We often find investors asking the same questions about commercial real estate terminology. It can be a confusion world to navigate so we’re hoping this article helps to clear up some confusion.
Let’s take a look at an investment with the following assumptions:
Purchase Price: $1,000,000
Units (Apartments): 10
Square Footage: 10,000
Average Rent: $1,000
Operating Expenses: $60,000
A typical offering memorandum or listing package will include many terms such as EGI, OpEx, NOI, Cap Rate, cash-on-cash return and DSCR. This list is by no means exhaustive but we thought it would be helpful to define some of the most common terms you’ll see when looking at various opportunities.
In the example above, the property contains 10 units or apartments, with each unit renting for an average of $1,000 per month, which translates to $10,000 per month or $120,000 each year. This is known as the Effective Gross Income or EGI.
Operating expenses or OpEx, are the costs associated with the operation of a property. These include payroll, utilities, repairs and maintenance, property management fees, insurance and property taxes. In the example above, these costs are assumed to be $60,000.
We subtract the Operating Expenses from the Effective Gross Income to come up with the Net Operating Income which in this case would be $60,000.
NOI stands for Net Operating Income. This metric is the amount of profit a property generates after paying all expenses required to run the property.
This means that if you purchased this property in cash today, you can expect to generate a profit of $60,000 in the first year.
In addition, this brings us to our next term which is Cap Rate or Capitalization Rate. This is the percentage rate of return an investor would realize if they purchased a property for cash.
In this case, the property generates a Net Operating Income of $60,000, while the asking price is $1,000,000. In order to calculate the capitalization rate, you would divide the NOI of $60,000 by the asking price of $1,000,000 to come up with 6%. This number also can be used to determine a property’s value.
If a given property produces an income of $100,000 per year and similar properties in the area sell for a 6% cap rate, this means the property is worth roughly $1,600,000. You calculate this by dividing the NOI of $100,000 by 6% in order to come up with the value.
Cap Rate is used as a comparison tool to determine whether a property is undervalued, overvalued or fairly priced in a given marketplace. Its value as an analysis metric can vary depending on a property’s condition, potential upside, location and many other factors so it’s not the only measure to adhere to, but useful nonetheless.
Most acquisitions are financed with a combination of debt and equity, which is a fancy way of saying you put a down payment for a portion of the purchase price and secure a mortgage for the remaining balance.
In a typical apartment building scenario you will put down 20-25% of the purchase price in cash, and secure a mortgage of 75-80% of the purchase price for the balance.
Let’s go back to our initial scenario with a purchase price of $1,000,000. In this scenario, we would purchase the property with $250,000 in cash as a down payment (equity) and finance the remaining $750,000 with a mortgage (debt).
If we assume we have a 30 year payment period (amortization) and a 4.00% interest rate, this translates to a mortgage payment of approximately $3,500 per month or $42,000 per year.
Assuming a net operating income of $60,000 and a mortgage payment of $42,000, this property will generate cash flow of $18,000 per year after paying all expenses and the mortgage.
If we take $18,000 and divide it by our down payment of $250,000, we come up with 7.2%. This number is known as our “Cash-on-Cash” return and illustrates one of the most valuable aspects of real estate investment.
By utilizing leverage (debt) when purchasing this property we can improve the yield (income) we receive. If you had purchased this property for cash, your investment would generate a 6% yield or $60,000 per year in income. However since you purchased this property with a combination of debt and equity, your yield grew to 7.2%, a 20% increase even though the actual dollar amount is lower ($18,000 vs $60,000.)
Leverage allows you to improve your investment returns and grow your capital more rapidly than otherwise possible while allowing you to purchase multiple properties.
The last term we’ll discuss is DSCR or debt service coverage ratio. Debt service is a fancy term for a mortgage payment. Banks and other lenders are concerned with your ability to repay the loan and they want protection from unforeseen events (recessions, rent declines, vacancies, etc.)
In order to secure a loan, most banks will require a property to demonstrate a 1.25x DSCR at a minimum. This means if a property has a mortgage payment of $40,000 per year, the property must generate an NOI of $50,000 or greater. The greater the number the safer a loan is perceived to be.
Going back to our initial scenario, this property generates an NOI of $60,000. We assume the acquisition is financed with a bank loan of $750,000 and has a mortgage payment of $42,000 per year.
If we divide the NOI of $60,000 by the mortgage payment (debt service) of $42,000 we come up with a debt service coverage ratio of 1.428x. This means the property generates a profit of $1.42 for every $1 in mortgage payment, a very healthy number that most banks would be delighted to see as there is a strong cushion against any unforeseen events that may cause the property’s income to decline.
In closing, these are some of the most common terms you’ll see when looking at investment properties. We hope this helped improve your understanding of commercial real estate terms and their significance.
Next week we’ll break down some of the return metrics such as IRR, NPV, Total Return, MOIC and some others so please check back soon.
As always, if you have any questions or would like to speak to us further, please don’t hesitate to contact us by telephone at 212-426-2641 or via email at JB@WynManage.com. You can also reach out through our website at www.WynManage.com.