Whether a lawyer, architect, engineer or broker, a young professional in real estate often hears expressions—some slang, others simply arcane—that neither the finest education nor the thickest dictionary is likely to illuminate. And the professional must solemnly nod, as if understanding came with sunlight, when his client invokes acronyms and mathematical formulas to brag about the steal she made in buying a property. A combination of years, deducing meaning from context and gradual insight serve to answer most questions, but some have to be asked. And asking questions one fears to be stunningly basic can prove awkward while billing hundreds an hour.
This informal guide to some of these uncommon terms will answer a few of these questions and, hopefully, spare a little of the beginner’s inevitable anxiety.
Capitalization rate or cap rate or simply cap (as in, “The property capped out at an 8.”): A capitalization rate is a shorthand way of stating the yield a buyer would receive by purchasing a certain property. Or, to turn it around, the cap rate expresses the initial return on investment a buyer requires before buying.
Example: if you have $1,000,000 to invest and wish to earn a 6 percent return on your investment, then you would have to buy at a 6 cap or higher. If a property is selling at a 7 cap, its buyer would receive a 7 percent return on his money, if it is selling at a 5 cap, the buyer would receive a 5 percent return and so on.
Cap rates vary because of many factors, ranging from the attributes of the property itself (its location, vacancy rate, the creditworthiness of its tenants, the age of its roof and so on)—to the economy as a whole—interest rates, Treasury bill rates and what product types are in favor at the moment with the buying crowd.
The mathematical formula is simple, but easy to trip over because the relationship between the purchase price and the cap rate is inverted. The price rises when the cap rate is lowered and falls when the cap rate is raised. The formula is: Purchase price equals net operating income (NOI) divided by cap rate (expressed as decimal); example: assume NOI is $200,000; if the cap rate is 8, then the purchase price equals $2,500,000 ($200,000/.08); if the cap rate is 12, then the purchase price equals $1,666,666. Extreme examples underscore the inverse relationship between cap rate and price: if the cap rate is 1 and the NOI is still $200,000, the purchase price would be $20,000,000; conversely, if cap rate is 25, the purchase price would be $800,000.
Note: Historically, this concept was a bit more confusing to beginners because at a once-standard cap rate of 10 percent (unheard-of in the modern era), the relationship between price and cap appears to be direct: a property with $1,000,000 in NOI sells for $10,000,000, a property with $100,000 in NOI sells for $1,000,000 and so on. This is the case only because 10 is the number—and only number—at which the teeter-totter of rising price and falling cap is exactly balanced.
Gross multiplier: another, far simpler method for arriving at price used in the sale of small apartment buildings. One takes the property’s annual gross income and multiplies it by the agreed-upon gross multiplier. If the apartments gross $90,000 a year and the gross multiplier is 12, the price will be $1,080,000 ($90,000 x 12 = $1,080,000).
Internal rate of return or IRR: the IRR is in—a perfect world—a method to determine an investor’s total return from a property during his period of ownership, including both its annual cash flow and its ultimate sales proceeds. The calculation is neither simple nor without breathtaking guesswork. One takes the projected annual cash flow an investor hopes to receive from a property for a given holding period—usually 10 years—and adds to that the property’s estimated sale value in the 10th year. The IRR is the percentage required to discount this combined sum back to zero on the date the property is purchased.
Example: if a property produces 5 percent in annual cash flow over 10 years and then sells at the end of that 10th year for twice what the investor originally paid for it, the IRR would be—trust me—10.98 percent; that is, in order to get all that cash dribbling in over the next 10 years to have a net present value of zero today, you would have to discount it at 10.98 percent. Framed positively, this means you would have received a total return on your investment of 10.98 percent. Since this highly speculative 10.98 percent sounds much better than the 5 percent return you know you’re getting from day one, the IRR is wildly popular.
The fallacy behind every IRR analysis ever prepared is obvious; it requires one to predict the unpredictable—cash flows years into the future and the selling price of a property ten years from now. The IRR calculation assumes one can predict highly complex and interrelated financial conditions—interest rates, capitalization rates, tenant demand, new competition, population growth, personal income shifts, etc. long into the future. Predicting what a given property will sell for ten years hence is likely to be as accurate as predicting today how much rainfall the city in which the property is located will receive in that tenth year.
Net operating income or NOI: NOI has a widely-held general meaning, but because it is the cornerstone of a property’s value, its definition is subject to arm-wrestling. Simply put, NOI is a property’s annual gross rental income minus the property’s—not the owner’s—expenses attributable to the same period.
The definition of “gross rental income” has relatively few pitfalls—whether to include one-time payments (a lease termination fee) or bank interest on deposits or a tenant’s repayment of over-standard tenant improvements; sellers invariably consider t.i. repayments to be rent, while buyers view them as loan payments and thus not part of gross income.
The definition of “expenses” can be more problematic. For purposes of defining NOI, expenses never include the owner’s debt service or depreciation; i.e. the property is viewed as being free and clear of mortgages and the tax situation is put aside. The debate begins after that: what the management fee and vacancy factor should be, whether and how much to include for reserves for future tenant improvements and leasing commissions, structural maintenance reserves, roof replacement reserves, how to handle capital repairs or improvements and so on.
Note to young lawyers: If possible, avoid a purchase contract where your buyer is paying a floating price dependent on an NOI formula (this usually occurs where the sale is agreed-upon before the property is fully leased). The contract has yet to be drawn that can save a buyer from being screwed by a desperate developer whose new building is failing to meet his rosy pro-forma.
Architectural and Construction Terms
Alligatored: a parking lot in the midst of failure (after the first cracks but before the pot holes) is said to be alligatored. The term refers to the bumpy, cracked asphalt surface that does indeed resemble an alligator’s back. Note: A simple seal or slurry coat will not solve this problem despite whatever contrary advice your client may receive.
Bollard: a short, sturdy post used to prevent vehicle access or to protect an object (e.g. an outdoor electrical panel box) from traffic.
Clear span: a building or tenant space constructed so as to be free of interior columns. This is important in retail buildings because of merchandising requirements and sight lines.
CMB: the abbreviation for “concrete masonry block”; the term describes a type of exterior wall construction. (“Is it a tilt-up?” “No, CMB. “).
Cornice: a projecting (or overhanging) continuous horizontal feature at the top of a building.
Curtain wall: the outer “skin” of an office building, usually glass, hung from a steel frame. Common construction method for high-rises.
Dock high: means that the floor of a building’s loading docks are flush with a delivery truck’s floor so that goods can be rolled off the truck on a level plane. This is usually accomplished by lowering the outside loading area where the trucks park.
Elevation: a drawing of a building’s exterior wall viewed as if one were standing in front of it. The elevation is the stylish drawing with which the architect impresses the city council and to which the finished building sometimes bears a passing resemblance.
End cap: the space at the end of a row of shops nearest the street (hence, usually the most visible and desirable of the shop spaces).
Façade: the front of a building; the architectural treatment, hopefully impressive, of a building’s principal elevation. The terms cornice and parapet tend to be used loosely (and interchangeably) as meaning the architectural treatment at the top of the facade.
Fascia: the flat portion of a building’s front or principal elevation, just above the tops of the doors and windows. Also called the sign-band, the fascia is typically where building signage is placed.
Footprint: the exterior or perimeter dimensions of a building. Building footprints are typically found on site or leasing plans.
Mullion: the vertical element that separates window panes. Note: one can roughly calculate an office’s size in an office building by counting its mullions and the acoustical tile squares in its drop ceiling; mullions are typically spaced four feet apart and ceiling tiles are usually either two by four feet or two by two feet.
Pad: the land area for a small building (a McDonald’s) on the perimeter of a shopping center. The small building itself is also often referred to as a pad.
Parapet: a vertical wall, usually extending above a roof line. In addition to making buildings appear larger, parapets hide rooftop equipment and exterior walls (a fire wall between two buildings).
Plenum: the enclosed space between the acoustical tile ceiling (the drop ceiling) and the underside of the roof structure or, in the case of a multi-story building, the floor above.
Surveys, site plans, leasing plans, plot plans, etc. The when and why of these various drawings can be confusing.
Boundary Survey: a formal survey prepared by a licensed surveyor of a parcel’s exterior dimensions. (If not already in existence, the first step in developing a parcel).
Topo: a topographic survey (the second step in the pre-construction process) is prepared by a civil engineer and details all changes in a parcel’s altitudes; i.e. every hillock and declivity is calculated. This is essential for planning the parcel’s site work, its drainage and whether earth needs to be removed or imported. Note: if a site is too low and needs earth or fill, the fill will be expensive; if, on the other hand, excess earth must be trucked away, the hauling costs will be ruinous and the dirt brokers will tell you no one is buying fill at the moment.
Geotech: a geotechnical survey (the third step in the pre-construction process) is prepared by a soils engineer and evaluates the quality and consistency of a parcel’s substrata through soil borings; knowing whether earth is predominantly sandy or clay-like or rocky is critical to the building’s structural design. A geotech report could kill a deal if, for example, a solid layer of granite were encountered beneath the surface.
As-built: the survey prepared by a licensed surveyor when construction is complete, showing the exact location of the buildings and site improvements (e.g. light poles and fire hydrants). The as-built serves as the basis for a subsequent ALTA survey (assuming an institution is involved). To the as-built, the ALTA adds easements, encroachments and anything else the lender’s counsel is fretting over.
Site plan: this is a less formal document, sometimes simply sketched by the project architect, showing the proposed lay-out of the new building and the site improvements (the parking lot and landscaping). The site plan is often, but not always, based on a boundary survey (it can be prepared from the assessor’s map attached to the preliminary title report) and is used for initial presentation to planning staffs, neighbors and so on. Typically, site plans go through numerous revisions as comments are encountered; when the size, shape and location of the buildings are finally agreed upon, the architect or civil engineer takes the site plan to use as the rough basis for his working drawings for the site work. The term plot plan is a less frequently used synonym.
Leasing plan: a site plan that delineates the proposed dimensions of the spaces the developer wishes to lease. The leasing plan is what a developer and his brokers huddle over with potential tenants.
Tilt-up: a method of construction so common to warehouses that the buildings themselves are referred to as tilt-ups. With tilt-up construction, the form (or mold) for the exterior wall is assembled on the ground next to where the wall will stand, the concrete is poured into the form and, when it dries, the wall is tilted up into its permanent vertical position. Because this is perhaps the cheapest means of construction, the term tilt-up is sometimes used derisively.
Truss: the wooden or metal horizontal support for a roof; the roof’s understructure. Often prefabricated.
Wood frame or Stick construction: short-hand ways of referring to a building constructed of wood framing and an applied exterior, usually stucco or wood siding.
Absolutely net: what a landlord strives for in a ground lease—the tenant paying absolutely all of a property’s expenses. Note: even with an absolutely net lease, the landlord will typically have some unreimbursed expenses (e.g. his partnership’s tax preparation fees, the cost of excess umbrella liability insurance).
Base year: The year in which the landlord’s share of a building’s expenses vis-à-vis a particular tenant is established—usually the calendar year in which a lease commences or the 12 month period beginning when that tenant opens for business. In a base year lease, the tenant pays costs but only to the extent they exceed base year costs. Note: establishing a fair base year is tricky with new or under-leased buildings.
Definitions of Area: Note: Because money is more important than math in the definition of a tenant’s leased premises, the industry standards are subject to negotiation and one can appear foolish insisting upon a particular definition as if it were an inalienable right. A Manhattan developer once said there are more interpretations of net rentable area than languages spoken in New York.
Gross Leasable Area or GLA: the standard for retail leasing which, as often as not, connotes “outside wall to outside wall”, meaning that the GLA is the entire building or space with no deductions. Occasionally, the measurements are from the inside—and sometimes, the mid-point—of the perimeter walls. Industrial buildings are also often leased on a gross square footage basis.
Net rentable area: this is an office leasing term and, assuming one were leasing an entire floor of a building, would be the standard for the leased premises. It is generally understood to be the total floor area less “vertical penetrations”- elevators, utility ducts and stair cases being the most readily agreed upon, while the janitor’s closet and light wells are sometimes debated. Net rentable area includes all of what would be the floor’s common areas if the floor contained more than one tenant; i.e. the elevator lobby, the hallways and the rest rooms.
Net useable area: This is the calculation usually applied to multi-tenant floors in an office building. Net useable area is the net rentable area minus the common areas. Each tenant leases its pro-rata share of the net useable area and a pro-rata share of the deducted common areas; this is called a load factor. Depending on the efficiency of the floor plate (in English, the floor) and the relative bargaining strength of landlord and tenant, the load factor can vary wildly, but an average load seems to be about 10-12%. Above 15%, tenants scream, below 5% is unheard of.
Expense stop or Stated expense stop: A variation to the base year approach found in office leasing in which the tenant pays the building costs over an agreed-upon maximum level: e.g. if the expense stop were $10 per square foot and the building expenses rose to $12, the tenant would pay $2 per square foot as its share of building expenses.
Full service or Gross: a lease under which the landlord pays all costs (including janitorial and utilities) without reimbursement from the tenant.
Go dark: in retail, powerful tenants insist upon the right to close their business or go dark at any time (without, however, terminating the lease or any of its other obligations); once-burned landlords insist upon the right to recapture the space if the tenant goes dark.
Industrial-gross: a typical lease format for industrial buildings wherein the tenant pays for maintenance, utilities and increases, if any, in the landlord’s taxes over those payable in the first year of the lease. The landlord pays for base year taxes and insurance.
Kick-out: in addition to a go dark provision, retail tenants often try for a kick-out clause through which they can terminate the lease upon the occurrence of some event, usually the tenant’s failure to reach an agreed-upon minimum level of sales.
Percentage rent: If a retail tenant is compelled to grant rent increases, all but the most successful prefer it to be in the form of percentage rent. The rate or percentage varies depending on the tenant’s particular business. High sales volume, low profit margin tenants (supermarkets) typically pay no more than 1% in percentage rent; a discount department store may pay 2-3% while a fast food restaurant may pay as much as 6% of sales or more.
Percentage rent is determined by dividing the tenant’s fixed rent by the percentage rent factor (expressed as a decimal). The resulting sum is the tenant’s break point or natural break point or breaker. When the tenant’s annual gross sales exceed the break point, the tenant pays the landlord the agreed-upon rate of percentage rent on the excess sales only. Example: a supermarket agrees to pay $500,000 a year in fixed rent and 1% in percentage rent; thus, this supermarket will pay 1% of its annual sales in excess of $50,000,000 ($500,000/.01 = $50,000,000); put another way, it will not pay any percentage rent until its sales reach $50,000,000. Example: a Mexican restaurant agrees to pay $220,000 in fixed rent and 5% in percentage rent; the restaurant will then pay 5% of its sales but only to the extent its sales exceed $4,400,000 ($220,000/.05 = $4,400,000).
An artificial break point or breaker occurs when the parties agree that, the formula aside, percentage rent will be payable on sales above an agreed-upon dollar amount. If the supermarket from the foregoing example agreed that percentage rent would commence above $40,000,000, then the artificial break point would be $40,000,000.
An observation. Because they are efficient at keeping fixed rent high, landlords rarely receive percentage rent; typically only very old leases or exceptionally successful tenants pay percentage rent.
Triple net: While the most basic of lease terms, triple net means many things to many people. It usually means a tenant is required to pay its pro-rata share of taxes, insurance and maintenance and that the landlord is responsible for maintenance of the roof and bearing walls. The term leaves open for debate a host of lesser issues such as who pays for capital improvements or replacements (the parking lot), who pays the increase in property taxes upon the building’s sale, who pays for insurance the tenant views as excessive or frivolous (a 25 million dollar liability policy or earthquake insurance).
Ammo: slang for principal amortization or amortization schedule; as in “What’s the ammo?”
Basis point: a basis point is one hundredth (1/100th) of one percent (1%). 25 basis points are 1/4 of 1% and so on. Thus, to impress you, your client will crow about saving 100 basis points on a new loan when he might simply have said 1%. Basis points are often called bips.
Constant: the fixed payment of both principal and interest due under an amortizing loan, expressed as a percentage of the outstanding loan balance. In other words, the constant is determined by taking the total monthly debt service, multiplying it by 12 and then dividing that sum by the outstanding loan balance. The greater (or swifter) the principal amortization, the larger the constant. Older loans may have an attractive interest rate, but because so much of the fixed payment is principal, the cash-flow conscious buyer will object to the constant. Example: A $1,000,000 loan payable in thirty years with interest at 8% has a constant of 8.8% in the first year; in the fifteenth year of the same loan, the constant has risen to 11.5% (the payments are unchanged, but are higher in proportion to the then remaining loan balance of $767,700).
Debt coverage ratio or coverage: the ratio that a property’s NOI bears to the annual principal and interest payments (or debt service) due under its loan. To obtain the coverage ratio for an existing loan, one simply divides the NOI by the debt service. If a property has NOI of $125,000 and debt service of $100,000, the coverage is called “1.25”; if the NOI were unchanged but the debt service fell to $60,000, the coverage would be “2.08”. The higher the coverage, the more conservative the loan.
To determine the maximum new loan for a property, obtain the probable lender’s coverage requirement and the new loan’s constant; divide the property’s NOI by the coverage ratio and then divide that result by the constant (expressed as a decimal). Example: NOI is $327,000, the coverage is 1.15 and the constant is 8.8; thus, ($327,000/1.15 = 284,348) /.088 = $3,231,225 maximum loan. Note: It is easy to forget this is a two-step process.
Leverage: A property is leveraged when it has debt on it. 50% leverage means a property is encumbered with a loan for 50% of its value; being completely leveraged means the owner has no cash investment in the property.
Investors love leverage because it can exponentially increase their returns. If a buyer pays $1,000,000 all-cash for a property which then appreciates $50,000 a year in value, he makes 5% a year on his $1,000,000 investment (on paper at least); if the buyer instead puts down $100,000 and borrows $900,000 from the bank, the $50,000 annual appreciation becomes a 50% return on his $100,000 investment. This is how the audacious become wealthy in a rising market. Turning this example on its head illustrates what happens to the audacious in a falling market; if instead of appreciating, the property depreciates by $50,000 a year, the all-cash buyer will suffer mild discomfort while the leveraged buyer will wear out knee pads in meetings with his lender.
Positive leverage: if the interest rate on the mortgage is lower than the cap rate, the buyer enjoys positive leverage. Example: If she buys a hotel for $1,000,000 all-cash at a 7 cap rate, she will net $70,000 a year (a 7% return on her $1,000,000 investment). If rather than paying all cash, she instead borrows $750,000, payable at 5% interest with a 30 year amortization schedule, she will pay $48,113 in annual principal and interest, but her cash investment will be reduced to $250,000. After her debt service payments, she will be left with a net cash flow of $21,886—an 8.75% return on her $250,000 investment. And she will benefit from annual principal amortization starting at $13,113 (and increasing yearly after that). If one counts principal amortization as part of one’s return—one should—then her overall return would be 14%. Quite positive.
Negative leverage: This is the reverse. It occurs when the interest rate on the loan is higher than the cap rate on the purchase price. If our buyer bought that hotel at a 4 cap, the NOI of $70,000 would be unchanged, but her purchase price would have soared to $1,750,000. If the buyer has the same loan, she will still have $21,886 in net cash flow but, instead of an 8.75% return on investment, she will receive 2.19% ($21,886 cash flow I $1,000,000 equity). Buying at a 4 cap but getting 2.2% in cash flow is distinctly negative leverage.
FF&E: a hotel term meaning “furniture, fixtures and equipment”.
Flip: a verb meaning to sell a property at the same time one is purchasing it. With a signed purchase contract and a sufficiently long escrow, a buyer of a property may, in a hot market, raise the price and secretly market it for resale before he closes escrow. The property is usually flipped (or double-escrowed or double-clutched) to the second buyer at the same moment as the flipper’s purchase, with the second buyer’s money the only funds in escrow. A client who indulges in this practice is a good candidate for referral elsewhere.
Rack rate: a hotel term meaning the average nightly room rental rate.
John E. McNellis is a Principal at McNellis Partners in Palo Alto, Calif.