You’re about to discover 8 commercial real estate terms that you should know if you plan on investing in commercial real estate. 7 of these Key Terms are mandatory to understand for any property you are looking to purchase. There is one last bonus term per se that is the key to making all your deal transactions successful. I'll share that secret commercial investing key term last.
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.
8 Commercial Investing Real Estate Terms
1. Net Operating Income (NOI)
There are 7 key commercial real estate terms that you must know before you make any commercial real estate buying or investment decisions. 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 just property expenses. NOI is the heart of every commercial real estate deal you’ll ever do. Here’s why you should know this. As the NOI increases, the property value will increase as well (and vice versa). If the NOI goes down, the property value goes down.
A huge part of world creation in commercial real estate is to increase the NOI, for example, through rent expenses and spends reductions. That’s probably the easiest way. 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 the course of year or 2 or 3.
2. Cash and Cash Return
Cash and cash return is also known as your ROI, return on investment. It is the heart of your money, right? It is the heart of your money or your investor’s money. Now, here’s a quick calculation. Again, I can’t show in a board, but cash and cash is basically your annual cash flow divided by your down payment. That’s the cash and cash return. Okay? Here’s why you should know that. First of all, cash and cash return is my favorite term.
This is again your return on investment or your ROI. It’s a very important term because it’s not how much money you spend on the property, but how fast is your money coming out of the property. Again, it’s not how much money that you spend on your property going in. It’s how fast the money is coming out.
If all you have is $50,000 of spend and it takes 20 years to get back your $50,000 through cash flow, that’s not too exciting, right? By the way, that’s a 5% return. Perhaps that’s okay for stock broker, but not for us commercial real estate guys. We are expecting a double digit return minimum, right? What if it takes you 3 years to earn back your $50,000 down payment? That’s much better, right?
That’s a 33% return on investment and that’s good and very doable in commercial real estate, right? When you can pull off a 33%, sometimes that 50% return on investment is because you are working on what we call value added opportunities. Value add commercial properties are great investments!
Another thing I want to share with you is when you are raising capital from an investors, what determines 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 you look for the heart of a singular calculation that everyone uses in the industry is the cap rate. It’s an industry wide. It’s a standard practice to use cap rate. The calculation by the way of the cap rate equals NOI divided by the sales price.
Now let me share with you why you should know this. A 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/financing, 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 what is your return on investment if you paid all cash for the property.
High Cap, High Risk
Now, here’s some more correlation. 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 regions, neighborhoods. Now on the other hand a low cap rate and let me defined low cap rate, I would say a 6, 5, and 4. That’s what I call a low cap rate, right? That usually typifies a lower risk investment but a high sales price.
Okay. 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, okay? Every neighborhood has a cap rate. With that said, if you know the NOI, if we know the NOI is and you know the giving cap rate, then you can calculate what the sales price would be, right?
Because if cap rate is equal to NOI divided by the sales price, you can flip that equation over and say sales price is equal to NOI divided by the cap rate. I know I said that quickly, but if you watch my videos, you know what I mean.
4. Debt Coverage Ratio
We call it DCR. Get used to this term. This is a term used frequently with your lenders. Here’s what it is. When you think of commercial real estate and you think of financing, at the heart of commercial real estate and financing is the DCR. It’s defined as the amount of cash flow available to pay your mortgage.
All commercial lenders want your deal to be able to pay the mortgage and have something left over. Debt coverage ratio, DCR, tells you how much is left over, right? Here’s why you should know it. It’s a very important number for your lender. It’s their first check to see if this deal is lendable. By the way, lenders usually want to see a debt coverage ratio of at least 1.2 or more. Now you asked me what’s 1.2 mean, right?
Let me give you the quick calculation. DCR, debt coverage ratio is calculated using this formula: NOI divided by your annual debt service. Debt service is your annual mortgage payments, okay? Again, DCR is equal to NOI divided by your 12 months of mortgage payments. If it comes up to 1.0, that means you have no excess cash flow, that means your NOI is equal to your mortgage, right? If it goes over one, that means you have cash flow. Banks want to see an average of 0.2 or more.
Getting Started in Commercial Investing
Commercial Investing is great! My first commercial apartment building was a quaint 7 unit building that was close by. It was very affordable and I got great seller-financing. A big plus was that it came with an established property management company at the helm. My first small residential apartments were duplexes and four-plexes that were a few minutes from my house.
When you’re first starting out as an investor, there are lots to learn and there are lots of mistakes to be made. Small property mistakes usually equals small pains. That’s why it’s smart to start off with a small property. I will share on you Part 2 of “8 Commercial Real Estate Terms Investors Should Know” on my next blog so you will have all the right information you will need to make an offer on an apartment or commercial investment deal – Good Luck Investing!