Here are 10 commercial real estate terms that are essential for real estate investors to understand when seeking investment opportunities.
1) Cap Rate:
The Capitalization Rate, commonly referred to as the "Cap Rate", is the rate of return on an investment property if a buyer were to purchase using all cash. The Cap Rate is based on the income the property generates. It is calculated by dividing the NOI (Net Operating Income) by the purchase price or market value of the property (Cap Rate = NOI / Market Value).
2) Net Operating Income (NOI):
The Net Operating Income is all of the revenue a property generates minus all expenses, excluding the debt service (or mortgage). For example, let's imagine a 100-unit apartment complex where each unit is rented at $1,000/mo. The property would have a monthly income of $100,000. The total annual income over 12 months would be $1,200,000. Let's say this apartment complex has a total annual operating expenses are $600,000. $1,200,000 - $600,000 = $600,000. Therefore, this property has an NOI of $600,000. (NOI = Operating Income - Operating Expenses)
3) Debt Service Coverage Ratio (DSCR):
Debt Service Coverage Ratio is the ratio between the cash flow produced and the debt service (or mortgage) on a property. In this case, the debt service is principal and interest only. For example, a 100-unit apartment with a 10-year mortgage of $3,750,000 amortized over 30 years at 3.75% interest will have a yearly debt service of $208,401.96. Assuming a yearly cash flow of $275,000 the DSCR would be 1.32 (DSCR = Cash Flow / Debt Service).
4) Cash Flow:
Cash flow is the revenue after all operating expenses, debt service, and fees are subtracted from the gross income. For example, a 100-unit apartment complex with $1,000,000 in gross income minus operating expenses of $600,000 (this is the NOI), minus the debt service (DS) of $208,401.96, minus the asset management fees of $20,000, results in $171,598.04 cash flow. (Cash Flow = NOI – DS – Fees).
5) Cash on Cash Return:
Cash on Cash is a rate of return expressed as a percentage, based on the cash flow the property generates and the equity investment. This is calculated by dividing the cash flow by the initial investment. For example, a 100-unit property with a cash flow of $275,000 and an initial equity investment of $3,200,000 will produce a Cash on Cash return of 8.59%. (Cash on Cash Return = Cash Flow / Initial Investment)
6) Average Annual Return:
Average Annual Return is a rate of return expressed as a percentage, based on the total return a property generates over a hold period. It is calculated by the sum of cash flows divided by the hold period (years). For example, let's imagine a 100-unit apartment complex with the following annual Cash on Cash returns:
Year 1: 7.5%
Year 2: 8%
Year 3: 8%
Year 4: 8.5%
Year 5: 9%
These hypothetical returns will result in an Average Annual Return of 8.2%.
7) Internal Rate of Return (IRR):
The Internal Rate of Return represents time value of money and the speed of cash flows that an investment will produce. It is expressed as a percentage and it is the rate that each dollar earns while it remains in the investment, based on the sum of all future cash flows to equal the equity investment.
For example, let's say you invest $50,000 in a syndicated apartment deal. Let's assume the investment produces a cash flow of $10,000 in Year 1 and $15,000 in Year 2. At the end of Year 2, the investment is sold and your principal investment of $50,000 is returned. The total accumulated cash flow from the two year period is $25,000. Simple math would say your return is 50% ($25k / $50k). However, when the time value of money over those two years is factored in, the return is affected. The IRR is actually 24.46%.
If you had received the $25k profit and $50k return of your principal in Year 1, then the IRR would be 50%. However, in our original example, we had to "spread" the return over two years, thus negatively impacting the return and producing a lower rate of 24.46%.
Time value of money is vitally important when evaluating the impact on returns. A dollar today is worth more than a dollar tomorrow. The sooner you receive the cash flow, the higher the IRR will be.
Depreciation is an income tax deduction that measures the decline in the value of an asset over time. Residential real estate is depreciated over 27.5 years. With Cost Segregation, an investor has the potential to accelerate the depreciation based on the building components individually over 5, 7, or 15 years.
Amortization is the rate that the debt service is paid down over time as a reflection of principal and interest. For example, a 100-unit apartment with a loan amount of $3,750,000 amortized over 30 years at 3.75% will result in equal monthly mortgage payments of $17,366.83.
10) Equity Multiple:
Equity multiple is the rate of return based on the net profit (including sales proceeds) from an investment. Equity multiple is calculated by taking the investment cash flows and total net profit upon sale, divided by the equity investment. For example, a 100-unit apartment with gross cash flows over 5 years of $1,375,000 and with a profit of $5,000,000 from sale proceeds will have a net profit of $6,375,000. If the equity investment was $3,200,000, the equity multiplier is 1.99 [($1,375,000 + $5,000,000) / $3,200,000].
Understanding these 10 key multifamily real estate terms will greatly increase your aptitude as an investor. They are very important to consider when evaluating potential investment opportunities.
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