical deterioration. This expense is used to offset a property’s rental income and reduce its overall tax liability.
15. Hold Period
An investor’s “hold period” is the amount of time that they plan to hold a property before they sell it. Although it varies by deal, it is common for commercial real estate holding periods to be in the range of 5-10 years.
16. General Partner
In a commercial real estate syndication, the General Partner is one of two groups investors. In their role, they are responsible for the identification, selection, financing, and management of the commercial real estate asset. Depending on the syndication structure, it is possible for there to be more than one General Partner in a deal.
17. Limited Partner
In a real estate syndication, the Limited Partner is one of two groups of investors. While they provide some portion of the total equity needed to close the transaction, their role is strictly passive. They have no say in the day to day management of the property or major renovation decisions.
18. Downside Protection
All commercial real estate investments involve some level of risk. Because it can’t be avoided, property owners and investors try to manage it. One of the ways that they do this is to develop strategies that provide “downside protection” to minimize the chances of declining property values. For example, one common strategy to provide downside protection is to keep a sufficient amount of operating capital in reserve to ensure that expenses and debt service can be paid during an economic contraction.
19. Investment Entity
Commercial properties are typically bought and sold through a single purpose Limited Liability Corporation, which is commonly referred to as the “Investment Entity.” Shares in the Investment Entity are sold to raise the required equity in the transaction.
20. Market Value
A property’s “Market Value” is the price that it could be bought or sold for on the open market in an arm’s length transaction.
In commercial real estate transactions, a property’s market value is impacted by a variety of factors such as: supply & demand, length and stability of the income stream, interest rates, job creation, and location.
21. Commercial Real Estate Broker
A commercial real estate broker is a licensed professional who helps their clients buy, sell and/or lease properties in return for a commission or fee.
22. Core Deal
Commercial real estate transactions can be categorized according to the risk/return profile that they present. A “Core” deal presents the lowest level of risk, and the lowest, but most stable, return. Examples of Core deals include Class A properties that are fully leased with a stable stream of income.
23. Core Plus Deal
Commercial real estate transactions can be categorized according to the risk/return profile they present. A “Core Plus” deal represents the next level up of risk from a “Core” deal. They may have a slightly inferior location or rent roll and the deal may carry slightly more debt. A good example of a “Core Plus” deal is a fully leased office space that requires minor renovations to bring the property to market standards and rents.
24. Value-add Deal
Commercial real estate transactions can be categorized according to the risk/return profile they present. A “Value Add” deal represents the next level up of risk from a “Core Plus” deal.
Value-Add transactions are ones where an investor purchases a property and then spends weeks or months “adding value” in the form of renovations and/or management efficiencies with the goal of increasing the property’s Net Operating Income (and thus its value).
At First National Realty Partners, we prefer a value-add strategy because we believe our experience and operational expertise bring significant value to the property and allow us to unlock the true value of the asset.
25. Opportunistic Deal
Commercial real estate transactions can be categorized according to the risk/return profile they present. An “Opportunistic” deal represents the next level up of risk from a “Value-Add” deal. In fact, on the spectrum of risk, it carries the most risk, but also the most potential for a high return.
Opportunistic deals are characterized by properties with a heavy value-add component, major renovations, and/or repositioning of an asset. It may also include the ground up development of a new project. Opportunistic deals should comprise only a small portion of an investor’s overall portfolio.