As a commercial real estate investor or agent, there are several key terms that you need to know before you begin investing in real estate.
Understanding the core terminology used in the commercial real estate field will help you more easily navigate your investment negotiations and showcase your expertise in the field.
Commercial Real Estate Investment Terms to Know
Below is a list of the top phrases, terms, and tidbits of knowledge that you should undoubtedly be aware of if you’re involved in commercial real estate investment in any capacity.
Net Operating Income
Net operating income (NOI) is an essential idea you need to get to grips with to be successful in your commercial real estate investments.
The term refers to the income you generate annually from an income property, after property expenses have been taken into consideration.
- NOI = (Rental Income + Other Income – Vacancy and Credit Losses) – Operating Expenses
Aside from rent, you may also generate other income from your commercial space—for example, through parking or even laundry.
Property expenses refer to any expenses that enable you to run and maintain an income property, such as utility, property management fees, and property tax.
NOI does not include loan payments, depreciation, amortization, or capital expenditures, and is always calculated before tax.
Cash on Cash Return
Cash on Cash Return (CoC) is perhaps one of the easiest and most popular metrics used by commercial real estate investors.
CoC is used to measure the ratio between an asset’s annual cash flow in relation to the commercial property’s down payment.
Similar to NOI, cash on cash return is also typically calculated before taxes.
- Cash on Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested
Return on Investment
Return on investment (ROI) stands for the calculated benefit of an investment (called the return), divided by its cost.
Your ROI is impacted by several variables, such as renovation and maintenance costs, and how much you originally borrowed in order to invest in your property.
ROI is one of the more widely used metrics in commercial real estate due to its high-level measuring of an asset’s profitability.
At the same time, however, the most sophisticated investors will turn to more sophisticated metrics to gauge profitability, so they can do so on a deeper, more accurate level.
- ROI = (Current Asset Value – Cost of Investment) / Cost of Investment
The capitalization rate, often referred to as the “cap rate,” refers to the net operating income (NOI) divided by an income property’s current market value (or asking price – whichever figure is lower).
A cap rate can be used to help figure out your potential return on investment before factoring in mortgage financing.
Typically, a low cap rate comes with a higher price point, but less risk than an investment with a higher cap rate.
- Cap Rate = Net Operating Income / Asset Market Value
Debt Coverage Ratio
Debt coverage ratio (DCR), also known as the debt service coverage ratio (DSCR), compares an investment property’s NOI with its impending debt service.
Lenders use this ratio to calculate whether or not you will be able to generate enough income to pay your debts.
Most commercial lenders require a DCR of 1.15-1.35 times the NOI/annual debt service.
- DCR = Net Operating Income / Total Debt Service
Loan to Value Ratio
When considering how to invest in real estate, one term you may see come up again and again is loan to value ratio (LTV).
The LTV is determined by what percentage an asset’s sale price or value is attributed to financing.
Income property lenders perceived as lower risk are assigned a higher LTV.
- Loan to Value Ratio = Mortgage Amount / Appraised Asset Value
Property values are determined by asset classifications.
Investment property falls under one of four main categories: Class “A”, “B”, “C”, or “D.”
Property class is determined by an asset’s market value.
Class A properties refer to property in the most in-demand markets.
They typically boast impressive aesthetics and construction, and require little renovations. Class “A” properties demand the highest rents.
In comparison, an income property that falls into classes “B”, “C”, or “D,” will be categorized by less appealing features, such as an older property, poorer construction, or a less desirable location.
The higher the class, the more expensive and in demand the investment property.
With class “A” properties, you typically see a lower ROI.
However, while you may get higher returns with the lower classes, they are also a riskier investment, as the property is less enticing to the market, and often requires greater upkeep and renovations.
As such, class “B” and “C” income property may be the wisest choices for new investors, striking a balance between risk and return.
Of course, that all depends on what type of investment you’re looking to sink your feet into.
A real estate investment trust (REIT) refers to a corporation that owns or finances income property. REITs function similarly to stocks.
Shares in investment property are bought and investors receive dividends on the rent payments collected by the property management companies that own the property.
REITs are an inviting investment choice for many commercial real estate investors as they offer the potential for sizable returns on investments.
However, REITs also come with a certain level of risk, as they are vulnerable to share price volatility—again, much like the stock market.
As such, many savvy investors diversify their commercial real estate portfolios—outright buying property and mixing and matching with REIT investments.
Mastering the Terminology
In searching for your next investment deal, it’s important to be well versed in industry terminology.
A good understanding of commonly used terms will enable you to rapidly excel in the commercial real estate field, and will establish a nice foundation of knowledge for you to continue building upon over time.
Getting to grips with popular definitions will also provide a boost to your business negotiations, allowing you to confidently negotiate and have honest discussions with your prospects.
In the end, there’s no such thing as “too much” preparation in commercial real estate.