Commercial real estate has its own specific terms.  Many of these terms have specific meanings that are not always clear to beginning or even sometimes experienced real estate investors.  This blog will discuss some of these terms and clarify what they mean.

Stabilized properties:  A “stabilized” property is a property that is fully leased or leased up to the normal occupancy for its location.  It is a property where the leases are made at market rates instead of below market rates.  Ideally in a stabilized property the leases do not all expire at the same time but have rolling lease terms.  Also, a stabilized property should have minimal need for capital improvements.  Stabilized properties will command a higher price than properties that are not at this level.  Large institutional investors such as life insurance companies typically purchase stabilized properties.

Value-Added properties:  These are properties that, unlike stabilized properties, have room to increase the occupancy level and/or increase the rental income.  This type of property is frequently purchased by savvy real estate investors who, because of their knowledge and experience, believe they can increase the net operating income (see below) of a property and then sell it for a higher price than they paid for it.

Net operating income:  This is perhaps the single most important term for commercial real estate investors to understand.  It is the major decision-making criteria that buyers and sellers use to value a commercial property.  Net operating income – typically shortened to NOI – simply means taking all the income a property generates and subtracting all expenses except principal and interest debt service payments and except depreciation.  Net operating income is sometimes called unleveraged cash flow.  This is the cash income the property owner would receive if the property were owned free and clear.  Both stabilized and non-stabilized properties have NOI.  The value of a property is typically determined by using a “cap rate” (see below) to arrive at a fair market value of a property.

Cap rate:  The “cap rate” – shorthand for capitalization rate is how buyers and sellers typically create the “fair market value” (see below) of an income property.  Land, which does not produce income, cannot have a cap rate.  The cap rate of an income property (usually a stabilized income property) is obtained by dividing the NOI of a property by a figure typically between 4.5 and 9.5.  The lower the cap rate the more value a property has.  The cap rate is the rate an investor is willing to pay for a property.  A fully leased income property with stable tenants at market rate might have a low cap rate – say 5.  Take an office building with great tenants at fair market rates which has a NOI of $100,000.  If one uses a cap rate of 5 then divide $100,000 by .05 to obtain a fair market value of $2,000,000.  Take an office building with lots of vacancy and with tenants that are not reliable – in this case a buyer might decide that a cap rate of 7.5 is appropriate.  Divide the $100,000 NOI by 7.5 and you arrive at a fair market value of $1,333,333.  A life insurance company probably will be willing to buy a high-quality property that is stabilized for a 5 cap.  A real estate investor that believes they can increase the NOI by hard work and by making additional capital investments in the property might offer to buy it at a 7.5 or 8.0 cap.  Although cap rates can be set at any number, they are typically found between 4.0 and 9.0.

Fair market value:  This is a term that real estate buyers and sellers and appraisers use.  It means the amount that a willing buyer will pay a willing seller for a property.  It must be an “arms-length” sale – that is – a sale where both parties are unrelated so there is no favoritism between them.  Fair market value is dependent on the cap rate used.  Cap rates vary between city to city.   Some investors prefer major cities – like Denver – and are willing to take a lower cap rate.  Other investors are willing to buy in smaller markets – like Grand Junction – and may want a higher cap rate.

For Part II of this Blog, click here.