Discover the 18 most important commercial real estate terms you must know if you want to become a successful commercial investor. The first 7 terms help you determine cash flow and the next 11 terms help you analyze potential investments and make decisions. Armed with a clear understanding of these 18 fundamental terms, you can intelligently invest in commercial real estate.
7 Basic Commercial Real Estate Terms
Using a 5 unit multi family apartment building as our example, you'll learn the 7 basic commercial real estate terms which are used to determine the Net Operating Income (NOI) and Cash Flow (CF). Those basic terms are:
- 1. Gross Rental Income (GRI)
- 2. Vacancy Factor
- 3. Effective Gross Rental Income (EGI)
- 4. Total Operating Expenses (OpEx)
- 5. Net Operating Income (NOI)
- 6. Annual Debt Service (ADS)
- 7. Cash Flow (CF)
11 Decision Making Commercial Real Estate Terms
Once the NOI and Cash Flow have been determined, the next set of commercial real estate terms are used to make intelligent investment decisions. Those terms are:
- 8. Cash on Cash Return
- 9. Capitalization (Cap) Rate
- 10. Debt Coverage Ratio
- 11. Actual vs Pro Forma Financials
- 12. Building and Location Class
- 13. Occupancy Rate
- 14. Occupancy Break Even Point (OBEP)
- 15. Ratio Utility Building System (RUBS)
- 16. Capital Reserves
- 17. Price per Unit
- 18. Price per Square Foot
7 Basic Commercial Real Estate Terms
1. Gross Rental Income (GRI)
The gross rental income is the total income generated by a rental property before deducting expenses. To calculate the monthly gross rental income, multiply the monthly rent by the number of units and then multiply by 12. If each unit of our 5-unit apartment example rents for $1,200/month, the calculation is:
Gross Rental Income Calculation
$1,200/unit/month x 5 units = $6,000/month x 12 months = $72,000 per year gross rental income.
2. Vacancy Factor
Commercial real estate rarely remains 100% rented 100% of the time. Vacancy factor accounts for this reality and therefore you must subtract a vacancy factor from the gross rental income. A vacancy factor provides safety into your calculations and the industry standard for multifamily apartments is a 5% vacancy factor. At a minimum, calculate a vacancy factor of at least 5%, and depending on the deal, it could be more. Understanding what the vacancy factor should be is where a mentor is so crucial.
Vacancy Factor Calculation Example
5% of $72,000 = $3,600/year vacancy factor
3. Effective Gross Rental Income (EGI)
The subtraction of the vacancy factor from the gross rental income is your effective gross income.
Effective Gross Rental Income (EGI) Calculation
$72,000 Gross Rental Income - $3,600 Vacancy Factor = $68,400 Effective Gross Income (EGI)
4. Total Operating Expenses (OpEx)
Operating expenses are the recurring costs that support the day-to-day operations of the property, including taxes, insurance, management, utilities, repairs, maintenance, supplies, bookkeeping, legal and contractors. Obtaining truthful, real-world operating expenses from a commercial property seller can be extremely difficult because in commercial real estate, it's Caveat EmptorCaveat Emptor whereby the Buyer is responsible for verifying the validity of all information provided by the Seller. Sellers often lie or don't tell the whole truth. Here is how to get the REAL expenses on any commercial deal. While the most accurate way to calculate operating expenses is to add up all of the yearly operating expenses one line item at a time, a very helpful rule of thumb for multifamily apartments is to multiply the EGI by 35% to get the operating expenses.
Total Operating Expenses Calculation
35% of $68,400 EGI = $23,940 in Total Operating Expenses
What are NOT Operating Expenses
Beginners oftentimes mistakenly include costs that are NOT operating expenses. The following are NOT operating expenses:
- Occupancy: This was already accounted for in the Vacancy Factor
- Loan Payments: This will be accounted for in the Annual Debt Service (ADS) below.
- Depreciation: This is an income tax deduction, not an actual expense.
- Improvements: Upgrading the property to increase gross rental income (such as adding washers & dryers to each of the 5 units) are not considered operating expenses because they are not day to day repair or maintenance costs, they are capital improvements.
5. Net Operating Income (NOI)
The Net Operating Income (NOI) is one of the most important commercial real estate terms you'll ever need to know. It is the value driver in commercial property because as your NOI increases, the property value increases. Therefore, unlike residential real estate, with commercial, you can increase the value of the property by improving the property's financial performance (which is defined by the NOI). NOI describes how much money the property earns if you owned it free and clear without any loans against it. To determine the NOI, subtract your operating expenses (OpEx) from the effective gross income (EGI).
Net Operating Income (NOI) Calculation
$68,400 (EGI)- $23,940 (OpEx) = $44,460 Net Operating Income (NOI)
6. Annual Debt Service (ADS)
It is financially astute to maintain a loan against commercial real estate rather than own it free and clear of any financing. Therefore, there will be debt payments, or what homeowners refer to as mortgage payments. The total yearly loan payments is called "Annual Debt Service" in the world of commercial real estate. The purchase price of our example property was $600,000 and the down payment was 25% (or $150,000) and the other 75% was financed at 6.5% interest amortized over 30 years, making the monthly loan payment $2,844/month.
Annual Debt Service Calculation
$2,844/month loan payment x 12 months = $34,128 Annual Debt Service (ADS).
7. Cash Flow (CF)
The first 6 commercial real estate terms above help us determine this incredibly important calculation, the property's Cash Flow (CF). The Cash Flow is how much money the property puts in your pocket as the owner. This is your net profit. The purpose of owning commercial real estate is to make a profit and the Cash Flow is a critical component of that purpose. There are other ways to profit from commercial property, as you'll discover below, but Cash Flow is arguably the most important one. It is calculated by subtracting the Annual Debt Service (ADS) from the Net Operating Income (NOI).
Cash Flow Calculation
$44,460 NOI - $34,128 ADS = $10,332 Cash Flow per year, or $861 per month
11 Decision Making Commercial Real Estate Terms
Once you have calculated the NOI and Cash Flow accurately and responsibly, your focus can turn to decision making commercial real estate terms. Bad investments come from investors making bad decisions. Bad decisions come from lack of knowledge and wisdom. By understanding the following 11 commercial terms, you'll avoid making bad decision.
8. Cash on Cash Return
Cash on Cash return makes up part of your overall return on investment (ROI). This benchmark begins to help you compare a commercial real estate investment to other investment options that exist in the marketplace. For example, traditionally the "safest" investments include Certificate of Deposits from a Bank or Government Treasury Bonds. Since commercial real estate requires more of your time, has less liquidity and may have more risk, you certainly want a higher Cash on Cash Return (or ROI) than a Bank CD or a Treasury bill. However, other investments like a stock market no load mutual fund historically deliver a much higher return than a CD with much more volatility and risk. Since commercial real estate is much safer than the stock market, having a Cash on Cash Return somewhere between the two makes financial sense. Moreover, there are several other ways in which you can obtain a return on your investment from commercial real estate, including Tax Benefits of Commercial Real Estatetax benefits as well as being able to do a When to Refinance Commercial Real Estate?cash out refinance so you don't want to compare this one factor alone in deciding on a deal. Cash on cash return is important but not the whole story. Cash on Cash Return is calculated by dividing the Cash Flow by the money invested in the deal, or in this case, the down payment.
Cash on Cash Return Calculation
$10,332 Cash Flow divided by $150,000 down payment = 6.9% Cash on Cash Return
9. Capitalization (Cap) Rate
Capitalization Rate, or what commercial investors shorten to Cap Rate, is defined as your return on investment if you paid all cash for the property and did not get a loan. There are actually two types of Cap Rate; the first is the Deal Cap Rate, which is defined as the NOI divided by the Purchase Price and the second is a metric commonly used by commercial real estate brokers called the Market Cap Rate, which is also the NOI divided by the Sales Price but it is calculated on every single commercial property sale and is used to gauge what investors are willing to pay for properties in a given area. From a Deal Cap Rate perspective, the higher the cap rate, the higher the return on investment, which is a good thing! From a Market Cap Rate perspective, the higher the cap rate, the worse an area is because the most desirable areas have the most competition and therefore the lowest cap rates. Confused? That's why all commercial real estate investors need a mentor!
Calculating Capitalization (Cap) Rate
$44,470 NOI divided by $600,000 Purchase Price = 7.4% Cap Rate
Determining if You Overpaid
While in residential real estate, you can easily compare similar property sales to determine if you overpaid or got a great deal on the home you bought, with commercial, it's not quite that simple. The fastest and easiest way to figure out if you are overpaying (or getting a great deal) is to compare the property's Deal Cap Rate with the Market Cap Rate. Ideally, your Deal Cap Rate is higher than the Market Cap Rate, since the Market Cap Rate is what other properties in the neighborhood have sold for in terms of a cap rate. For example if there are four or five transactions in the immediate area of your property that closed at a cap rate of 6.5%, then the market cap rate is 6.5% and if your deal cap rate is 7.4%, then you got a good deal! However, what if the market cap rate is 8%? Then $600,000 is paying too much for the property. That's because:
$44,460 NOI divided by 8% market cap rate = $555,000 Price
Capitalization Rate (Cap Rate) is therefore crucial to deciding if your purchase price is too high or if you are getting a great deal.
10. Debt Coverage Ratio (DCR)
The Debt Coverage Ratio (DCR) determines the property's ability to pay (or cover) the property’s loan payments out its Net Operating Income (NOI). You want the NOI to cover the debt by at least 1.2 times because most lenders require the DCR to be at least 1.2. If the DCR is 1.0, your annual debt service and your NOI are the same and therefore you are just breaking even. Even worse, if your debt coverage ratio is less than 1.0, then you have negative cash flow and are losing money each month! The DCR is calculated by dividing the NOI by the Annual Debt Service:
Debt Coverage Ratio Calculation
$44,460 (NOI) divided by $34,128 (ADS) = 1.3
11. Actual vs Pro Forma Financials
When you're actively looking at commercial deals listed with a broker, you will most likely be presented with two sets financials, the current or actual income and expenses as well as the Pro Forma, or future potential financials. Actual is what has been happening with the property whereas Pro Forma is what is possible given the right improvements and adjustments. Actual Financials tell the real story and Pro Forma Financials describe what could happen if everything goes right. Sellers prefer to illustrate the Pro Forma Financials because it makes their property look better than it really is. Buyers like to negotiate based on Actual Financials because the future is not always as good as we hope it to be. To illustate this, we have already determined the Actuals for the 5 Unit example:
Actual Income & Expenses Financials
- GRI: $72,000/yr
- Vacancy: 5%
- EGI: $68,4000/yr
- OpEx: $23,940
- NOI: $44,460
- ADS: $34,128
- CF: $10,332
What if each of the 5 units could be upgraded and the rents could be raised? What if there were other income producing improvements that could be made like covered parking? Let's assume you did your own research, rather than relying on the Seller or the Broker, and you determined that with certain improvements, the Pro Forma Financials would be:
Pro Forma Income & Expenses Financials
- GRI: $93,600
- Vacancy: 5%
- EGI: $88,920
- OPEX: $31,122
- NOI: $57,798
- ADS: $34,128
- CF: $23,670
How does an increase in the NOI from $44,460 to $57,798 impact the value of the property? It increases the value by $190,543. And here’s how that was determined:
- Pro Forma Property Value: $57,798 / 7% Market Cap = $825,686
- Actual Property Value: $44,460 / 7% Market Cap = $635,143
- $825,686 - $635,143 = $190,543 Value Increase
This is how commercial real estate investors become so incredibly rich. They increase the NOI of the properties they acquire, which drastically increases the value of those properties and then they either refinance to pull out their cash or they sell.
12. Building and Location Class
Knowing the "Class" of the building (A, B, C, or even D) is important when analyzing a potential commercial deal because it is key to implementing value add strategies that increase your NOI and increase the value. However, determining building class can be quite subjective. There are 3 key factors used to distinguish between A, B and C Class properties: the price, the quality of the property (including location) and the amenities on the property.
Multifamily Apartment Real Estate Classification
Class A: These are newer buildings of the highest quality. They have great curb appeal with immaculate landscaping, are less than ten years old, and are located in the best market with high income earners. A-class apartment buildings have the highest rents and tenants get access to great amenities like a clubhouse, a media room, exercise room, swimming pool and even a tennis court. They are in high price markets with the lowest cap rates.
Because the price is so high and there's really no work to do, A-Class properties are for the investor with a lot of money who wants to preserve their capital. Their goal is to purchase commercial real estate and let it cash flow. Investing in A-Class multifamily apartments has less risk but there isn’t lot of upside to look forward to.
Class B: A step down from A-Class is B-Class. These properties are well maintained and are about ten to twenty years old, which means they may need slight renovations or updating but nothing major. They are situated in good neighborhoods where the middle class live. So, B-Class is an average looking property and the price is lower than A-Class.
For an investor, B-class is in between A and C. And although there may be some upside opportunity with renovations, overall these properties are stable with limited investment risk.
Class C: In the U.S. we have a lot of C-Class properties because there are a lot of old buildings. C-Class buildings are twenty to thirty years old (or older) and often in need of major renovations. They are in a less desirable location, mostly lower to middle class neighborhoods.
C-Class properties have the lowest rents, but for investors C-class properties can be an attractive value-add opportunity. After renovating an older C-Class property, the rents can be raised over a couple of years, increasing the NOI and forcing the appreciation. These properties have the most risk but also the most potential for investors to grow their investment.
13. Occupancy Rate
Determining occupancy rate is important because it helps investors accurately predict cash flow and evaluate risk. This calculation determines the percentage of units occupied by tenants. So, if you have a 10-unit building and nine are occupied, that is a 90% occupancy rate. This is the same, but defined a different way, as the Vacancy Rate.
Occupancy Rate Calculation
The formula for calculating the occupancy rate is the number of units occupied divided by the total number of units of the apartment building. So, in the case of our example, we have five units. If 4 units are occupied, our formula is:
4 divided by 5 = 0.8 or 80%
Our 5-unit apartment has an 80% occupancy rate.
Why is calculating the occupancy rate important? Well, let’s say you own a 10-unit building and 9 units are occupied. That gives you 90% occupancy rate. On the other hand, if you own a duplex and one tenant moves out, you have a 50% occupancy rate, and your cash flow is cut in half. Do you see how occupancy rate impacts cash flow? With more units you get stable cash flow and a less risky investment.
14. Occupancy Breakeven Point
Occupancy breakeven point is a practical tool for commercial real estate investors when evaluating the cash flow of a potential deal. It measures the amount of occupancy needed to reach the cash flow breakeven point. In other words, how many tenants do you need to cover your expenses and break even in terms of cash flow.
Occupancy Breakeven Point Calculation
The formula for calculating OBEP is:
Annual Operating Expenses + Annual Mortgage Payment divided by Gross Potential Rental Income (Gross Potential Rental Income is the amount of income the property will generate if it is 100% occupied)
Again, using our 5-unit apartment as the example:
(Operating Expenses) $23,940 + (Mortgage) $34,128 divided by (Gross Potential Income) $72,000 = 80%
That means once I achieve 80% occupancy, I am breaking even. Anything over that 80% and my asset is cash flow positive. When occupancy dips below 80%, I have negative cash flow and am operating in a deficit. So, if this was a 100-unit property, and the breakeven point was 80%, then once the 81st person moves in, that's positive cash flow.
One situation where calculating the occupancy breakeven point is especially helpful is when you are renovating an apartment and the property is distressed with a lot of vacancy. Knowing the OBEP will give you the benchmark you need to reach in your renovation timeline to cover expenses and debt.
15. Ratio Utility Building System (RUBS)
Ratio Utility Building System (RUBS) is a powerful value-add strategy that helps to manage expenses and increase cash flow. It is a system that investors implement to bill back to the tenant monthly utility costs such as electrical, gas, water, trash, and sewer.
Investors and property managers determine the bill back ratio themselves. For this example, I will divide utility costs equally among the tenants of my 5-unit apartment building.
The utility costs for water, sewer, and trash are $375/month which means each tenant will be charged $75.00/month in addition to the rent. I now have that $375 back from the tenants which seems like a small number, but when multiplied by 12 it increases my bottom line by $4,500. But it gets better.
This $4,500 increase also impacts value. Let’s say the market cap rate is 6%. Divide $4,500 by 6%, and that equals $75,000. So at a 6% market cap rate, we have forced the appreciation on the property $75,000. See how powerful that is? Imagine the value-add potential for a 100-unit multifamily property. And all we did was implement a billing system where the tenant covers the cost of utilities.
16. Capital Reserves
Capital reserves are a necessary practical requirement for all commercial investments. But how much do you set aside? Here are 3 different ways you can calculate the amount to set aside so you have cash on hand for future capital expenses or to offset any short-term losses.
Why You Need a Capital Reserve Fund
But first, let’s answer the questions, “Why do I need capital reserves and how are they used?” Let's say you have a property, and you know that it will need a new roof in the next four or five years. Between now and then, your capital reserve fund needs to be built up so that when the time comes to replace your roof you have the cash on hand for it. Or let's say the parking lot has a lot of potholes and you know that next summer you will need to repave the parking lot. This is what the capital reserves fund is for.
It’s also to offset any short-term losses. For example, during COVID some tenants were unable to pay their rent. Those of us who had reserves were able to cover the expenses and the mortgage. Having a capital reserve fund is just a smart thing to do.
How Much Should Capital Reserves Be?
Now the question remains, how much should capital reserves be? Here are 3 ways to determine how much to set aside.
Option #1: 5% of the Gross Rental Income
One way to calculate how much to put in a capital reserve fund is to set aside 5% of the annual gross rental income before taking any cash flow. So, before you take any cash flow, put 5% of the gross rental income into a property savings account to be built up.
Option #2: 3-6 Months of Operating Expenses
Another way to determine how much capital expenses should be is to set aside 3-6 months of operating expenses: taxes, insurance, property management, utilities, etc. Simply calculate your annual operating expenses and divide it in half and put it in your rainy-day fund.
Option #3: 6 Months of Mortgage Payments
The final option is to save up 6 to 12 months of mortgage payments. With that amount of money set aside, investors can sleep well at night because they are prepared for any unexpected expenses or short-term losses.
17. Price per Unit
Price per unit for multifamily real estate is a helpful metric for determining if you are over or under paying for a potential multifamily investment. When an apartment building is appraised, price per unit is how the appraiser determines the value. Also, when evaluating a multifamily deal, price per unit (or price per door) is used as a sales comparable. You need to know how much a multifamily property is worth so that it can be compared to similar properties in the area. This helps to determine if the property is priced below, above or at market value.
Price per Unit Calculation
Purchase Price divided by Number of Units = Price per Unit
$500,000 divided by 5 Units = $100,000 per unit
18. Price per Square Foot
Price per foot is what appraisers, lenders, and real estate professionals use to determine and compare the value of industrial, office and retail commercial real estate.
Price per Square Foot Calculation
Calculating price per square foot on a commercial property is done by dividing the purchase price by the total square footage.
Using a 20,000 square foot office building with a purchase price of $1 million as an example, the formula is:
$1,000,000 divided by 20,000 = $50 per square foot (PSF)
This 20,000 square foot office building is selling for $50 PSF.
Understanding Commercial Real Estate Terms
Through evaluating actual deals, you'll better understand the significance of these commercial real estate terms. This hopefully gives you a foundational understanding of what they mean and how to calculate them but until you are analyzing actual deals, all of this knowledge will be useless. Furthermore, understanding how to calculate these commercial real estate terms doesn't tell you the whole story. Knowing what the numbers mean in relation to other deals is the real magic. And that comes from having a mentor. Every successful commercial real estate investor has a mentor. Get your mentor here: Protege Program.