Real Estate Finance – Unit 12 (Commercial Income)

Commercial Properties – Office building – Retail Properties – Hotels and motels – Industrial and warehouse – Agricltural Property- Most institutional real estate
Office Building – Major tenant building. Or single tenant building, sometime built for a specific tenant’s needs such as medical office near a hospital.
Retail Properties – Shopping centers with millions of square feet of space- Or small stores with individual tenants that you see in downtown areas of most cities and towns
Hotels and motels – Mainly attract business travelers and families who want to spend the night. – Hotels: tourists who plan, typically located near other attractions that a tourist might want to visit. – Resorts are away from cities, and guests usually stay there for days even weeks.
Mixed-use development – Some commercial building can contain both office and retail. Some cases building could even have residential units. When the uses for one property are combined its called Mixed-use development
Industrial and Warehouse – Special purpose buildings designed specifically for an industrial use that would would be hard to convert to another use. – Often, older buildings that were designed for office use tends to become light industrial use or a warehouse.
Agricultural Property – Land primarily for growing crops or livestock like farms, pastureland, orchards, and timberland.
Recreational Real Estate – Country clubs, marinas, sport complexes, parks, forests, and campgrounds. – Sometimes have retail space that complements the recreational activity like a golf shop or convenience store at campground
Institutional Real Estate – Unique use to people who own and use it. – Government agency, church, hospital, or university. – Physical construction could be similar to other properties but space that is used by universities, churches, hospitals are usually ear-marked for a specific function and would not be easily tailored to other uses.
Reasons to Lease – Most tenants find leasing to be more cost-effective than owning. – Owning would require a large capital outlay to purchase 50,000 square feet, when money could be used for other business purposes. – Purchase would have to lease, collect rents, maintain and insure the additional space that it does not use- Owning a building would reduce flexibility of the business (if business wanted to move) – When business owns property, must operate, maintain and repair the building. – If wantd to downsize from using 50,000 square feet the owner would have to find someone else to buy the extra space.
Building’s potential for generating income depends on two factors: – It’s ability to attract tenants to rent space- The expenses involved with the building’s operation
Net operating Income (NOI) – net income produced by a specific property after all expenses have been deducted from the gross receipts. Factors effect net operating income: – Market rent – Vacancy – Expenses
Market Rent – (aka economic rent) – price that a specific property is likely to draw under the current market conditions. Could be higher or lower than amount the property is actually renting for under its current lease. – Depends on:- National economic outlook- Economic base of the property’s surrounding area – Demand for the type of space the particular property provides in the local area – Availability and supply of similar competitive spaceEx: Market rent on an office building depends on:- How many similar firms are doing business in the area – How likely it is that new firms will locate to the area – How many employees are currently employed or will be employed in the near future. – How much space the firm needs for its employees
Market rent on apartments depends: – Demographic makeup of area’s population- Median income of families in the property’s location – Availability of homes or condos to purchase in local area – Cost of those available homes or condos- Market rent can change over the economic life of a building. – changes can significantly affect the amount of rental income a property will receive over a time. – Anyone interested in purchasing income-producing property must think about changes in the supple and demand for space might affect market rental rates.
Vacancy – To determine how much income a property may bring, investor must try to predict how much of the space will be occupied by tenants during the time period the investor expects to hold the property.
Expenses Variable Expenses – fluctuate according to the degree of occupancy. Field Expenses – do not fluctuate
Variable Expenses – Management fees are based on percentage of rental income. – Utility expenses – water, electricity, gas- Cleaning specific rooms used by tenants depend on how many tenants are using different areas of the building.
Field Expenses – Real Estate taxes – assessed value of property determines real estate taxes – Insurance premiums – Replacement cost of the project determines insurance premiums that investor will pay. – Repairs and maintenance – expenditures are usually incurred after a tenant leaves and space must be ready for next tenant. – Advertising and promotion – Investor can set a weekly or monthly budget for these types of expenses.
Arriving at NOI – Once investor estimated market rent for property, vacancy rate, and operating expenses, they can calculate the potential net operating income that they will get.
Check Your Understanding 1) What are subcategories of commercial real estate?- office buildings, retail space, and hotels/motels. 2) What makes institutional real estate different from other types?- Unique to the persons who use it – government agency, church, hospital, or university and wouldn’t be easily tailored to others. 3) Three reasons why a business might prefer leasing over purchasing property?- More cost effective than purchasing – More flexible option if decides to move to different location – Involves operation, maintenance, and repair of building4) What factors affect net operating income?- Market rent – Vacancy- Expenses
Leases – Income properties are usually leased – Lease assigns rights, duties and responsibilities between the owner and the tenant. – Evaluating financial ability of tenants is very important. – Owner must also understand tenant’s business, competitive position int the industry, and the health of the industry itself. – Owner should consider the following:- Financial Statements – Credit Ratings – Analyst reports on the firm or the industry- Bank relationships – Existing obligations, debts, and other leases the tenant may have – Underwriting the lease is a very critical aspect of risk assessment because it affects the cash flow which is it’s value – If tenant files for bankruptcy, tenant may be allowed to continue to occupy the space and conduct business while paying little or no rent during reorganization process.
Lease Contents – Contains legal considerations that are intended to guard the interests of both the owner and the tenants over the life of their association. Leas agreement usually includes:- Date of agreement – Starting date and length of the lease – Parties to the lease – Description of the leased space – Description of how property can be used – Description of any restrictions regarding alterations or improvements – Restrictions that may exist on operation of the tenant’s business – Restrictions regarding assignment or subleases of property – Use of common areas and facilities – Requirements for liability insurance – Method for handing delinquent payments 0 Conditions for surrendering the premises – Amount of rent – Method that will be used to calculate additional rent – How expenses will be divided between the owner and the tenant – Any allowances for improvements that will be made by the tenant but paid for by the owner – Any lease renewal options- Any right of refusal to release the space – Any equity participation that tenant may have in ownership of building- Tenant relocation options.
Calculating Rent and Determining Increases – Leases typically last up to 10 years. – Initial rent that tenant pays under a lease contract is usually a precise dollar amount – BASE RENT – Base rent depends on what method owner uses to calculate rent. Rent Calculation methods: – Flat lease – Step Up – Indexed – Percentage Rent
Flat Lease – Rents may remain the same. Common in apartment leases. May apply to relatively short terms
Step-Up – Spells out how rent will increase periodically and gives the specific amounts and specific dates of those increases. – Tenant knows exactly how much the rent will be. – Common in office, warehouses, and retail leases.
Indexed – Using a specified index like the Consumer Price Index (CPI) – Rent changes according to the particular index. – More riskier but since it ties increase in rent to the level of inflation, it tends to preserve the real value of the lease payments.
Percentage Rent – Commonly used for shopping centers. – Based on partially the tenant’s sales volume – There is a minimum rent and if the sales volume exceeds a certain amount, the owner calculates rent on percentage of the amount. – CALCULATED AMOUNT – CALLED OVERAGE RENT
Defining Expense Responsibilities – Gross lease: – Owner pays all of the operating expenses, and tenant has no responsibility for these expenses. Owner bears the risk of all unexpected changes in operating expenses – Net Lease: – Tenant pays the operating expenses. (A full service lease). Management fees are still paid by the owner. Triple net lease – requires tenant to pay fixed expenses of property taxes, insurance, and maintenance in addition to other operating expenses and rent. Tenant bears entire risk of all unexpected changes in the operating expenses.
Pass through expenses – Shared between owner and tenant. – Benefit of this lease arrangement to the owner is that only increases in expenses are passed through to the tenants, but any decease in expenses is kept by the owner.
Offering Lease Concessions – Lower the rental rates. Ex: Lease can contain a free rent period- Usually written into leases during period of time when there is more than a normal supply of rentable space in the area. – This method allows owner to collect higher rents in later years of the lease. – Another concession: Owner agrees to pay for any improvements the tenant makes to the property.
Proposing an Equity Participation – Owners might offer equity interest in the building when market is soft, to attract tenants. – Provides a hedge against changes in the cost of leasing the space, since tenant is partial owner of building.
Less Renewal Option – Allows tenant to renew lease for specified rent amount when lease expires. – Only valuable if renewal rate is below market rates, if it’s not below, it is not a good value for tenant.
Right of First Refusal – Option tenant has right at end of term to renew the lease at current market value to get priority over new tenants. Also, sometimes has option to rent out space adjacent to their own when needing to expand. – Risk for owner, cause opening it to “new blood” could improve the property if new tenant has an upscale image and could attract other tenants. Example, shopping enter, a new upscale tenant might attract more shoppers to the shopping center, increasing the percentage rates which owner will get.
Tenant Relocation Option – Option allows owner to relocate tenant to another space in same building. – Advantage to owner. Disadvantage to tenant cause relocation costs and may be in less desirable part of building.
Lease Terms for Different Property Types – Hotel and motel rooms – rent on a daily basis – Homes and Apartments – Usually leased on a yearly basis- Office buildings – tends to lease for 3-5 year term.
Office rents vary by location within property itself. Owner could charge higher rents for: – Ground floor offices, trandfer points or offices near elevators- Higher floors with good views – Corners of the building Discount rent for:- Middle floors or space far from elevators – Poor or obstructed views – Nonadjacent space – having part of business on one floor and rest on another floor – Retail space leases vary considerably. Smaller business smaller terms, larger business may be able to commit to larger terms
Lease Terms for Different Property Types Industrial properties – Many have special purpose buildings so leases are usually individualized. Tenants often want long term leases and most leases are net leases. – Owner can charge higher rents for following spaces in an industrial or warehouse complex: – Space near the entrance to the park – Space near interstates or railroads Owner can discount: – Space with poor entrance or exit – Space where traffic flow is poor.
Agricultural Leases – Leases for hunting rights are usually shorter than farming leases. – hunting: usually one year, Farming – last three or more years. – Most farming leases need to address environmental concerns. Important that tenant agree in lease to adhere to appropriate and accepted farm practices and legislation like manure disposal.
Check Your Understanding 1) List five items normally contained in a lease Date of agreement – Starting date and length of the lease- Parties to the lease – Description of how property can be used. 2) What is a step-up lease? – A lease containing a provision that rent will increase periodically and gives specific amounts and specific dates of those increases3) Describe difference between a gross lease and a net lease. – Gross lease: Owner pays for all of the operating expenses and tenant has no responsibility for those expenses. – Net lease: tenant pays the operating expenses 4) Why might tenants leasing industrial property prefer to have very long term leases?- If they are installing expensive equipment that would be very hard to move.
Using an Operating Statement to Determine Cash Flow – Investor will choose property based on the certainty of the expected cash flows from ownership or in the long run rom the sale of the property. – Before lender loans money, lender wants some assurance that cash flor form property will be enough to service the debt and positive cash flor will continue over life of the loan.
Operating History – The history and looking of anticipated future changes will affect property’s ability to generate rents. – Analysis of property will also include forecast of changes in property’s market value over the period of time the investor will be holding the property.
Operating Statement – Consists of cash inflows and outflows from operations and include non-operating cash flows, such as those from debt service, income taxes, and capital expenditures.
Gross Rental Income – amount of revenue property would generate if it had no vacancies.
Effective Rental Income – Gross rental income amount first adjusted to include income fro other sources which results in effective rental income
Gross operating Income – It is then further adjusted to reflect any losses fom vacancies or rents that can’t be collected.
Operating expenses – All cash expenditures that are needed to maintain and operate the property. Include property taxes, insurance, utilities, advertising, repairs and maintenance, and other fees.
Net operating income – Difference between gross operating income and the operating expenses.
Debt Service – Principle and interest payments made on a debt over a period of time.
Cash flow before taxes – Subtracting the debt service from the net operating income
Cash flow after taxes – amount of cash that remains after all the operating expenses have been paid, obligations to lender have been satisfied and income tax responsibilities have been met
Estimating Current Operating Results – Best starting point is looking at the property’s recent past operations. – Verify all records by looking at the original documents and comparing the reported operating results with known or predictable outcomes from similar properties in the same neighborhood.
When trying to determining recent gross income, examine list of tenants and leases to find out: – Current rental rates – Number of vacancies – Concessions that the landlords may have extended to the tenants that would make the actual rents less than what they appear on leases.
Estimating current operating costs is two step process: – Identify comparable properties – Compare data to published sources
Identify Comparable Properties – Looking at comparable properties is the most accurate way of estimating a property’s recent operating history. – to be comparable, property must operate in much same way, offer same conveniences as subject property and also be in similar location.
Two physical traits that affect a property’s ability to stay competitive: – Functional Efficiency- Physical Durability
Functional Efficiency Assessment of how well a property doe the job it is supposed to do.
Physical Durability – Calculation of building’s remaining physical life, which is based on how well the building was originally designed couples with how well it has been maintained over its life.
Compare data to published sources – There are published sources of information on operating expenses for different types and sizes of properties which are averages of a group of properties and are not site specific. It is a valuable measure to determine whether other data that been collected is reasonable.
Institute of Real Estate Management (IREM) has these published sources for sale: – Income/Expense Analysis: Conventional Apartments – Income/Expense Analysis: Federally-Assisted Apartments – Income/Expense Analysis: Office Buildings – Income/Expense Analysis: Shopping Centers – Income/Expense Analysis: Condos, Cooperatives, PUDs
Ratio Analysis – Used to determine the reasonableness of operating results that have been reported or forecasted, to help make decisions about purchasing or selling investment property.
Four common ratios: Income Multipliers: relationship between price and either gross or net income. Current price of property is divided by income to give idea of how effective the property is at generating income compared to market price. Operating Ratio: Percentage of effective gross income that is consumed by the operating expenses. Calculated by dividing the operating expenses by effective gross income. Lower ratio more efficient property is. Break Even Ratio – shows percent of gross income required to meet cash expenditures. Calculate by adding debt service to operating expenses and dividing by operating income. too high of a break even ratio would cause lender to be cautious. Debt Coverage measures investor’s ability to pay property’s monthly mortgage payment from cash generated from renting the property. Lender uses this to figure out if property generate enough cash to pay rental expenses plus loan payment. Calculated by dividing the annual net operating income (NOI) by annual debt service.
Check Your Understanding 1) What’s the best way to forecast the future potential benefit of a particular property? – By looking at its past operating history. 2) An investor owns an apartment building with the following figures: – Gross rent – $176,500- Vacancy Estimate – $6,700- Parking Lot Proceeds – $5400- Operating Expenses – $32,800Effective Rental Income (Gross rent) + (Other income) =181,900Gross Operating Income(Effective Rental Income) – (vacancies) = $175,200Net Operating Income(Gross Operating Income – (Expenses) = $32,8003) What is debt service?- Principal an dinterest payments mad eon a debt over a period of time. 4) What two physical traits affect a property’s ability to stay competitive? – Functional Efficiency- Physical Durability

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