The world of commercial real estate is vast and it’s clearly punctuated by “isms” and chatter that are very specific to the industry. Understanding key financing terms is critical when it comes to making informed decisions and bringing the big sale home. In your path to master this complex niche, we’ve provided 14 financing terms every CRE investor should know.
Accrued Interest
Accrued interest represents the interest that has been generated on a mortgage or loan but has not yet been paid or received. Calculating your monthly accrued interest can help you estimate potential income from future interest payments. This is vital when it comes to monitoring and managing a business’s finances.
Loan-to-Value Ratio (LTV)
The loan-to-value or LTV ratio represents the percentage of the property’s value that the lender is willing to finance. Essentially, this ratio shows how much of the property’s value is being borrowed compared to the down payment from the buyer. A lower ratio suggests less risk for the lender while a higher ratio presents more risk as it might also incur higher interest rates and stricter loan requirements.
Debt Service Coverage Ratio (DSCR)
The debt service coverage ratio presents a quick formula that measures a property’s ability to cover its own debts. When you divide the net operating income by the debt service a number is generated. If the number is above 1 then this indicates that the property can operate efficiently and clear its anticipated debt load. If the number is below 1 then this suggests that the property will not be able to generate enough revenue to sustain itself.
Net Operating Income
This term is a little more straightforward than others. Your NOI is exactly that. What does it cost to operate or maintain your commercial real estate property or investment? Net operating income is determined by subtracting your operating expenses from your gross operating income. It’s that simple but it’s also a very important number to keep up with. As economic conditions fluctuate, so will your NOI.
Cap Rate or Capitalization Rate
The capitalization rate represents a property’s annual net operating income as it relates to the current market value or purchase price of a commercial property. This equation results in a percentage which suggests the potential ROI or return on investment over the life of the lease or loan. Like the LTV mentioned above, a higher rate implies higher risk while a lower rate signals a lower return on investment. Financing and taxes are not included in this formula.
Cash-on-Cash Return
This number is determined by dividing the annual dollar income by the total dollar investment. CRE investors use this equation in order to determine or estimate the amount of cash that will be earned every year on a cash investment. It can also be used to compare return profiles from one investment to another.
Distressed Assets
A distressed asset is a commercial real estate property or properties that are priced well below market value. Why is this done? Generally speaking, this indicates a seller’s need for fast cash because of the property’s overall underperformance. In other words, it’s just another saying for “cutting anchor” and moving on.
A distressed asset might appear to be truly distressed. That is to say that by appearance alone it might suggest an investment opportunity for those who recognize the commercial potential of its location or purpose. Generally speaking, distressed assets might literally be in a distressed or deteriorating state as a result of mismanagement and the aforementioned underperformance. The win here is that a distressed asset can represent a good investment opportunity with improved management. However, the term “money pit” also comes to mind.
Value-Add Real Estate
If distressed assets look like a good investment then this is where Value-Add Real Estate comes into play. This is a term used to define an investment strategy when it comes to refurbishing or renewing a distressed commercial property. While this approach comes with obvious risks, it can also be profitable. It’s simply a matter of overcoming potential pitfalls and creating a new, viable and functional commercial space. The end result here is to flip the property to a new buyer and claim a quick profit.
Fixed vs. Variable Interest Rates
A fixed-rate loan is just that. The interest rate is fixed and remains the same throughout the life of the loan. A variable-interest rate can fluctuate over time and it is generally based on current market conditions. Is one better than the other?
A fixed rate easily suggests stability. There are no surprises with this particular loan. A variable loan might present nice and affordable numbers when market rates are on the decline. However, that can change quickly and suggest problems or unexpected alterations with one’s monthly operating budget if a buyout or refinance to a lower interest rate opportunity does not present itself upon a change in your contractual variable-interest rate.
Bridge Loan
The term “bridge loan” has been tossed around enough to warrant placement on this list. Like most of these financing terms, a bridge loan can be applied in both the residential and commercial real estate sectors. A bridge loan is secured when a buyer needs to “bridge” a financial gap between the purchase of a property and securing the actual loan. This is typically done when a buyer needs to close quickly but does not have financing in place. While a bridge loan might allow a quick influx of financial flexibility it also comes with higher interest rates.
Mezzanine Debt
Mezzanine debt refers to an extra loan or existing debt that an investor takes on in order to help finance a CRE project. This loan helps investors bridge the gap between the available investor monies and the asking price of a specific property. In other words, if an investor has an eye on a $5 million property but only has $4 million in investor monies, then a mezzanine loan of $1 million dollars would likely be considered.
Equity Financing
This strategy involves raising capital by selling shares in a property or project. This happens often by way of private equity partners or REITs. REIT stands for real estate investment trusts. The difference here is that there’s no need to repay these debts. The partners buying into the financing are doing so in exchange for sharing the profits with the initial investors. However, if those profits become debts then that, too, must be absorbed.
Pari Passu
It sounds very French but it is, in fact, Latin. This phrase means “equal footing” and that’s exactly the intent of this arrangement or clause. When applied in the commercial real estate market Pari Passu means that a commercial property or project’s investors will each receive the same or equal payouts if the initial borrower defaults on the loan. “Equal” indicates investors will be paid proportionate to their own investment.
Pro Forma
This is another Latin term. This document helps investors to determine the potential profit of a property or project. Pro Forma includes real-world property details. This is where one will find information on net operating costs as well as possible cost of repairs, upkeep and tenant history and expectations. How could low occupancy or high turnover rates affect the overall investment now and down the road? This is a document that presents the answers to these questions.
Helpful Terms and Definitions for CRE Professionals
These are just a few financing terms every CRE professional should know. As most in the industry can tell you, it’s a very involved and fluid business. These days commercial real estate is more exciting than ever because the industry is having to reinvent itself as a result of COVID and other fluctuating economic factors. New challenges await and this will likely mean reinventing or reassessing the concept of how loans and leases play out in the coming years and decades.
If you’re looking to dive into the industry or otherwise expand your commercial real estate portfolio, let us help you connect with the right software for your business. Schedule a free demo today.
