In order to understand investing in commercial real estate, you need to master a few commercial real estate terms. Some of the more important terms are as follows:
Capitalization or Cap Rate: Net operating income (NOI) divided by the purchase price.
Net Operating Income (NOI): Gross Operating Income minus Operating Expenses.
Cash on Cash Return: Cash Flow Before Taxes (CFBT) divided by the initial investment. Best indication of the quality of the investment.
NPV (Net Present Value): Method for calculating the present value of future cash flows. Useful for comparing different investments and their returns. Most calculators provide NPV calculations.
IRR (Internal Rate of Return): Calculated by setting NPV = 0 and finding out what the discount rate would be. Use a calculator to do this calculation.
Debt Coverage Ratio: NOI/loan payment. This is what your banker will want to know before lending you money for the investment.
Return on Equity (ROE): CFBT divided by equity. Equal to Cash on Cash the first year, then decreases because your equity grows faster than NOI (due to depreciation and mortgage retirement).
Discount Rate: Rate of which future cash flows are discounted (devalued) per year.
Yield Capitalization: More complex form of income capitalization which looks further into the future and attempts to estimate return over a projected holding period (typically 10 years).
Credit-tenant property: A single-tenant commercial property occupied by a tenant who has a credit rating by Moody’s or Standard & Poor of BBB or better.
Projected Gross Operating Income: Property’s annual income if all spaces were rented and all of the rent actually collected, minus an allowance for vacancy and credit loss.
Optimum Holding Period: Number of years to hold a property in order to maximize ROE. After this period it’s best to sell or exchange the property.
Triple Net (NNN) Lease: This is lease whereby the tenant pays for the common area maintenance (CAM), real estate taxes and insurance for the building and property. Most retail leases are considered triple net. Tenants who have a triple net lease are responsible for payment of these items in addition to the base rent on a pro rata basis.
Useable square feet: Total square feet within the walls of the space being leased. Actual space available for Tenant’s exclusive use.
Rentable square feet: Total square feet used to calculate the rent rate; may include an apportionment of lobby, hallways and other areas in the building available to and used by all the building tenants. Expressed as a multiplying or load factor of Useable SF. Example: Rentable SF = Useable SF x 1.15 (multiplying or load factor).
Load Factor: If the tenant has rights to hallways, elevators, restrooms outside their space, lobby, etc., the landlord will determine how many square feet of this area exist and prorate it to the other tenants. The tenant will pay rent on their prorata share of this number when the landlord calculates minimum rent.
If you can get to understand these commercial real estate terms, you can begin to understand commercial real estate.