7 Commercial Real Estate Terms You Should Know

1. Net Operating Income (NOI)

Net Operating Income, also known as NOI. The net operating income calculation is NOI is equal to your gross rental income minus your expenses.
NOI = Rental Income – Expenses

Those expenses do not include mortgage payments or depreciation; but specifically just property expenses. NOI is the heart of every commercial real estate deal you’ll ever do. Here’s why you should know this. As the NOI increases, the property value will increase as well (and vice versa). If the NOI goes down, the property value goes down.

2. Cash and Cash Return

Cash and cash return is also known as your ROI, return on investment. It is the heart of your money.  Cash and cash is basically your annual cash flow divided by your downpayment.
ROI = Return On Investment

It’s a very important term because it’s not how much money you spend on the property, but how fast is your money coming out of the property. It’s how fast the money is coming out. If all you have is $50,000 of spend and it takes 20 years to get back your $50,000 through cash flow, that’s not too exciting.  But it is good investment if it takes you 3 years to earn back your $50,000 downpayment.

3. Capitalization Rate

A cap rate is used to measure a building’s performance without considering the mortgage financing.

Cap Rate = NOI divided by the sales price

A high cap rate which is 10, 11, 12% usually typifies a higher risk investment and a low sales price. A low cap rate, is a 6, 5, and 4%. that usually typifies a lower risk investment but a high sales price.
If cap rate is equal to NOI divided by the sales price, you can flip that equation over and say sales price is equal to NOI divided by the cap rate.

4. Debt Coverage Ratio

This is a term used frequently with your lenders. All commercial lenders want your deal to be able to pay the mortgage and have something left over. Debt coverage ratio, DCR, tells you how much is left over.

DCR = Debt Coverage Ratio

lenders usually want to see a debt coverage ratio of at least 1.2 or more. DCR, debt coverage ratio that the formula is NOI divided by your annual debt service. Debt service is your 12 months of mortgage payments.

5. Price Per Unit

This term is at the heart of where to start in determining what a property is worth and also what to offer when you’re considering buying a property.  At the heart of knowing how much you’re going to pay for the property is basically the price per unit and price per square foot.  For example, If you have a $500,000 apartment building and you have 10 units in it, that’s $50,000 a unit. Price per unit.You would do the same calculation on the square footage.

If you want to know how to gauge your offer price, where to start, you need to know price per unit or price per square foot, to sure you don’t overpay for your deal.  Price per unit and price per square foot are stamped on to your neighborhood, onto your market.

6. Building Classification

Class A

A class A building represents the newest and highest quality, the best location, highest rents. They attract the highest quality tenants. It’s just a beautiful building in a beautiful neighborhood. The most expensive thing. B class is a next step down.

Class B

Class B buildings are usually a little odor, but they’re still good qualities. They’re good buildings. Oftentimes value added investors target these types of buildings as investments since well-located class B buildings can be returned to their A class glory.  Here’s your goal. Your goal is to find a B class building in an A class neighborhood and then you will renovate that building to get that A class rents. That’s your goal.

Class C

C class is the lowest official classification and the buildings are odor. You’ll find section 8 tenants in them. They’ll be subsidized buildings. There’ll be odor. They’re built in the ’80s and back.  If you are an apartment investor, these days today class C is the way to go because the ratio between the price per unit and the rents are still good.

Class D

Class D, it’s not an official class, but some buildings do fall in the class.  It is better to stay away from them because they need extensive renovation. A lot of them are vacant buildings and it’s not for the beginner.  They are good for experts who have deep pockets.

7. Types of Leases

Apartments

There are one year lease,  9-month lease, or month to month leases, all written by attorney. If you don’t have a strong legal instrument, a legal agreement, your tenants can just mess around and play with you and stay in your apartments rent free without paying rent. Okay, so the leases are really, really important.

Office Buildings and Shopping Centers

Now in office buildings and in shopping centers, we have this 3 types of leases. We have the full service lease where the landlord pays for everything. We have the triple net (NNN) lease where the tenant pays for everything. Then we had a modified gross lease where it’s halfway between the full service and the triple net lease.

Source: Commercial Property Advisors