Real estate is a sound investment choice, which might be why hundreds of thousands of people have jumped up the next rung of the property ladder into commercial territory. However, commercial real estate investment can be considerably different from single homeownership or even residential property investment.
If you’re about to broaden your horizons with commercial real estate investment, here are a few common terms you may need to familiarize yourself with first.
Loan to Value Ratio (LTV)
Most banks, lenders, and commercial real estate agents understand the importance of the loan to value ratio (LTV). LTV refers to the percentage of the loan amount to the value of that property to understand the debt level. Banks often set maximum LTVs to ensure both they and investors are making wise financial decisions.
Calculating an LTV is a straightforward process that simply involves dividing the loan amount by the property value. The loan amount refers to the debt balance, and the value is the appraised value. The general LTV guideline is 75% and should not exceed 80% unless in exceptional circumstances.
The capitalization (cap) rate helps investors compare the prices of two properties and indicate an expected return. It’s calculated as the net operating income divided by the property’s asking price. The result is a percentage, showing that you can earn X% each year.
Net Operating Income (NOI)
The net operating income is one of the most crucial considerations when purchasing commercial property. It refers to a property’s gross potential rent minus its operating expenses. For example, if a property earned $100,000 per year with $10,000 in operating costs, its NOI would be $90,000.
Real Estate Investment Trust (REIT)
Not everyone wants to purchase real estate by themselves. Instead, they may wish to be a part of a company that owns real estate. Such investors need to become familiar with real estate investment trusts (REIT).
REITs are publicly-traded companies that own real estate and allow people to purchase shares in them. For a company to be a REIT, it needs to have at least three-quarters of its assets in real estate and make at least three-quarters of its gross income from property rent, interest, or sales. There are also several other requirements like having a board of directors and being a taxable entity.
Cash on Cash Return (CoC)
This term describes your annual return on the amount of money you’ve invested into a property. You may see the CoC formula written as cash received / annual cash investment as a percentage.
Market value is an essential term to learn when the time comes to buy or sell commercial property. It refers to how much you can buy or sell a property for on the open market and is generally driven by supply, demand, interest rates, and location.
Equity multiple is the relationship between the money you’ve invested in a property and the cash you’re getting from it. The formula takes the total cash received and divides it by the total cash invested for a decimal answer. For example, if you invest $100,000 in a property with a $200,000 return, your equity multiple is 2.0x.
Commercial real estate investment can be a far different game than residential real estate investment. Before you start looking for properties for sale, take a moment to learn some of the crucial terms above.