Commercial Real Estate Investing Lingo
Commercial real estate investing is all about numbers. In order to evaluate and analyze a commercial real estate investment, you need to know a few important numbers, what they're called, and how to figure them. Having these terms under your belt is crucial on two fronts:
- Most likely, you'll use a real estate broker to help you locate and close the deal. Real estate brokers know and use most of the terms mentioned here. If you can speak their language, you gain instant credibility and a relationship advantage over someone without this vocabulary.
- Just by increasing your word power, you gain increased confidence, which enables you to make sound, efficient investment decisions and gives you an increased ability to hold your position, especially in negotiations.
Here are the names, numbers, and equations you need to know:
- Capitalization rate: The capitalization rate is a measure of a property's performance without considering the mortgage financing. Also known as the cap rate, it's your net operating income divided by the sales price. Cap rates tell you how much you'd make on an investment if you paid all cash for it:
- Cash flow: Your annual cash flow is net operating income minus debt service. You can also figure monthly cash flow by dividing your annual cash flow by 12:
- Cash-on-cash return: This is the velocity of your money — how long it takes for your down payment to come back to you. To find your cash-on-cash return, divide your annual cash flow by the down payment amount:
- Debt service: Debt service is calculated by multiplying your monthly mortgage amount by 12:
- Effective gross income: You can find your effective gross income by subtracting vacancy from gross income:
- Gross income: Gross income is all of your income, including rents, laundry or vending machine income, and late fees.
- Net operating income (NOI): Your net operating income is one of the most important numbers when analyzing any deal. The NOI is the dollar amount that's left over after you collect all your income and pay out your operating expenses. This money is used to pay the mortgage. Your NOI is your effective gross income minus operating expenses:
- Operating expenses: Your annual operating expenses of the property typically include taxes, insurance, utilities, management fees, payroll, landscaping, maintenance, and supplies. This category doesn't include mortgage payments or interest expense.
- Vacancy rate: Your vacancy rate is the number of vacancies divided by the number of units:
Cap rate = net operating income ÷ sales price
Annual cash flow = net operating income – debt service
Monthly cash flow = annual cash flow ÷ 12
Cash-on-cash return = annual cash flow ÷ down payment
Debt service = monthly mortgage amount x 12
Effective gross income = income – (vacancy rate % x income)
Net operating income = effective gross income – operating expenses
Vacancy rate = number of vacancies ÷ number of units