As with any industry, the world of healthcare real estate as a subset of commercial real estate has its own language—terms, concepts and calculations—that help investors evaluate properties and analyze opportunities. Although not comprehensive, the below list briefly defines some of the basic terms in the industry. An understanding of the concepts underlying these terms is a starting point to help you evaluate the performance of a property.
Sale-leaseback: An arrangement in which a commercial real estate owner occupant sells the property he or she is occupying and simultaneously leases the property back from the new owner. In a healthcare real estate transaction, for example, a healthcare organization may sell its property to a third-party investor and lease the property from the investor upon the sale. This arrangement allows the healthcare organization to maintain operational control of the property and unlock capital that can be redeployed to other areas, such as into the investment or expansion of the medical practice.
NNN Lease vs. Gross Lease: In commercial real estate, leases are structured based on who pays the expenses on the property. In general, a triple net (NNN) lease is one in which the lessee pays a base rental rate and is responsible for additional expenses which usually included property taxes, property insurance and common area maintenance (CAM).
With a gross or “full-service” lease, the tenant pays a fixed base rent, and the owner is responsible for paying the property expenses. A modified gross lease is a hybrid arrangement in which the owner pays some expenses, and the tenant pays some expenses.
Because the terminology defining lease structures can vary by submarket and even among commercial real estate professionals, refer to the lease language to determine who pays for what expenses and how those expenses are calculated and paid.
Rent Escalation: A term in a lease specifying how and when rent will increase over time.
Net operating income (NOI)
Formula:
Effective gross income (gross income – vacancy) – operating expenses = Net operating income
Formula Explained: Net operating income or NOI is a formula used to measure the performance of a property. It’s defined as effective gross income minus operating expenses. Effective gross income is the potential gross income minus vacancy and credit losses. NOI measures net income of a property (before debt service is paid).
Capitalization Rate
Formula: Net operating income/Sales Price (Value)
Formula Explained: The capitalization or “cap” rate is a formula used to measure the profitability of a real estate investment. It is calculated by taking a property’s net operating income and dividing it by its sales price (value). In other words, it’s a ratio of the NOI to the property’s value. It does not account for debt service. If for example, a property has an 8% cap rate, an investor will expect an 8% return on his investment if he or she paid all cash. A cap rate allows an investor to compare different investment opportunities across markets and asset classes by quickly evaluating the cash flow potential presented by the opportunity. It is an initial step in a more detailed underwriting of the asset.
Cash-on-Cash Return
Formula: Annual Cash Flow/Initial Cash Invested
Formula Explained: Cash-on-cash return is a formula used to analyze the profitability of a property by measuring the cash flow in relation to the initial cash investment made to purchase the property. It measures how much of the initial cash investment is returning to the investor each year.
Operating Expenses: Expenses incurred in operating and maintaining a property. These expenses include: property taxes, insurance, maintenance and repairs, administrative fees, payroll, landscaping, utilities and supplies.
Operating expenses do not include debt service or capital expenses.
Debt Service: This is the cash required to pay the principal and interest on a mortgage. Annual debt service would be calculated as monthly mortgage (principal and interest) x 12 months.
Cash Flow:
Formula: Net operating income – debt service
This formula, which can be calculated on a monthly or annual basis, represents the net cash left over after subtracting debt service from net operating income.
Vacancy Rate: The number of vacancies/total number of units. It represents how many units/suites in a property are unrented.
Effective Gross Income: Gross income – vacancy rate. This is the amount of income a property is projected to generate considering revenue lost from unpaid rents or vacancy. Formula: Gross Income – (Vacancy Rate x Income)
Gross Income: Income from all sources, including rents, fees, laundry facilities, vending machines, concierge services.