As a commercial real estate investor, there are several key terms that you need to know before you begin investing in investment property for sale. Understanding the core terminology used in the commercial real estate field will help you more easily navigate your investment dealings and highlight your expertise in the field. Read on for the top phrases you need to be aware of.
Net Operating Income
Net operating income is an essential idea you need to get to grips with to be successful in your commercial real estate investments. Net operating income (NOI) refers to the income you generate annually from an income property, after property expenses have been taken into consideration.
Aside from rent, you may also generate other income from your commercial space, such as parking or laundry. Property expenses refer to any expenses that enable you to run and maintain an income property, such as utility, property management fees, and property tax. NOI does not include loan payments, depreciation, amortization, or capital expenditures. Your NOI is calculated before tax.
Cash on Cash Return
Cash on Cash Return (CoC) is perhaps one of the easiest and most popular metrics used by commercial real estate investors. CoC is used to measure the ratio between an asset’s annual cash flow in relation to the commercial property’s down payment. CoC is generally calculated before taxes.
Return on Investment
Return on investment (ROI) stands for the calculated benefit of an investment (called the return), divided by its cost. Your ROI is impacted by several variables, such as renovation and maintenance costs, and how much you originally borrowed in order to invest in your property.
The capitalization rate, often referred to as the cap rate, refers to the net operating income (NOI) divided by an income property’s sale price (or asking price – whichever figure is lower). A cap rate can be used to help figure out your potential return on investment before factoring in potential mortgage financing. Typically, a low cap rate comes with a higher price point and less risk than a higher one.
Debt Coverage Ratio
Debt coverage ratio (DCR), sometimes known as the debt service coverage ratio (DSCR), compares an investment property’s NOI with its debt service. Lenders use this ratio to calculate whether or not you will be able to generate enough income to pay your debts. Most commercial lenders require a DCR of 1.15-1.35 times the NOI/annual debt service.
Loan to Value
When considering how to invest in real estate, one term you may see come up again and again is loan to value ratio (LTV). The LTV is determined by what percentage an asset’s sale price or value is attributed to financing. Income property lenders perceive as lower risk are assigned a higher LTV.
Property values are determined by asset classifications. Investment property falls under one of four main categories: Class “A”, “B”, “C”, or “D”. A property’s classification is determined by its market value. Class A properties refer to property in the most in-demand markets. They typically boast impressive aesthetics and construction, and require little renovations. Class “A” properties demand the highest rents.
In comparison, an income property that falls into classes “B”, “C”, or “D”, will be categorised by less appealing features, such as an older property, poorer construction, or a less desirable location. The higher the class, the more expensive and in demand the investment property. With class “A” properties, you typically see a lower ROI. While you may get higher returns with the lower classes, they are also a riskier investment, as the property is less enticing to the market. In addition, lower class properties commonly require greater upkeep and renovations. As such, class “B” and “C” income property may be the wisest choices for new investors, striking a balance between risk and return.
Learn how to successfully identify the various asset classes, and search for them using Reonomy, in our past post.
A real estate investment trust (REIT) refers to a corporation that owns or finances income property. REITs function similarly to stocks. Shares in investment property are bought and investors receive dividends on the rent payments collected by the property management companies that own the property.
REITs are an inviting investment choice for many commercial real estate investors as they offer the potential for sizeable returns on investments. However, REITs also come with a certain level of risk, as they are vulnerable to share price volatility. As such, many savvy investors diversify their commercial real estate portfolios – outright buying property and mixing and matching with REIT investments.
Find out more about how to invest in REITs here.
Mastering the Terminology
When sourcing investment property for sale, it’s important to be well versed in industry terminology. A good understanding of the commonly used terms will enable you to rapidly excel in the commercial real estate field. Getting to grips with popular definitions will also provide a boost to your business negotiations, allowing you to confidently negotiate and discuss your prospects.