Definitions of Useful Terms

Capitalization Rate (CAP Rate)

The Capitalization rate, or cap rate, is a widely used method of property valuation.  Cap rate measures the annual rate of return of a property based upon the profit the property is projected to generate.  The formula is…

 

 Net operating income (NOI) / property sale price (SP) = Property Capitalization Rate                                              

 

         Ex: $800,000 (NOI) / $8,000,000 (SP) = 10% Cap Rate

 

In this example, the property would be said to be selling for a 10 Cap.  Generally, the lower the cap rate, the lower the market’s perceived risk for that property.  Cap rates are driven up or down by a variety of factors including perceived risk of owning a particular property, the level of interest rates in general and the current supply of capital for real estate investment.

Net Operating Income

Net operating income (NOI) is the cash remaining after collecting a property’s income and paying the expenses associated with the property.  The formula is…

 

Total Operating Revenue – Total Operating expenses = Net Operating Income (NOI)

 

NOI is calculated before subtracting for mortgage payments.

Gross Potential Rental Income

Measures a property’s potential rental income if every unit was leased at the property’s market or stated rents.

Effective Rental Income

Measures the monthly rental income the property currently generates.

Operating Expenses

Operating expenses include all cash expenditures required to operate the property. Total Operating Expenses typically includes real estate taxes, insurance, maintenance, management, utilities, landscaping, legal, leasing commissions, etc.  Capital Expenses are generally not included in a property’s operating expenses for purposes of calculating NOI.

Cash-on-Cash Return

A measurement of the total annual return on your equity invested.  The formula is…

 

Annual pre-tax cash distribution / equity Invested = Cash on Cash Return

 

The cash on cash return measures an investor’s return on the cash invested in a property.

Capital Expenditures (CapEx)

These are generally large expenditures such as a roof or parking lot that contribute to the long term value of the property.  CapEx items are generally not expenses that occur annually.  These types of expenditures are deducted or “depreciated” over multiple years.

1031 Tax-Deferred Exchange

The sale of a commercial property will trigger a “taxable event” in which the sellers will have taxable gains or losses to report for tax purposes.  Section 1031 of the IRS tax code allows a taxpayer under certain circumstances the ability to trade into a different property and postpone capital gains and income tax liability into the future.

Capital Appreciation

The increase in value of a property over a period of time.  Commercial properties increase (and decrease) in value for a number of reasons.  Generally, property appreciation is driven by increasing in net operating income and/or increased demand for that property which is often reflected in a low cap rate for the property.  Depreciation is the decrease in value of the property over time generally driven by the same two factors, i.e. reduced net operating income and/or higher cap rates.

Equity

The amount of money an investor invests in a property. The formula is…

 

Property Value – Debt on the property = Owner’s Equity

Return on Investment (Equity)

This measures the returns an investor receives over time on their investment in a property.  The formula is…

 

Annual Cash on Cash + Equity Received on Sale / Original Equity Invested

Equity Received on Sale

Upon the sale of a property, the equity would be the money you receive after paying off the mortgage in full.

Capital Gains

Capital gain or loss is the difference in the value of a property compared to its purchase price. If the property has increased in value there is a gain realized at the time of sale.  Likewise, if the property has decreased in value there is a loss realized at the time of sale.  Long or short term gains or losses are calculated after a property has been sold.  A short-term capital gain is one year or less; a long-term gain is more than a year.

Debt to Equity Ratio

This measures the ratio of debt to equity in a property.  The higher the ratio the more perceived risk there is in investing in a property.  The formula is…

Total Property Debt / Property Value = Debt Ratio

Internal Rate of Return (IRR)

The interest rate that results in the present value of all cash flows (inflows and outflows) of an investment equaling zero.  The IRR is one method of evaluating an investment but it has limitations.  Among the limitations are that you can’t compare investments with different ownership periods, IRR assumes cash flows are invested at the same rate of return and the IRR tends to overstate returns that have high cash flow returned in the early years of ownership.

Commercial Real Estate

Refers to income producing real estate encompassing four general categories; multifamily, office, retail and industrial.

Debt Service

This is the property’s monthly mortgage payment. It includes the interest on the loan and any pay back of the loan balance, i.e.principal reduction.

Net Cash Flow

Measures the amount of cash flow from a property distributable to investors.  The formula is…

 

Net Operating Income (NOI) – Mortgage Payment & Capitalized Expenses

= Net Cash Flow (NCF)

Debt Service Coverage Ratio (DCR)

This ratio measures the amount of cash available after expenses to make the monthly mortgage payment.  The formula is…

 

Net Operating Income / Monthly Mortgage Payment = Debt Coverage Ratio

 

A  DCR of 1.30 means that for every $1.30 of debt service due there is $1.30 of NOI to pay for that debt service.  The higher the DCR the more cushion there is to service the monthly debt payments.

Dollars Per Square Foot

A measurement for evaluating the cost of a property.  The formula is…

     

                  Purchase Price / Net Rentable Square Footage = Dollar/ Square Foot

 

This is one tool to compare costs of different projects.  This formula will provide a measurable value but costs / sq. ft. vary widely by real estate property type, location and property age.  Therefore, this measurement should be one of several tools in evaluating a property’s current value and future value.

Real Estate Tax Assessment

The real estate taxes paid every year on a commercial property.  The formula for real estate taxes is…

 

Property’s assessed value X the county’s tax rate = Real Estate Tax Owed

 

A property’s assessed value for tax purposes may or may not be the same as the property’s market value.  A number of factors can cause the two to diverge.

Loan to Value

This measure the amount of leverage (debt) on the property.  The formula is…

 

Debt / Property Value = Leverage %

 

The higher the percentage, the higher the perceived risk of ownership.

Amortization

The pay down of the principal on a mortgage over time. The longer the amortization period, the lower the monthly payment amount.  A loan that has a 15 year amortization will result in the regular, monthly pay down of principal in addition to the loan’s interest and a zero loan balance at the end of 15 years. Principal reduction is not an expense, it is repayment of a loan.

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