We’ve created a beginner series to help you avoid the pitfalls we encountered when we first started, especially when we didn’t understand real estate jargon or how to calculate and use the metrics. It can feel like a completely foreign language when talking with other investors and not understanding what they’re saying. Plus, we’ve created a cheat sheet of these metrics for you to dip your toes in and understand the basics of commercial real estate investing (join our Free FB group to see cheat sheet).
What is Commercial Real Estate?
Let’s dive in, starting with the question: What is commercial real estate?
Commercial real estate, specifically in the context of multifamily residential, which is the focus of this series, refers to properties with five units or more. So, if you’re buying an 8-plex, 12-plex, or an apartment complex, those would all be considered commercial real estate. These types of properties have different rules, lending regulations, and processes compared to purchasing a single-family home, duplex, or even a four-plex.
Other types of properties also fall under the commercial category, like office space, retail, and industrial. Those are usually what come to mind when people think of commercial real estate.
Residential Real Estate vs Commercial Real Estate
The main difference between residential and commercial real estate is that commercial properties are profit-driven, meaning they generate income. Residential properties, on the other hand, are typically for living purposes—everyone needs a home. Most of us own residential properties that don’t generate income. In contrast, all commercial properties should produce income; otherwise, there wouldn’t be much reason to own them unless you’re considering other factors.
4 Basic Terms of Commercial Real Estate Investing
Now, let’s discuss the four key metrics we use daily and believe will be most helpful for you as a beginner. We don’t want you to feel overwhelmed, so we’ll focus on just four.
#1- NOI (Net Operating Income)
The first metric is net operating income (NOI). You’ll hear this term frequently. It’s simple to understand: NOI is your income—rent collected plus any other income, such as laundry fees or utility reimbursements—minus your expenses. Expenses include things like utilities, property management fees, and maintenance. After subtracting those, what’s left is your net operating income.
To put it simply, in our daily lives, we manage household income and expenses in much the same way. You bring in your paycheck, subtract expenses like gas, car payments, groceries, and entertainment, and what you have left is your net operating income. To boil it down, it’s really just income minus expenses.
#2- Cap Rate
The second metric is capitalization rate, or cap rate. The cap rate tells you the profitability of a property. For example, if a property has an NOI of $10,000 and is valued at $100,000, you divide $10,000 by $100,000, giving you a cap rate of 10%. This means if you bought that property for $100,000 in cash, you’d get a 10% return.
Cap rates are often used to compare one property’s profitability to another. For instance, if another property has an NOI of $5,000 with the same $100,000 value, it would have a cap rate of 5%. You’re getting a 5% return on one property and a 10% return on another. The cap rate helps you compare profitability.
The market also dictates cap rates based on property class. A new construction, or Class A property, will have a different cap rate than an older, Class C property. You may have a higher return on a Class C property, but there are other factors to consider. The market can dictate cap rates, and an easy way to find out what the cap rates are in your market is to talk to your local broker.
Each market has different cap rates, so if you see a cap rate higher than the average for your area, it’s a good idea to investigate why. It could be a sign of something unusual about that property. If you want some more info on Cap Rates, check out another vlog HERE.
#3- COC (Cash-on-Cash Return)
The third metric is cash-on-cash return, which is simply the amount of cash you put into the property compared to the amount of cash you get back annually. For example, if you invested $10,000 and received $1,000 back, you’d divide $1,000 by $10,000 to get a cash-on-cash return of 10%. It’s the same with real estate: the cash you get back divided by the cash you invested gives you your cash-on-cash return.
This metric is important because when comparing investment vehicles, you want to know your return on cash, whether you’re investing passively or actively.
#4- IRR (Internal Rate of Return)
The fourth and final metric is the internal rate of return (IRR). This is a bit more complex because it factors in all elements of your return over time, and it’s calculated using spreadsheets rather than simple math. The IRR projects your overall return over an extended period, like five or seven years, taking into account various factors beyond just cash flow.
So, to recap:
- Net Operating Income (NOI),
- Capitalization Rate (Cap Rate),
- Cash-on-Cash Return (COC), and
- Internal Rate of Return (IRR).
Now you have a basic understanding of the key metrics in commercial real estate.
But How Do You Make Money Through Commercial Real Estate Investing? 3 Ways to Generate Income
Next, let’s talk about how commercial real estate generates income. It’s simple—at the end of the day, it’s all about cash flow. If the rent collected minus expenses leaves you with cash, you’ve made money. If a property doesn’t cash flow and you don’t know how to make it cash flow, it won’t generate income and likely won’t qualify for financing.
The second way to make money is through equity. Ideally, tenants are paying down your mortgage and other expenses, and the property is appreciating. On average, properties appreciate about 3% a year, although that can vary based on market conditions.
Finally, the third way is through tax savings. Real estate offers great tax benefits, including depreciation, which reduces your taxable income. It’s highly recommended to work with a real estate-focused accountant to maximize your savings. In our first year using a real estate-driven tax accountant, we saved over $40,000 on our taxes.
So, to recap how you make money in commercial real estate:
- Cash flow (more info on increasing cash flow HERE)
- Equity growth
- Tax savings
So, at the end of the day, we’ve left you with 4 basic metrics and 3 ways to make money aka what we consider to be the basics of commercial real estate. We can’t wait to share with you more!
Join our Community!
Now that you know the basics, stay tuned because we are just getting started! In the meantime, head over to Facebook and join our FB group. We are going to chat through all things commercial real estate, give tips and tricks, talk through sticking points, and most importantly, support each other! Join HERE!
