Commercial Real Estate Terms Explained

commercial real estate terms explained

Understanding a few key investment property terms is critical when considering purchasing a commercial property. Knowing commercial real estate terms will help you determine whether a property is worth the investment and how much money you can expect to earn after you choose which type of investment property to purchase.

Here are Several Important Commercial Real Estate Terms Explained

What is Value Add?

Value add requires an investor to identify an operational or physical issue that, if corrected, will increase the value. Here are a few examples of value add property:

  • A landlord that does not respond promptly to tenants

  • Deferred maintenance is a constant eyesore for existing or new tenants

  • An owner that lacks funding to make improvements

  • A property that is dated and requires modernization

  • A property that is short on parking

All make it difficult to lease or keep a property leased 100%. Thus, properties of this nature typically have a higher vacancy rate in the marketplace and can be more valuable with proper management, upgrades, or additional services. This equates to low vacancy, higher rental income, and a higher value when completed.

What is a Cap Rate?

A cap rate, or capitalization rate, is determined when dividing the net operating income (NOI) by the property value. The NOI is the net revenue to a landlord that a property provides after expenses are paid, such as real estate taxes, property insurance, and maintenance. Credit tenants who sign long-term leases with the tenant being responsible for all property costs (taxes, insurance, maintenance) have less risk and, therefore, a lower cap rate. Noncredit tenants who sign shorter-term leases and have fewer property responsibilities for maintenance or paying for taxes or insurance have a higher risk and, thus, a higher cap rate. A warehouse leased to a national tenant in a prominent downtown area near an international airport and various interstate highways would be considered low risk or a low cap rate. The higher the cap rate, the higher the return to a buyer, and the higher the risk that a shorter lease term could cause an inferior location, the tenant’s credit, or the property‘s condition.

What is a Gross Lease?

In a gross lease, the tenant is responsible for a fixed fee for the space, while the landlord takes care of all expenses related to the property, including taxes, insurance, utilities, and repairs. Landlords incorporate the costs they assume in a gross lease into the rental price, which has advantages and disadvantages for both parties involved. Tenants may choose a gross lease as it simplifies budget planning. There are no additional costs associated with the property, only a fixed fee that covers everything.

Landlords who invest in energy efficiency upgrades for their property might find a gross lease more favorable. With the landlord covering the utility expenses and passing on a fixed cost to the tenants, they can quickly recover these expenses. Additionally, since tenants will continue to pay the agreed-upon rate even if utility costs decrease, they effectively contribute to the cost of the upgrade.

Gross leases do not motivate tenants to decrease their resource consumption since they are already paying a set fee for the use of resources such as water and energy. Discussions and agreements between tenants and landlords can address this misalignment of interests.

What is a Net Lease?

A net lease is the opposite of a gross lease. In a triple-net lease, the most common type of net lease, tenants are responsible for covering taxes, utilities, and operating costs and paying the landlord for the use of the space.

A triple-net lease typically costs less than a gross lease because it includes additional expenses. Although triple-net leases are the most common, modified lease structures are available to accommodate various circumstances. For instance, a “net of electric” lease may require the tenant to cover electricity consumption while the landlord covers most other expenses.

A net lease changes the dynamics of a gross lease. Tenants are encouraged to decrease their utility usage. Still, landlords do not have an immediate reason to make energy-efficient upgrades apart from the long-term value of their property, and it is difficult for them to recover their expenses. For instance, a landlord who installed windows with a high R-value would decrease their tenants’ heating expenses, but they would not personally benefit from the energy savings. However, collaboration between landlords and tenants resolves this misalignment of interests.

What is a Parking Ratio?

Having ample parking is an essential factor for any commercial tenant. As a landlord, ensuring your tenants have adequate and convenient parking should be one of your top priorities. For this reason, it’s essential to understand and use the concept of parking ratio to ensure each tenant has enough space reserved for their employees.

The formula for calculating a parking ratio is simple: divide a space’s total rentable square footage by the number of parking spaces. This number will give you an accurate understanding of how many slots are reserved for each tenant in a particular property. While calculating a parking ratio, you may also want to consult with your potential tenants to identify how many of their staff members drive vehicles to work each day versus taking public transportation; this will provide you with extra information to accommodate all employee needs regarding parking. Allocating sufficient spaces ahead of time and discussing these details with prospective tenants will improve their perception of you as a landlord who takes care of their every need.

What is Common Area Maintenance?

Common area maintenance (CAM) is a fee tenants may be required to pay in conjunction with their lease agreement. The landlord assesses it to cover operating expenses and upkeep of common shared building areas, such as lobbies, hallways, elevators, or other onsite amenities. This fee allows landlords to recoup some of the costs associated with these maintenance activities.

The amount of CAM charged is determined using a load factor, which considers various factors such as size and type of unit, number of occupants, floor area ratio, struggle rating, etc. This formula helps landlords calculate accurate common area maintenance fees for each tenant and ensure fairness across leases within the building. Prospective tenants should ask their landlords about the formula for determining CAM fees before signing their lease agreement.

What are the Wetlands?

Wetlands are areas with water covering the soil all year or for varying periods. The presence of water determines the soil’s development and the types of plant and animal communities. Wetlands can support both aquatic and terrestrial species. The prolonged presence of water creates conditions for specially adapted plants and characteristic wetland soils to develop.

What is a 1031 Exchange?

A 1031 exchange is a transaction in which one real estate investment property is exchanged for another, resulting in the deferral of capital gains taxes. Real estate professionals commonly use this term along with investors and others familiar with the Internal Revenue Code (IRC), specifically Section 1031. Some individuals even use it as a verb, saying, “Let’s exchange that building for another.”

IRC Section 1031 is a complex area of the tax code that requires careful understanding by real estate investors. It allows for property exchanges, but only between like-kind properties, and there are limitations for using it with vacation properties. Additionally, there are tax implications and time constraints that may pose challenges.

What is the Opportunity Zone?

Opportunity Zones are communities with economic distress, designated by states and territories and certified by the U.S. Treasury Department. Certain investment types in these areas may be eligible for preferential tax treatment. This tax incentive aims to encourage economic development and job creation in these distressed communities by providing tax benefits to investors.

What is a Sub-Lease?

A sublease is when a current tenant rents their property to a new person for a part of their lease agreement, also known as a sublet. Subleasing may or may not be allowed according to the terms of the original lease, and additional restrictions may apply depending on the jurisdiction. If subleasing is permitted, the original tenant remains responsible for fulfilling the obligations outlined in the lease agreement, including the monthly rent payment.

What are Operating Expenses?

Operating expenditures, also known as OpEx, are the expenses that businesses regularly incur for their everyday operations. These expenses encompass a variety of costs, such as utilities, wages, maintenance, repairs, marketing, accounting, and legal fees. Property and business managers are responsible for minimizing expenses without compromising the quality of business operations, ensuring profitability and competitiveness in the market.

Are you looking for a broker to walk you through more investment terms? At Ullian Realty, located in Melbourne, FL, we utilize the Ullian Process to help you determine the best commercial property for your investment goals. With over 50 years of combined experience, our team of brokers is ready to help today. Give us a call to learn more.

This article was originally published on August 9, 2018 but has been updated for accuracy and freshness.