As an experienced investor, you might be familiar with common terms like cap rate or cash-on-cash returns. However, you may find it challenging when dealing directly with real estate financing companies, sellers, or brokers who may use more complicated terms during negotiations.
We will cover some crucial mid-level and advanced commercial real estate terms you need to know to engage in top-level investment discussions seamlessly.
The net operating income (NOI) is the revenue a property generates after subtracting all operating expenses – but before deducting capital expenditures and debt service payments.
NOI = Gross Rental Income – Operating Expenses
Cash-on-cash (COC) return is a measure of return on investment (ROI) that calculates the cash income earned on a commercial real estate property relative to the amount of cash invested in the said property. It is calculated by dividing the property’s annual pre-tax cash flow by the total cash invested. A higher cash-on-cash return typically indicates a higher return on investment.
COC Return = Annual Pre-Tax Cash Flow / Total Cash Invested
The debt service coverage ratio (DSCR) is a financial metric used by mortgage companies to evaluate a borrower’s capacity to repay a commercial real estate loan. DSCR is calculated by finding the property’s net operating income ratio to its annual debt service payments. A higher DSCR indicates a lower risk of default and a greater likelihood of loan approval.
DSCR = Net Operating Income / Annual Debt Service
In commercial real estate, building classifications categorize properties in terms of their size, age, quality, amenities, and price. Investors, developers, lenders, and brokers employ these classifications to evaluate properties for crucial investment decisions.
The three major classifications of commercial real estate properties include the following: Class A, Class B, and Class C.
Class A buildings are the most desirable properties in areas with easy access to major transportation and business hubs. These are often the newest properties with sophisticated amenities and higher rents.
Class B buildings are also in good condition but a little older. These are often the ideal properties for the average, working-class tenants. Interestingly, Class B buildings in prime locations can be a massive opportunity for any commercial real estate investor because they can be transformed into Class A properties through minor renovations.
Class C buildings are the lowest classification in terms of location, amenities, and condition. However, due to their affordability, these properties are in high demand (especially by lower- to middle-income tenants). Their major downside is that they need a lot of maintenance. Moreover, dealing with tenants in this building class could be more challenging since they are mostly low-income earners who may afford the low base rent but not the higher operational fees (due to the property’s poor condition).
A property owner or tenant uses a number of lease types to structure their lease agreements. Examples are gross lease (full service lease), net lease, and modified gross lease.
Here’s a breakdown of these three main types of commercial real estate leases and what they mean for both tenants and landlords:
- Gross Lease: In this type of lease, the landlord covers all or most operating expenses for the property, including property taxes, insurance, utilities, and maintenance. The tenant pays a fixed rent amount that includes these expenses, making the base rent higher than other lease types. Some tenants prefer this lease type since they rarely get involved in the property’s day-to-day operations. Further, since the rent is fixed, even if expenses aren’t, tenants under a gross lease will pay the same rent even during summer, for instance, when the increased use of air conditioners typically results in higher electricity charges.
- Net Lease: In this lease type, the tenant is responsible for paying some or all the property’s operating expenses in addition to their rent. The three types of net leases are single, double, and triple net leases.In a single net lease, the tenant pays property taxes and rent while handling utility and other service charges directly. The double net lease allows tenants to pay property taxes, insurance, and rent. They are also responsible for their own utilities and garbage services, while the landlord pays for the common area maintenance. In the triple net lease, the tenant is not only paying rent but also paying property taxes, insurance, and maintenance costs. Notably, although a net lease may be similar to a gross lease in some respects, net leases have lower base rents and are widely adjustable.
- Modified Gross Lease or Net Lease: This lease offers a conducive middle ground for landlords and tenants. Here, the payment of the property’s operating expenses is divided between the landlord and tenant via specified terms in the lease agreement. The landlord receives a stipulated rent, depending on the degree to which the tenant or landlord is responsible for operating costs.
Other types of leases in the commercial real estate sector include the ground lease, build-to-suit lease, and percentage lease.
A 1031 exchange (also known as a like-kind exchange) allows investors to sell a property and use the proceeds to purchase one or more similar properties without immediately incurring taxes on the gain from the sale. In other words, a 1031 exchange is a tax-deferred exchange of one investment property for another.
One qualification requirement for a 1031 exchange is that the property sold and purchased must be considered “like-kind” and held for business or investment purposes. This means the properties must be similar but not necessarily the same quality or value. For example, an apartment building could be exchanged for an office building or a shopping center.
It is important to note that the like-kind exchange under section 1031 is not tax-free but tax-deferred. When the replacement property is eventually sold (not as part of another exchange), the original deferred gain, and any additional gain since the purchase of the replacement property, are taxable.
Absorption in commercial real estate describes the change in the total amount of occupied space in a particular market over a certain period (usually a year). It measures the units of a specific commercial property type that become occupied (sold or rented) during a specified time in a given market. This calculation is typically reported as the absorption rate.
Basis points (bps) are a financial unit of measurement for calculating changes in interest rates, equity indices, and the yield of a fixed-income security. Bonds and loans are generally quoted in terms of bpss which are values equal to one-hundredth of one percentage point. For instance, 100 bps are equal to one percentage point.
In commercial real estate, capital expenses (CapEx) are the costs associated with improvements or upgrades to a property to increase its market value or useful life. Examples of CapEx are the cost of large, durable items like new roofs, heating, ventilation, and air conditioning (HVAC) systems, building envelopes, or parking lots.
It’s crucial to note that standard maintenance and minor repairs (like plumbing and repainting) are not considered capital expenditures but operating expenses.
Commercial mortgage-backed securities (CMBS) are bonds backed by a pool of mortgages on commercial properties. CMBS are primarily grouped according to property type, geography, or underlying credit rating.
This is an investment in high-quality, stable, income-producing real estate properties located in an accessible and desirable submarket with a long-term track record of performance. Core investments are considered less risky since they target 80 to100%-leased properties. In addition, they carry long-term leases with creditworthy tenants and are among the most sought-after assets in the market, suggesting significant market liquidity.
Real Estate Investment Trust (REIT)
A REIT is a company that owns or finances income-producing properties like apartment buildings, shopping centers, warehouses, and office buildings. Since REITs are publicly traded like stocks, they allow people to delve into real estate investments without necessarily owning commercial properties.
LTV is the ratio between a mortgage amount and the appraised property value pledged as security, usually expressed as a percentage.
This is an investment in a real estate property with existing cash flow (and value) that can be improved by increasing rents, occupancy, or both. Some ways commercial property owners add value to a building include the following:
- Introducing new amenities
- Improving or replacing building systems
- Improving access or circulation to the building
- Providing new finishes
- Adding square footage
Amortization is the repayment of a loan over a period through a series of regular installments, including principal and interest.
An FHA lender is any financial company authorized to provide loans backed by the Federal Housing Administration (FHA), a government agency within the U.S. Department of Housing and Urban Development (HUD).
Portfolio loans are originated and held by a lender (typically a bank or credit union) rather than being sold in the secondary mortgage market. These loans are used for unique or non-conforming properties or borrowers with unique financial situations that may not fit traditional lending criteria.
Rent concessions are special offers or discounts from landlords or property managers to attract prospective renters or retain existing tenants.
A real estate broker is a licensed professional who facilitates transactions between property buyers and sellers. Brokers generally have more education and experience than real estate agents. They typically work for brokerage firms and are often responsible for managing a team of agents and overseeing transactions.
This is the fee an investment sales broker receives for closing a real estate transaction. Brokers charge brokerage commissions for services like purchases, sales, consultations, negotiations, and delivery.
Financial modeling in real estate is the systematic projection and analysis of expected investment outcomes. In other words, this modeling allows a professional to analyze a property from the perspective of a debt Investor (lender) or an equity investor (owner) to determine the risk level or potential returns of the investment and advise the equity or debt investor accordingly.
KPIs are numerically measurable metrics that help analyze a real estate investment performance. Transaction KPIs include internal rate of return (average compounded annual return), net cash flow (net profit), net present value, etc. Each KPI provides unique vital information about the performance of your invested capital.
The capitalization rate (also known as cap rate) is a percentage that relates the value of a commercial property to its future income. It evaluates the potential return on investment (ROI) of income-producing property and is calculated by dividing the property’s NOI by its market value. A higher cap rate generally indicates higher potential profitability but could also mean a higher risk level.
Cap Rate = Net Operating Income/Property Market Value
This is a property that has reached full occupancy or has attained a steady state of operations, where its net operating income, expenses, and occupancy rates are expected to remain relatively constant in the foreseeable future. In other words, a stabilized property is considered fully operational with consistent cash flows and occupancy rates.
Stabilized NOI is the estimated net operating income of a property that has reached a stabilized state.
Normalized reserves (also called normal reserves) are approximate “normal” levels of capital reserves for an operating property.
Adjusted NOI is unlevered cash flow, where the adjustment to the net operating income is the deduction of normal reserves.
A lessor is a commercial property owner, otherwise called a landlord. They are responsible for maintaining the property, collecting rent payments, and enforcing the lease agreement terms.
Lessee is another word for a tenant obligated to pay rent to a lessor and has the right to occupy a commercial property while complying with the terms and conditions of the lease agreement.
These are commercial real estate operating costs that change in proportion to the level of building occupancy. Examples of these expenses include utilities, repairs, and maintenance.
Fixed expenses are necessary for property ownership. They don’t change from time to time in relation to the building occupancy. Examples are property taxes, insurance premiums, and mortgage payments.
Costs for the upkeep of shared spaces like parking lots, lobby, sidewalks, and common storage spaces.
Lument delivers a set of capital solutions (including Fannie Mae, Freddie Mac, and HUD/FHA financing) while specializing in the following services:
- Real Estate Investment Banking
- Investment Management
- Real Estate Investment Sales
- Loan Servicing & Asset Management
- Mortgage Banking Services
We also offer a quote tool that allows small-balance investors to instantly obtain quotes for commercial real estate loans and start investing right away.
Although the acronym “CA” could mean many things in commercial real estate, including “confidentiality agreement” or “conditional approval,” the most common meaning remains “common area.” A common area is any part of a multifamily or commercial property all tenants use (lobbies, hallways, elevators, parking lots, and landscaped areas).
“Upside” in commercial real estate is the potential for an increase in property value or revenue. This predicted value increase could be due to factors like property improvements or changes in market conditions. An upside is usually a major motivating factor for real estate investors, especially when the risk level (of the investment) is low.
Net Annual Pass-Through (NAP) refers to the operating expenses a tenant pays in addition to their base rent. In other words, pass-through expenses are costs “passed through” from the landlord to the tenant in addition to base rent. They typically include common area maintenance (CAM) fees, property taxes, insurance, utilities, janitorial, etc.
The eight common types of commercial real estate include
- Multifamily buildings
- Industrial properties
- Hospitality properties (hotels)
- Medical and healthcare properties
- Retail buildings
- Office buildings
- Special-purpose properties (theaters, religious buildings, schools, or government buildings)
- Mixed-use buildings