As a commercial real estate (CRE) investor, do you know the difference between cash-on-cash return and cap rate? Could you quickly explain how to calculate NOI or ROI, without making a mistake?
You’re not alone if you can’t answer those questions! Even seasoned investors sometimes have a job telling one CRE investment term apart from the other.
We’ve put together a simple guide with some of the top commercial real estate investment terms, covering a few of the metrics you absolutely need to know. Keep it somewhere handy to refer to whenever you need it.
Appreciation refers to the increase in the value of a property over time.
This rise in value can occur due to various factors such as:
- Inflation – As the cost of goods and services increases over time, so might the value of commercial real estate.
- Favorable market conditions – If a commercial district becomes trendy, the demand for properties in that area might drive up prices.
- Property improvements – Upgrading a commercial building's facade or interior could attract higher-paying tenants, increasing the property's value.
- Area development & regeneration – If a new shopping mall or transit hub is built nearby, surrounding commercial properties may appreciate.
- Interest rates – Lower interest rates could lead to increased property buying, driving up property values.
- Location – A commercial property located in a bustling downtown area might appreciate more over time compared to a similar property in a less desirable area.
The importance of appreciation lies in its potential to boost the resale profits.
It can also create opportunities for refinancing the property, thereby improving an investor's return on investment (ROI).
Having said that, keep in mind that the appreciation in a property's value often differs from the appreciation in an investment's equity. Property value appreciation considers the property's present market value. Investment equity appreciation is determined in the context of the value of your specific investment in the property.
2. Capitalization Rate (Cap Rate)
The capitalization or cap rate is a critical indicator of the property's potential to generate a return on investment.
Use it to assess the long-term risk potential of rental properties that you anticipate will generate a consistent, predictable revenue stream.
Cap rate is calculated by dividing the property's net operating income (NOI) by its current market value.
A high cap rate implies a higher potential return, but also higher risk. Conversely, a low cap rate suggests lower risk, but with a potentially lower return. Cap rate is a useful tool for comparing returns across similar commercial assets, although it necessitates thorough research.
Investors commonly use the cap rate when evaluating different types of properties, including:
- Multifamily rentals
- Apartment buildings
- Office spaces
- Retail properties
Cap rate may not be suitable for properties with inconsistent income or irregular cash flows.
It should be utilized in conjunction with other metrics like cash flow and appreciation to mitigate risk and choose properties for CRE portfolios effectively.
3. Cash Flow
Cash flow is the net amount of money moving into and out of an investment property. In CRE, it assesses a property’s financial health or liquidity.
Cashflow = rent + other revenue – associated expenses.
Positive cash flow shows a profitable property investment as it means the property generates enough income to cover expenses and provide a cushion against unexpected costs. Effective management of cash flow is vital for maintaining profitability and meeting financial obligations.
For unleased properties, evaluating potential cash flow by comparing projected rents against mortgage payments and other expenditures can provide insight into the investment's viability.
4. Cash-on-Cash Return
Cash-on-cash return is a measure of the income earned on the cash invested in a property.
It’s a straightforward metric that helps investors calculate the return generated on the actual cash invested.
Cash-on-cash return is calculated by dividing the annual income by the amount of cash invested in the property. Income received can be from:
- Retail spaces
- Office buildings
- Multifamily rentals
- Industrial properties
Cash-on-cash return differs from other return metrics, like cap rate, as it focuses on the initial cash invested rather than the property's current market value.
It’s great for assessing and comparing investment opportunities within the same market, or across other markets.
Thus, it’s an excellent tool for choosing a CRE market that aligns with your strategy and budget.
Depreciation is the reduction in the value of an asset over time, often due to wear and tear.
In CRE, depreciation is calculated using a specific method, like the straight-line method, where the asset's cost is divided evenly over its useful life.
Since depreciation is a non-cash expense, investors can subtract a percentage of the value of the asset from their annual taxable earnings, potentially leading to significant tax savings and increased cash flow.
Depreciation affects financial reporting in various ways, including:
- Lowering a property's book value (the asset's cost minus accumulated depreciation) over time, which can impact metrics like equity and ROI.
- Reducing asset values on the balance sheet, which creates expense on the income statement and reduces the company's reported profit.
- Affecting financial ratios like return on assets and return on equity.
- Promoting transparency because companies must disclose their accounting policies in their financial statements.
Equity refers to an investor's ownership interest in a property. It's the difference between the property's current market value and the outstanding amount on any loans or mortgages tied to the property.
Essentially, equity is the amount you'd pocket if you sold the property and paid off the mortgage.
As property values increase and mortgages are paid down, equity accumulates which increases an investor's ownership stake in the property. This accumulated equity can be a powerful tool, enabling investors to purchase additional properties or finance improvements. It gives investors the potential to grow their real estate portfolio over time.
Leverage is the strategy of using borrowed money to increase the potential return on an investment in CRE. The goal is to earn a return that exceeds the interest owed on the borrowed amount.
While leveraging can amplify returns when property values rise, it can equally magnify losses if values decline. Using leverage in a CRE investment necessitates a thorough analysis of a few factors, including:
• The property in question
• The prevailing market conditions
• The risk tolerance of the investor
8. Net Operating Income (NOI)
Net Operating Income, or NOI, is the total income generated by a property minus its operating expenses.
It is a fundamental financial metric in CRE.
NOI helps investors to evaluate a property's financial performance objectively.
It accounts for the day-to-day operational costs. NOI is unaffected by financing methods but requires other metrics to provide a full picture. It plays a significant role in capitalization rate and is a key determinant of property valuation:
Cap Rate = NOI / Current Market Value
Some other metrics that also use the NOI in their calculations:
- Cash on Cash Return = (NOI - Annual Mortgage Payments) / Cash Invested
- Debt-Service Coverage Ratio (DSCR) = NOI / Annual Debt Service (Principal + Interest Payments)
9. Return on Investment (ROI)
ROI is a measure of the profitability of an investment, after deducting all expenses. It indicates the return generated relative to the amount invested.
ROI helps investors compare different investment opportunities, allowing them to assess the potential returns and risks associated with each option.
Factors such as these all contribute to the ROI of a real estate investment:
- Property appreciation
- Rental income
- Financing costs
- Local market conditions
- Type of property
An easy way to calculate ROI is:
ROI = (Current Value of Investment – Cost of Investment) / Cost of Investment x 100
While the actual ROI is only achieved when a property is sold, it’s essential to estimate it beforehand, to gauge the profitability of your asset.
10. Vacancy Rate
Vacancy rate is the percentage of unoccupied units in a property, such as shops, office spaces, or apartments.
A high vacancy rate can lead to reduced rental income, affecting the property's overall profitability and valuation. Lower vacancy rates generally indicate a healthier investment.
Strategies to minimize vacancy rates include:
- Effective marketing
- Tenant retention programs
- Responsive property management and maintenance
- Reasonable and fair rental rates
- Easy and streamlined application processes
If you want to optimize profits and maintain a healthy cash flow, you should take vacancy rates into account when you look at potential rental property investments.
Final Thoughts on the Top Commercial Real Estate Investment Terms
Staying informed is a surefire way to achieve long-term CRE success. Armed with these top commercial real estate investment terms, you’ll have a basic foundation for evaluating potential CRE opportunities. It's important to recognize, though, that these metrics are interconnected and should be used collectively to make well-informed investment decisions.
Understanding the broader context of each investment is also key. Due diligence, coupled with thorough research, market analysis, and risk assessment, are essential steps for every CRE professional. Don’t take shortcuts! As always, seek the expert advice of your broker or solicitor before proceeding. Wishing you all the best with your CRE endeavors!