Commercial Real Estate Vocabulary 101 – Commercial Deal Analysis

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This is the final installment on the 3 part series discussing the different terms that relate to commercial real estate. In this post I want to discuss how to put all of the terms that we learned in the previous two posts together, in order to analyze properties and quickly determine whether or not they are suitable for your investment goals.

If you have not already done so, please read the first two posts in this series so you can have a better understanding of the concepts in this post.

Commercial Real Estate Vocabulary 101 – Part 1

Commercial Real Estate Vocabulary 101 – Part 2

Assuming you have read the previous articles in this series, you should now have a better understanding for Gross Income and how to account for vacancies and bad debt in order to get your Effective Gross Income (EGI). You should also have a better understanding for Operating Expenses, Net Operating Income, and Debt Service.

Now you need to put all of those terms together in order to properly analyze a property.

1.) Cash Flow

As it relates to real estate investing, cash flow is the amount of cash that a property is generating after all of the expenses and debt service is paid. This number should ALWAYS be positive. If this number is negative, then that means that the property is operating at a loss and will be taking money out of your pocket on a monthly basis. For Example:

Effective Gross Income (EGI): $100,000

(minus) Operating Expenses: $45,000

(equals) Net Operating Income (NOI): $55,000

(minus) Debt Service: $35,000

(equals) Cash Flow: $20,000

2.) Cash-on-Cash Return

Your cash-on-cash return is a ration that allows you to see what your annual return would be on your cash invested for the down payment. For example, let’s say you purchased a commercial property for $1,000,000 with a 20% down payment of $200,000. From the example above, the property is generating $20,000 a year in positive cash flow. Based upon these numbers, your cash-on-cash return would be 10%. See Below:

Cash Flow: $20,000

(divided by) Down Payment: $200,000

(equals) Cash-on-Cash Return: .10 or 10%

Now this example gave you the cash on cash return based off of your down payment, however, if you wanted to be more accurate with your return, you would include your total acquisitions costs and not just your down payment. So you would take the cash flow and divide it by your total acquisition costs which would include down payment, closing costs, soft costs, etc. This number is very important to investors because it symbolizes how long it will take for investors to recoup their principal investment. Depending on your market and the needs of your investors, you will probably want to acquire properties that generate at least a 12% cash-on-cash return for you and your investors. This will allow your investors to get a good upfront return on their capital and still have the potential for greater returns if the property sells at a profit at a later point in time.

3.) Capitalization Rate (Cap Rate)

The capitalization rate is the rate of return that a property would generate if it was purchased with all cash and not financed. So, if you were to pay $1,000,000 cash for a building and it generated $100,000 in net income, your “cap rate” would be 10%. See Below:

Net Operating Income (NOI): $100,000

(divided by) Purchase Price or Value: $1,000,000

(equals) Capitalization Rate: .1 OR 10%

Capitalization rates are used to value commercial properties in relation to other comparable properties (“Comps”) in the area. As a simple reference point, you want to purchase properties at a higher cap rate than the comps in the area and sell at a lower cap rate than when you made the purchase. The reason for this, is because the lower the cap rate, the more the property will be worth. For example using the information above, you purchase a building at a 10% cap rate and made some repairs and upgraded the quality of tenants and the quality of the building. Let’s say that buildings in the area that are similar to your newly renovated building are selling at a 8% cap rate. To make the example simple, we will assume that there has been no increase in your Net Operating Income. At an 8% cap rate, your building would be worth $1,250,000. Below is how we came up with that value.

Net Operating Income (NOI): $100,000

(divided by) Capitalization Rate: .08 OR 8%

(equals) Value: $1,250,000

Now I kept these numbers simple for illustration. In reality if you made renovations to a property and increased the quality of tenant and quality of building, your net operating income would increase as well, which would make the building worth more than $1,250,000. When you are doing your due diligence on commercial properties, you always want to know the “cap rate” that comparable properties are selling at, so you can attempt to acquire a building at a higher “cap rate” than the current market. This will give you the opportunity to renovate and reposition the property so that you can increase the equity in the property, similar to the way residential real estate investors purchase properties below the market comps so they can fix them up and have additional equity built into the property.

By combining all of the terms and formulas from the three posts in this series, you will have a good foundation to analyze a variety of commercial properties in your marketplace.

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.

Photo: neilpomerleau

About Author

Khary Reynolds is a real estate investor and freelance copywriter with more than 10 years of experience in developing content for savvy real estate investors and executives that will build trust and credibility within their marketplace and aggressively grow their sales and profitability.

5 Comments

  1. Great article Khary, this breaks it down in a very simple and understandable way. I have a question about the NOI used. For Cash Flow you have EGI 100K – 45K expenses = NOI 55K. Then NOI of 100K is used instead of 55K for the Cash on Cash & Cap Rate & Value. Is it accurate to use 55K for the NOI there as well?

    • Khary Reynolds on

      Hey Ryan,

      Thanks for the comment. The example I gave for #3 Capitalization Rate (Cap Rate) is totally different from the example I gave in #1 & #2. I should have used the same example for all three, just to keep things uniform and less confusing.

      So, to answer your question if we were to use $55k as the NOI for example #3, the numbers would look as such:

      Net Operating Income (NOI): $55,000

      (divided by) Purchase Price or Value: $550,000

      (equals) Capitalization Rate: .1 OR 10%

      At an 8% cap rate, your building would be worth $687,500. Below is how we came up with that value.

      Net Operating Income (NOI): $55,000

      (divided by) Capitalization Rate: .08 OR 8%

      (equals) Value: $687,500

      Thanks again for your question Ryan. Hopefully, this helps to clarify the numbers in example #3.

  2. Great article. I use these formulas with my clients for industrial real estate in the Chicago market. Many owners are not aware of an investment approach to value an industrial property because they usually focus on end user pricing. It is important for a seller and buyer to understand both the end user and investment approach to determining the value of a property.

  3. Thanks for clarifying Khary. This is truly a great article. I believe it is 5 units and up that you can appraise a property based on operations. We stick to the nicer blue collar areas form cash flow and many of the unit properties are foreclosures so an appraisal based on comps vs an appraisal based on operations like you illustrated could be an astronomical difference. 50K vs 200K is not out of the questions. Thanks for sharing, great article!

  4. Great articles Khary. Understanding the basics you’ve presented is the beginning of success in commercial real estate. We use these plus ten or twelve more every day when evaluating apartment deals. To do that quickly and accurately we developed the Dealizer which will calculate and display all the important numbers in a detailed but simple to use worksheet. See our website to find out how you can put the Dealizer to work finding good opportunities today.

    Keep up the great posts!

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