If you’re new to the world of commercial real estate investing, you’ve probably heard some lingo you’re unfamiliar with. Don’t worry, you’re not alone and we’ll get you up to speed in no time.
We’re going to go over the key terminology used in commercial real estate so you can more easily navigate future investment opportunities.
Net Operating Income
Understanding Net Operating Income, or NOI, is essential to understanding any deal in commercial real estate investing. Thankfully, it’s a very simple concept that’s easy to learn and apply. NOI is simply the income generated by a property after expenses have been deducted. Here’s the basic formula:
NOI = (Rental Income + Other Income) – Operating Expenses
So rental income is straightforward enough, it’s just the gross rent collected by the property. Other income is simply income generated from sources other than rent; think laundry and vending income, parking fees, pet fees, etc.
Operating expenses include repairs & maintenance, payroll, utilities, property taxes, and any other expense related to running and maintaining the property.
The real key to operating expenses is understanding what’s NOT included. Loan payments, depreciation, income taxes, and capital expenditures are not included when calculating NOI. NOI is important as it’s incorporated into many other metrics used by investors.
Easy enough?
Capitalization (Cap) Rate
Capitalization Rate, or “Cap” Rate, is an essential tool that can be used as an indication of the expected rate of return of an investment property. Essentially it tells you the expected rate of return if you were to pay all cash for a property since it doesn’t take into account debt.
This is important because debt structure, taxes, etc. are never standard, so it allows us as investors to compare apples to apples when looking at available opportunities. Cap Rate is calculated by dividing the NOI by the market value of the property.
Cap Rate = NOI / Asset Value
Cap Rate can also be helpful when making projections for an investment. When reviewing an investment offering, you’ll likely come across references to the “Entry Cap Rate” and the “Exit Cap Rate.” Entry Cap Rate is the cap rate based on the purchase price and the annualized income of the property at closing. Exit Cap Rate is an estimate of the market cap rate on the expected sale date and is used to determine a likely selling price using projected incomes.
Exit Cap Rate is very important as it has a significant effect on projected returns, so it’s important it is conservative (Hint: higher than the entry cap!) to avoid unrealistic expectations.
Cash on Cash Return
Cash on Cash Return (CoC) is one of the most popular metrics used by investors to evaluate a deal. It’s also one of the easiest to calculate and comprehend. CoC just shows the ratio between the annual cash flow to the total cash invested into the property.
Cash on Cash Return = Annual Cash Flow (Pre-Tax) / Total Cash Invested
For example, let’s say you invested $100,000 into an apartment syndication. If you received $8,700 in cash-flow distributions in the first year, your CoC would be 8.7%! Investors love this metric because it’s clean, quick, and right to the point.
I told you it was easy.
Equity Multiple
Another core metric used when evaluating real estate opportunities, and possibly the simplest to employ is the equity multiple. The equity multiple provides a snapshot of the total return on investment. Equity multiple calculates the ratio of total profit plus total investment, to total investment.
Equity Multiple = (Total Profit + Equity Invested) / Equity Invested
For example, suppose you invested $100,000 in a multifamily syndication. over the lifetime of the investment you received cash flow totaling $47,000 and profits from the sale of $55,000. In this scenario your equity multiple would be 2.02x, indicating you essentially doubled your investment! Here’s the math:
$47,000 + $55,000 + $100,000 = $202,000
$202,000/$100,000 = 2.02x
One thing to note about Equity Multiple is that it doesn’t factor in time, which is often a critical component to consider.
Imagine you’re comparing two investments: Investment A has an equity multiple of 1.9x while Investment B has an equity multiple of 2.7x. Which is better? All things being equal, Investment B certainly sounds better. But what if Investment B has a 10-year timeline while Investment A has only a 3-year timeline? In this example, Investment A is the better option. Remember that when using the Equity Multiple metrics.
Internal Rate of Return
Ok, now we’re getting somewhere. Remember when I said that Equity Multiple doesn’t account for time? You should, it was in the last paragraph. Well, luckily Internal Rate of Return (IRR) allows investors to account for the time value of money when vetting a potential investment.
In essence, the IRR is a discount rate that makes the net present value of all cash flow returned by the investment, across time periods, equal to zero. The actual IRR formula is complex (see below), so rather than focus on that I think it’s best to just focus on what it reflects.
Since IRR is consistent across investments of various types, it’s often used to compare multiple opportunities on an equal basis. All things being equal, the opportunity with the highest IRR would be the best.
One way to think of IRR is as an approximation of the annual growth rate of a given investment. Although the actual rate of return will differ, IRR is useful because it accounts for the time that your money is tied up in the investment.
Despite its usefulness, IRR does have some limitations that you need to be aware of. One such limitation is most apparent when comparing projects with different timeframes. Projects with short durations may have a higher IRR than a longer duration project, but the longer duration project might actually add more value overall.
Similarly, an investment with solid and consistent cash flows throughout the investment will have a different IRR than a project that has no cash flow over the same time period, even if the total return is equal. In that case, IRR alone doesn’t give an accurate representation of the projected returns.
So there you have it, Five Key Terms Every Investor NEEDS to Know. Obviously, there's plenty more terminology where that came from, but these are the terms most often asked about. Happy investing:)