Whether as a lawyer, an architect, an engineer, or a broker, a young professional in real estate often hear 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 the client invokes abbreviations, acronyms, and mathematical formulas to brag about the steal made when buying a property. A combination of years—spent deducing meaning from context and gradually gaining insight—will serve to answer most questions, but some must be asked. And asking questions that one fears to be stunningly basic can prove awkward when billing hundreds of dollars an hour.
This informal guide explaining some of those uncommon terms will answer a few of questions and, I hope, spare a little of the beginner’s inevitable anxiety.
Capitalization rate, 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 that a buyer would receive by purchasing a certain property. Or, to turn it around, the cap rate expresses the initial return on investment that a buyer requires before buying.
Example: if you have $1 million 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 that 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, its vacancy rate, the creditworthiness of its tenants, the age of its roof, and so on), to the economy as a whole. That economy includes interest rates, Treasury bill rates, and whatever product types are in favor at the moment with the buying crowd.
The mathematical formula is simple, but it is 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 as follows: Purchase price equals net operating income (NOI) divided by cap rate (expressed as a decimal). For 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, then the purchase price would be $20 million. 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. That is, a property with $1 million in NOI sells for $10 million; a property with $100,000 in NOI sells for $1 million; and so on. This is the case only because ten is the number—and only number—at which the teeter-totter of rising price and falling cap is exactly balanced.
Gross multiplier: This is another, far simpler method for arriving at a 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 if the gross multiplier is 12, then 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 that an investor hopes to receive from a property for a given holding period—usually ten years—and adds to that number the property’s estimated sale value in the tenth 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 over ten years and then sells at the end of that tenth year for twice what the investor originally paid for it, the IRR would be—trust me—10.98 percent. That is, to get all the cash dribbling in over the next ten years so you will have a net present value of zero today, you would have to discount it at 10.98 percent. Framed positively, this result means you would have received a total return on your investment of 10.98 percent. Because 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—the cash flows for 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 (a) one-time payments (a lease termination fee) or (b) bank interest on deposits or (c) a tenant’s repayment of over-standard tenant improvements. Sellers invariably consider tenant improvement (TI) 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. When one is 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 determination: (a) what the management fee and vacancy factor should be; (b) whether and how much to include for reserves for future tenant improvements and leasing commissions, structural maintenance reserves, and roof replacement reserves; (c) 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 that depends on an NOI formula (this type of contract usually occurs when 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 the developer’s rosy pro forma.
Architectural and Construction Terms
Alligatored: a parking lot that is in the midst of failure (after the first cracks but before the pot holes) and that is thus 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 that is 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 that is constructed so as to be free of interior columns. This space is important in retail buildings because of merchandising requirements and sight lines.
CMB: the abbreviation that stands 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 that is at the top of a building.
Curtain wall: the outer “skin” of an office building, usually glass, that is hung from a steel frame. This is a common construction method used for high rises.
Dock high: a term meaning that the floor of a building’s loading docks is flush with a delivery truck’s floor so that goods can be rolled off the truck on a level plane. This leveling is usually accomplished by lowering the outside loading area where the trucks park.
Elevation: a drawing of a building’s exterior wall that is 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).
Facade: the front of a building; that is, the architectural treatment—which one hopes is 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 that is 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 windowpanes. 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 roofline. In addition to making buildings appear larger, parapets hide rooftop equipment and exterior walls (e.g., 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 multistory building, the floor above.
Surveys, Site Plans, Leasing Plans, Plot Plans, etc., Terms
The when and why of such various drawings can be confusing.
As-built: the survey prepared by a licensed surveyor when construction is complete. It shows 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 American Land Title Association (ALTA) survey (assuming an institution is involved). To the as-built, the ALTA adds easements, encroachments, and anything else that the lender’s counsel is fretting over.
Boundary survey: a formal survey that is prepared by a licensed surveyor and shows a parcel’s exterior dimensions. If not already in existence, this survey is the first step in developing a parcel.
Geotech: a geotechnical survey (the third step in the pre-construction process) that is prepared by a soils engineer and that evaluates the quality and consistency of a parcel’s substrata through soil borings. Knowing whether the 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.
Leasing plan: a site plan that delineates the proposed dimensions of the spaces that the developer wishes to lease. The leasing plan is what a developer and that developer’s brokers huddle over with potential tenants.
Site plan: a less-formal document that is sometimes simply sketched by the project architect. It shows the proposed layout 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 that is attached to the preliminary title report), and it 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 the working drawings for site work. The term plot plan is a less frequently used synonym.
Tilt-up: a method of construction that is 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. 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.
Topo: a topographic survey (the second step in the pre-construction process) that is prepared by a civil engineer and details all changes in a parcel’s altitudes (i.e., every hillock and declivity is calculated). This survey 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, conversely, 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.
Truss: the wooden or metal horizontal support for a roof, or the roof’s understructure. It is often prefabricated.
Wood frame, or stick construction: a shorthand way of referring to a building that is constructed of wood framing and that has an applied exterior, which is usually stucco or wood siding.
Absolutely net: what a landlord strives for in a ground lease with 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. It is 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 underleased 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 on 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 that, as often as not, connotes “outside wall to outside wall,” which means that the GLA is the entire building or space with no deductions. Occasionally, the measurements are from the inside—and sometimes the midpoint—of the perimeter walls. Industrial buildings are also often leased on a gross square footage basis.
Net rentable area: an office leasing term that—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 staircases are the most readily agreed-upon verticals, while the janitor’s closet and light wells are sometimes debated as being in that category. Net rentable area includes all of what would be the floor’s common areas if the floor contained more than one tenant. Such common areas would include the elevator lobby, the hallways, and the restrooms.
Net usable area: a calculation usually applied to multitenant 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 calculation 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 percent. Above 15 percent and tenants scream; below 5 percent 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 if 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, a term that means powerful tenants insist on 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 on 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: a term meaning that, 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. Such an event is 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. Tenants such as supermarkets that have a high sales volume and low profit margin might pay no more than 1 percent in percentage rent. A discount department store may pay 2–3 percent while a fast food restaurant may pay as much as 6 percent 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 percent in percentage rent. Thus, that supermarket will pay 1 percent of its annual sales in excess of $50 million ($500,000/.01 = $50 million). Put another way, it will not pay any percentage rent until its sales reach $50 million. Example: a Mexican restaurant agrees to pay $220,000 in fixed rent and 5 percent in percentage rent; the restaurant will then pay 5 percent 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 million, then the artificial break point would be $40 million.
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: Although the most basic of lease terms, a term that means many things to many people. It usually means that 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 on the building’s sale, or who pays for insurance that the tenant views as excessive or frivolous (a $25 million 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 one-hundredth (1/100th) of 1 percent. For example, 25 basis points are one-quarter of 1 percent, and so on. Thus, to impress you, your client will crow about saving 100 basis points on a new loan when the client might simply have said 1 percent. Basis points are often called bips.
Constant: the fixed payment of both principal and interest that is due under an amortizing loan. It is 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 million loan payable in 30 years with interest at 8 percent has a constant of 8.8 percent in the first year. In the 15th year of the same loan, the constant has risen to 11.5 percent (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. Example: if a property has an NOI of $125,000 and a 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, you obtain the probable lender’s coverage requirement and the new loan’s constant. Next, you divide the property’s NOI by the coverage ratio. Then you divide that result by the constant (expressed as a decimal). Example: The 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 term meaning that a property is leveraged when it has debt on it. A 50 percent leverage means a property is encumbered with a loan for 50 percent 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 million in all cash for a property that then appreciates $50,000 a year in value, the buyer makes 5 percent a year on the $1 million 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 percent return on the $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, then the all-cash buyer will suffer mild discomfort while the leveraged buyer will wear out kneepads in meetings with the lender.
Positive leverage: if the interest rate on the mortgage is lower than the cap rate, the buyer enjoys positive leverage. Example: If a woman buys a hotel for $1 million in all cash at a 7 cap rate, she will net $70,000 a year (a 7 percent return on her $1 million investment). If rather than paying all cash, she instead borrows $750,000, payable at 5 percent 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 percent 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—and one should—then her overall return would be 14 percent. Quite positive.
Negative leverage: The reverse of positive leverage. It occurs when the interest rate on the loan is higher than the cap rate on the purchase price. If our female 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 percent return on her investment, she will receive 2.19 percent ($21,886 cash flow I $1 million equity). Buying at a 4 cap but getting 2.2 percent 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 the buyer 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, California.