Commercial real estate is very different than residential real estate in many respects. If you are looking to begin investing in this space, whether actively or passively, it is important to know some of the key terms. One of the most common phrases you hear when evaluating a commercial real estate deal is the net operating income, or NOI. This is  important because commercial properties, unlike residential ones, do not derive their value from sales comparables. Rather, they are valued based on the income that they produce.

To begin understanding NOI we must define the term. Investopedia defines it as:

Net operating income equals all revenue from the property minus all reasonably necessary operating expenses. NOI is a before-tax figure which excludes principal and interest payments on loans, capital expenditures, depreciation and amortization.

Put simply, NOI is income minus expenses, but not including the mortgage. This metric does not factor in debt service because it is a property level calculation and debt is not a part of the property’s operations. Each investor may get a mortgage with different down payments, interest rates, terms, and amortization schedules so including debt in NOI would generate a different NOI for every investor. Because NOI is calculated the same for all properties, it can be used to make an apples to apples comparison between deals. Once you understand NOI, you can then begin analyzing a deal with use of a cap rate.

Most investors will calculate a cap rate (short for capitalization rate) in order to determine if a real estate opportunity meets their investment criteria. Cap rates are calculated as:

Cap Rate = Net Operating Income / Property Value

As an example, if a seller’s property has an NOI of $100,000 and her asking price is $1,500,000 we can calculate the cap rate as $100,000 NOI / $1,500,000 Price = 6.67% Cap Rate. Is this good? Bad? That can depend on each individual investor and their market.

Cap rates, very generally speaking, will range anywhere between 5% – 10% or more. 10% cap rates might be found in places like Trenton or Camden while 5% cap rates are likely to be found in places like Hoboken or Princeton. This means that a building that generates $100,000 in NOI may sell for $1,000,000 in Trenton ($100,000 / $1,000,000 = 10%) but fetch $2,000,000 in Princeton ($100,000 / $2,000,000 = 5%). Practically speaking, most cap rates fall somewhere between 5 and 10% though this ranges fluctuates as interest rates change.

Another way to think about this is that a lower cap rate equates a higher price. This makes sense when you consider that you might be willing to accept the lower 5% return in Princeton as opposed to the 10% return in Trenton due to the perceived difficulty of managing a property in a rough part of town. Of course, some investors would rather a management intensive building with high returns. As mentioned, this depends on each investors goals. In order to know if a building is being sold for an appropriate cap rate, investors should see what cap rates other comparable properties had sold for in the area. This can by analyzing recent sales or speaking with brokers, appraisers, and other investors in your area.

Capitalization rate and net operating income are some of the more basic and fundamental real estate terms. Once you have a firm grasp of what they are and how they are used in commercial real estate, you will be well on your way to  analyzing a potential deal.