Glossary of Commercial Real Estate Terms
CAP RATE Capitalization Rate is simply the net operating income (NOI) of the investment property divided by the selling price. For example, a multi-family property has a NOI of $100,000 per year. If an investor wants to pay no more than 7.0% cap rate he would pay $1,428,571 ($100,000/.07).
If you are a stock market investor, you may be familiar with the P/E ratio of a stock. This is the price/earnings ratio or capitalization rate…the same principle. A stock selling for $20.00/share and it has earnings per share (EPS) of $2.00/share, then it has a P/E ratio of 10 or a capitalization rate of 10.0%.
CAM Common Area Maintenance is what a lessor will charge a lessee on a triple net lease. Common area maintenance typically consists of landscaping, snow removal, common area utilities, cleaning, scavenger. It may also include a maintenance & repair amount to fund such things as parking lot sealing/striping, roof repair/replacement, etc. Usually, but not always, property taxes, insurance and management fees are separate.
CASH ON CASH RETURN
This is a term (just like CAP rate) that is widely used by real estate investors. This is the amount of cash (either pre-tax or after-tax) that is generated by an investment property divided by the amount of cash you have invested in the property. Most investors will ask you what the cash-on-cash return is or what the cap rate is. For example, the net cash you have invested in a property is $80,000 ($100,000 down payment less $20,000 of seller credits at closing) and the cash generated by this property, after-tax, is $15,000. Your after-tax cash-on-cash return is 18.75% ($15,000/$80,000).
Cash Flow is the net operating income of an investment less depreciation, interest, mortgage principle and income taxes. Cash flow is what most investors are interested in because this is what goes in their pocket.
Some sophisticated investors are only interested in cash flow…not earnings.
DEPRECIATION This is an expense that the IRS allows an investor to deduct over the useful life of an asset. It lowers your taxable income. For example, the IRS will allow you to depreciate a multi-family property over 27.5 years. A commercial property (i.e. a strip center) is depreciated over 39 years and is an important figure in determining the after-tax cash flow which is needed to calculate after-tax cash-on-cash return.
DSR This is the Debt Service Ratio. This is what the lenders (underwriters) will look closely at when determining if they want to lend on a particular property. This is the principle and interest (P&I) of all mortgages divided into the NOI. For example, the P&I is $325,000 and the NOI is $400,000. The DSR would be $400,000/$325,000 or 1.23. Lenders generally want to see a 1.15 – 1.3 DSR. Ask the lender, who will make the final decision as to what ratio is acceptable as it maybe over 1.3 DSR (130%).
EBT This is Earnings Before income Taxes. Earnings before taxes is NOI less interest expense and depreciation expense.
EAT This is Earnings After income Taxes.
EGI This is the Effective Gross Income of an investment property. This is a total of all the rents for a property less an appropriate vacancy factor.
LTV This is Loan To Value. This is the percentage of the purchase price that a lender will give a mortgage on. For example, most lenders will do a 80% LTV on multi-family properties. However, on strictly commercial (mixed- used, strip centers, etc.) they will only lend 75% LTV.
FIT This is Federal Income Taxes. When calculating an investor’s tax rate in a financial model you should use his/her’s incremental tax rate. ..not the average. For example, if the investor were to purchase a multi-family property that was going to add an additional $100,000/year to his/her income, the tax bracket that they may be at for new income could be 35% although their overall average taxes are at 25%.
SIT This is State Income Taxes.
NOI This is Net Operating Income. This is the Effective Gross Income less all expenses required to operate the property, i.e. real estate taxes, janitor, property management company fee, utilities, waste disposal, pest control, insurance, maintenance & repairs, supplies, advertising, legal fees, etc.
ROI Return On Investment. This is the current, or future projected, equity of your investment property divided by the amount of original equity (cash) that you invested to purchase this property. For example, you paid $100,000 cash to purchase a $1,000,000 property. Five years later, the property has increased in value to $1,300,000 and your $900,000 mortgage has been paid down to $850,000. You now have $450,000 of equity in the property, less your original equity of $100,00 is $350,000 divided by your original investment of $100,000 equals 350.0% or 70.0% per year ROI.
IRR This is the Internal Rate of Return, which is often used in capital budgeting. It is the interest rate that makes net present value of all cash flows equal zero.
NPV This is the Net Present Value. It is the difference between the present value of cash inflows and the present value of cash outflows. Net present value is also used in capital budgeting to analyze the profitabilities of an investment or project. Net present value is sensitive to the reliability of future cash inflows that an investment or project will yield.
VACANCY RATE This is the percentage that you will apply to the gross revenues of a multi-family property to allow for a certain number of units being vacant for partial periods during the year. A rule of thumb is: 10 – 12 units and less, use a 10.0% vacancy factor…over 12 units use 6.0% – 7.0%. Ask the lender what % vacancy factor they would use if the buyer is not paying cash.