In commercial real estate (CRE), understanding the industry-specific jargon is not only beneficial but essential. Whether you're an investor, broker, or tenant, the ability to comprehend and utilize these terms can lead to more informed decisions and lucrative investments. Here, we explain 18 crucial commercial real estate terms you should know so that you can navigate this complex sector.
1. Net Operating Income (NOI)
Net Operating Income, or NOI, refers to the profit generated by a property after deducting all operational expenses. It is an essential term in CRE and is used to ascertain the value of a property. Here's the basic formula to calculate NOI:
NOI = Gross Operating Income - Operating Expenses
The Gross Operating Income is the total income your commercial property generates. Operating Expenses are related to the daily operations of the property, including payroll, repairs, and maintenance.
2. Capitalization Rate (Cap Rate)
The Capitalization Rate, commonly known as the Cap Rate, is a ratio that illustrates the expected return on an investment annually, in percentage form. It is determined by the formula:
Cap Rate = NOI / Property’s Market Value or Sales Price
For instance, if a property is worth $500,000 and the NOI is $50,000, the cap rate would be 10%. The Cap Rate is calculated on every commercial property sale and is a crucial metric in CRE, allowing investors to compare property values and assess an investment's profitability.
3. Per Square Foot (PSF)
Per Square Foot (PSF) is a term used to evaluate the value of a commercial real estate property based on its total square footage. The rental price for commercial real estate is typically discussed as "per square foot." The PSF price will typically either be listed by year or by month.
4. Lease Agreement
A lease agreement in commercial real estate is a legally binding contract between a landlord and a tenant that outlines the terms and conditions for renting a commercial property. It specifies the duration of the tenant's occupancy or term of the lease, the rental payment and other financial considerations, maintenance responsibilities, and other terms agreed upon by both parties. The lease agreement helps protect the rights and obligations of both the landlord and the tenant during the lease term.
5. Rental Rate
The rental rate in commercial real estate refers to the amount of money that a tenant pays to the landlord for leasing a commercial property. It is typically quoted as a per square foot or per unit basis and is a key component of the lease agreement. The rental rate can vary based on various factors such as location, size of the property, market demand, lease term, and the condition of the property.
6. Lease Types
The type of lease associated with a property significantly impacts its value. There are two main types of leases in CRE: gross leases and net leases.
In a Gross Lease, the tenant pays a fixed rental price, and the landlord is responsible for the property’s operating expenses, like insurance, repairs, and property taxes.
In a Net Lease, the tenant will pay some or all of the operating expenses of a property in addition to a base rent. These leases are common for retail and office buildings, where a tenant may desire more flexibility and control over the property. Net leases are further divided into Single Net Leases (N), Double Net Leases (NN), and Triple Net Leases (NNN).
7. Vacancy Rate
Vacancy rate in commercial real estate refers to the percentage of vacant or unoccupied properties within a specific market or area. It is a metric used to measure the health and competitiveness of the commercial real estate market. A high vacancy rate indicates an oversupply of available properties, while a low vacancy rate suggests a high demand and limited availability of commercial space.
8. Ground Lease
A ground lease in commercial real estate refers to a long-term lease agreement between a landowner (known as the ground lessor) and a tenant (known as the ground lessee). In this arrangement, the ground lessee leases the land from the ground lessor without any improvements, such as buildings or structures. The ground lessee then develops and constructs improvements on the leased land, usually for commercial purposes.
The ground lease typically has a lengthy duration, ranging from 30 to 99 years, and may include terms such as rent payments, renewal options, and restrictions on land use and development. At the end of the lease term, the improvements made by the ground lessee usually become the property of the ground lessor.
Ground leases are common in urban areas where landowners prefer to retain ownership of valuable land while allowing tenants to utilize the property for commercial purposes. This arrangement allows both parties to benefit. The ground lessor receives rental income and retains ownership of the land, while the ground lessee gains access to a prime location without the burden of purchasing the land outright.
9. Debt-Service Coverage Ratio (DSCR)
The Debt-Service Coverage Ratio (DSCR), also known as the debt service ratio, is the ratio of available operating income to debt service. According to Investopedia, "Debt service refers to the money required to pay the principal and interest on an outstanding debt for a particular period of time."
DSCR is a crucial calculation in CRE used to determine how much income an investor will have left over after the debt service. Here's how to calculate DSCR:
DSCR = NOI / Total Debt Service
10. Annual Cash Flow
Annual Cash Flow is the amount of money that moves in and out of a business per year. It's calculated using the formula:
Annual Cash Flow = NOI - Debt Service
When the Annual Cash Flow is positive, the property is profitable. When it's negative, the income on the property is not enough to cover the debt service.
11. Cash-on-Cash Return
The Cash-on-Cash Return is the ratio of the annual cash flow before tax to the total cash invested in the property. This number is expressed as a percentage. Here's how it's calculated:
Cash-on-Cash Return = Annual Cash Flow / Down Payment
This is important because it's one of the metrics by which you can gauge whether a specific property would be a good investment.
12. Interest Rate
The Interest Rate on a loan is the cost you pay to borrow money. Interest rates on commercial real estate loans typically range from 3% to 18%. Banks and agency lenders like Freddie Mac and Fannie Mae usually offer lower interest rates, while private debt funds often have higher interest rates.
Leverage is a crucial part of commercial real estate investing. In simple terms, leverage refers to using debt to potentially yield a higher rate of return on your real estate investment.
14. Building Classifications
Commercial buildings are classified into three categories: Class A, Class B, and Class C.
Class A Buildings
Class A buildings are almost new, located in highly attractive locations, and are known for good maintenance.
Class B Buildings
Class B buildings are average, about 15+ years old, with fewer amenities.
Class C Buildings
Class C buildings are usually older than 20 years and often require substantial improvements and repairs.
A submarket in the commercial real estate industry refers to a smaller and more specific segment within a larger real estate market. It is typically categorized based on geographical location or other defining characteristics such as property type, price range, demand, or economic factors. Submarkets enable a more detailed analysis of the real estate market and provide insights into the specific dynamics and conditions within a particular area or property type. Examples of submarkets could include a downtown district, an industrial park, or a high-end retail corridor within a larger metropolitan area.
16. Rent Concessions
Rent Concessions are allowances that permit discounted or free rent for a fixed period. Typically, rent concessions are linked to renovations or adaptations performed by the new tenant.
17. Tenant Improvements
Tenant Improvements are changes made to the property by the tenant. Such improvements may include flooring, ceilings, painting, etc., and should be negotiated before signing the lease.
18. Purchase & Sale Agreement (PSA)
A Purchase & Sale Agreement (PSA) is a document prepared by the buyer's agent or attorney, which is presented to both parties – the buyer and seller – after mutual acceptance of a written offer. The PSA includes details such as the final sale price, earnest money details, timelines for due diligence, contingencies, and other legal information.
Bottom Line on Key Commercial Real Estate Terms
Understanding these key commercial real estate terms is crucial for successfully navigating property transactions. Being well-versed in the industry’s terminology will help you make more informed decisions, negotiate better deals, and ultimately realize higher returns on your property investments.