4 Must-Know Commercial Real Estate Terms

When I first got started in commercial real estate, sometimes I felt like I was listening to an entirely different language when sitting in meetings, and there’s definitely some industry “lingo” used in the business on a day-to-day basis that you won’t find in a textbook.

So to make sure you’re in the loop when these things come up in meetings, conversations with your manager, or even in an interview, this article walks through four must-know commercial real estate terms (and groups of terms) going into the industry, and what each of these is referring to in the context of CRE.

If video is more your thing, you can watch the video version of this article here:

The Bid-Ask Spread & Price Discovery

The first group of terms here is a pack of two industry phrases, and these are the bid-ask spread and price discovery.

The bid-ask spread is exactly what it sounds like, describing the difference between what property owners are willing to sell their properties for and what prospective buyers are willing to pay for those same properties. This is primarily determined by the current state of the economy, the cost of capital for investors, and future projected performance of the real estate sector as a whole.

When the bid-ask spread is referred to as “wide”, this means that buyers and sellers are far off from one another on what each believes valuations should be in the market, which generally leads to a significant slowdown in transaction activity overall.

And price discovery is directly related to this spread, referring to the time period in which a significant bid-ask spread exists, and a general state of the market when buyers and sellers are struggling to agree on valuations.

When prices have fallen, many sellers won’t be willing to let properties go for a price that’s less than what they could have sold their properties for at the peak of the cycle. However, buyers in the market won’t be able to justify paying these prices given the change in market conditions, which creates a stalemate that prevents transactions from occurring.

Cap Rate Compression & Cap Rate Expansion

The next two terms you’ll want to know are related to the cap rate, or the initial unlevered yield that investors expect to generate on commercial real estate deals, and these are cap rate compression and cap rate expansion.

Cap rate compression refers to decreases in market cap rates, meaning that investors are willing to accept lower initial NOI yields, leading to higher valuations in the market.

Cap rate expansion refers to increases in market cap rates, meaning that investors are requiring higher going-in NOI yields, leading to lower property valuations in the market.

You’ll often hear these terms used when investors are trying to determine a projected sale value within an acquisition analysis, or sometimes when describing how they believe pricing is going to change in the future.

The Risk Premium

The risk premium of an investment refers to the incremental return over the assumed “risk-free” rate of return in the market, which investors will require to justify the risk associated with investing in a deal.

The risk-free rate of return refers to the yield on an investment vehicle that the market believes has very little (or no) default risk, and virtually 100% certainty that investors will receive all of their capital back plus interest payments owed.

In the United States, the risk-free rate used as a benchmark for both debt and equity investors is generally the equivalent-term U.S. Treasury yield, meaning that the 5-year U.S. Treasury rate is generally going to be used as a benchmark for a real estate deal that also has a projected hold period of 5 years.

From there, a risk premium will be added on top of that risk-free rate by an investor when determining a targeted annualized rate of return, in an amount that will properly compensate them for the risk and effort associated with the deal.

Widening Spreads & Tightening Spreads

The risk premium also applies to how lenders price out commercial real estate loans, and the widening and tightening of lending spreads.

Similar to the risk premium that equity investors use to come up with their targeted returns, lenders also price in a risk premium on commercial real estate loans. This risk premium is generally referred to as the spread on the debt, which is also going to be added to the assumed risk-free rate in the market to arrive at an all-in interest rate on a CRE loan.

For example, if a lender is considering making a commercial real estate loan with a 7 year term, that risk-free rate (which is commonly referred to as the index rate for the lender) is also usually going to be the 7-year U.S. Treasury yield.

However, the lender is also going to add a spread on top of that index rate figure, to make sure they’re being compensated for the risk associated with lending on the property.

With interest rate volatility being one of the biggest risks to lenders, volatility in the credit markets can create significant upward pressure on lending spreads. And when spreads increase, this is referred to as spreads “widening”, or “going out”, which commonly occurs when there’s a significant amount of uncertainty in the market.

And when lending spreads decrease, this is referred to as spreads “tightening”, or “coming in”, which tends to happen in normalized market conditions without significant fluctuations in the risk-free rate.

Ultimately, if you hear someone talking about spreads “coming in” or spreads “going out”, this is referring to the risk premium changing on the lending side of the equation, with widening spreads indicating the risk premium is increasing, and tightening spreads indicating the risk premium is decreasing.

How To Learn More About Commercial Real Estate Terminology

If you’re in the process of the commercial real estate job search and want to make sure you’re ready to “speak the language” of commercial real estate during the application and interview process, make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam. This exam covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.

As always, thanks so much for reading, and make sure to check out the Break Into CRE YouTube channel for more content that can help you take the next step in your real estate career.

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