Ch 5, Unit 11

Investing in nonresidential properties

Advantages of Commercial or Industrial Investment Nonresidential property investment has several advantages: -If a property has a long-term lease with a strong tenant, the likelihood of a steady income is strong. Commercial and industrial ownership offers the advantage of greater stability of tenants as well as potentially low vacancy rates when compared with residential income properties. -Most commercial leases contain either a cost-of-living increase or a percentage lease. This allows an owner to take in increased rents as operating costs mount. If the property is in a prime location, the success of the business results in a high percentage of the gross and therefore increased rents to the owner-investor. -When a city is growing, the demand for commercial properties grows, which gives an owner-investor increased rents. -Unlike apartment properties, there is very little risk of any kind of rent control. -Business tenants are generally easier to deal with than apartment house tenants. -Lease insurance is available which protects both the owner and the tenants if business is interrupted because of such things as fire, storm, earthquake or other hazards.

Generating income

All the property types we have talked about can generate income by renting their space. For example, most businesses need office space to run their operations. Most often, these businesses decide to lease the space instead of owning the building. Reasons to Lease There are some important reasons why a business would choose to lease space rather than purchase the building. Most tenants find leasing to be more cost-effective than owning. This is especially true when a business owner requires less space than the amount of space he or she would have to purchase in order to satisfy the business needs in a preferred location. For example, suppose that a tenant requires 10,000 square feet of space to operate his business and the space must be in a specific location. However, the only buildings available in that location have a minimum of 50,000 square feet. In this case like this a user would prefer to lease 10,000 feet of space rather than purchase 50,000 feet of space and not have to worry about leasing an additional 40,000 square feet that the business may not need. In an example such as this, purchasing is not usually a good idea because: -Owning would require a large capital outlay to purchase the 50,000 square feet when that money could be used for other business purposes. -In addition, the purchaser would have to lease, collect rents, maintain and insure the additional space that it does not use. Other reasons that the business in our example might choose to lease even if it could occupy the entire 50,000 square feet are: -Owning a building would reduce the flexibility of the business. For instance, if the business wanted to move it might have to sell the property, which could take a long time and tie up their staff and their capital. When the property is leased, the business could move when the lease expires or even renegotiate a release from the lease. -When a business owns the property, it must operate, maintain and repair the building. Engaging in these activities could cause the business to lose focus on its major business activities. -If the business decided it wanted to downsize from using the 50,000 square feet, the building owner would have to find someone to use or purchase the excess space. In such a case, the owner might have to renovate the space to meet the requirements of the new tenants. Again, this activity distracts the business from its primary focus. A particular building's potential for generating income depends on two factors: -Its ability to attract tenants to rent space -The expenses involved with the building's operation

Lease terms for different property types

As with residential properties, income properties are usually leased to tenants for a designated time period. We discussed the types of leases and their terms in an earlier unit, so we won't go into detail about that here. Different property types customarily have different lease terms. Hotel and motel rooms typically rent on a daily basis. Homes and apartments are usually leased on a yearly basis, although leases could be longer or shorter. The terms are usually renegotiated when the lease expires. Space in office buildings tends to be leased for a three to five year term. Often the tenant has the option to lease for an additional three to five year term. As we discussed in an earlier unit, leases may include provisions for rent increases as step ups or as an inflation adjustment tied to the Consumer Price Index. Tenants must also share in the payment of expenses such as property taxes, insurance, and maintenance. As you might imagine, office rents vary by location within the property itself. An owner could choose to charge higher rents for the following spaces: -Ground floor offices, transfer points or offices near elevators -Higher floors with good views -Corners of the building On the other hand, an owner could choose to discount the rent for the following spaces: -Middle floors or space far from elevators -Offices with poor or obstructed views -Nonadjacent space - for example having part of the business on one floor and the rest on another floor

Commercial properties

Commercial real estate can be further subcategorized into office buildings, retail space, and hotels/motels. Let's take a look at each of these subcategories. An office building can be a major multi-tenant building that you would find in the central business district of a large city. Or it can be a single tenant building, sometimes built for a specific tenant's needs, such as a medical office building near a hospital. Retail properties can be large regional shopping centers, with millions of square feet of space. Or they can be small stores with individual tenants that you see in the downtown areas of most cities and towns.

Commercial properties - hotels and motels

Hotels and motels vary considerably in size and what facilities they have available. Motels and smaller hotels attract mainly business travelers and families who want to spend the night. These properties have just a few amenities and are often located very close to a major highway. Hotels intended for tourists who plan on longer stays will usually have restaurants on site, a swimming pool and other amenities. Typically, these hotels are located near other attractions that a tourist might want to visit. Hotels that are located at resorts provide the most amenities. The resorts themselves are away from major cities and the guests usually stay for several days or even several weeks. The facilities that these resort hotels offer can be quite deluxe and include several restaurants or dining rooms, swimming pools, tennis courts, golf courses, etc. Hotels that host conventions may be popular destination resorts or may be located near the hub of a large city. People who go to conventions usually want a variety of choices for dining and want to be able to add some pleasure to their business experience. In some cases, a commercial building can contain both office and retail space. In other cases, that same building could even have residential units. When the uses for one property are combined, we refer to that as a mixed-use development.

Market rent

In addition to the demographic makeup of the population and the median income of families in a particular area, the market rents for retail space will depend on the percentage of income families in the area usually spend on the purchase of goods and services from the retail companies in their area. Since real estate has a relatively long economic life, market rents can change repeatedly over the economic life of a building. Market rents can change due to variations in the demand for space from potential tenants and fluctuations in the supply of space as new units are added or other units are removed from availability. These unpredictable changes can significantly affect the amount of rental income a property will receive over time. In light of this, anyone interested in purchasing income-producing property as a real estate investment must think about how changes in the supply and demand for space might affect market rental rates over the economic life of the property.

Vacancy

In many cases, at any particular point in time all the space that is available in a building may not be leased. Some tenants leave after the lease has expired. In a few situations, tenants even walk away from their lease before it expires. In cases of newly-constructed buildings, some of the space may not yet have been rented. In order to determine how much income a property may bring, an 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. The investor must always allow for periods of vacancy in the projections, even if the leasing activity is strong. When a current tenant leaves, the owner needs time to make the space ready for new tenants. Therefore, an investor must take into account and plan for some loss of rent during the holding period. Predicting vacancies for new buildings is more difficult. Even though some tenants sign their leases before the project is completed and ready for occupancy, it's often the case that parts of the building will remain unoccupied for a period of time after it's completed. So an investor must try to predict how long it will take for the remaining unoccupied space to be leased in the current market, knowing that the longer it takes to rent the space, the less income he or she will receive during the early years of the project. Because the time period it takes to bring the rental up to normal levels affects cash flow, it will also have an important effect on the investment value of the property.

Other nonresidential properties

Industrial and warehouse properties comprise buildings used for light or heavy manufacturing, in addition to any associated warehouse space. This category includes special-purpose buildings designed specifically for an industrial use that would be difficult to convert to another use. It also includes buildings that wholesale distributors use and warehouse/show room/office combinations. Often older buildings that were initially designed and used as office space later become available for warehouse or light industrial use. Agricultural property includes land used primarily for growing crops or raising livestock, such as farms, pastureland, orchards and timberland. Recreational real estate includes country clubs, marinas, sports complexes, parks, forests and campgrounds. These are very specialized uses and sometimes also have retail space that compliments the recreational activity, for example a golf shop at the country club or a convenience store at the campground. Depending on the level of recreation available, restaurants and possibly hotel facilities may also be at the site or nearby. Most institutional real estate has a unique use to the persons who own and use it, such as a government agency, a church, a hospital or a university. The physical construction could be similar to other properties. For example, a government office building might be similar to other office buildings and could, in fact, be in the same building as other offices. However, space that is used by universities, churches and hospitals is usually ear-marked for a specific function and would not be easily tailored to other uses.

Lease terms - industrial and agriculture

Many industrial properties have special-purpose buildings. Because of this special use nature, leases are usually individualized. Most leases have a three to five year term, although many tenants prefer longer-term leases, especially when they are installing expensive equipment that would be very difficult to move. Most industrial leases are net leases. An owner could choose to charge higher rents for the following spaces in an industrial or warehouse complex: -Space near the entrance to the park -Space near interstates or railroads On the other hand, an owner could choose to discount the rent for: -Space with poor entrance or exit -Space where traffic flow is poor Agricultural leases can vary depending on the use of the property. Leases for hunting rights are typically shorter than farming leases - hunting leases are usually for one year while farming leases typically last three or more years. Many of the terms for agricultural leases are the same as those we've already discussed. However, most farming leases need to address the issue of environmental concerns. While in the event of an environmental problem the owner is ultimately responsible, it's important that the tenant agree in the lease to adhere to appropriate and accepted farm practices and legislation relating to the environment, such as manure disposal and pesticide and herbicide applications.

Net operating income

Net operating income or NOI is the term that describes the net income produced by a specific property after all expenses have been deducted from the gross receipts. Several factors affect the net operating income. -Market rent -Vacancy -Expenses Market Rent Market rent, also known as economic rent, is the price that a specific type of property is likely to draw under the current market conditions. The market rent could be higher or lower than the amount the property is actually renting for under its current lease. The rent depends on several factors: -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 space For example, the market rent on an office building will depend on several factors: -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 employee to do their job It can be very difficult to estimate these issues because they may depend upon some uncertain and complex aspects of a firm's operations. For example, due to continuing technological advances or other changes in operations, the number of employees or the amount of space that a firm needs could be significantly different today and again in the future than it was in the past.

Disadvantages of commercial or industrial investment

Nonresidential property investment also has several disadvantages: -During times when many buildings are being built, the market can become flooded with unused commercial space. This would result in lower rents and poor investment returns. -Investing in older buildings can be risky, because tenants may tend to move to newer facilities creating vacancies which could take a long time to fill. -Changes in neighborhood patterns could result in a commercial building becoming less desirable, remaining vacant and possibly becoming subject to vandalism. If a commercial enterprise has a long-term lease with fixed rental rates, the new owners are forced into receiving a fixed income during a time when taxes and other expenses continue to rise. -Local governments often require owners to add expensive safety improvements to buildings. This can result in a substantial amount of capital outlay for the investor.

Arriving at NOI

Once an investor has estimated the market rent for property, its vacancy rate, and operating expenses, he or she can calculate the potential Net Operating Income that he or she can receive from the property. This estimate assumes that the space is rented at current market rents. Note: It is important for an investor to understand that some of the space in a property may have already been leased to tenants at a rate that is higher or lower than current market rents. This situation would impact the NOI the investor receives from the property. Existing leases can have a significant impact on the property's income potential, especially since many commercial leases extend for terms of 3 -5 years or, in some cases, for 10 years.

Lease term - retail space

Retail space leases vary considerably. If the business is small, the tenant may lease space for only one or two years. Larger businesses may be willing to commit to much longer lease terms. Most shopping centers have percentage leases with minimum rents. Retail properties are subject to many changing trends. In addition to rent and expenses, retail leases often contain provisions that affect how tenants may or may not operate their businesses. This is because most retailers will be operating their businesses close to other retailers. Furthermore, some tenants may have the right to approve leases being negotiated with competing retailers. Retail leases with some tenants may also prohibit leases to certain other tenants that may be considered incompatible or that may detract from or interfere with the operations of the existing retailers.

Property types

There are several kinds of property that exist in real estate markets, but in effect, they fall into two major classifications: residential and nonresidential. Residential properties include single-family homes and multiple-family properties such as apartments, condominiums, and co-ops. By definition, residential properties provide dwelling places for individuals or families. Although, in fact, hotels and motels sometimes provide residences for people, they are considered to be only temporary, so they are not classified as residential property. Economic factors that affect supply and demand for hotels and motels are very different from those that affect properties designed to be permanent homes. Single-family homes are characterized as detached units found in subdivisions, neighborhoods or in cluster home developments, where the owners share outdoor and common areas. Another category of residential housing is income-producing and is referred to as multifamily housing. Multifamily housing is usually distinguished by its location, whether it's urban or suburban, and its size, whether it's a high rise, a low rise or garden apartments. Nonresidential properties are broken down into five major subcategories: -Commercial -Industrial -Agricultural -Recreational -Institutional Most real estate agents deal more frequently with residential properties because they are more common. But handling commercial properties can be an exciting part of a real estate career. In this unit, we'll be discussing the aspects of commercial and other nonresidential properties.

Expenses

There are two kinds of expenses that are normally associated with income properties: variable expenses and fixed expenses. Variable expenses fluctuate according to the degree of occupancy. Here are some examples. -In most cases, management fees are based on a percentage of the rental income. -Utility expenses - water, electricity, gas - typically fluctuate according to the number of tenants in the building at a given time. (However, many utility companies charge a minimum amount, even for a vacant building). -Expenses for cleaning specific rooms used by the tenants depend on how many tenants are using different areas of the building at any given time. Fixed expenses do not fluctuate. Here are some examples of fixed expenses. -Real estate taxes - The assessed value of the property determines the real estate taxes. -Insurance premiums - The replacement cost of the project determines the insurance premiums that the investor will pay. -Repairs and maintenance - These expenditures are usually incurred after a tenant leaves and the space must be made ready for the next tenant, so they are relatively fixed. -Advertising and promotion - an investor can set a weekly or monthly budget for these types of expenses. Categorizing expenses in this way makes it easier to estimate future expenses, by showing how different categories of expenses may change over time and how changes in occupancy can affect expenses.