Understanding the jargon of commercial real estate is essential for anyone looking to invest in this field. In this article, we will discuss the 10 must-know commercial real estate terms that will help you make informed decisions and analyze potential investments.
These terms can help you determine cash flow, analyze potential investments, and make intelligent investment decisions. Armed with a clear understanding of these fundamental terms, you can intelligently invest in commercial real estate and maximize your returns. Whether you are a seasoned investor or a beginner, these terms will help you navigate the complex world of commercial real estate with ease.
Common Area Maintenance
Common Area Maintenance (CAM) is a term used in commercial real estate to describe the expenses associated with maintaining the common areas of a property. These expenses are passed on to commercial property tenants to reimburse the owner for the costs of maintaining the common areas.
Here are some examples of common area maintenance charges:
- Parking Lot Maintenance: CAM charges pay for the costs of sealing parking lots, repairing their cracks, and resurfacing them when needed.
- Lawn Care and Landscaping: CAM charges cover the costs of maintaining the lawn and landscaping of the property.
- Sidewalks: CAM charges pay for the upkeep of sidewalks and walkways.
- Utilities: CAM charges cover the costs of utilities like electricity, water, and gas.
- Janitorial Services: CAM charges pay for the costs of cleaning and maintaining shared restrooms, lobbies, and elevators.
The methodology used to calculate Common Area Maintenance Fees is specific to each lease. However, the most common method is to allocate costs to each tenant based on their pro rata share of the total square footage in the property. CAM Fees are typically seen in Net Leases where the tenant is responsible for paying a monthly base rent amount plus their share of the CAM Costs. In a Gross Lease, tenants pay one monthly rental amount and the landlord is responsible for paying the common area expenses
Usable Square Footage
Usable Square Footage is the area of a commercial property that is available for the exclusive use of the tenant. It is the space that the tenant can actually occupy and use for their business operations. Rentable Square Footage is the total area of the tenant’s usable space plus a portion of the building’s common areas, such as hallways, lobbies, and restrooms.
To calculate the Usable Square Footage, you need to measure the area of the space that is available for the tenant’s exclusive use. This includes the area inside the walls of the tenant’s space but excludes any common areas, such as hallways, restrooms, and lobbies.
The Rentable Square Footage is calculated by adding the Usable Square Footage to a portion of the building’s common areas. The portion of the common areas that is added to the Usable Square Footage is called the Load Factor or Common Area Factor. The Load Factor is calculated by dividing the total rentable square footage of the building by the total usable square footage of the building.
Here is an example of how to calculate the Usable Square Footage and Rentable Square Footage of a commercial property:
- Measure the area inside the walls of the tenant’s space.
- Subtract any areas that are not available for the tenant’s exclusive use, such as columns, mechanical rooms, and elevator shafts. This will give you the Usable Square Footage.
- Calculate the Load Factor by dividing the total rentable square footage of the building by the total usable square footage of the building.
- Multiply the Usable Square Footage by the Load Factor to get the Rentable Square Footage.
Net Operating Income (NOI)
Net Operating Income (NOI) is a metric used in real estate to measure the profitability of income-generating properties. It is calculated by subtracting all operating expenses from all revenue generated by the property. NOI is a before-tax figure that excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization.
Does net operating income include mortgage costs?
NOI does not include mortgage payments because they are not considered an operating expense. NOI is used to determine the precise value of income-producing properties and helps real estate investors compare different properties they may consider buying or selling.
Commercial Real Estate Interest Rate
Commercial Real Estate Interest Rate is the rate at which interest is charged on loans used to purchase or refinance commercial real estate. Interest rates can have a significant impact on the commercial real estate market.
When interest rates are low, it is easier for investors to obtain financing for commercial real estate investments. This can lead to an increase in demand for commercial properties, which can drive up property values and rental rates. However, when interest rates rise, borrowing costs increase, which can lead to a decrease in demand for commercial properties, higher vacancy rates, and potentially reduced property values.
Higher interest rates can also impact the cash flow and financial performance of commercial real estate investments. When interest rates rise, the cost of debt increases, which can reduce the amount of cash flow generated by the property.
Cap Rate (Capitalization Rate)
Capitalization Rate (Cap Rate) is a metric used in commercial real estate to compare different real estate investments. It is calculated by dividing the Net Operating Income (NOI) of a property by its current market value and is expressed as a percentage.
Cap Rate is used to estimate the investor’s potential return on their investment in the real estate market. It is the most popular measure through which real estate investments are assessed for their profitability and return potential.
Here is the formula for calculating Cap Rate:
Cap Rate=Current Market Value / Net Operating Income
Cap Rate is used to determine the exit rate or terminal capitalization rate for a property when it is sold at the end of the projected holding period. While the Cap Rate can be useful for quickly comparing the relative value of similar real estate investments in the market, it should not be used as the sole indicator of an investment’s strength because it does not take into account leverage, the time value of money, and future cash flows from property improvements, among other factors.
Gross Lease
A gross lease is a type of commercial real estate lease where the tenant pays a flat rent amount, and the landlord is responsible for all property expenses. In contrast, a net lease requires tenants to pay not only their rent but also some or all of the property's operating expenses, allowing landlords to shift financial responsibility onto tenants.
The choice between gross and net leases depends on factors such as market conditions, property type, and individual preferences of both landlords and tenants. Flexibility in lease terms is more common with net leases, allowing for negotiation of expense allocation and adjustments based on market conditions.
Tenant Improvement Allowance
A tenant improvement allowance (TIA) is a sum of money provided by a landlord to a tenant to cover the cost of improvements to a commercial property. The total amount of the allowance and the eligible costs to which it can be applied are negotiated as part of the lease agreement.
The TIA is intended to improve the value of the landlord’s property and is usually included in the lease contract of the property. The tenant improvement allowance does not have to be returned to the landlord, as it is treated like an ‘allowance’. However, most landlords will usually seek to recoup the cost of the allowance by including a portion of the TIA in base rent or extending the duration of the lease.
The amount of the TIA can vary depending on many factors, such as the market, the asset type, and the nature of the project. The average tenant improvement allowance is around $15 to $25 per square foot. However, the amount of the TIA can be influenced by various factors, such as the location, the condition of the property, and the tenant’s creditworthiness.
It is important to note that what constitutes a reasonable tenant improvement allowance is subjective and depends on the specific circumstances of the lease agreement. Negotiating a TIA requires careful consideration of the tenant’s needs and the landlord’s expectations. It is recommended that tenants work with a commercial real estate broker to help them navigate the negotiation process.
Sale Leaseback
A Sale-Leaseback is a financial transaction where an owner of an asset sells it and then leases it back from the new owner. This type of transaction allows owners of real property the opportunity to free up the balance sheet capital they’ve invested in an asset without losing the ability to continue using it. The seller can then use that capital for other things (to finance business expansion, reduce debt, or return cash to investors) while the buyer owns an immediately cash-flowing asset with a tenant already in place.
In a real estate sale-leaseback, the current owner sells their property to a buyer (typically an investor) and then leases it back for a long-term period. The current owner is called a seller-lessee or seller-tenant, and the investor is a buyer-lessor.
The benefits of a sale-leaseback transaction for a seller include the ability to access capital that was previously invested in a real estate asset and the continued occupancy of the property with a long-term lease agreement that locks in expenses.