The commercial real estate world is incredibly complex and has many different asset classes (multifamily, office, industrial, hospitality, etc.) and mainly three different types of transactions – buying, selling, or leasing. All these various combinations result in very different transactions with different types of brokers, contracts, and terminology. It is important to know the key components of a commercial real estate transaction but also the terminology.
Some terms carry across multiple types of transactions in the commercial world such as the ones we will touch upon here. We will cover not only the definition but also explain its relevance in the marketplace. Read below for the ten must know commercial real estate terms!
1. 1031 Exchange
Under Section 1031 of the United States Internal Revenue Code, an income property owner may defer recognition of capital gains and related federal income tax liability on the exchange of real property. One of the most common occurrences in the commercial world because of its complete deference of capital gains taxes allows investors to grow their portfolios untouched by the IRS as long as they keep doing it. This one tax item has helped the real estate industry immensely as it keeps real estate transacting and not sitting in fear of taxes realized. Exchanges happen on all types of commercial properties as they are all income driven.
2. C.A.M. Charges
Common Area Maintenance Charges, typically charged by the Landlord of an Office, Retail, or Industrial space to the Tenant above the base rent to maintain the common areas from which all the tenants benefit. These charges are paid by tenants typically in office, retail, or industrial buildings to help cover the landlord’s costs incurred.
For these types of properties, the Landlord passes all costs to the tenant as opposed to residential properties like multifamily. Most common in commercial leases but also applicable when selling these types of properties in helping to valuate them by seeing which monetary responsibilities fall on the landlord and which on the tenant.
3. Cap Rate
Capitalization Rate is equal to the Net Operating Income divided by the Sales Price of the Property. Used to compare income properties to one another in various markets and is a quick and easy way to see if the property is worth pursuing.
By knowing the market’s average cap rate for this type of asset along with the net income you can quickly ascertain the market price for the property, granted there are always other mitigating factors such as the property having development possibility or if the property has no income then other methods must be used. Cap rates can be used for comparing any type of commercial properties for purchase or sale.
4. Debt Service Coverage Ratio (DSCR)
The ratio of cash available to debt servicing for interest, principal and lease payments or net operating income divided by total debt service. It is a popular benchmark used in the measurement of an entity’s ability to produce enough cash to cover its debt payments.
Similar to cap rate DSCR can be used to compare similar properties within an asset class to gauge their viability in producing income to support the debt placed on the property. Commercial banks will typically require at least 1.15 to 1.35 DSCR in order to loan on a property. Purchasing any type of commercial property, this factor will be used.
5. Full Service Gross (FSG)
Lessee pays a base rent and the landlord pays for all operating expenses related to occupancy of the space such as common area maintenance, utilities, property insurance, and property taxes. The less common method of landlords to handle their spaces as it is more costly for them, full service gross is used in some office, retail, and industrial properties to make it more attractive for tenants as opposed to triple net (NNN) where all costs are instead passed through to the tenant.
6. Gross Operating Income (GOI)
The result of subtracting the vacancy losses from a property’s gross potential income. The gross income of a property shows the maximum potential of a property. Eliminating expenses or lowering them as much as possible will allow the Net Operating Income to get more and more closer to this number.
7. Net Operating Income (NOI)
Scheduled Gross Income (SGI) less vacancy and expenses (after taxes) for the owner. One of the most important factors when calculating the value of a property because if the cap rate is known for the type of asset and area and the NOI is known, one can determine the market value of the property by reverse engineering this formula.
Investors, especially for multifamily properties, look at this number to determine overall value and how much debt can be placed on the property as this cash flow will have to be used to pay down the mortgage and interest. NOI is a huge determinant for how to close a commercial real estate deal.
8. Tenant Improvement (T.I.)
Changes made to the interior of a commercial property to accommodate the needs of a tenant such as floor and wall coverings, ceilings, additional rooms/walls, HVAC systems, and security. It is negotiated between the lessor and the lessee on who will bear these costs and is documented in the lease agreement in a dollar per square foot form, i.e. T.I. will be $15 psf.
Primarily used in leases for retail and some office spaces, T.I. dollars are spent by both parties to make the space aesthetically pleasing and attractive for the tenant and their clients. The landlord will usually cover any base buildout and if the tenant is looking for additional customization to their need, they would cover that.
9. Triple Net (NNN)
The lessee (Office, Retail, Industrial) pays not only a fixed base rent but also expenses on the rented property, including taxes, insurance, maintenance and utilities for operating the property. If not triple net, then the space would have a full-service gross. Triple net is more attractive to the landlord and buyers of the property as all the overhead costs for the building are covered by the tenant. Triple net applies for leases on retail, industrial, and office spaces.
The percentage of all available units in a rental property, such as a hotel or multifamily building, that are vacant or unoccupied at a particular time. The opposite would be the occupancy rate, which is the percentage of units in a property that are occupied. Lenders typically calculate a 5% vacancy rate for properties, sometimes more some times less depending on asset type and area. Vacancy applies to all commercial types and is important in understanding the true income of a property accounting for the times when the building is not 100% occupied.
These are ten of the most common terms used in commercial real estate but there are lots more! Reach out to Commercial Consult to connect with a broker in your area to help you with your next commercial transaction.