Glossary
The underwriting vocabulary
60 terms, defined properly. Each one has the formula, a worked example with arithmetic that ties out, and the mistake people actually make with it. No sign-up and nothing gated.
Income and the rent roll
- Gross potential rentGross potential rent is the rent a property would collect if every unit were occupied for all twelve months at full rent, with no vacancy, no concessions and no delinquency. It is the top line of the pro forma, and everything below it is a deduction.
- Loss to leaseLoss to lease is the difference between what a unit could rent for at today's market rate and what the sitting tenant is contractually paying. It appears as a deduction from gross potential rent when the pro forma is stated at market rent.
- Effective gross incomeEffective gross income is all the revenue a property is expected to collect in a year: gross potential rent, less vacancy, loss to lease, concessions and bad debt, plus other income. It is the revenue figure operating expenses are subtracted from to reach net operating income.
- Net operating incomeNet operating income is a property's effective gross income less all operating expenses, before debt service, income taxes, depreciation and capital expenditure. It is the figure a cap rate is applied to, the numerator of debt yield and DSCR, and the number a purchase price is ultimately negotiated against.
- Other incomeOther income is every dollar a property collects that is not rent for the space itself: utility reimbursements, parking, storage, pet rent, application and administrative fees, late fees, laundry, and amenity or trash charges. It is added to rent revenue on the way to effective gross income.
- Rent rollA rent roll is the unit-by-unit or tenant-by-tenant schedule of who occupies a property, what they pay, and when their lease ends. It is the primary evidence behind every revenue assumption in an underwriting model.
- T-12A T-12 is a trailing twelve month operating statement: every income and expense line a property actually produced over the last twelve months, normally shown as twelve monthly columns with an annual total. It reports what happened, as opposed to what a seller projects.
- Economic versus physical occupancyPhysical occupancy is the share of units that are occupied. Economic occupancy is the share of potential rent that is actually collected. The gap between them is everything that stops an occupied unit from paying full rent: loss to lease, concessions, bad debt, employee units and down units.
- Operating expense ratioThe operating expense ratio is total operating expenses divided by effective gross income. It is a fast sanity check on whether an expense budget is plausible for the asset type, the market and the way the property is run.
- Break-even occupancyBreak-even occupancy is the occupancy level at which a property's collections exactly cover its operating expenses and debt service, with nothing left over. Below it, the property consumes cash instead of producing it.
- Concessions and free rentA concession is rent given away to sign or renew a lease, most often as free months at the start of the term. It is a deduction on the way from gross potential rent to effective gross income, and it is what separates the asking rent on a rent roll from the rent a tenant actually pays.
- Bad debt and credit lossBad debt is contracted rent that was billed and never collected. It is deducted alongside vacancy on the way to effective gross income, and unlike vacancy it does not resolve when the unit is leased, because the unit is already leased.
Capital and reserves
- Capital expenditure versus operating expenseAn operating expense keeps a property running in its current condition and is deducted above the net operating income line. A capital expenditure replaces or improves a component with a life beyond the current year and is deducted below it. Which side of the line an item lands on changes the property's value.
- Replacement reservesReplacement reserves are an annual allowance set aside for the periodic replacement of building components that wear out: roofs, HVAC, appliances, parking surfaces, elevators. They smooth lumpy capital spending into a level annual charge.
- Sources and usesA sources and uses statement lists every dollar going into a transaction and every dollar it pays for, and the two columns have to be equal. Uses are the purchase price plus all the costs of closing and funding; sources are the debt and whatever equity is left to fill the gap.
- Renovation budgetA renovation budget is the funded capital a value-add plan spends to lift rents: the scope and cost per unit, the pace at which units can be delivered, and the rent premium the finished unit is expected to earn. It belongs in the sources and uses at closing, not in operating expenses.
Returns and valuation
- Cap rateA cap rate is a property's net operating income divided by its value or price, expressed as a percentage. It is the unlevered first-year yield on the purchase price and the standard shorthand for what a market is paying for a stream of property income.
- Going-in versus exit cap rateThe going-in cap rate is year-one NOI divided by the purchase price. The exit or terminal cap rate is the rate applied to the forward NOI at the end of the hold to estimate the sale price. The spread between them is one of the largest and least evidenced assumptions in any underwriting.
- Internal rate of returnThe internal rate of return is the discount rate at which the net present value of a deal's cash flows equals zero. It expresses a full investment, including the timing of every contribution and distribution, as a single annualized percentage.
- Equity multipleThe equity multiple is total distributions divided by total equity contributed, expressed as a multiple. A 2.0x means an investor received two dollars back for every dollar put in, counting the original dollar.
- Cash-on-cash returnCash-on-cash return is a year's cash flow after debt service divided by the total equity invested. It measures the current income yield on the money actually at risk, ignoring appreciation and any eventual sale.
- Yield on costYield on cost is stabilized net operating income divided by total project cost, including land, hard costs, soft costs, financing costs and carry. It is the development and value-add equivalent of a cap rate, and the spread between it and the market cap rate is where the profit comes from.
- Positive and negative leverageLeverage is positive when the going-in cap rate exceeds the loan constant, so each borrowed dollar earns more as real estate than it costs as debt service and the levered cash return sits above the unlevered one. It is negative when the constant exceeds the cap rate, and then borrowing lowers the current return.
- Discount rate and net present valueA discount rate is the annual rate at which a future dollar is converted into a present one. Net present value is the sum of a deal's cash flows after that conversion, less the equity invested: positive means the deal beats the rate, and the rate at which it is exactly zero is the internal rate of return.
- Gross rent multiplierThe gross rent multiplier is the purchase price divided by annual gross rent. It is a screening ratio, useful because it needs no expense data at all, and unreliable for exactly the same reason.
- Price per unit and price per square footPrice per unit is the purchase price divided by the number of units; price per square foot divides it by rentable area instead. Both are comparison shorthand rather than valuation methods, and they disagree with each other whenever unit sizes differ.
- Stabilized NOIStabilized NOI is the net operating income a property produces once the business plan is finished: renovations delivered, lease-up complete, concessions burned off, rents at plan. It is the income a yield on cost is measured against and the income an exit value is usually built from.
- Sensitivity analysisSensitivity analysis re-runs a model across a range of values for the assumptions that carry the outcome and reports how far the answer moves. Its purpose is to identify which two or three inputs the deal actually depends on, so that those get the evidence and the rest do not.
Debt and financing
- Debt service coverage ratioThe debt service coverage ratio is net operating income divided by annual debt service. A 1.25x means the property produces $1.25 of income for every $1.00 of principal and interest owed, so net operating income could fall by 20 percent before coverage reaches 1.00x and the loan stops being covered.
- Debt yieldDebt yield is net operating income divided by the loan amount, expressed as a percentage. It measures the return a lender would earn on its loan if it took the property back and operated it, and unlike DSCR it is unaffected by interest rate, amortization schedule or loan term.
- Loan to valueLoan to value is the loan amount divided by the property's value, expressed as a percentage. It is the most familiar leverage constraint and, on a purchase, is normally tested against the lesser of the appraised value and the purchase price.
- Loan to costLoan to cost is the loan amount divided by total project cost. It is the leverage constraint used on construction and heavy value-add loans, where the property has no stabilized value to lend against and cost is the only verifiable basis.
- Loan constantThe loan constant is annual debt service divided by the original loan balance, expressed as a percentage. It combines the interest rate and the amortization schedule into one number, which is what makes it the right rate to compare against a cap rate.
- Interest-only periodAn interest-only period is a stretch at the start of a loan during which the borrower pays interest and no principal. It raises early cash flow and coverage, and it ends with a step up in debt service that has to be modeled.
- Loan sizingLoan sizing is the process of determining the maximum loan proceeds a property supports. A lender runs three independent tests, a loan-to-value cap, a minimum debt service coverage ratio at a stressed rate, and a minimum debt yield, and lends the lowest of the three.
- Yield maintenance and defeasanceYield maintenance and defeasance are the two standard mechanisms that make a fixed-rate commercial mortgage expensive to repay early. Yield maintenance charges the lender's lost interest as a lump sum; defeasance substitutes a portfolio of government securities for the property as collateral.
- AmortizationAmortization is the repayment of loan principal through the regular payment, computed over a schedule that is usually much longer than the loan term itself. It is cash leaving the property that never appears as an expense, and the length of the schedule decides how much of it there is.
- Cash-out refinanceA cash-out refinance replaces an existing loan with a larger one and distributes the difference, after costs, to the owner. The new loan is sized by the same three tests that size any loan, applied to the property's income on the refinance date rather than at purchase.
- Mezzanine debtMezzanine debt sits between the senior mortgage and the equity: repaid after the senior loan and before the equity, priced above the mortgage and below equity, and normally secured by a pledge of the ownership interests rather than by a mortgage on the property.
- Bridge loanA bridge loan is short-term, usually floating-rate debt that carries a property while its business plan is executed and is repaid by a sale or a permanent loan at stabilization. It funds capital in draws and carries an interest reserve, because the property cannot yet cover its own debt service.
Leasing
- Tenant improvements and leasing commissionsTenant improvements are the landlord's contribution to fitting out a space for a tenant, quoted per square foot. Leasing commissions are the brokerage fees paid on a signed lease, quoted as a percentage of the rent over the term. Together they are the cost of putting a tenant in place, and they are capital, not operating expense.
- Lease rolloverLease rollover is what happens when a lease expires: the tenant renews, or leaves and the space sits empty until a new tenant is found and fitted out. Modeling it means applying a renewal probability, downtime, leasing capital and a new market rent to every expiring lease.
- Weighted average lease termWeighted average lease term is the average remaining term across a property's leases, weighted by either rent or leasable area. It is the standard single-number summary of how long a commercial property's income is contracted for.
- Triple net and expense recoveriesUnder a triple net lease the tenant pays base rent plus its share of the property's taxes, insurance and common area maintenance. Expense recoveries are the mechanism that bills those costs back, normally as a pro rata share based on the tenant's proportion of the building's leasable area.
- Expense stop and base yearIn a gross or modified gross lease, an expense stop is the level of operating expenses the landlord absorbs, with the tenant reimbursing everything above it. A base year stop sets that level equal to the actual operating expenses in the lease's first calendar year.
- Percentage rentPercentage rent is additional rent a retail tenant pays based on sales above a threshold called the breakpoint. It gives the landlord participation in a tenant's success while keeping base rent at a level the tenant can carry in a weak year.
- Expense gross-upA gross-up provision restates a building's variable operating expenses to what they would have been at a stated occupancy, usually 95 or 100 percent, before recoveries are calculated. It exists so that a tenant's reimbursement measures expense inflation rather than how full the building happened to be.
- Renewal probabilityRenewal probability is the assumed chance that an expiring tenant stays rather than leaves, applied lease by lease. It blends the two very different outcomes of an expiration into one expected cash flow, and it is usually the single most valuable assumption in an office, retail or industrial model.
- Load factorThe load factor is the percentage by which a tenant's usable area is grossed up to a rentable area for rent purposes, covering its share of lobbies, corridors, restrooms and mechanical space. Rent is charged on the rentable figure, so two buildings quoting the same rate per foot are not quoting the same rent.
Partnership economics
- Preferred returnA preferred return is a threshold rate of return that limited partners receive on their capital before the general partner participates in profits beyond its own pro rata share. It is a priority in the distribution queue, not a promise that the money will be there.
- Distribution waterfallA distribution waterfall is the ordered set of tiers that determines how cash is split between limited and general partners. Each tier is filled completely before any money reaches the next one, and the general partner's share rises as it goes.
- PromoteThe promote is the general partner's share of profits in excess of its pro rata capital contribution, earned once the limited partners have received their capital back plus the preferred return. It is the performance compensation in a real estate partnership.
- GP catch-upA general partner catch-up is a waterfall tier in which the general partner receives most or all of the distributions after the preferred return has been paid, until it has received its full promote percentage of all profit distributed so far. It restores the economic bargain the preferred return interrupted.
- ClawbackA clawback requires a general partner to return promote it has already been paid when the final result shows it was not earned. It exists because deal-by-deal waterfalls pay promote on the winners before the losers are known.
- Capital callA capital call is a demand on partners to fund committed equity, at closing or in stages as the business plan needs it. Calling capital later rather than all at once raises the internal rate of return without changing the equity multiple, and failing to fund a call carries penalties written into the operating agreement.
Tax
- DepreciationDepreciation is the annual deduction that lets an owner recover the cost of a building over a fixed period set by statute. It reduces taxable income without reducing cash flow, which is why after-tax returns on real estate exceed pre-tax returns more often than in most asset classes.
- Depreciation recaptureDepreciation recapture is the portion of the gain on sale attributable to depreciation previously deducted, taxed at a rate above the long-term capital gains rate. For real property the recaptured amount is unrecaptured section 1250 gain, subject to a statutory rate cap of 25 percent.
- Cost segregation and bonus depreciationA cost segregation study reclassifies parts of a building into shorter-lived asset categories, typically five, seven and fifteen year property. Bonus depreciation then allows a percentage of that reclassified basis to be deducted immediately rather than over the shorter schedule.
- Section 1031 exchangeA section 1031 exchange lets an owner defer capital gains tax and depreciation recapture on the sale of investment real property by reinvesting the proceeds into like-kind replacement property within statutory deadlines. It is a deferral, not a forgiveness: the deferred gain carries into the basis of the new property.
- Passive activity lossA passive activity loss is a tax loss from an activity the taxpayer does not materially participate in, which rental real estate generally is. Those losses can normally offset only passive income, and any excess suspends and carries forward until there is passive income to absorb it or the activity is sold in a fully taxable disposition.
A to Z
- Amortization (Amortization schedule)
- Bad debt and credit loss (Bad debt)
- Break-even occupancy (Break-even ratio)
- Bridge loan (Bridge financing)
- Cap rate (Capitalization rate)
- Capital call (Capital contribution)
- Capital expenditure versus operating expense (CapEx)
- Cash-on-cash return (Cash yield)
- Cash-out refinance (Refinance proceeds)
- Clawback (Clawback provision)
- Concessions and free rent (Concessions)
- Cost segregation and bonus depreciation (Cost seg)
- Debt service coverage ratio (DSCR)
- Debt yield
- Depreciation (Cost recovery)
- Depreciation recapture (Unrecaptured section 1250 gain)
- Discount rate and net present value (NPV)
- Distribution waterfall (Waterfall)
- Economic versus physical occupancy (Economic occupancy)
- Effective gross income (EGI)
- Equity multiple (EM)
- Expense gross-up (Gross-up provision)
- Expense stop and base year (Base year stop)
- Going-in versus exit cap rate (Terminal cap rate)
- GP catch-up (Catch-up)
- Gross potential rent (GPR)
- Gross rent multiplier (GRM)
- Interest-only period (IO period)
- Internal rate of return (IRR)
- Lease rollover (Rollover)
- Load factor (Common area factor)
- Loan constant (Mortgage constant)
- Loan sizing (Debt sizing)
- Loan to cost (LTC)
- Loan to value (LTV)
- Loss to lease (LTL)
- Mezzanine debt (Mezzanine)
- Net operating income (NOI)
- Operating expense ratio (OER)
- Other income (Ancillary income)
- Passive activity loss (PAL)
- Percentage rent (Overage rent)
- Positive and negative leverage (Negative leverage)
- Preferred return (Pref)
- Price per unit and price per square foot (Price per unit)
- Promote (Carried interest)
- Renewal probability (Renewal rate)
- Renovation budget (Renovation program)
- Rent roll
- Replacement reserves (Reserves for replacement)
- Section 1031 exchange (1031 exchange)
- Sensitivity analysis (Sensitivity table)
- Sources and uses (Sources and uses statement)
- Stabilized NOI (Stabilization)
- T-12 (Trailing twelve)
- Tenant improvements and leasing commissions (TI and LC)
- Triple net and expense recoveries (NNN)
- Weighted average lease term (WALT)
- Yield maintenance and defeasance (Prepayment penalty)
- Yield on cost (YOC)
Keep reading
Put the vocabulary to work
Drop in an offering memorandum and a rent roll.