January 14, 2020
There’s little doubt that commercial real estate can be challenging to learn. Its potential is far-reaching, and opportunities exist across the board. It’s worth learning as much as you can about this industry. To aid in that process, we’ve created a cheat sheet, a simple-to-use guide that helps you to know exactly what someone in the commercial real estate industry is talking about. Here are the key terms you need to know.
This cheat sheet represents Pro Forma figures. These are figures that play a role in the cash flow projections of a property. Generally speaking, this projection is created to showcase the potential income and return of a commercial property. Most of the time, the Pro Forma is presented to property buyers to showcase the various income and expenses that relate to that property, providing a clear indication of its potential. Here are some of the most common terms found on such Pro Forma documents.
Potential Gross Income, or PGI, is the total income associated with the real estate. This represents the total income if the property is at full occupancy. It does not include any adjustment for vacancy. It also does not deduct for operating expenses.
When calculating income, the Effective Gross Income, or EGI, represents the anticipated income from the property from all operations within it. This figure includes allowances for both collection losses and vacancy within the property.
Net Operating Income, often called NOI, provides insight into the annual gross income for the commercial real estate after all operating expenses have been subtracted. This cost represents the gross income prior to deducting the income tax and any cost of property financing.
Cap rate is something you’ll hear about often. More formally called a capitalization rate, it refers to the ratio between the current market value of an asset and the Annual Net Operating Income, also called NOI, of an asset. Here’s an example. Let’s say a commercial building has an NOI of $500,000. The property’s current market value is $10,000,000. In this case, the cap rate is 5%. $500,000 divided by $10,000,000.
The cap rate provides insight into what the return will be for the property. For example, this commercial building will return 5% of the property’s cost with the annual net proceeds. This is a key factor in determining how competitive a property can be. In some markets, especially those in prime or hot markets, a lower cap rate may be acceptable if it means lower risks or the property value is going to grow faster. The higher the cap rate, the higher the annual return from the property.
Cap Rates compare the purchase price of a property to the income it will generate, the Cash on Cash Return will determine how much return you make on the actual amount you invested.
A commonly found commercial real estate term is yield on cost, YOC. It is the net operating income for the property divided by the total project cost. This is sometimes also known as the total project cost. By comparison, the cap rate is the stabilized net operating income that is divided by the real estate’s market value. These two figures are commonly necessary when creating Pro Forma information for comparison reasons.
When creating comparative information, the yield on cost and cap rate are two key figures. The difference between market cap rate and the yield on cost is what the development spread is. It helps to provide some measurement to determine if taking up the construction or leasing up the property is ideal based on the risks involved. When the development spread is higher, that indicates the property will likely be seen as a positive financial investment.
The equity multiple is a specific metric used to show how the investment of capital into a project has increased in value over a period of time. To determine what this figure is, the sum of all capital inflows for the project is divided by the sum of all capital outflows. This factor does not account for the time value of money. Rather, it describes the total amount of money returned to the property’s investor.
Internal Rate of Return, or IRR, is the discount rate that leads to a property having the current present value of zero. In commercial real estate, this figure provides insight into competing investments or in project alternatives. As such, when a project has a higher IRR, that indicates the project is likely to produce better results than the other from simply a financial standpoint.
The classification of property is essential for making investment decisions. There are six subsets of commercial real estate. They include office space, industrial space, retail, multifamily property, special purpose property, and hotels.
From there, these subsets are then classified based on their use and condition. For example, Class A properties tend to provide the highest potential return for the largest investment. Class A multifamily projects may include high rise properties that are under 10 years old with landscaping and higher quality amenities. By comparison, Class B multifamily properties are generally mid-rise properties located in an urban setting, with an elevator. These may be up to 20 years old with some dating. The classifications, which you can further learn about here, are used to represent value from the perspective of the buyer when investing in real estate.