When jumping from residential real estate to commercial real estate, you’ll find that although the general flow is the same, the steps are far more complex. Plus, making a mistake can be detrimental. That’s because not only do commercial properties cost more, but the due diligence process has greater out-of-pocket expenses. In order to avoid costly mistakes, a commercial real estate investor must become knowledgeable about the process. The best way to get started is to learn about the different commercial real estate terms.
Valuation Analysis
CAP Rate
The CAP rate stands for capitalization rate. This is a calculation that will help an investor determine if the deal has potential. You get the CAP rate by dividing the net operating income (NOI) by the sales price of the property. The NOI is determined by adding together all the income and then subtracting the expenses. Whenever possible, use real numbers and not Pro Forma numbers, which are numbers provided that represent the best possible outcome. The resulting number gives you a return rate on your investment.
Gross Rent Multiplier
The Gross Rent Multiplier (GRM) is another method for valuing commercial property. Rather than NOI, the GRM is based on the rental income. You can find out the average GRM of similar properties in the area. Then, simply multiply the GRM by the gross rents of the property you are considering. This will provide you with an estimated value of that property.
Cash-on-Cash Return
The cash-on-cash return helps you determine how much net cash flow the building produces in comparison to the amount of equity you invested in the building. This is a good number to know when you are looking for consistent positive cash flow. You determine the cash-on-cash return by dividing the before-tax cash flow by the amount currently invested in the property.
Building Space Terms
Usable Square Footage
Usable square footage, sometimes written as USF, represents the space that tenants will have for working space. Usable square footage does not include hallways, staircases, bathrooms, parking lots, lobbies, security, or any other shared space. This number should never be the same as the actual square footage of a building.
Rentable Square Footage
Rentable square footage (RSF), on the other hand, is all the space available to rent, which includes all shared elements. As a landlord, you will use this number to set rents for the commercial property.
Common Area Maintenance
When maintaining a building, the common area maintenance (CAM) designates the amount spent to maintain the shared elements. The CAM is estimated at the beginning of each year, and in some leases, the tenants are responsible for their portion. You can determine a tenant’s portion of CAM by dividing the Tenant’s Square Footage by rentable square footage and multiplying that number by the estimated CAM expenses. What is included in CAM depends on the industry type and the type of lease.
Lease Terms
Right of First Refusal
The right of first refusal (ROFR) is a clause in the lease that allows a current tenant in the building to choose to rent additional space in the building before the landlord offers the vacant space to the general public. This clause does not, however, require the tenant to rent additional space.
Sublease Clause
This is a clause in a lease that states whether or not a tenant can sublease their space to another business. To sublease means that the contracted tenant will not use some or all of the space during the lease period and offers it to another business for the remainder of the lease period. The new renter pays the original renter who continues to pay the landlord. At the end of the lease, the original tenant may choose to reassume the space. As a landlord, you need to determine if subleasing is in your best interest or not.
Assignment Clause
An assignment clause is similar to a sublease clause except that the original tenant is not in the middle of the equation. The new tenant pays the rent directly to you, and the old renter assigns all of their interest to the new renter. At the end of the lease term, only the new tenant may resign the lease.
Escalation Clause
This is a lease clause that states how much the rent will increase annually. How this increase is determined depends on the landlord. The most likely factors include property taxes, operating expenses, and the current economy.
Of course, this is just a few of the CRE terms you will learn as you become acquainted with the commercial real estate process. To learn more about CRE, contact the Real Estate Knowledge Institute (REKI). We have a team of experts ready to help you learn the ins and outs of CRE.
