How to Speak the Lingo

Let’s say you decide you want to buy an income-producing commercial real estate property, but you are not sure where to start or what questions to ask. My goal is help you “speak the language.”  One important first step is to understand a few key terms, and the second step includes five key questions to ask. The terms involve some basic math, but don’t worry;I have faith you can pick this up and learn the “lingo.”

Five Key Terms

1.  Net Operating Income (NOI)—The NOI is simply the gross income, minus vacancies, minus the property expenses. Simply put, how much is left over at the end of the day?

 2. Debt Service Coverage Ratio—This is an important number from the bank’s perspective. This is the NOI divided by the annual debt service. It is a ratio that tells the bank the amount of safety margin built into the deal. Most banks require a ratio of 1.25 or higher. A ratio of 1.0 means every dollar that comes in after expenses goes to pay the bank, with nothing left over.

 3. Capitalization Rate (cap rate)—This is determined by dividing the NOI by the purchase price. If you do finance the property, this will tell you the annual return. Some people call the cap rate the “Unleveraged ” return. It is a great tool for comparing two properties or to quickly discard deals that are too expensive.

 4. Gross Income—This is simply the total top line revenue. If you own a 100-unit apartment complex and each unit rents for $1,000 per month, then the gross revenue is $1,200,000 (100 x $1,000 x 12 mo. = $1,200,000).

 5. Internal Rate of Return (IRR)—This is an interesting metric that you must be very careful using. The IRR is the annual growth rate an investment is expected to generate while factoring in a future sales price. The problem is future sales prices are determined by interest rates, which in turn affect cap rates and property values.  I am not saying the metric is garbage, but I am saying be very careful when using an IRR. One can assume a high sales price in five years and make the IRR jump through the roof.

Five Key Questions to Ask:

1.       Am I applying the standard market vacancy rate?

2.       Are the seller’s expenses in line with my new expenses going forward?

3.       What is the condition of the large capital items? For example, the roof, HVAC units, parking lot, etc.

4.       Am I accounting for capital repairs that do not show up in the P&L (Namely broker commissions, tenant improvements, and repairs)?

5.       How can I add value to this property to increase the rents or decrease the expenses?

By knowing some key terminology and a few basic questions to ask, you will be light years ahead of the average Joe looking for some easy money in real estate.