- Knowing a few commercial real estate terms can help you to navigate opportunities and transactions better.
- Common real estate terms describe building values, transactions, return on investment, and similar concepts.
- Unique Properties can help you to navigate these terms and more in commercial real estate.
Commercial real estate can be a very lucrative field to invest in. However, if you want to make profitable real estate transactions, you will need to know the industry’s terminology. The following are seven commercial real estate terms to know if you want to succeed in this field.
Net Operating Income
Of all the commercial real estate terms, this is arguably the most important. Your net operating income is your gross rental income minus the expenses of operating the property. Importantly, these expenses do not include items such as mortgage payments or asset depreciation. Instead, they are the operating expenses you incur, such as maintenance and insurance.
The formula for NOI is extremely simple: total rental income minus operating expenses. You may need to examine your NOI at the point of making the deal (if there are existing tenants) and at different levels of occupancy for multi-unit properties. Chances are that you will not consistently average 100% tenancy. It is often a good idea to look for deals in which you think you can increase the NOI.
Debt Coverage Ratio
Financing is one of the most important parts of commercial real estate transactions. Lenders will frequently talk about the debt coverage ratio. This is your net operating income divided by your annual debt service. Your annual debt service is the total payments you make on debt in a year.
In other words, this is a simple ratio for calculating how likely you will be to pay back your loans. If your mortgage payments would take up your entire NOI, you will not make a great borrower. However, if you have plentiful income to cover your payments and more, the lender may be excited to do business with you.
Typically, banks want to see commercial real estate that will have a DCR of at least 1.2 (your NOI from the property is at least 20% higher than the debt service). However, it is often a good idea to aim for 1.4 or more.
Capitalization Rate
The above two terms alone can help you understand a large portion of any real estate deal. However, there is a glaring omission: the sales price. For this, the capitalization rate is an important concept. This is the NOI divided by the sales price. Obviously, having a high NOI to sales price ratio is important.
A high cap rate will typically be around 10, 11, or 12%. Conversely, a low cap rate will likely be around 4, 5, or 6%. Although a high cap rate is a good thing, it often comes with a higher-risk property. The seller also knows the NOI and risk of the property and will price accordingly. Don’t expect to score a 12% cap rate on a low-risk, super-reliable property.
However, you can improve your cap rate by identifying a situation in which you can increase the NOI. This is often how the most valuable deals are scored: the buyer has identified an opportunity that the seller hasn’t seen.
Building Classification
The above commercial real estate terms to know are mostly focused on building deals. However, it is also important to understand the type of building you are working with. There are three official classifications of buildings and one common but unofficial one:
- Class A: These are new, high-quality buildings, typically in downtown areas. They attract high-quality tenants and provide low returns. Class A buildings are usually owned by institutional investors.
- Class B: These buildings are a little older and may be in slightly less desirable locations. However, they still have a lot to offer and can even be returned to Class A status in some cases. These are excellent targets for investors with a good amount of capital.
- Class C: The buildings in this lower class are older and need some work to make them desirable. They are typically less able to attract high-quality, stable tenants. However, they are available for much lower prices. They can deliver high cap rates due to the risk.
- Class D: This unofficial class is used to describe buildings that are in need of serious renovation work. Beginner investors should not consider these commercial properties.
Cash on Cash Return
This is an important term that is common in commercial real estate but known by a different name elsewhere: return on investment. Specifically, cash on cash return focuses on the liquid cash you make back on the money you spend upfront.
Typically, your returns are calculated on an annual basis. They can include both the cash flow income from a positive NOI and any increase in your asset value. However, the increased asset value only counts towards cash on cash return if you can realize it. This term is very important if you are raising money from investors to help with your transaction.
Price Per Unit/Price Per Square Foot
Different buildings are of different sizes. Some may have lots of units or space, while others may be smaller. This obvious fact sometimes gets overlooked when comparing opportunities. You need to calculate the price per unit and the price per square foot.
Both of these numbers are very easy to calculate. They are just the price of the building divided by the number of units and the square footage, respectively. Keep in mind that the number of units may be more variable because units can be renovated.
Lease Type Names
Strictly speaking, this isn’t a single term but rather a group of terms. However, they are closely related, so we can have combined them under one heading. Commercial leases work a little differently than residential ones. There is a lot more flexibility in the lease terms. Therefore, there is a shorthand way to understand different types of leases. These are the key terms you need to know:
- Full Service/Gross Lease: The tenant only pays base rent and sometimes utilities in this type of lease. The landlord covers building maintenance, taxes, and insurance.
- Single/Double/Triple Net Lease: The tenant pays a portion of other building expenses in this type of lease. With a triple net lease, the tenant pays for everything but the mortgage.
- Modified Gross Lease: This is a combination of the above two. The tenant and landlord split various building expenses.
We have covered these and other types of leases in more detail in a separate blog post. Check it out if you would like to learn more. Keep in mind that lease types are just general terms for similar leases; the terms can be almost anything that the parties can mutually agree to.
Get Help With Your Commercial Real Estate Transactions in Denver, CO
With the above commercial real estate terms in mind, you will be more prepared to find success in this field. However, you will likely still need the help of real estate experts. Unique Properties can help you with buying, selling, and leasing real estate. Contact us today to learn more.
Featured Image: Gorodenkoff/Shutterstock
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