Commercial Real Estate Vocabulary 101 – Part 2

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In my previous post, Commercial Real Estate Vocabulary 101 – Part 1, we discussed the vocabulary that relates to the income of commercial real estate in general, and we discussed in detail how these terms relate to apartment buildings.

In this post, I want to discuss the 3 terms that relate to the expenses and profitability of a property.

1.) Operating Expenses

Your operating expenses are the costs associated with operating a building. These expenses will vary depending on the size of the building and the type of building (i.e. apartments, office building, retail shopping center, etc.).

These expenses can include management fees, utilities, taxes, insurance, landscaping, trash collection, and basic day to day expenses. Ideally, you want to move as many operating expenses as possible over to your tenants, but your ability to accomplish this will greatly depend on market conditions and the property type. For example, in an apartment building, it is not unusual for tenants to pay their own utility costs, however, you probably won’t be able to convince them to pay a portion of the real estate taxes  on the apartment building. But, if you were investing in office buildings, it is common for office tenants to pay a portion of the taxes, insurance, and maintenance costs associated with the office building. In the case of the office tenant having them pay these additional costs would be dependant on the market conditions and your negotiations upon them signing the lease.

Overall, you want to lower your operating expenses as much as possible without forgoing needed services and repairs. If you can lower your expenses and still keep the property well maintained and operating efficiently, it will result to more income in your pocket.

2.) Net Operating Income (NOI)

In simple terms, your net operating income, or “NOI” for short, is the profit that your property is generating before your mortgage payments. When viewing the NOI, imagine that you are paying all cash for the property and consequently you don’t have a mortgage. The NOI will be the profit that the your property is generating and this will be the number that is used to determine the value of your property.

The Net Operating Income is determined by taking the annual income of the property and subtracting the annual operating expenses of the property. For Example:

Annual Income: $100,000

(minus) Annual Operating Expenses: $45,000

Net Operating Income (NOI): $55,000

The Net Operating Income of a property is a critical figure because it will be the number that will be used to determine the profitability and value of a building. It will also be used by mortgage lenders in determining whether or not the building can adequately cover the mortgage payment. Overall, it is a very important number and you should always be looking for new ways to increase it, either by increasing income or lowering expenses.

3.) Debt Service

The Debt Service in its simplest terms is the mortgage payment associated with the property. So, your annual debt service would be your monthly mortgage payment multiplied by 12 months. So, if your monthly mortgage payment on a property was $3000, then your annual debt service would be $36,000 ($3000 X 12 months). Once you have your annual debt service, you will subtract it from your net operating income (NOI) in order to get the cash flow of the property. For example:

Net Operating Income (NOI): $55,000

(minus) Annual Debt Service: $36,000

Annual Cash flow (money in your pocket): $19,000

Another, term that you will need to know that relates to debt service is the Debt Service Coverage Ratio (DSCR). The debt service coverage ratio is a calculation that is done to determine how if a property is generating enough income to comfortably cover the debt service (mortgage payments). The ratio is generally calculated as such:

Net Operating Income (NOI): $55,000

(divided by) Annual Debt Service: $36,000

= 1.53 (DSCR)

A debt service coverage ratio of less than 1 means that the property has negative cash flow and can not cover the mortgage payments. Most financial institutions like to see a DSCR of at least 1.25 in order to consider financing the property, so this is a good ratio to keep in mind when you are conducting your due diligence and running the numbers on a potential deal.

This post is the second post in a three part series discussing the vocabulary and formulas needed to  analyze commercial property. In the next post we will talk more about how to put all of the terms from the first two posts together to analyze the value and potential returns of a property investment. Once you put all of these concepts together, you will have a better understanding of how a property is operating and whether or not is suitable for your investment goals.

If you have any questions, we can carry the conversation over into the comments below so please let me know your thoughts and comment below.

Comments are always welcomed and encouraged! Let me know your thoughts below in the comment section and feel free to retweet this post on Twitter or share on Facebook.

Photo: juliehclark

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.