Must-Know Commercial Real Estate Terms and How to Use Them
At Wellings Capital, we believe investing in commercial real estate should be understandable. If you can’t explain a deal in plain English, it’s probably too risky.
Understanding these commercial real estate metrics isn’t about impressing people at cocktail parties.
As you dive deeper into commercial real estate investing, remember that knowledge is power. The more you understand these concepts, the better you’ll be at identifying solid deals, avoiding costly mistakes, and building long-term wealth. And if you ever find yourself overwhelmed by the alphabet soup of CRE terms, just come back to this guide.
Before we get into it, this guide doesn’t dive deep into every term mentioned; it’s just an overview.
Investing Without a Decoder Ring: Key Metrics
Let’s start with the most important—the terms you’ll see and hear in most offering memorandums, investor calls/webinars, and probably your dreams if you read this late at night.
MOIC or Multiple on Invested Capital or Equity Multiple or Multiple – The first question from most investors: "How much do I get back?" MOIC measures total return by dividing total cash distributions by the initial investment. If you invest $100k and walk away with $250k, you have a 2.5x MOIC. Simple…but take note: the MOIC is only a helpful metric when factoring in the timeframe. A 2.5x MOIC in five years vs. 50 years would be a much different investment outcome!
Apply This: Imagine someone offers you a 3x return, but it takes them 40 years to deliver it. That’s like waiting decades for a meal—you might still get fed, but the excitement has long worn off.
IRR or Internal Rate of Return – The investor’s second question: "How fast do I get it back?" IRR calculates the annualized return, factoring in time value. A 15% IRR means your money is compounding at 15% per year…sort of. There are other technical assumptions built into IRR calculations, including this: it assumes that cash flows along the way are reinvested at the same iterated return rate. (Fully understanding IRR requires further study.)
Apply This: A projected IRR of 18% might sound amazing—until you realize it’s from a two-year deal with high risk. On the other hand, a projected 12% IRR over 10 years with reliable cash flow might be the better play. Fast money isn’t always safe money.
Cash-on-Cash Return or CoC Return – Think of this as your "real-world dividend." If a property generates $8,000 in annual cash flow on a $100K investment, that’s an 8% CoC return. When using debt, CoC is typically the net cash flow divided by the equity investment rather than [dividing by] the total project cost.
Apply this: This is what many passive investors care about most—steady, predictable income. But don’t ignore appreciation! Would you rather have an 8% CoC return today or a 5% return with the potential for a huge payday later?
Cap Rate or Capitalization Rate – The ultimate shortcut for valuing a property. It’s NOI (Net Operating Income) divided by purchase price. Higher cap rates = lower price = higher potential returns (and usually higher risk). Another way to view the cap rate: a “measurement of risk” that measures the compensation required by an investor to take on such risk.
Apply This: A 10% cap rate property may seem like a steal—until you find out it’s a half-empty strip mall in a town with 10,000 people. Low cap rate deals often have less risk, but make sure you’re not overpaying for "safety." In simple terms, capitalization rates can be viewed as the inverse of the EBITDA multiple. For example, a cap rate of 8% translates into a 12.5 multiple (1/.08%) while a 5% cap rate would be equivalent to a 20 multiple.
Yield on Cost or YOC – The cousin of cap rate, but forward-looking. It’s the stabilized NOI divided by the total cost of a commercial real estate project. If you’re getting a 7% yield on cost, but similar stabilized assets are selling at a 5% cap rate, you could be looking at potential upside.
Apply This: This metric tells you whether a development is worth the cost and effort. If your yield on cost isn’t significantly higher than market cap rates, why take the risk? That’s like remodeling a house over the course of a year just to sell it at cost.
Money Matters: Financial & Operational Metrics
These important metrics are like gauges on your luxury car. Strong operators and investors monitor these and regularly compare them to original projections.
Net Operating Income or NOI – Revenue minus operating expenses (OPEX), before debt service. This is the true income of a property, and it’s what lenders and buyers often care about most.
Apply This: NOI drives valuation. Increase NOI, and you proportionately increase property value—without relying on market swings. It’s like increasing value by adding square footage to your house without depending on a crazy housing boom.
Operating Expenses or OpEx – These include maintenance, taxes, insurance, utilities, payroll—basically everything it takes to keep the lights on (literally and figuratively).
Apply this: If an operator claims a property’s expenses are lower than industry norms, ask how. Are they cutting corners? Will deferred maintenance turn into expensive surprises later?
Breakeven Occupancy or BEO – The minimum occupancy level needed to cover expenses and debt. If a property’s breakeven is 70%, you should start making a profit once you lease beyond that. BEO is similar to DSCR, just expressed differently.
Apply This: If your breakeven is 95% in a ten-unit apartment building, one bad tenant can throw your entire investment off balance. Lower breakeven occupancy = better margin of safety.
Debt Service Coverage Ratio or DSCR – NOI divided by debt (principal and interest) payments. A DSCR of 1.25x means you’re making 25% more than your mortgage payment, which makes lenders and investors sleep better at night. 1.75x, a 75% margin of safety, would be even better.
Apply This: A DSCR of 1.01x means you’re barely scraping by. A DSCR of 2.0x? Now that’s a buffer! Always aim for a comfortable margin.
Risk and Reward: Understanding Leverage and Debt
Debt can be a powerful tool—or a financial time bomb. It all depends on how you use it.
Loan-to-Value Ratio or LTV – The percentage of a property's value that’s financed with debt. If you have a $700K loan on a property valued at $1M, your LTV is 70%. Similarly, the Loan-to-Cost Ratio is the loan amount divided by the property cost at acquisition. (People commonly refer to both as LTV.)
Apply This: Think of LTV like your mortgage. A lower LTV (more equity) typically equates to a safer investment, while a higher LTV might provide better returns (because of lower equity invested)—unless things go south, in which case, it’s like maxing out your credit card for a "sure thing" that flops.
Recourse vs. Non-Recourse Loans – Recourse loans mean the lender can come after your personal assets if the investment tanks. Non-recourse loans limit the lender to just the property as collateral.
Apply This: A recourse loan is like co-signing your buddy’s car loan—if he skips town, you’re on the hook. Non-recourse is more like a security deposit—if things go wrong, they keep the deposit but don’t take your house.
Interest-Only vs. Amortizing Loans – Interest-only loans keep payments low by postponing principal repayment. Amortizing loans chip away at both interest and principal from day one.
Apply This: Interest-only loans are like paying minimums on a credit card—great for cash flow, but you’re probably not reducing what you owe. Amortizing is like paying off a car loan—you gradually own more and more of it outright. But unlike most cars, real estate typically appreciates, providing owners/investors an increasingly higher equity stake.
Bridge Loans – Short-term financing designed to "bridge" the gap until permanent financing is secured or the property is stabilized.
Apply This: If real estate was a Monopoly game, a bridge loan is similar to mortgaging a property to buy another one—risky but sometimes necessary to get ahead.
The Deal Structure: Who Gets Paid and When?
Real estate deals have layers—kind of like a wedding cake but with money instead of frosting.
Preferred Return or "Pref" – The minimum return investors must receive before sponsors get a cut of profits.
Apply This: Think of it like first dibs on the pie—investors eat first, and only after they have been served does the sponsor get dessert.
Waterfall Structure – The distribution hierarchy of profits between investors and sponsors. Typically, it starts with a preferred return and then splits profits after hitting specific return thresholds. A common structure is an 8% cumulative preferred return, then a 70/30 split (in favor of investors) for returns above that number.
Apply This: It’s like a tiered loyalty program—basic members (investors) get perks first, but the VIPs (sponsors) get extra bonuses once certain milestones are hit.
GP (General Partner) vs. LP (Limited Partner) – The GP manages the deal and takes on the work (and liability). LPs are passive investors who provide capital but don’t make day-to-day decisions.
Apply This: Think of it as a road trip. The GP is driving, making all the turns (and taking the risk of getting lost), while the LPs are in the backseat, funding the gas and hoping for smooth roads.
Promote or Carried Interest or Carry – The GP’s share of profits once a deal reaches a certain return threshold.
Apply This: The promote is like a tip for great service—if the sponsor delivers strong returns, they get a well-earned bonus on top of management fees.
Exit Strategies: How (and When) You Get Your Money Back
Every deal needs an exit plan—because no one wants to be stuck holding the bag.
Hold Period – The expected timeframe before the property is sold or refinanced. It could be anything, but it often ranges from 3 to 10 years. (Warren Buffett says: “Our ideal hold period is forever.”)
Apply This: A short hold is like flipping a house, while a long hold is more like buying rental property for retirement. Know what you’re signing up for!
Disposition – A fancy way of saying "selling the property." Investors usually receive their biggest payday at this stage.
Apply This: If buying is "I do," disposition is the divorce—hopefully amicable, and hopefully with a big check at the end. (The difference is that this divorce is typically planned on the wedding day!)
1031 Exchange – A tax-deferral strategy that allows investors to roll profits into a new property, avoiding capital gains tax (for now).
Apply This: It’s like trading in your old car for a new one without paying sales tax—except with real estate and with the IRS watching.
Refinance and Recapitalize – Instead of selling, some investors refinance the property, pulling out equity to return capital to investors or reinvesting while holding onto the asset.
Apply This: Imagine you bought a fixer-upper, it doubled in value, and instead of selling, you took out a new loan to cash out your gains—without giving up ownership.
Development & Market Terms: Building Wealth (Literally)
Real estate development isn’t just about pouring concrete and hoping for the best. It’s a mix of strategy, patience, and navigating a mountain of paperwork. Whether you’re flipping a run-down strip mall or developing a high-rise, here are the key terms you’ll want to know.
Hard Costs vs. Soft Costs – Hard costs are the tangible, physical expenses (like materials and labor), while soft costs cover everything that happens behind the scenes (like permits, legal fees, and financing costs).
Apply This: If developing a property was a Hollywood movie, hard costs would be the set construction and special effects, while soft costs would be the lawyers, producers, and coffee budget for the cast. Both are necessary—but one is a lot easier to grasp.
Entitlement Process – The bureaucratic marathon that developers must complete to get government approvals before construction. This includes zoning, environmental reviews, and permits.
Apply This: Imagine throwing a huge block party but needing approval from every neighbor, the city council, the fire department, and a historical preservation society. That’s entitlements—except the stakes are in the millions, and delays are almost guaranteed.
Value-Add Investment – A strategy where investors buy underperforming properties, make improvements (like renovations, better management, or rebranding), and create new value—ideally leading to higher rents and/or occupancy. These deals are attractive for investors who want a balance of income and appreciation.
Apply This: Buying a run-down apartment complex and adding a gym, fresh landscaping, and better security can justify higher rents. It’s like giving a ’90s mall a facelift and suddenly making it the place to be again.
Exit Strategy – The plan for how investors will get their money back, whether through selling the property, refinancing, or recapitalization. Without a solid exit strategy, a great investment can turn into a long-term headache.
Apply This: It’s like planning a road trip—you need to know your destination before you start driving. Otherwise, you might just keep circling the block with no gas (or profit) left.
Absorption Rate – The speed at which available properties lease up. A high absorption rate means strong demand, while a low rate suggests an oversupply of properties.
Apply This: Picture a new apartment building in a hot market—if all units lease up within months, absorption is high. If they sit empty for a year, it’s like trying to sell pumpkin spice lattes in June…probably not the best timing. Or maybe you’ve priced the units too high.
Risk-Adjusted Return – The golden rule of investing: "Am I getting paid enough for the risk I’m taking?" High returns sound great, but smart investors always weigh the risk level before jumping in.
Apply This: Chasing a 20% return on a sketchy development deal in an unproven market might not be worth it if there’s a high chance of losing everything. It’s like betting on a long-shot horse—tempting, but you might be better off with a safer bet.
Preferred Equity – A middle ground between debt and common equity, preferred equity investors get paid before common equity holders but after lenders. It often comes with fixed returns and downside protection, making it a popular option for investors looking for a mix of security and upside. For more information on preferred equity terms, check out our other blog post.
Apply This: Think of preferred equity like the VIP section at a concert—you get better perks than general admission (common equity) but don’t have the same priority as the backstage crew (lenders).
If you have any questions, please contact us or use this link to schedule a call with us.
DISCLAIMER: This article is for educational purposes only and is not to be relied upon as the basis for entering into any transaction or advisory relationship or making any investment decision. Information and any opinions contained in this article have been obtained from sources that we consider reliable, but we do not represent that such information and opinions are accurate or complete and thus should not be relied upon as such.
Wellings Capital Management, LLC is an Investment Adviser registered with the SEC. All investments pose risk, including the possible loss of all principal invested. Past performance is no guarantee of future results. There is no guarantee that any projected results will be achieved. Investors should consider the investment objectives, risks, charges, and expenses of any Welling Capital investment vehicle before investing. For a Private Placement Memorandum (“PPM”) with this and other information, please call 800-844-2188 or email invest@wellingscapital.com. Please read the PPM carefully before investing. We do not provide tax, accounting, or legal advice, and all investors are advised to consult with their tax, accounting, or legal advisers before investing.