You're about to discover 7 commercial real estate terms that you should know if you plan on investing in commercial real estate. These 7 terms are mandatory to understand on any property you are looking to purchase. There's a quote I want to share with you from the Greek philosopher, Aristotle. He says, "Educating the mind without educating the heart is no education at all." I truly believe that. What I want to do in this short training is very quickly share with you what's in the heart of every commercial real estate investment deal that you will find and come across.
There are 7 commercial real estate terms that you must know before you make any commercial real estate investment decisions. I've taken the most important terms from my YouTube Channel and I condensed them right here for you.
1. Net Operating Income (NOI)
The first of 7 commercial real estate terms you must know is Net Operating Income, also known as NOI. The net operating income calculation is NOI is equal to your gross rental income minus your expenses.
NOI = Rental Income - Expenses
Those expenses do not include mortgage payments or depreciation; but specifically property expenses. NOI is at the heart of every commercial real estate deal you'll ever evaluate. It will determine the property worth now and in the future, what your cashflow will be, and how you will make an offer. It's important because as the NOI increases, the property value will increase as well. If the NOI goes down, the property value goes down. We teach our students to find deals with net operating income upside. Meaning, they find ways to get the NOI to go to a new and higher level over two or three years.
Commercial Cash Out Refinance:
This leads me to a technique of all commercial real estate syndicators and our students. It's called the commercial cash out refi. To learn more you can read my blogpost called Commercial Cash Out Refi. It's basically buying a commercial property, increasing the NOI through rent increases and spends reductions, and then refinancing the loan to pull out the original down payment or your investor's down payment while keeping the property. Let me ask you this. After you put your money in, you fix at the property, refi, you take your money out, what is your return on investment if you have no money in? It's infinity. That's the power of the NOI.
2. Cash On Cash Return
Cash on cash return is also known as your ROI, or return on investment. It is the heart of your money or your investor's money and is basically your annual cash flow divided by your down payment.
Return on investment or your ROI is a very important term because it's not how much money you spend on the property, but how fast your money is coming out of the property. If all you have is $50,000 to spend and it takes 20 years to get back your $50,000 through cash flow, that's not too exciting. That's only a 5% return. Perhaps that's okay for a stock broker, but not for us in commercial real estate. We are expecting a double digit return minimum. Instead, it would be better if you could earn back your $50,000 down payment in three years.That's a 33% return on investment and that's good and very doable in commercial real estate.
When you can achieve a 33%, or sometimes even 50% return on investment, it is because you are working on what we call value added opportunities and that is what we focus on here in our company. Value add commercial properties. Another thing I want to share with you is when you are raising capital from an investor, how you determine what you can pay them is your cash and cash return, because it comes straight off the top. That's why it's really important to know this term.
3. Capitalization Rate
If you look at the commercial real estate industry as a whole, and are looking for a singular calculation that everyone uses in the industry, it is the cap rate. It's an industry standard to use the cap rate which is the NOI divided by the sales price. It's important to know this because the cap rate is used to measure a building's performance, without considering the mortgage financing. For example, if you paid all cash out without investment, how much money does it make? What's your return? That's what a cap rate is. In layman's terms, a cap rate is your return on investment if you paid all cash for the property.
High and Low Cap Rates:
A high cap rate which is 10, 11, 12% usually typifies a higher risk investment and a low sales price. High cap rate investments are typically found in poor, low income neighborhoods. In comparison, a low cap rate, such as 4, 5 and 6%, usually typifies a lower risk investment but a high sales price. Low cap rates are usually found in upper middle class to upper neighborhoods. Therefore, neighborhoods within cities have stamped on them their assigned cap rates. Every neighborhood has a cap rate. If you know what the NOI is and you know the cap rate, then you can calculate what the sales price would be.
If the cap rate is equal to the NOI divided by the sales price, you can flip that equation over and the sales price is equal to NOI divided by the cap rate.
4. Debt Coverage Ratio
We call it DCR. This is a term used frequently with your lenders. The DCR is at the heart of commercial real estate and financing. It's defined as the amount of cash flow available to pay your mortgage. The formula is the DCR is equal to your NOI divided by your annual debt.
All commercial lenders want you to be able to pay the mortgage and have something left over. Debt coverage ratio tells you how much is left over. One of the reasons this is so important is because it's the first number the lender will check to see if a deal is lendable. Lenders usually want to see a debt coverage ratio of at least 1.2 or more. You may be wondering what 1.2 means. Let me give you the quick calculation.
In the formula DCR equals NOI divided by your annual debt service, debt service is your annual mortgage payments. In other words, DCR is equal to NOI divided by your 12 months of mortgage payments. If it calculates to 1.0, that means you have no excess cash flow, and your NOI is equal to your mortgage. If it goes over one, that means you have cash flow. Banks want to see an average of 1.2 and I think a good target for a strong deal is 1.4 DCR.
5. Price Per Unit and Square Footage
Price Per Unit:
This term is at the heart of determining what a property is worth and also what to offer when you're considering buying a property. It also varies depending on the neighbourhood or what sub-market you are in. Price per unit is a term usually used for apartments and is calculated by dividing the price of the property by the number of units. If you have a $500,000 apartment building and you have 10 units in it, that's $50,000 a unit. That is how you calculate the price per unit.
Price Per Square Footage:
We use price per square foot for office buildings, retail centers, and industrial buildings. To determine the price per square foot, you use the same calculation as price per unit, but instead divide the price by the square footage. So, a $500,000 building that is 10,000 square feet would be $50/sqft.
If you know the price per square unit in your sub-market and compare it with the price per unit of your property it will help you:
- Gauge your offer price
- Not over pay for your deal
- Know if a seller's asking price is realistic
Commercial Wholesaling is when you find a good deal, get it under contract, find a good buyer and flip it to the buyer. Knowing the price per unit and square foot is a valuable skill for wholesalers to determine whether they have a good deal and position themselves to make a lot of money. Again, knowing the price per unit and price per square foot in your sub-market and your property is at the heart of determining what your property is worth and what your offer price will be.
6. Building Classification
Commercial buildings are separated into three classes. These classifications mean different things to different types of investors.
Class A Building:
Class A buildings are the newest and highest quality, with the best location and highest rents. They are beautiful buildings in beautiful neighborhoods and attract the highest quality tenants. They are typically downtown with commercial on the main level and residential units on the top. As a beginner investor, Class A is not for you. The reason is because the price is too high, with low returns and you get steep competition from institutional buyers and funds. They can pay all cash and are okay with the low returns.
Class B Building:
Class B buildings are usually a little older, but they are still good quality and attract average, working class tenants. Oftentimes value added investors target these types of buildings as investments since well-located class B buildings can be returned to their A class glory. These are the most stable properties. As a commercial real estate investor, your goal is to find a B class building in an A class neighborhood and then renovate that building to get A class rents.
Class C Building:
Class C is the lowest official classification and the buildings are older and need updating. They have the lowest rents and you'll find lower to middle income tenants in them. If you are an apartment investor, class C is the way to go because the ratio between the price per unit and the rents are still good and you can get the highest returns. There will always be a demand for them because they are the most affordable, especially with the rising rents of Class A and B apartments. However, you need to be careful because the buildings tend to need a lot of maintenance and the neighborhoods and tenants could be challenging. Managing these properties requires skill.
Class D Building:
There is also another class but it is not an official class. The buildings are often vacant and in need of extensive renovation. Class D properties are for experts who have deep pockets. If you're a beginner, don't even consider a class D building.
7. Types of Leases
Leases are the lifeline, they're the life blood of a commercial property keeping the money flowing, thus protecting you from foreclosure. They are legally binding written agreements between the property owner and tenant. Let me briefly highlight several types of leases. In a previous blog, I went over it in great detail.
For apartment buildings the lease could be a one year lease, a 9-month lease or a month to month lease. All our leases are strong leases written by our attorney. Why are they strong? Because you are in the income business. Leases give you the legal right to collect rent, evict people and take them to court if they don't pay. If you don't have a strong legal instrument your tenants can take advantage of you and stay in your apartments without paying rent. So, having a strong lease is really important.
3 Types of Leases for Office Buildings and Shopping Centers:
- Full Service Lease: The tenant pays a flat fee and landlord pays for everything, including insurance, taxes, repairs and utilities.
- Triple Net Lease: The tenant pays for everything. This is a passive option, where the landlord only has to pay the mortgage. Watch my video Truth Behind Triple Net Lease to learn more.
- Modified Gross Lease: The tenant and landlord split certain expenses.
Again, leases are the lifeblood of any commercial real estate investment. Another way to look at it is, you're buying the building for free and you're paying for the leases. The building is worth nothing without the leases.
Bonus Term: Relationships
I have a bonus term I want to share with you and it is probably the most important term of all if you want to have long lasting success as a commercial real estate investor. Knowing this will:
- Help you get the best deals.
- Convince the seller to work with you instead of others.
- Help you work with their broker that will send you his or her off market deals.
The bonus term is relationships. Commercial real estate is a relationship based business. This is probably the most important term of them all because if you don't get this part right, none of the other 7 terms matter. Here's the question. What do you think will get you the best deals, knowing terms or knowing people? What will convince a seller to work with you instead of others, is not knowing terms but understanding the needs, motivations and building rapport of the seller.
Commercial Real Estate is a Relationship Based Business
There's a saying that you have probably heard, "No one cares how much you know until they know how much you care." That is so true in commercial real estate, with commercial property owners and brokers as well. Study the terms and know them, but I want you to start with relationships first. Commercial real estate is a relationship based business. I want you to build relationships with brokers, sellers, mentors, and other successful people. That's where success happens first.