1. Net Operating Income (NOI)
Net Operating Income (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 property expenses. NOI is the center of every commercial real estate transaction. 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 on Cash Return
Cash on cash return is also known as ROI, return on investment. Cash on cash is basically one’s annual cash flow divided by owner down payment.
ROI = Return On Investment
It’s a very important concept because it’s not how much money one will spend on the property, but how fast money is coming out of the property. The time it takes to receive an overall return on investment is critical to financial cash flow as well.
3. Cap (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 between 10-12% usually typifies a higher risk investment and a low sales price. A low cap rate, is between 4-6% making for a lower risk investment with a high sales price.
If cap rate is equal to NOI divided by the sales price, one 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 among lenders. All commercial lenders want the mortgagor (buyer) to be able to pay the mortgage and have something left over. Debt coverage ratio, DCR, determines 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 can be determined by NOI divided by annual debt service. Debt service is 12 months of mortgage payments.
5. Price Per Unit
This term is at the heart of determining what a property is worth and also what to offer when considering buying a property. Knowing how much to pay for the property is essentially the price per unit and price per square foot. For example, a $500,000 apartment building with 10 units would equate to a $50,000 price per unit. The same calculation can be done for the square footage.
6. Building Classification
Class A buildings represent the newest and highest quality, the best location and highest rent potential – attracting top quality tenants. Modernized buildings in ideal neighborhoods are common.
Class B buildings are usually a little older, but they’re still of exceptional quality. Oftentimes value added investors target these types of buildings as investments since well-located Class B buildings can be returned to their Class A level. An ideal objective to have is to find a Class B building in a Class A neighborhood and renovate that building to achieve Class A rents.
Class C is the lowest official classification and the buildings are identifiable as older. Sometimes one can find Section 8 tenants inhabiting Class C buildings. 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.
7. Types of Leases
There are one year leases, 9-month leases, or month-to-month leases. A strong strong legal instrument is advised to lock in any legal agreements.
Office Buildings and Shopping Centers
When it comes to Office Buildings and Shopping Centers, there are three types of leases. A full-service lease where the landlord pays for everything is identified as a “Gross Lease”. Contrarily there is a triple net lease (NNN) where the tenant pays for everything from taxes, improvements and amenities. Lastly, a modified gross lease is somewhat of a hybrid version of the previous two.