Commercial Real Estate Terms Investors Should Know

Commercial real estate is in a league of its own when it comes to the real estate world. Evaluations, terminology, due diligence, and requirements all change when one ventures into this type of investment. Here are a few popular terms to help you feel more confident in this arena:

Real Estate Broker A licensed real estate agent/firm that has completed additional training and who negotiates deals between buyers and sellers serving as intermediaries.

Letter of Intent (LOI) – a pre-agreement between two parties to hold terms while due diligence is being conducted and finalized terms are being set.

Executive Summary – Summarization of the proposed business plan. Gives an outline of strategy, management, financial projections, exit plan, descriptions, property details, improvement, etc. This is usually the first document potential lenders/investors see and will determine whether they decide to move forward on a deal and learn more.

Building Classifications – Industry standard divides commercial buildings into three letter classifications to help investors better understand a potential investment.

(Classifications can be upgraded through renovations)

  • Class A: These are the best quality buildings in said market area. Rents are typically above average; buildings are newer with better amenities and fewer maintenance issues. Class A investments generally hold the least amount of risk.
  • Class B: These would be considered your “average” properties that command average market rents, have mid-grade cosmetics, show slight wear and tear and are usually a bit older than your Class A’s.
  • Class C: These properties tend to have the most maintenance issues but are the most affordable of all classes, so they are often in demand.

Net Operating Income (NOI) – A standard real estate formula, used by lenders and borrowers alike, to determine the potential profitability of a commercial property in relation to operating costs.  This is calculated by subtracting the operating expenses from the total income of the property.

Balance Sheet– a report which includes a list of a company’s assets, liabilities, equity capital and debt at a point in time.

Profit and Loss Statement (P&L) – is a record of revenue, cost, and expenses incurred by a business in a given period of time.

Pro Forma – A report that outlines a properties future projected potential cash flow. This can be found by subtracting the projected future expenses from the gross rental income minus vacancy rate.

Capitalization (CAP) Rate – A formula used to determine what a potential investor’s return will be on a property. Net Operating Income/Property Value = Cap Rate

Rent Roll – a document that shows rental income (present and historical) from a real estate asset. This information is then used in many formulas to determine profitability.

Debt Service Coverage Ratio (DSCR AKA DCR) – The annual net operating income from a property divided by the annual cost of debt service (Insurance, Taxes, HOA fees, etc). A DSCR below 1 means the property is generating insufficient clash flow to cover debt payments.

Scope of Work – a document that outlines work to be completed and estimated cost for materials and labor on a specific property. This document will be used to determine loan amounts and the After Repair Value (ARV)

Environmental Site Assessment (ESA) –  a report often required by  your state and or lender for commercial acquisitions that identifies  the existence or potential for environmental contamination liabilities.  This is one of the first steps in commercial due diligence. If contamination is found a Phase II assessment may be performed.

Easement – a legal right to use another person’s property for a specific public or private purpose written into public records.  Easements can be created for a variety of reasons. Common easements include driveways, fences, utility, etc. These should be listed in your title commitment.

Encroachment – The intrusion of a structure that extends, without permission, over a property line, easement boundary or set back line. This can be found out by conducting a survey.

Whether you’re looking to buy, sell or lease commercial real estate, knowing these commercial real estate terms will benefit your business. This knowledge will help you make informed decisions, like determining if a property is a good commercial real estate investment. It will also help you prepare for conversations you will have with potential lenders when looking at commercial real estate loans. Armed with the right knowledge and vocabulary, you will be ready to dive into the world of commercial real estate investing and have the important conversations needed to grow your investment portfolio.