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.
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
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.
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.
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%.
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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