When you’re just getting started in commercial real estate, you’ll likely come across a few unfamiliar terms. As complicated as they may seem at first, these terms are the building blocks to understanding how commercial property investments are evaluated. We’ve put together a brief guide of the terms you’ll come across over and over as you continue your CRE research.
10 Commercial Real Estate Terms to Know
Below, you’ll find a description of some of the key commercial real estate terms. Some of these contain simple formulas. Once you understand how these formulas work and how they relate to evaluating a CRE deal, you’ll be better positioned to consider solid investments.
1. Net Operating Income (NOI)
You’ll likely hear the term NOI discussed in relation to the value of commercial real estate investments. The term refers to a property’s profit after expenses. It’s a common term in CRE used to determine the value of a property. NOI is also necessary when filing your income taxes and you’ll find it on your income statement.
The formula to calculate net operating income is simple:
NOI = gross operating income of a property – operating expenses
The gross operating income is the total profit your commercial property is making. The operating expenses refer to anything tied to the building operations, like payroll, repairs and maintenance. Operating expenses do not include less tangible expenses like debt service and interest expenses.
2. Capitalization Rate (Also Known as Cap Rate)
Capitalization rate tells an investor the amount of money they can expect to earn per year as a percentage.
Here is the formula for cap rate:
Cap rate = net operating income (NOI) / property’s market value or sales price
So if a property is worth $400,000 and the NOI is $40,000, this would give you a cap rate of 10%.
The cap rate is considered the gold standard across the industry to interpret a deal, particularly because it allows you to easily compare property values and measure an investment’s profitability. Cap rates only measure the net operating income over the net cost. The formula does not include financing or taxation.
However, it’s also important to consider that the cap rate does not tell the full story, as it doesn’t include every calculation that’s important for understanding the profitability and strength of an investment, such as financing, tenant reliability or other factors that will play a large role in the profitability of your deal.
3. Cash Flow
Cash flow is the profit you make on your property after paying all expenses.
The formula for cash flow is:
Cash flow = gross income – expenses
When cash flow is positive, an investor can save money and reinvest their profit. When cash flow is negative, there is not enough profit left after all expenses are paid.
4. Types of Leases
In commercial real estate, the type of lease that comes with a property plays a huge role in the value of the property. There are two main types of leases in CRE: gross leases and net leases.
Gross lease: When you have a gross lease, the tenant pays a fixed price for rent, and the landlord foots the bill for the property’s operating expenses, like insurance and repairs. Residential properties typically use gross leases for tenants when rent is a fixed fee.
Net lease: In a net lease, a tenant pays the operating expenses a fixed fee for rent. These leases are common for retail and office buildings, or properties where a tenant may want more flexibility and control over the property. Landlords also find net leases more desirable because these leases guarantee a fixed income every month without the liability of potential damages and repairs.
There are three types of net leases: single net leases (N), double net leases (NN) and triple net leases (NNN). For a single net lease, the tenant is responsible for the property taxes while the landlord will be responsible for covering all other expenses. For a double net lease, the tenant will pay for both property taxes and insurance, and the landlord will cover all other operating expenses. A triple net lease is considered the optimal choice for landlords, as the tenant is responsible for covering all of the property’s operating expenses, including insurance, maintenance and property taxes.
5. Debt-Service Coverage Ratio (DSCR)
The debt-service coverage ratio (DSCR), also called debt service ratio or DSR, refers to the ratio of available operating income to debt service. This is a common calculation in CRE used to determine how much income an investor will have left over after the debt service.
The formula to calculate DSCR is:
DSCR = net operating income / the total debt service
Here’s an example of this calculation:
$1,000,000 (net operating income) / $400,000 (total debt servicing) = 2.5 (DSCR)
This means the investor’s operating income will be able to cover their debt service more than 2.5 times.
When the DSCR is above one, it means the business is cash flow positive. This is an important number for lenders to evaluate borrowers, because it tells them whether a borrower is cash flow positive or negative and whether they have enough cash to cover the loan.
6. Annual Cash Flow
The annual cash flow is the amount of money that is moved in and out of the company per year.
Here is the formula to calculate the annual cash flow:
Annual cash flow = NOI – debt service
When annual cash flow is positive, the property is profitable. When it is negative, the income on the property is not enough to cover the debt service.
7. Cash-on-Cash Return
The cash-on-cash return is the ratio of annual cash flow before tax to the total cash invested in the property. This number is expressed as a percent.
Here is the formula for cash-on-cash return:
Cash-on-cash return = Annual cash flow / down payment
Let’s consider an example of how this might work. Let’s say an investor purchases a $2 million property and spends $400,000 on the down payment. Each month this property makes $15,000 in income from apartment rentals. That means the investor will be making $180,000 per year before tax.
That number doesn’t reflect the debt the investor has to repay. Say the mortgage payment on this property is $10,000. This adds up to $120,000 per year. The cash-on-cash return would be:
($180,000 – $120,000) / $400,000 = .15 (x100) = 15%
8. Interest Rate
The interest rate on a loan is the cost you pay to borrow money. Typically, interest rates on commercial real estate loans range from 3% to 18%. You can expect banks and agency lenders like Freddie Mac and Fannie Mae to have interest rates on the lower end, while private debt funds (especially those that offer bridge loans) will tend to have higher interest rates.
Leverage is an indispensable part of commercial real estate investing. Simply put, leverage refers to using debt for the possibility of yielding a higher rate of return on your real estate investment. Of course, there are risks involved with leveraging your assets for the hopes of a higher rate of return, but the potential benefits of a high-leveraged deal will far surpass those with less leverage.
10. Per Square Foot (PSF)
Per square foot is a term you’ll see a lot that is used to evaluate the value of a commercial real estate property. The price of rent for commercial real estate is typically discussed per square foot. The price PSF will typically either be listed by year or by month.
These Basic Commercial Real Estate Terms Are Essential to Success
A solid grasp of these terms is essential to successfully navigate commercial property transactions. You’ll find they come up over and over. While terms like NOI or cap rate may seem abstract the first time you are introduced to them, the more exposure you have, the easier it will be to make smart judgments about CRE deals.