You don’t need to be a rocket scientist to analyze a commercial real estate deal. If you lack fancy diplomas or letters after your name, don’t worry – you’re in good company, and many investors (some far less qualified than you) have been able to find success through commercial real estate investing.
First things first
There’s a few terms you should start to understand, but before we dive into the terms, let’s quickly touch on why they’re important.
Why you need to learn to talk the talk
- If you want to buy commercial real estate, you’re going to be interacting with other owners and brokers. Other owners and brokers will utilize most of the terms listed below. Understanding their language levels the playing field. If you can speak their language, you will gain immediate credibility.
- By familiarizing yourself with CRE lingo, you will increase your confidence, which will further enable you to not only make more prudent investment choices, but it will also augment your skillset and your ability to hold your position (especially when negotiating)
Gross Income: all of your income including rents and additional income (laundry, late fees, etc.); expressed annually or monthly
Monthly gross income = rental income + additional income
Annual gross income = rental income + additional income x 12
Effective Gross Income: EGI is a measure of the property’s potential income after expenses such as vacancies and credit costs have been subtracted
EGI = income – (vacancy rate % x income)
Operating Expenses: these are the expenses that are required to operate the property, e.g., insurance, utilities, management fees, payroll, landscaping, repairs & maintenance, taxes, etc.
Vacancy: any unit that is not producing income is considered “vacant; vacancy rate = percentage of property that is vacant
Vacancy rate = number of vacancies ÷ number of units
Net Operating Income (NOI): effective gross income minus operating expenses; this is your bottom line; NOI is the amount of dollars that are left over after you collect all your income and pay out your operating expenses. The amount that is left over is what will be utilized to pay the mortgage, and the remainder of dollars after debt service is what goes into your pocket, i.e., your cash flow
NOI = effective gross income – operating expenses
Capitalization Rate (or “Cap Rate”): a cap rate is the most basic way to measure profitability in commercial real estate. Cap rates represent what return % you can expect on an investment if you purchased the property all cash (e.g., cap rates do not include debt service and taxes). If you paid all cash for a property, how much money would it generate? A high cap rate usually signifies a higher risk investment and a lower sales price, whereas a low cap rate usually signifies a lower-risk investment and a higher sales price.
Cap rate = net operating income ÷ sales price
Debt Service: the amount of money you owe your lender, e.g., principal and interest on a loan
Debt service = monthly mortgage amount x 12
Cash Flow (CF): a measure of how much income the property is generating after debt service; positive cash flow is the most important aspect to any real estate deal as it creates healthy investment momentum and it allows lenders to get comfortable with your business plan when seeking leverage on a loan
Cash flow = net operating income – debt service
Cash-On-Cash Return (CoC): this is the velocity of your money, i.e., how long it will take for your down payment to come back to you
CoC return = annual cash flow ÷ down payment
And that’s it. No fancy calculus, no trigonometry – just some simple addition, subtraction, a little division, and some multiplication. Master these few terms and formulas, and you will be on your way to analyzing deals (which we will cover in the next post!)