Key Commercial Real Estate Investment Terminologies
Like any other industry, the commercial real estate sector has its fair share acronyms, jargon, and technical terminology. All these words can intimidate those new to property investing, so we’re here to help. Below is a list of the most common commercial property investment terms explained to become much easier to understand and remember.
We hope that you find this glossary helpful. It’s not just for newbies to commercial real estate—it’s also beneficial for those working in this industry for quite some time and would like to get reacquainted with these important terminologies.
This refers to an increase in an asset’s value over time. Appreciation can occur for many reasons, such as increased demand for commercial space, inflation, or even interest rate fluctuations. It’s an important metric to use when evaluating an investment property’s overall appeal and profitability. Appreciation has a direct effect on ROI.
The opposite of appreciation is depreciation, which refers to any decrease in an asset’s value over time.
Adjustable-Rate Mortgage (ARM)
An adjustable-rate mortgage is a type of mortgage that doesn’t carry a fixed interest rate. The ARM may change annually or monthly throughout the loan’s life based on the fluctuations of the benchmark interest rate and capital market conditions. In an ARM, the initial interest rate is usually fixed for a predetermined period (usually the first few years of the loan) and then periodically resets after that.
If you choose an ARM to finance your commercial real estate property, your monthly mortgage payments may increase (or decrease) based on market conditions. It’s important to understand this concept as you assess your risk.
There are four main categories in commercial investment properties: Class A, B, C, or D. Its market value largely determines the class to which a property belongs.
Class A commercial property typically refers to those in the most high-in-demand markets. They are characterized by superb construction and aesthetics, requiring little to renovations. Because of this, they also tend to demand the highest rents.
Meanwhile, income properties falling into the B, C, and D classes have less appealing features. These are typically older commercial properties, those made with poorer construction methods and materials, and those in less desirable locations.
Are higher-class properties better investments? Not always.
Class A properties usually see a lower ROI because they are expensive, to begin with. There are opportunities for higher returns with commercial properties in lower classes. That said, they also tend to be riskier investments because they are less enticing and often require more money in renovations and upkeep. As such, new investors often go for Class B and C income properties that strike a stable balance between risk and return.
Cash on Cash Return (CoC)
Cash on Cash Return or CoC is among the most popular metrics used in the commercial real estate investment industry.
It is essentially the ratio between a property’s annual cash flow and its down payment. In other words, it shows the pre-tax cash inflows the investor receives from the property, and the pre-tax outflows the investor pays.
Here’s how to calculate for it:
CoC = Annual Cash Flow Pre-tax / Total Cash Invested
The CoC metric measures only the return for the current period (usually one year—not for the project’s life or investment.
Let’s say that a commercial building’s total purchase price that does not produce monthly income is $1 million. The investor decides to put $100,000 in down payment and borrows the remaining $900,000 from a mortgage lender. The investor also pays closing fees, maintenance costs, and insurance premiums amounting to $10,000 out of pocket.
A year passes, and the investor has paid $25,000 in mortgage payments, of which the principal repayment is $5,000. The investor has decided to sell the commercial building for $1.1 million at this point. By this time, the investor’s total cash outflow has amounted to $135,000. After the remaining debt of $895,000 is repaid, the investor is left with a cash inflow amounting to $205,000.
The cash-on-cash return is:
(205,000 – 135,000) / 135,000 = 51.9%.
Aside from showing the current return, the CoC is also a good forecasting tool for determining an investment’s expected future cash distributions. However, the result is not a “promised” return—it is simply a target for assessing a potential investment. When used in this manner, the CoC is an estimation of what a commercial property investor can reasonably expect to receive over the investment’s life.
Similar to NOI, CoC is also calculated before taxes.
You might hear the term “cap rate” being thrown around in investment meetings, and it refers to capitalization rate—or simply the NOI (net operating income) of an income property divided by either its current market value or asking price, whichever is lower.
You can use the cap rate to figure out the potential returns on a commercial real estate asset before factoring in financing costs. A property with a low cap rate is usually more expensive but less risky than a property with a higher cap rate.
Here’s the formula:
Net Operating Income / Asset Market Value = Cap Rate
In its simplest terms, cash flow refers to how much money you can pocket from the property each month after deducting all operating expenses, including loan payments. You have a positive cash flow if the property spends less money than it earns. If the amount of money it takes to run the property is more than what it earns, the cash flow is negative.
It’s very important to look at a commercial real estate asset’s cash flow to determine if it is worth investing in. Ideally, a CRE property should generate positive cash flow. This means that it earns a higher rental income than the mortgage and operating expenses, thereby providing a reliable stream of passive income.
Capital Expenditures or CapEx refer to major renovations, improvements, or purchases that extend the commercial real estate property’s life—generally one-time expenses. Examples include roof replacement or adding an extension. CapEx also includes any equipment and supplies necessary for these improvements.
Capital Gains Tax
Capital gain (or loss) refers to the property’s value and purchase price. The short-term gain is a year or less, and long-term gain is more than one year. Short-term capital gains are taxed higher than long-term capital gains. You must understand how your commercial real estate investments will be taxed so you can optimize returns and performance.
These refer to fees that have to be paid to close a real estate transaction. Closing costs vary depending on the CRE asset’s location, the type of CRE asset, and the kind of loan you choose. They include expenses related to inspections, loan origination fees, transfer of title, etc.
Comparative Market Analysis (CMA)
This report shows sold and active listings, listings that have been taken off of the market, and listings that have expired without getting sold during a period in a specific geographical area. CMAs are not always complete, but they are fairly accurate guides for assessing current market trends.
For sellers, these reports are useful for determining fair market values and asking prices. It also shows market demand (indicated by how long it takes similar listings to sell). CMAs can also give sellers an idea of how motivated buyers are because they show the ratio between sales and listing prices.
CMAs can be useful for spotting properties that have been relisted after being taken off of the market for buyers. Sellers of such properties may be more motivated and more willing to negotiate their prices this time around, having failed to sell the property before.
Debt Coverage Ratio (DCR)
DCR stands of debt coverage ratio, also known as the DSCR or the debt service coverage ratio. It essentially compares a commercial property’s net operating income with its impending debt service. The formula is:
Net Operating Income / Total Debt Service = DCR
The DCR is used by lenders when reviewing commercial mortgage applications. It shows whether or not you, as the property investor will generate enough income from the property to pay your debts. Commercial lenders typically require a DCR that is 1.15 to 1.35 times the net operating income/annual debt service.
Debt-to-Equity Ratio (DER)
This shows how much of a CRE property is yours (if you did not pay for it in cash and took out a mortgage or a loan).
It is often defined as a measure of ownership. The D/E ratio helps you see a holistic picture—how much you invested and how much you still owe, and therefore how much you will likely earn if you sell. This ratio is also important if you want to refinance the property, as lenders typically look at the debt-to-equity ratio to measure creditworthiness.
When you buy a CRE property, you will likely be required to pay a part of the down payment ahead of time. The funds will be “escrowed”—an impartial agent will hold it until the deal is closed. Escrow helps to remove a lot of the risk inherent in transactions for both sellers and buyers. A third party holds the funds until the buyers and sellers meet all their agreed-upon conditions. The escrowed funds are released to the seller once everything is settled.
This refers to the property’s current market value minus any amount you owe on its mortgage. Should you decide to sell your commercial investment property, the equity is the money left after you fully pay the mortgage. Equity builds up over time as the building’s market value appreciates, and as your mortgage balance declines.
Fair Market Value (FMV)
FMV is the reasonable price a CRE property will probably fetch on the open market (provided that both the seller and buyer are reasonably knowledgeable, behave in their own best interests, and are not under undue pressure to rush into the transaction). A property’s FMV reflects an accurate valuation at that specific point in time.
For a buyer, knowing the FMV of a potential investment property is critical to determine if they are not overpaying. For a seller, the FMV helps ensure that they are not underpricing. FMVs can be determined by third-party appraisers, real estate agents, and BPO or broker price opinion. Many brokers and agents provide free CMAs or BPOs to gain future business.
FMCs are also important for insurance claims and property tax assessments. Note, however, that there are differences in the FMV for buying and selling commercial real estate and Appraised Value for tax purposes.
The opposite of an ARM, a fixed-rate mortgage, applies a predefined interest rate that never changes throughout the entire term of the loan. This arrangement allows CRE investors to know exactly how much they need to pay every month until they are fully paid off. Fixed-rate mortgages appeal to some investors because of its predictability. They can count on their monthly mortgage payments staying the same, making planning and budgeting for future investments easier.
Gross Rental Income (GRI)
This refers to how much is collected in rent, plus additional income from the property (such as parking fees or any extra fees not required as part of the lease and paid by the tenants to the owner). Note that security deposits are NOT treated as income. These refundable deposits are written on the balance sheet as short-term liabilities for rental properties because they will eventually be refunded to the tenant.
GRI is useful for investors who want to predict the total income a commercial rental property can generate. Investors typically begin with the GRI when creating a pro forma, then deduct for credit loss, vacancy, and bad debt to figure out the adjusted gross income the property may generate before the mortgage and normal operating expenses.
Aside from this, the GRI is necessary for calculating a property’s gross rent multiplier (GRM). Lenders likewise look at the GRI when reviewing a new loan application or refinancing a mortgage (such as cash-out refinancing).
Gross Rent Multiplier (GRM)
This refers to the ratio of the rental property’s price to its gross income before expenses. This number essentially represents how long it would take for a CRE asset to “pay for itself,” as indicated by the gross rental income it generates. In general, a lower GRM indicates a better investment opportunity (all else being equal).
To compute for the GRM, simply divide the property’s market value by its gross rental income. Here’s an example:
$1,000,000 market value / $120,000 gross rental income = 8.33
This indicates that the property will take 8.33 years to pay for itself.
GRM makes it easy for investors to quickly rank several potential investments before spending resources on deeper analysis. It can also be useful for estimating property values. For instance, if the GRM for similar properties in the market is around 7.5 and the asset generates a gross rental income of $150,000 yearly, it should be worth around $1,125,000 (GRM of 7.5 multiplied by the gross income of $150,000).
An inspection contingency is a clause in the purchase agreement that allows the buyer to do the following:
Have an inspector look at the property and receive a report to know about the condition of the property
Negotiate on the possibility of sharing repair costs with the seller or terminate the purchase agreement and getting their earnest money deposit back
Loan to Value (LTV) Ratio
The loan to value ratio or LTV is a term you will likely see often as you learn how to invest in commercial real estate. It shows what percentage of a property’s value or sale price is attributed to financing.
It is computed as:
Amount Borrowed / Appraised Value of Property = Loan to Value Ratio
For example, if you purchase a commercial property appraised at $1M and make a $100,000 down payment, you will borrow $900,000. This results to an LTV ratio of 90% (i.e., 900,000/1,000,000).
A critical component of commercial mortgage underwriting, the LTV determines the risk exposure a lender takes on. Generally, the risk is higher when a borrower requests a loan amount that has a high LTV ratio. It indicates that there is very little equity in the commercial property—which means that should the borrower default and a foreclosure ensues, the lender will likely find it challenging to sell the property for an amount that adequately covers the outstanding balance and make a profit from that transaction.
Net Operating Income (NOI)
The acronym NOI stands for net operating income. It refers to the income a commercial property generates every year (annually) after all property expenses have been deducted.
Here’s the formula:
(Rental Income + Other Income – Vacancy and Credit Losses) – Operating Expenses = NOI
As an example, let’s say that a small commercial building generates $200,000 a year in rental income, plus another $55,000 in other income. Losses amount to $36,000 and operating expenses tally up to $45,000. Here’s how to compute for its NOI:
(200,000 + 55,000 – 36,000) – 45,000 = 174,000
This particular property has a net operating income of $174,000. You may be wondering: What exactly is “other income”? This refers to all income generated from the commercial space other than rent. This can include parking fees, for example – “Operating expenses” denote any expenditures involved in running and maintaining the building, such as utilities, taxes, and property management fees.
Important: NOI is always calculated BEFORE taxes and does NOT include depreciation, amortization, loan payments, or capital expenditures.
Real Estate Investment Trust (REIT)
A REIT or real estate investment trust is a corporation that finances or owns income property/properties. They work very similarly to stocks. Investors can buy shares in investment property and receive dividends on the corporation (usually rent payments). REITs appeal to many commercial real estate investors because of their potential to yield sizable returns. That said, REITs come with risk, too, mainly because of share price volatilities. This is why savvy commercial property investors diversify their portfolios by buying actual properties and mixing in REIT investments.
Real Estate Owned (REO)
REO properties are foreclosed properties now owned by the lender or bank but haven’t been sold at auction. Bigger banks typically have REO teams whose job is to remove these properties off their balance sheet by selling them through agents who specialize in REO listings.
REO properties are attractive to some investors who want to purchase an asset below market value. Do note that REO properties are sold “as-is, where-is,” with no guarantees and only basic warranties. Some REO commercial properties are in poor condition, requiring major repairs before they can be made to generate cash flow. Investors who specialize in buying and rehabbing REO commercial properties typically give lenders strong offers with no contingencies to show that they are serious about purchasing the asset. They are also willing to put down larger earnest money deposits.
Return on Investment (ROI)
The calculated benefit of commercial property investment (return) divided by its total cost is its return on investment or ROI.
It is one of the industry’s basic metrics because it quickly shows the profitability of an asset. That said, sophisticated commercial real estate investors don’t rely on ROI computations alone. They use it in combination with more sophisticated metrics to truly gauge a building’s profitability more accurately.
The ROI of a property is affected by several factors, including maintenance and renovation costs and how much an investor originally borrowed to invest in it.
To calculate the ROI on a cash purchase, divide the net profit or net gain on the property by the original cost. If you have a mortgage on the property, you need to factor in the cost of the down payment and the mortgage payment
Here’s the formula:
(Current Asset Value – Cost of Investment) / Cost of Investment = ROI
For example, let’s compute for the ROI on a commercial property paid in full with cash.
Say you paid $100,000 to fully pay for a small commercial rental. The closing costs amounted to $1,000. You decided to remodel the property and spent $9,000. This brings your investment to $110,000 in total. You collect $1,000 every month on rent.
After one year or 12 months, you have earned $12,000 in commercial rental income. Your expenses (including property taxes, insurance, etc.) reached $200 per month or $2,400 for the year.
Your return for year was $9,600 (that’s $12,000 – $2,400).
Divide this annual return by the total investment. That’s $9,600 ÷ $110,000 = 0.087, which means that your ROI was 8.7%.
Calculating for the ROI on financed transactions is a little bit trickier.
Let’s say that you bought the same $100,000 commercial rental property but took out a loan instead of paying it off in cash. You made a down payment of 20% or $20,000, and closing costs amounted to $2,500 upfront. You spend $9,000 on renovations. Add all of these up to see the total out-of-pocket expenses. In this case, it’s $31,500.
Now you have to take into account the ongoing costs of your commercial mortgage.
If you have a 30-year loan with a fixed interest rate of 4%, then the monthly principal and interest payment should be $381.93 for the $80,000 you borrowed.
Add to this $200 a month to cover taxes, insurance, and other expenses, bringing the total monthly payment to $581.93. You get the same $1,000 rental income per month or $12,000 for the year.
Your monthly cash flow is $418.07. That’s $1,000 in rental income minus $581.93 in loan payments and other expenses.
After a year, you would have earned an annual return of $5,016.84. That’s $418.07 x 12 months.
Divide this annual return by your initial out-of-pocket costs—the $20,000 down payment, the $2,500 in closing costs, and th3 $9,000 you spend on remodeling to get your ROI.
That’s $5,016.84 / $31,500 = 0.159, or an ROI of 15.9%.
This refers to a commercial real estate property that is completely move-in ready. These types of CRE assets are appealing for investors who want to simply purchase a property and immediately rent it out without needing to make any major renovations or repairs.
these are the key commercial real estate terminologies you need to know
They may sound like fluffy verbiage if you’re just starting. After all, breaking into the property investment business can be intimidating when complicated acronyms and are tossed around, and you’re hearing them for the first time.
But don’t worry. You can save or bookmark this glossary to quickly develop a solid working knowledge of all the definitions and concepts related to buying, renting, and owning commercial investment properties. Understanding these core terminologies—and being able to explain them to those who don’t—can help you navigate investment negotiations more easily while showcasing your expertise in this field.
If you come across other terminologies that you would like explained and added to this list, don’t hesitate to contact us here at Capital Investor Direct.
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