Have you ever sat through a presentation or had a conversation with someone who used acronyms you either did not understand or ever heard before?

Investing in commercial real estate can produce a high return on investment or ROI, but it requires at least a basic understanding of core terms like any investment.  Arming yourself with as much information as possible gives you a competitive advantage.  That advantage places you in the best position possible to make a sound decision for your hard-earned money.

Let’s review seven commonly used terms in commercial real estate.

Net Operating Income (NOI)

NOI refers to the total income produces from an asset minus any operating expenses.  It does not include the debt service (paying the loan) or any distributions to the investors.

Operating expenses refer to expenses such as utilities, management, taxes, and insurance.

The NOI is one of the most important considerations for a commercial investment. Unlike residential properties valued by comparable properties, commercial real estate is valued mainly by its NOI.

• NOI = (Rental Income + Other Income – Vacancy/Bad Debt) – Operating Expenses

Cash on Cash (CoC) Return 

Cash on cash return is one of the most popular ways to determine the value of an investment.

Put simply, CoC refers to the ratio between the investment’s net annual cash flow in relation to the amount of money invested.

The formula looks like this:

• CoC = Annual Net Cashflow (pre-tax) / Total Cash Invested

Return on Investment (ROI)

Return on Investment, or ROI, is one of the most common – and easy – ways to measure an investment.  ROI looks at how well an investment did in the past.  Simply put, it is the measurement of the gain or loss of an investment relative to its cost.

An example would be:

ROI = (Total gain (or loss) – Initial investment) / Initial Investment

One thing to note is that the timeframe for ROI should be taken into context.  For example, if your ROI for a one-year investment were 20%, that would be a fantastic return on your money.  However, if that same 20% were spread over ten years, you would probably not meet the kind of returns you are looking to achieve.

Capitalization Rate (CAP)

The capitalization rate, commonly referred to as the “cap rate,” is used to determine the potential return on an investment before factoring in the debt service.  Specifically, it is an asset’s net operating income divided by the asset’s current market value.

Cap rates are typically associated with the risk level—the lower the cap rate, the lower the risk level, but the higher the price point.

• Cap Rate = Net Operating Income / Asset Market Value

Debt Service Coverage Ratio (DSCR)

The Debt Service Coverage Ratio or DSCR factors in an assets NOI with its debt service.

Lenders use the DSCR to determine whether the asset will generate enough income to pay the debt.

A rule of thumb is a minimum of 1.25 DSCR, but that can increase or decrease based upon several risk factors.

• DSCR = Net Operating Income / Total Debt Service

Preferred Return (Pref)

A preferred return or “pref” simply describes the order of return that profits from a real estate investment are distributed to investors.  The priority of distribution is usually maintained for a predetermined amount of time or until a specific return threshold has been met.  Once that threshold is met, distributions are made to any other subordinate investors in the investment.

For example, if you invest and receive a 10% pref for your $100,000 investment into an asset, you would receive $10,000/per year.  It is important to note that the pref is paid from the income after expenses and the debt service.

A common question for pref is, “what if the operator is unable to pay the pref for a specific timeframe?” If this occurs, the amount of pref still owed should roll over into the next distribution cycle or capital event (refinance or sale) until the debt is satisfied.  However, it is essential for you as the investor to make sure to ask your operators these questions and read through any agreements before investing.

Asset Classifications

Commercial properties’ values are determined in part by their classifications.  They can fall under one of four main categories:  A, B, C, D

A-Class properties are usually newer builds, in great areas, have the top amenities, require minor renovations, and demand the highest rents.

B-Class properties are relatively new (5-15 years old) and may not have the top-of-the-line finishes, amenities but are in decent areas and demand average to above-average market rents.

C-Class properties are 20-30 years old have less appealing and outdated features.  They may not be in the best areas.  As an investor, you will see many Class C properties as “value-add” opportunities because many can be updated to increase the income and decrease the expenses (see NOI).

D-Class properties are older properties, in poor condition, in a less desirable location, high vacancy and turnover rates, and other factors that increase the investment risk.

It is important to note that your ROI is typically lower with the Class A properties, but your investment risk level is also low. However, if you are looking for higher returns, the lower-class levels may get you those returns, but they are also a riskier investment since they often require a higher level of management and renovations.

B and C class assets usually are the sweet spot for investors as they strike a good balance between risk and return.

Mastering Commercial Real Estate Terms 

When looking for your next commercial investment, you must be well versed in the standard terminology.  A good understanding of terms like the ones above will provide you the foundation of knowledge to excel and make informed investment decisions.

There is no such thing as too much knowledge in commercial real estate.  If you want to learn more, download our free passive investor guide here.

Do You Want To Learn More?

RIZE Equity is a private multifamily investment firm, and we work with accredited investors to help them achieve their long-term investment goals through high-quality multifamily investments in the Southeastern U.S.  If you would like to learn more about our investment strategy, we invite you to visit our website at www.rizeequity.com/invest and schedule a free no-obligation appointment with us.  Also, check out our free passive investor’s guide on investing in multifamily at www.rizeequity.com/passive

About the author: Sean Cullen is the founding partner and Director of Business Operations at RIZE Equity Group LLC, a privately held real estate investment company that helps current/former professional athletes, veterans, and business professionals create generational wealth through smart multifamily investments.