The terminology used in commercial real estate investing is quite different than what investors typically encounter in residential property investing. There are different lease structures, rent is quoted differently, and there are profitability and valuation metrics that are commonly used in commercial real estate investing.
With that in mind, here’s a list of 12 commercial real estate terms and phrases you’re likely to encounter once you start shopping for your first commercial investment property.
Net lease – A net lease is a common type of commercial lease agreement. The most common variety is known as a triple net lease (also known as an NNN lease) and requires the tenant to pay for property taxes, insurance, and most building maintenance costs. There is also a double net lease (also known as an NN lease), under which tenants pay insurance and taxes but not maintenance, and a single net lease where tenants only pay taxes. In many cases, any type of net lease other than a triple net lease is referred to as a modified gross lease.
Gross lease – A gross lease is the type of lease that most residential investors use but is also used in some commercial lease applications. Under the terms of a gross lease, tenants pay rent, and perhaps their own utilities, but the landlord is responsible for property taxes, insurance, and building maintenance.
Base rent – Base rent is typically used in lease terms to show how much the tenant will pay for just rent, not the other expenses they’re required to pay. For example, in a triple net lease, the base rent wouldn’t include property taxes, insurance, and maintenance costs.
Usable square footage – This term comes up quite a bit in multi-tenant property, such as an office building, and refers to the leased space that is exclusively occupied by the tenant. Usable square feet excludes things like common areas, parking spaces, and other shared commercial space. This is a different concept from the rentable area or rentable square footage of a commercial building, as it considers each tenant’s area.
Cap rate – Short for capitalization rate, this is a valuation metric that expresses a property’s net operating income, or NOI, as a percentage of its market value.
Net operating income (NOI) – A property’s net operating income is equal to its gross rental revenue minus its operating expenses. It does not consider mortgage payments or other debt service.
Cash flow – Cash flow refers to the actual amount of income a property generates after paying all of its operating expenses and mortgage/debt payments. This can be used to calculate cash-on-cash return of a property, which is cash flow as a percentage of the actual cash invested by the property owner.
Ground lease – A ground lease is a commercial leasing arrangement where the tenant leases land but owns the physical building on the land. For obvious reasons, ground leases typically have very long lease terms with options for the tenant to renew — in fact, a 99-year lease term isn’t unheard of with a ground lease.
Full service lease – This term’s precise meaning depends on who you ask, but at a minimum, a full-service lease refers to a gross lease where the owner pays the operating expenses of a property. In some cases, a full service, or fully serviced, lease means that the landlord covers certain other expenses, such as cleaning services, which is quite common in office leases.
PSF rent – Commercial real estate property rental rates are often quoted on a per-square-foot, annual basis. In other words, a rental rate of $10 PSF implies that a 1,000-square-foot space would cost $10,000 per year in base rent, or about $833 per month.
Debt service coverage ratio (DSCR) – This is a popular metric used by commercial lenders and is the ratio of the property’s net operating income divided by total debt service obligations. As a basic example, if your property generates $200,000 in NOI and you have to pay $100,000 in annual mortgage payments, your DSCR would be 2.0 — the NOI divided by your debt payments.
Class A properties – Property classification is something you’ll need to know when investing in commercial real estate. Class A is typically used to describe properties that are in great condition and are well-located, while Class B and Class C real estate is used to refer to somewhat lower-quality properties.
Commercial real estate is very different than residential
If you’ve primarily invested in residential real estate, making the leap to commercial property investing can be quite a challenge. As you can see in this article, even the language used in commercial real estate is quite different. So, be sure to learn all you can about commercial real estate investing and how to evaluate investment opportunities before you start shopping for your first commercial investment property.