Commercial real estate has long been favored by institutions and the ultra-wealthy for generating wealth insulated from Wall Street volatility. Whether investing directly or passively through a private investment fund, it’s easy to get lost in all the terminology when analyzing an opportunity.
When investing in commercial real estate, the crucial investing terms you need to know can be broken up into three categories:
1) Asset Class
2) Financial Terms
3) Lease Structure
ASSET CLASS
There are a couple of systems for classifying commercial property types, one that assigns a letter classification of A-D and another that categorizes properties by their risk-return profile by designating them as Core, Core-Plus, Value Add and Opportunistic.
Class A-D Properties – According to this classification system, properties are graded according to a combination of geographical and physical characteristics.
These letter grades are assigned to properties after considering a combination of factors such as the age of the property, location of the property, tenant income levels, growth prospects, appreciation, amenities, and rental income.
- Class A
Class A properties tend to be new construction or built within the last 5 to 10 years, with top of the line amenities and professional management. They are also located in the most desirable areas with a high potential for appreciation with high-quality tenant profiles and with little to no deferred maintenance issues.
The prime locations and condition of these properties command high rents and experience low vacancies. Because of their premium condition and locations, Class A properties also come with premium prices.
- Class B
These properties are generally 15-20 years old, with lower-profile tenants, and may or may not be professionally managed. Rental income is lower than Class A, and there may be some deferred maintenance issues. These buildings are typically well-maintained.
- Class C
Class C properties are typically more than 20 years old and located in less than desirable locations. These properties are generally in need of significant renovations for repositioning in the market to achieve steady cash flows.
- Class D
Class D properties are old, run-down, and typically, without exception, in need of significant repairs. They are located in distressed communities with high crime and poor schools.
Tenants have low income and bad credit, with many even having criminal backgrounds. These properties are relatively cheap to acquire but also experience high vacancies and low appreciation.
Core, Core-Plus, Value Add and Opportunistic Assets – Assets under this classification system are differentiated by their levels of risk vs. reward with Core real estate investments on the low end and Opportunistic real estate investments on the high end of the risk-reward spectrum.
- Core
Core investments are typically low-risk and require no improvements or active management. Along with the low risk, they also offer lower returns than other investment types.
These properties generate stable, consistent cash flow from established, high-quality tenants locked in with long-term leases. For example, a national drug store with a 30-year lease would be considered a core property. Core properties require little to no maintenance.
The majority of expected return is generated mostly from cash flow, as opposed to appreciation. Core investments generate between a 7% and 10% annualized return.
- Core Plus
Core Plus investments are low to moderate risk. Unlike Core properties, Core Plus properties offer the ability to improve cash flow through slight property or management improvements or by improving the tenant profile. Core Plus properties tend to be of high-quality and well-occupied from the get-go.
Unlike with Core properties that are occupied by long-term, established tenants, Core Plus cash flow is less predictable with more diverse tenants, and these properties require active management by ownership.
A 10-year-old apartment building with a good track record or occupancy and quality of tenants in need of light upgrades is an example of a Core Plus investment opportunity.
Core Plus properties will generate higher rates of cash flow than Core properties, but some of that cash will be needed for deferred maintenance. And unlike Core properties, a higher portion of the property’s expected return will be generated from appreciation because of the property improvements. Core Plus investors can expect to achieve returns between 9% and 13% annually.
- Value Add
Value Add investments are considered moderate to high risk. Value add properties underperform in terms of cash flow and occupancy but have the potential to see big bumps in occupancy and rents and, as a result, cash flow once the value has been added.
At acquisition, most of these Value Add properties have occupancy issues, management problems, infrastructure and maintenance problems, or a combination of all three. These investments require real estate expertise, strategic planning, and active management. Total expected returns are generated both from cash flow and appreciation. Investors can expect annual returns between 13% and 18%.
- Opportunistic
Opportunistic investments are the riskiest of all types of CRE investment strategies. Opportunistic properties involve the most complicated projects like ground-up developments, land development, of repositioning a building from one use to another.
Opportunistic typically involve dealing with entitlement, zoning, and rezoning issues that can last for years. As a result, investors may not see a return on their investment for three or more years. Opportunistic properties have the potential to generate annual returns of over 20%.
FINANCIAL TERMS
Most financial terms surrounding commercial real estate investments involve different metrics for calculating returns to investors.
The following are the most common terms:
Net Operating Income – Net operating income (NOI) is annual income less expenses.
NOI = (Rental Income + Other Income – Vacancy and Credit Losses) – Operating Expenses
Property expenses include expenses required to operate and maintain a property, including utilities, property management fees, insurance, and property tax.
Cash-on-Cash Return – Cash-on-Cash Return (CoC) is the ratio of the annual return an investor makes on a property relative to their investment in the property.
Cash on Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested
Return on Investment – ROI measures the amount of return on a particular investment, relative to the investment’s cost. To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment.
ROI = (Current Asset Value – Cost of Investment) / Cost of Investment
Cap Rate – Cap rate is probably the most accurate forecast of what an investor can expect to make in the first year of an investment because it’s based on actual current year numbers.
The cap rate is calculated by dividing the most recent year’s Net Operating Income (NOI) by the purchase price. Assuming nothing changes, an investor can expect a return equal to the Cap Rate in the first year of investment.
Capitalization Rate = Net Operating Income / Current Market Value
Debt Coverage Ratio – Debt coverage ratio (DCR), also known as the debt service coverage ratio (DSCR), compares an investment property’s NOI with its projected debt service.
DCR = Net Operating Income / Total Debt Service
Lenders use this ratio to calculate whether or not you will be able to generate enough income to pay your debts.
Loan to Value Ratio – The LTV is determined by what percentage an asset’s sale price or value is attributed to financing.
Loan to Value Ratio = Mortgage Amount / Appraised Asset Value
LEASE STRUCTURES
Lease structures are essential for analyzing potential returns weighed against the owner’s obligations with respect to the investment property. There are three principal lease structures based on rent calculation methods using both net and gross.
In a gross lease, the tenant pays one all-encompassing rent amount that covers the principal property expenses, including maintenance, property tax, and insurance. The net lease has a smaller base rent, with property expenses the obligation of the tenant. The modified gross lease is a hybrid of the two.
Gross Lease (aka Full-Service Lease) –
In a gross lease, the rent is all-inclusive. The landlord is responsible for all or most of the property expenses, including taxes, insurance, and maintenance.
This type of lease is convenient for the tenant, but the tenant must weigh the cost of this convenience to avoid overcharge.
Net Lease –
Unlike gross leases, net leases transfers one or more property expenses, in addition to rent and utilities, to the tenant.
As the name implies, in a triple-net (NNN) lease arrangement, the tenant is responsible for most of these property expenses, and as a consequence, the rent payments are net of:
- Property Taxes
- Property Insurance
- Maintenance
A double-net (NN) lease is a net of property taxes and insurance.
A single-net (N) lease is a net of property taxes.
From the landlord’s perspective, NNN leases are the most desirable forms of net leases since only NNN leases free the landlord of maintenance obligations.
Modified Gross Lease –
The modified gross lease is similar to a gross lease in that the rent is requested in one lump sum. This can include any or all of the “nets” – property taxes, insurance, and CAMS. Utilities and janitorial services are typically excluded from the rent, and covered by the tenant. Ultimately, tenants and landlords negotiate which “nets” are included in the base rental rate.
Commercial real estate investing can be a highly rewarding venture.
By becoming familiar with the most common investing terms, you’ll know how to adequately assess any opportunities presented to you.
You will additionally be able to make investment decisions confidently that align with your investment objectives.
Eric