REAL 4000 - DIETZ - EXAM 3

OTHER NEGOTIATED LEASE PROVISIONS: Conditions for Surrender of Premises

"Broom Clean & Good Order & Condition" . . . "Reasonable Wear & Tear"

MEZZANINE LENDING

"MEZZ" is more Expensive than the 1st Mortgage Loan . . . - But . . . may be LESS expensive than additional Equity Capital - And . . . Sponsor keeps a Larger % of Equity Ownership Mezz Lenders include: - Private Equity Funds - Off-Shore Investors - Insurance Companies, and - Pension Funds

TWO MAIN METHODS OF INVESTMENT ANALYSIS IN CRE

1. QUICK METHODS, looks at just One Year 2. DCF, looks at many years

MEASURING RENTABLE & USABLE SPACE IN OFFICE BUILDINGS: Expense Stops

A Clause frequently found in Office Leases is an EXPENSE STOP. With such Clause, the Owner is directly responsible for most, if not all, Property Operating Expenses up to a Specified ("STOP") Amount, stated as an Amount per Square Foot of Total Rentable Space in the Building. Reimbursable Building-Level Expenses beyond the Stop Amount are passed through to the Tenant based on each Tenant's Expense stop and Pro Rata Share of the Building Rentable Area. Common to have "Base Year Stops" EXAMPLE: An Office Building has 60,000 square feet of RENTABLE AREA, of which Tenant A occupies 6,200 square feet. If Tenant A has a $5.00 per square foot Expense Stop Clause, the Landlord is responsible or Property Operating Expenses up to $5.00 per square foot, Tenant A pays its Pro rate Share of the Excess Amount. If Total Reimbursable Expenses are equal to or less than $5.00 per square foot, Tenant A's Expense Reimbursement is EQUAL TO ZERO. However, if Total Reimbursable Expenses in the Current Year are $350,000, or $5.83 per square foot ($350,000 / 60,000) the $5,146 in Operating Expenses would be Recoverable from Tenant A, calculated as follows: $5,146 = ($5.83 - $5.00) x 6,200 The per Square Foot Expense Stop in Office Leases is often based on the Property's Total Recoverable Operating Expenses in the year PRIOR to when the Tenant signed the Lease. Thus, Tenants in our example who sign Leases in the next calendar year will likely be able to negotiate a $5.83 Expense Stop. Clearly, Owners of Multitenant Properties with Expense Stops usually recover a Larger Percentage of Operating Expenses from Older Lease with Lower Expense Stops.

COMMON LEASE PROVISIONS OF RETAIL PROVISIONS: Cotenancy Clause

A Common Clause in Retail Leases allows Tenants to cancel the Lease or pay reduced Rent if Key Tenants in the Center vacate. A Large or Key Tenant is a big draw for traffic and is often one of the major reasons a Smaller Tenant chooses to Locate in a Specific Shopping Center. A Cotenancy Clause provides the Tenant with some protection in the event a major Tenant "goes dark".

LEASE OPTIONS

A Lease Option is a Clause that grants that option Holder the RIGHT -- but not the Obligation -- to do something. EX: The Owner may grant a Tenant who is signing a Five-Year Lease the option to Renew the Lease at the End of its Term for an additional Five Years. Lease Options granted by Owners to Tenants reduce the expected Present Value of Lease Cash Flows to the Owner. Thus, in Competitive Rental Markets, Owners will usually require something of Value from the Tenant (often a higher Base Rent) if they grant the Tenant an Option. Conversely, Options granted the Owner that may be exercised to the detriment of the Tenant generally require some form of Lease concession from the Owner. The existence and pricing of Options in Lease Contracts will reflect current conditions in the Local Rental Market and the relative negotiating Strengths and abilities of the two Parties.

OTHER NEGOTIATED LEASE PROVISIONS: Sublease

A SUBLEASE occurs when the Tenant transfers a SUBSET of her Rights to another. EX: The Tenant may transfer only a portion of the Leased Premises or transfer Occupancy Rights for a Period of Time less than the remaining Lease Term. Usually, the Sublessee (i.e., the new Tenant) pays Rent to the original Tenant, who in turn pays the Owner the Rent stipulated in the Original Contract. Once again, however, the Original Tenant typically remains liable for fulfilling the Terms of the Original Lease. Owners can prohibit Assignment and Subletting or, alternatively, clearly state the Conditions under which one or both strategies may be Employed.

What is a Lease?

A legal Contract between a Property Owner (Lessor) and Tenant (Lessee) that transfers exclusive use and possession of space to the Tenant. During the term of the Lease, the Owner possesses a Leased Fee Estate with a Reversion Interest in the Space that allows him or her to retake possession of the Property at the termination or expiration of the Lease. Because the Lease is a document that sets forth the rights and obligations of each party, every Clause and Provision can affect the Property's net Operating Income or riskiness of the Income stream. "Engine that drive Property Values"

Responsibility for Operating Expenses

A recent trend in Commercial Leases is for Tenants to negotiate a Cap on the amount of certain Operating Expenses they must reimburse the Landlord. Such Caps are usually negotiated on Operating Expenses thought to be at least partially controllable by the Owner, such as lawn and landscaping expenses, irrigation painting, and general maintenance. Property-Level Expenses thought to be largely out of the control of the Owner include Property Taxes, Insurance, Building security, and utilities. Capping the amount of some or all of the "Controllable" Expenses helps mitigate the Risk Owners will fail to act in the best interest of the Tenants.

LEASE OPTIONS: Expansion Option

A tenant who expects her Business to grow may wish to negotiate an Expansion Option. A costly form of this Tenant Option obligates the Property Owner to offer the Tenant Adjacent Space, either at the end of the Lease Term or during some specified Time Period. Such an option is costly because the Owner may have to hold Space adjacent to the Tenant off the Market to ensure that sufficient Space is available should the Tenant choose to exercise the Expansion Option. A less costly alternative for the Owner is to offer a Right of First Refusal, which grants the Tenant the option to Lease Adjacent Space should it become available.

BORROWER'S DECISION MAKING PROCESS: From Loan Application to Closing

A typical Permanent Loan Submission and Approval Process is summarized below - Process can vary significantly by Property Type and Size and across Borrowers and Lenders HOW LONG DOES THIS TAKE? - A Commercial Loan may take 90 days from signing a Purchase and Sale Contract until LOAN CLOSING - But . . . some Loans can be Processed in < 45 days - Time depends on Numerous Factors - But . . . Loan Commitment is a WRITTEN Agreement that COMMITS Lender to make the Loan to the Borrower provided Borrower satisfies Terms and Conditions of Commitment

WHEN IS USE OF LEVERAGE EXPECTED TO BE FAVORABLE?

INCREASED Leverage will Increase Expected Return when the Investor's Rate of Return without Leverage exceeds the Costs of Debt - Unlevered IRR > Costs of Debt

OTHER NEGOTIATED LEASE PROVISIONS:

Advertising and Signage Subordination and Non-Disturbance Estoppel Certificate: - A Prospective Lender or Purchaser of a Commercial Property will usually require Certificates from Tenants stating that the Leases . . . are "In Full Force & Effect" or, if not, specifying Defaults by Landlord

OTHER NEGOTIATED LEASE PROVISIONS:

Amount of TIs paid by Landlord - Heavily negotiated Rebates/Concessions (e.g., Free Rent) Option for Tenant to Extend Lease Term EXPANSION RIGHTS: - Often referred to as "Right of First Refusal" on Vacant Adjacent Space - Reduces Landlord Flexibility Relocation Rights

CAPITAL EXPENDITURES

Appraisal Analysts commonly include in the Reconstructed Operating Statement for an Existing Property an Annual "Allowance" to recognize the Capital Expenditures typically required to Replace Building Components as they Age and Deteriorate. In Contrast to Operating Expenses, CAPITAL EXPENDITURES (CAPX) are Replacements and Alterations to a Building that materially prolong its Economic Life and therefore Increase its Value. Market Participants may refer to this item as a Reserve for Replacement, Replacement Allowance, Capital Costs, or another Similar Term. Examples of such Expenditures may include Roof Replacements, Additions, Floor Coverings, Kitchen Equipment, Heating and Air-Conditioning Equipment, Electrical and Plumbing Fixtures, and Parking Surfaces. In addition, the Costs Owners are expected to incur to make the Space Suitable for the needs of a Particular Tenant (i.e., "Tenant Improvements") are generally included as part of CAPX, or as an additional Line Item in the Operating Statement. Appraisers are typically able to obtain information on Past Capital Expenditures and Budgeted Expenditures from the Property Owner to help in Developing their Estimate of Future CAPX. In practice, CAPX is often estimated as the Expected Costs to Replace each Item, or all Items, allocated as a Constant Annual "Expenditure" over the Item's Expected Life. EX: If the Cost of replacing a roof is expected to be $47,000 in 15 Years (its Expected Useful Life), the Required Annual Set-Aside -- often called a Reserve -- is $2,347, assuming the Annual Deposits would earn Interest at a rate of 4%. In other words, of an Owner puts $2,347 into an Account or Investment that each Year yields 4.0%, he or she would have a $47,000 Reserve Balance for Roof Replacement at the END of 15 years. The recognition of Capital Expenditures in the Estimation of Annual Net Operating Income VARIES in practice. Many Appraisers include a Reserve for Expected Capital Expenditures Annually. Others, though, may attempt to Estimate the Actual Capital Expenditure in the Period it is Anticipated to Occur. The Treatment of CAPX generally reflects the Valuation Method Applied. The Use of Direct Capitalization requires an annualized Estimate (Reserve) for Capital Expenditures -- given that Cash Flows beyond the Next Year are not explicitly considered. In contrast, Multiyear DCF Valuation Models permit the Appraiser to be specific about the Expected Timing of Future Capital Expenditures.

NET OPERATING INCOME

Appraisers obtain the Final Estimate of NOI for the First Year of Rental operations after Acquisition by Subtracting all Operating Expenses and Capital Expenditures from EGI EX: Total Operating Expenses are estimated at $64,800 (40% of EGI) and Total Capital Expenditures are $8,100 (5% of EGI). Thus, Estimated Net Operating Income (NOI) over the Next 12 Months is $89,100. - NOI is Property's "DIVIDEND" - Projected Stream of NOI is FUNDAMENTAL determinant of Property's Value - NOI must be Sufficient to . . . 1. Service the Management Debt 2. Provide Equity Investor with an Acceptable Return on Equity

OTHER NEGOTIATED LEASE PROVISIONS: Assignment & Subleasing

Assignment and Subletting can be major problems in Commercial Leases. Owners seek to control who occupies Space in their Building. Otherwise, unqualified Tenants may default on Sublease Payments, engage in unsafe or hazardous business, or disrupt the Property's Tenant mix. Assignments may also trigger Use issues because the Landlord will likely want the Assignee/Sublease to maintain the permitted use of the Space. Most Commercial Leases PROHIBIT any Assignment & Subletting without Landlord's Prior Consent.

ATTRACTIONS OF A BALLOON MORTGAGE TO LENDER

BALLOON MORTGAGES (Partially Amortizing Mortgages) - Reduce Interest Rate Risk on "Permanent" Mortgages - Reduce Default Risk Default Risk is generally much GREATER for Commercial Mortgage Loans than Home Loans - Often NO Personal Liability - NO FHA/PMI Insurance (as in Home Mtg. Market) - Borrowers are more "ruthless" about exercising their Default Options than Homeowners

NEGOTIATED LEASE PROVISIONS: Retail (CAM CHARGES)

CAM Charges, CONTINUED Costs typically Included in CAM: - Resurfacing Parking Lot, Snow Removal - Updating & Maintaining Landscaping - Security - Outdoor Lightning & Irrigation - Repairs & Maintenance to Building Exterior & Interior (Malls) - Management & Administrative Fees - 5-10% of Total Operating Costs - May exclude items that require little or no "administration" - Utility Charges, Insurance Premiums, Property Taxes

OTHER COMMON CLAUSES: Subordination & Nondisturbance

Banks or other Lenders may request -- or Demand -- that Property Owners include a Subordination Clause in their Leases. Essentially, this Clause states that the Lease is Subordinate to any existing or future Mortgages on the Property. Thus, if the Owner Defaults on the Mortgage and the Lender Forecloses, the Lender has the right to terminate the Lease and evict the Tenant, even if the Tenant has fulfilled all of its responsibilities under the Lease. However, a Subordination Clause puts Tenants at risk of losing their Business location, which can be critical to their Operations and Customer Relationships. In addition, they risk losing any Investments they have made in Leasehold Improvements. One solution is to ask the Lender to enter into a Nondisturbance Agreement with the Tenant. This agreement prohibits the Lender from interfering with the Tenant's Use of the Premises, as long as the Tenant continues to pay Rent and otherwise complies with the Lease Agreement's Terms and Conditions.

EFFECT ON CASH FLOWS FROM ANNUAL OPERATIONS

Before-Tax Cash Flow from Annual Rental Operations (BTCF) is defined as Net Operating Income (NOI) MINUS the Sum of the Mortgage Payments (Debt Service). BTCF is the Expected Cash Flow left over from Rental Operations each year after paying all Operating Expenses, Capital Expenditures, and Servicing the Mortgage Debt. Centre Point Office Building Example: The Monthly Payment on the $792,000 Mortgage Loan is $5,005.98; Annual Payments total $60,072 ($5,005.98 x 12). The estimate of the BTCF for the First Year of Property Operations after Acquisition is $29,028. The BTCF is considered "Levered" Cash Flow because it represents Cash Flow to the Equity Investor AFTER the effects of Financial Leverage (i.e., Debt Service) have been Subtracted. In contrast, NOI is an Unlevered Cash Flow because it represents the Return on the Entire Investment (in this case $1,056,000), not just the Return on the Portion of the Investment financed with Equity Capital.

ALTERNATIVE FINANCING ARRANGEMENTS

Besides Fixed-Rate CRE Loans these are common: FLOATING (ADJUSTABLE) RATE LOANS: The index on a Floating-Rate Loan, to which the Contract Rate is tied, has typically been the London Interbank Offer rate - commonly referred to as LIBOR. Floating-Rate Loans Decrease the Lender's Interest Rate Risk and are tied to Short Term Interest Rates, both of which tend to reduce the Interest Rates on Floating-Rate Loans relative to Fixed-Payment Mortgages, all else being the same. However, Floating-rate Mortgages can Increase the Default Risk of a Mortgage because the Borrower may not be able to continue to Service the Debt if Payments on the Loan Increase significantly. Commercial Banks most commonly provide Floating Rate Loans. SALE-LEASEBACK: - Owner-User (Bank, Restaurant, Drug Store, etc.) sells Property to Long-Term RE Investor - User then Leases Property back from the Investor(s) and it occupies it under a Long-Term Net Lease - Common with Non Real Estate Companies (Amazon, for example)

ESTIMATING NET OPERATING INCOME (NOI)

Both Methods require the ESTIMATION of Net Operating Income. In Estimating the Expected NOI of an Existing Property, Appraisers and Analysts rely on 1. The Experience of Similar Properties in the Market and 2. The Historic Experience of the Subject Property The Current Owners may not be Renting the Subject Property at the Going Market Rate, and its Current Expenses may differ from Market Averages. Thus, an Appraiser must evaluate all Income and Expense Items in terms of Current Market Conditions. These items are then placed in a RECONSTRUCTED OPERATING STATEMENT Format, often referred to as a First-Year Pro Forma. It is important to emphasize that the Appraiser is basing her estimates of Future Operating Cash Flows on what she believes the Typical Market Participant is expecting, not what she expects. PGI - VC + MI ____________ = EGI - OE - CAPX ____________ = NOI

INCOME CAPITALIZATION

CAP RATEt = NOIt+1 / Sales Pricet The Cap Rate is a Result of a Market Transaction, and can be calculated AFTER Property Trades. EX: If Office Properties expecting to produce NOIs of $100,000 next year sell for $1,428,000 each this year, we can reasonably expect that the Market CAP RATE is about 7.00% or 0.0700 0.0700 = $100,000 / $1,428,000 The RATE someone Purchases a Property at is called a GOING-IN CAP RATE or ENTRANCE CAP RATE -- The other type is the GOING-OUT, a.k.a. EXIT or TERMINAL CAP RATE, which the Seller uses to estimate Equity Reversion (Sales Price) By Rearranging the Equation, we can estimate the Value of a Similar Office Property with an Expected NOI of $150,000 Annually Value t = NOI t+1 / Cap Rate t Value t = $105,000 / 0.0700 ESTIMATED PRICE (VALUE) = $2,142,857.14 *Note: In Commercial Real Estate, Large-Number Forecasts are commonly rounded; in this case, $2,143,000 would be fine By doing this, we are using the FIRST of TWO Income Approach Valuation Methods: the Direct Capitalization Method Direct Cap Value t = NOI t+1 / Market Cap Rate t

COMMERCIAL MORTGAGE "SPREADS" OVER TREASURIES

CRE MORTGAGES are "Priced off the Yield Curve" with Rates quoted as SPREADS Correlation between Monthly Rates/Yields on 10 - yr Mortgages and 10 - yr Treasury Securities: 0.85 from 1997 - 2016

DECISION MAKING IN REAL ESTATE CENTERS AROUND VALUATION: A Word of Caution

Chapter 18 in the Text focuses on QUANTITATIVE DECISION TOOLS Although Quantitative Tools and Techniques are widely used in Commercial Real Estate Markets, their usefulness is limited by the Quality of the Cash Flow Assumptions used by the Analyst and employed. In short, the "GARBAGE IN, GARBAGE OUT" maxim applies directly to Real Estate Investment Decision Making. Acronyms: CAP RATE: indicates the Rate of Return that is expected to be generated on a Real Estate Investment Property. This measure is computed based on the Net Income which the Property is expected to generate and is calculated by dividing Net Operating Income by Property Asset Value and is expressed as a PERCENTAGE. It is used to estimate the Investor's Potential Return on their Investment in the Real Estate Market. CAP EX: (Capital Expenditures) are Funds used by a Company to acquire, upgrade, and maintain physical assets such as Property, Plants, Buildings, Technology, or Equipment. "EQUITY DIVIDEND RATE" and "CASH-ON-CASH RETURN" are perfectly synonymous.

Responsibility for Operating Expenses

Clearly, required base Rent Payments are an important determinant of the Tenant's Cost of Occupancy and the Owner's Cash Flow from the Property. However, the TOTAL Rental Income generated by a Lease also depends on the proportion of Property-Level Operating Expenses. Thus, Owners must fully recover Operating Expenses in the Base Rent. In a GROSS LEASE, the Owner pays all of the Property's Operating Expenses. Thus, owners must fully recover Operating Expenses in the Base Rent. In NET LEASE, the Tenant must reimburse the Owner for a defined portion of the Property's Operating Expenses.

"COMMERCIAL" MORTGAGE LOANS VS. HOME LOANS

Commercial Mortgages and Notes for EXISTING PROPERTIES are NOT as Standardized as Home Loans - Documents are Longer and Complex - Often NO Personal Liability - Legal Borrower often is a Single Asset Entity (a Company that owns ONE PIECE of Real Estate, usually an LLC or LP) - Shields Sponsor from Personal Liability unless he/she provides other Guarantees

THE INCOME APPROACH TO VALUATION

Common among Commercial Property Owners is the anticipation that they will receive Cash Flows from the Property in the Form of Income from Rental Operations and Price Appreciation. The Current Value of a Property is therefore a function of the Income Stream it is expected to produce. Because the Income Approach is based on the premise that a Property's Market Value is a function of the income it is expected to produce, Appraisers FIRST estimate the Net Income that a typical Investor would be forecasting today for the Subject Property over the Expected Holding Period. Said differently, it is not the Appraiser's job to forecast Future Cash Flows based on her expectations. Rather, her job is to emulate the thinking and behavior of Market Participants. As long as the Appraiser properly identifies what the typical Investor would expect to occur, the Value Estimate for the Subject Property is credible. The Measure of Income generally sought by Property Valuers is Annual Net Operating Income (NOI), which is EQUAL to expected Rental Income over the next 12 Months, Net of Vacancies, MINUS Annual Operating and Capital Expenses. The SECOND Step in the Income Approach is to convert the NOI Forecast into an estimate of Property Value. This is sometimes referred to as Income Capitalization. VALUE = Present Value (PV) of Anticipated Income (Future Incoming Payments) - Often called "Income Capitalization" - CAPITALIZE: Convert the NOI Forecast into an estimate of Property Value There are many Models and techniques available to the Appraiser for Income Capitalization. However, these Models can be divided into TWO Categories 1. DIRECT CAPITALIZATION MODELS (With an "OVERALL" Cap Rate) 2. DISCOUNTED CASH FLOW MODELS (Discounted all Expected Future Cash Flows (CFs) at Discounted Rate ("DCF"))

DCR and MAXIMUM DEBT SERVICE FORMULAS

DCR = NOI / DS Maximum Debt Service = NOI / Minimum DCR

UNDERWRITING RATIOS USED BY CRE LENDERS

DEBT COVERAGE RATIO: Indicator of "Cash Flow Cushion" from Lender's Perspective DCR = NOI1 / DS WHERE: - NOI1 is First Year (next 12 Months) NOI - DS is Annual Debt Service (monthly Payment x 12) Lender's want DCR to be as HIGH as possible, but typically MINIMUM of 1.20 LOAN-TO-VALUE RATIO: An indicator of Borrower's incentive to maintain the Loan (i.e., NOT Default) LTV = Loan Amount / Acquisition Price Higher Initial LTVs Increase the Probability of subsequent Default, all else equal Typical Maximum LTV at Origination is 75% DEBT YIELD RATIO: Indicator of Lender's Mortgage "Return" DYR = NOI1 / Loan Amount Cash-on-Cash Return Lender would enjoy is it Foreclosed and took Title to Property on Day of Loan Origination Does NOT consider Contract Interest Rate or Amortization Period DYR only considers how LARGE Loan is relative to Property's NOI Typical MINIMUM DYR is 9.0% or HIGHER

USING DIRECT CAPITALIZATION FOR VALUATION

DIRECT CAPITALIZATION is the Process of estimating a Property's Market Value by Dividing a Single-Year NOI by a "Capitalization" Rate. The General Relationship between estimated Market Value and Operating Income is Expressed in the Basic Income Capitalization Equation: V = NOI1 / R0 Where V is Current Value, NOI1 is the Projected Income over the next 12 Months, and R0 is the Capitalization Rate.

MEASURING RENTABLE & USABLE SPACE IN OFFICE BUILDINGS: Formulas

Descriptions: RENTABLE AREA: Gross Area - "Vertical Penetrations" (i.e., Electrical Shafts, Stairs, and Elevators) USABLE AREA: Rentable Area - Common Areas (Conference Rooms, Lobbies, etc.) Rent is generally quoted on RENTABLE AREA FORMULAS . . . TENANT'S PRO RATA SHARE OF COMMON AREA = Tenant's Usable Area / Total Usable Area RENTABLE AREA: All Space to the Outside of the Exterior Walls, except Vertical Penetrations USABLE AREA: Rentable Area less the Public Spaces & Circulation Areas (Common Areas) TENANT'S RENTABLE AREA: Tenant's Usable Area + Pro Rata Share of Common Areas

TWO APPROACHES TO INCOME VALUATION: Discounted Cash Flow (DCF)

Discounted Cash Flow (DCF) Valuation Models differ from Direct Capitalization Models in several important ways. FIRST, the Appraiser must identify the Investment Holding Period that is typical of Investors who might purchase the Subject Property. SECOND, the Appraiser must convert the Expectations of Typical investors into explicit Forecasts of the Property's NOI for each year of the Expected Holding Period, NOT just a Single Year. This Forecast must also include the Net Income produced by a hypothetical Sale of the Property at the end of the Expected Investment Holding Period. THIRD, the Appraiser must select the appropriate Yield Rate, or Required Internal Rate of Return, at which to DISCOUNT all Future Cash Flows using "Discount Rate". The requirements of DCF Analysis place a GREATER analytical burden on the Appraiser because Forecasts of Future Cash Flows cannot be explicitly abstracted from Past Sales of Comparable Properties. Critics of DCF Models argue that Future Cash Flow Projections not supported by Market Evidence can result in Flawed Value Estimates.

TRADITIONAL SINGLE-YEAR INVESTMENT CRITERIA: Profitability Ratios - Equity Dividend Rate

EDR = Before-Tax Cash Flow (BTCF) / Equity Investment The Equity Dividend Rate shows Investors what percentage of their initial Equity Investment is expected to be Returned to them in Cash during the next 12 months (before Income Taxes). Note that the difference between EDR and R0 is that the effect os Mortgage Financing have been subtracted from both the Numerator and the Denominator of the EDR. Thus, the Cash Flow in the Numerator measures the Amount Received by the Equity Investor after paying all Operating and Capital Expenses AND after Serving the Debt. This "RESIDUAL" Cash Flow is then compared to the Equity Investors' Cash Investment. For this reason, the Equity Dividend Ratio is also referred to as the "Cash-on-Cash" Return. Common Reference Point for Smaller Investments. The EDR for the Centre Point Office Building is EDR = $29,028 / $287,760 = 0.1009 or 10.1%

NEGOTIATED LEASE PROVISIONS: Retail

EXCLUSIVE USE - Grants Tenant Sole Right to Sell a Specific Product or Service in Center - Why do Landlords dislike this Provision? PARKING - Landlord Requires Tenant Employees to park in Designated areas - Saves "Prime" Spots for Customers RADIUS - Prohibits Tenant from Opening Another Store nearby - Protects Landlord's Percentage Rent SIGNAGE - Major Negotiations often ensue over Placement and Size of Tenant's Signage

MEASURING RENTABLE & USABLE SPACE IN OFFICE BUILDINGS

How is the Tenant's Share of the Common Area calculated? First, the RENTABLE/USABLE RATIO for the Entire Floor is calculated by dividing the Total Rentable Area by the Total Usable Area. EX: The R/U Ratio, also called the LOAD FACTOR, is 1.1215 (21,500 / 17,700), indicating the Rentable Area is 21.5 percent LARGER than the Usable Area. To fully allocate the Common Area among the four tenants, the Load Factor is multiplied by each Tenant's Usable Area. For example, Tenant A's Rentable Area is 5,467.5 square feet (4,500 x 1.215).

Responsibility for Operating Expenses: CLASS NOTES

EXPENSE REIMBURSEMENT REVENUE: If Tenant is responsible for some, or all, Operating Expenses, according to Lease they may: - Pay them DIRECTLY (typical in Single-Tenant Properties) - Reimburse Landlord (typical in Multi-Tenant Properties) FOR VALUATION AND INVESTMENTS: Reimbursements show up in Investment CF Pro Forma as Expense Reimbursement Revenue (in addition to showing up as Operating Expenses) How are Reimbursable Expenses allocated among Tenants? IN RETAIL: - Generally Prorated based on Gross Leased Area (GLA) of the store as % of GLA of ENTIRE CENTER IN OFFICE: - Prorated based on Tenant's Rentable Area as a % of Total Rentable Area in Building. Rentable Area includes Tenant's Exclusive Area, plus Pro Rata Share of Building Common Areas. IN MULTI-TENANT INDUSTRIAL PROPERTIES: - Prorated based on Tenant's Rentable Area as a % of Total Rentable Area in Building. Rentable Area includes Tenant's Exclusive Area, plus Pro Rate Share of Building Common Areas

Negotiated Lease Provisions

Every Clause in a Commercial Lease can affect the Property's Operating Income and Value. Clauses that address Rent Payments and the responsibilities of Owners and Tenants for Operating Expenses have a direct effect on Property Income.

Negotiated Lease Provisions: Rental Payments

FLAT RENT: The simplest treatment of Rent is to keep it flat for the entire Lease Term. EX: a Five-Year Office Lease might specify a Fixed Rental Rate of $30 per square foot per year. The Shorter the Lease Term, the more a FLAT RENT arrangement is likely to be observed. When Fixed Rental Rates are observed, the Lease may include a Provision that requires the Tenant to pay some or all of the Property's Operating Expenses. GRADUATED RENT: A Graduated Rent Clause, also referred to as an ESCALATION RENT Clause, provides for prespecified Increases in the Contract Rental Rate. EX: a Five-Year Office Lease might specify a Rental Rate of $26 per square foot per year for the First Year, Increasing by $2 per square foot each year for the remaining four years of the Lease Term. Frequently, the increases are expressed as a percentage Increase over the previous years' Rent. Flat or Graduated Rent agreements that are clearly spelled out in the Lease are the simplest methods of specifying Rental Rates over the Term of a Lease. INDEXED RENT: Rent Increases are ties to, say, the CPI. Ties a Rental Rate to a commonly accepted Pricing Index that reflects changes in the Cost of Living. This allows Landlords to raise the Rents in conjunction with changes in the economy whenever the Lease is reevaluated, which is typically once a year.

BORROWER'S DECISION MAKING PROCESS (CONTINUED)

Financial Risk of using Debt: Risk that NOI will be insufficient to cover ("Service") the Mortgage Payment Obligation - This Negative Cash Flow may lead to Default and Foreclosure - This Risk Increases with Leverage Leverage also Increase VARIABILITY of Equity Returns

BORROWER'S DECISION MAKING PROCESS: Default

For Lenders, DEFAULT is the Signature Risk of Commercial Mortgages - Borrower seldom can cover for long the Loan payment for a crippled Commercial Property - Loan is often (effectively) Non-Recourse (good for Borrower, bad for Lender)

LEASE OPTIONS: Renewal Option

Grant the Tenant the Right to Renew the Lease. Tenants would prefer, all else being equal, the option to Renew the Lease with the same Terms and Conditions as the Original Lease, including the Rental Rate. Owners are reluctant to agree to such Renewal Options for several reasons. First, Local Market Rents may increase, perhaps significantly, over the First Lease Term; thus, owners could be forced to Renew the Lease at Below-Market Rental Rates. This potential Loss is not offset by the probability that Tenants will Renew at Above-Market Rents if Market Rents decline over the First Lease Term. Why? Because if Rents decline, Tenants will not exercise the option to Renew at the Original Contract Rental Rate

Negotiated Lease Provisions: Use of the Premises

If a Lease does not state a specific purpose for which the Property may be used or specifically forbid certain uses, the Tenant may use the Property for any legal purpose. Typically, however, Commercial Property Leases contain a Clause that indicates the purpose for which the space may be used. In addition to ensuring that the Space is used lawfully, such clauses prevent uses that may damage the Building, detract from its image and prestige, disturb or conflict with other Tenants or surrounding neighbors, or expose the Owner to potential Legal Liabilities. The Landlord prefers a BROAD LANGUAGE and the Tenant prefers a SPECIFIC LANGUAGE

DEFINING LEASABLE AREA IN RETAIL PROPERTIES

In Retail, Rents are quoted on the basis of Gross Leasable Area (GLA). The GLA for a particular Tenant captures the amount of Space occupied and controlled by the Tenant, and is therefore similar to an Office Tenant's Usable Area. The GLA of the Shopping Center is equal to the Total GLA, plus the square footage of the Common Areas, which include Courtyards, Walkways, and Escalators.

USING DIRECT CAPITALIZATION FOR VALUATION: Abstracting Cap Rates from the Market

In addition to abstracting Cap Rates directly from Comparable Sales Transactions, Appraisers and other Market Participants may also look to published Survey results for Evidence on Required Cap Rates. Situs Real Estate Research Corporation (RERC) regularly surveys the Cap Rate expectations of Institutional Investors in the United States. THREE Points are worth emphasizing in this Stage. FIRST, in most States, the Sales Price of the Comparable Properties are Publicly Recorded and therefore easily obtainable. However, the Comparable NOIs are not Publicly available; thus, the Appraiser must typically contact the Buyer and/or Seller of each Comparable Property, or a Broker involved in the Transaction, for Revenue and Expense information. These data must generally be adjusted and supplemented by the Appraiser because, for example, the Seller is generally too optimistic about the NOI Forecast of the Property. SECOND, R0 is a "Rate" that is used to Convert the First-Year NOI (the Property's Overall Cash Flow) into an Estimate of Current Market Value. Thus, R0, is referred to as the Overall Capitalization Rate, or the GOING-IN CAP RATE. THIRD, R0 is NOT a Discount Rate that can be used to Value Future Cash Flows. It is simply the Ratio of the First Year's Annual Income to the Overall Value of the Property. FINALLY, note that the reciprocal of R0 is 1 / 0.084 or 11.905. Thus, another way of looking at the relationship between Income and Value is to observe that Office Buildings similar to the Subject Property sell for 11.905 times their Estimated First-Year NOIs. Thus, the $1,061,000 Market Value estimate may also be obtained by multiplying the Subject's Expected NOI times the abstracted price/income multiple -- that is, $89,100 x 11.905 = $1,060,736, which rounds to $1,061,000. In contrast to the Discounted Cash Flow Approach to Valuation, the Market Value estimate produced by Direct Capitalization, which relies on Pirces paid by Investors for Similar Properties, may be MORE RELIABLE for the purpose of Estimating a Property's Market Value. WHY? Because Direct Capitalization requires FEWER EXPLICIT Forecasts and Judgements than are necessary if the Appraiser is constructing a 5- or 10-Year Discounted Cash Flow Analysis. In effect, the Appraiser relies on the Decisions and Valuations made by other Market Participants to help "read" what the Market is Forecasting for Rent Growth and Price Appreciation.

WHY INVESTMENT VALUE DIFFERS FROM MARKET VALUE

Investors have DIFFERENT Required Returns: - Different Risk Assessment/Opportunity Cost of Invested Equity - Everyone has different ideas of what a Property should cost or what they would pay for it, everyone has a different Opportunity Cost DIFFERENT Expectations about Future (ways to beat the Market): - Rental Rates - Vacancies - Operating Expenses - etc. "ALPHA" (the Greek Letter of a) is a term used in Investing to describe a Strategy's Ability to BEAT the MARKET, or it's "EDGE"

SECOND MORTGAGES & MEZZANINE LOANS

Investors will build a complex "Capital Stack" and bring in multiple Sources of Debt to supplement First Mortgage Loan: 1. Sometimes is a 2nd Mortgage Loan - i.e., Secured by Property . . . 1st Mortgage Lenders don't like this 2. More often is a Non-Mortgage Loan Secured by EQUITY via a pledge of Borrower's Ownership Interest(s) in Single-Asset Entity - Known as a MEZZANINE LOAN (Mezz): If Borrower Defaults, "Mezz" Lender takes over Borrower's Ownership Position - May give them more control . . . can negotiate with First Lien Holder

COMMON LEASE PROVISIONS OF RETAIL PROVISIONS: Hours of Operation

It is important to the success of Shopping Centers, both large and small, that Hours of Business Operation are consistent across Tenants. Most Retail Leases allow the Owner to set the Shopping Center's Hours of Operations or the Hours will be specified in the Lease.

EFFECTIVE GROSS INCOME

It is nearly impossible for an Owner to realize a Property's Full Potential Income. Some Existing Leases may be at Rental Rates Below Market. Even if there is no excess Supply of Space for a Lease in the Market, there will often be a few Premature Vacancies, some Rental Income will be Lost when tenants Vacate Space that then must be Refurbished and Released, and not all Rent will be Paid in a timely fashion. Furthermore, Owners often choose to Hold a Small Inventory of Space off the Market to have available to show Prospective Tenants. The NATURAL VACANY RATE is the proportion of Potential Gross Income not Collected -- even when Supply EQUAL Demand in the Rental Market. Of course, if there is an Excess Supply of Leasable Space in the Market, the Actual Amount of Vacancy and Collection Losses will Exceed the Natural Rate. Therefore, the Second Step in projecting NOI is to estimate the the Expected Vacancy and Collection (VC) Losses for the Property. Vacancy is due to Economic and Market Conditions influencing the Subject Property; Collection Losses are due to Creditworthiness and Financial Stability of the Tenant(s). Again, Apprasier should estimate these Losses on the basis of 1. Historical Experience of the Subject Property 2. Actual Current Vacancies 3. The recent Experiences of Competing Properties The Normal range for Vacancy and Collection Losses for an Apartment, Office, and Retail Properties is 5% to 15% of PGI, although Vacancies well in Excess of 15% have occurred in an Overbuilt Market. The existence of In-Place Leases, under which Tenants are contractually obligated to pay Rent During the Year, should affect Estimated Vacancy Losses. The Expected Vacancy and Collection Loss is SUBTRACTED from PGI. In addition to Basci Rental Income, there may be Miscellanous Revenue from Sources such as Garage Rentals, Parking Fees, Laundry Machines, and Vending Machines. Expected Miscellaneous Income (MI) should be added to the Potential Gross Income. The Net Effect of Subtracting the Vacancy Allowance and Adding the Miscellaneous Income is EFFECTIVE GROSS INCOME (EGI). An Alternative Approach to Estimating Effective Gross Income used by some Real Estate Professionals is to start with an Estimate of what Rental Income would be each year if the Property was continuously Fully Leased at Marker Rental Rates during the Year. Effective Gross Income for the Year would then be equal to Potential Gross Income if all Space was 100% Leased at Market Rates, minus the Difference between Market Rents and Contract Rents on any In-Place Leases, Minus Expected Vacancies and Collection Losses (VC). The Difference between Market Rents and Contract Rents, when POSITIVE, is often referred to as Income that is "Loss to Lease".

VALUATION'S ROLE IN FINANCE & INVESTMENT: RE Finance and Real Estate Valuation

LENDERS size Loans using "LOAN TO VALUE" (LTV) and by"DEBT YIELD"; both of which are based on Property Valuation EX: If a Lender's Terms were 65% LTV for the example on the left, the Maximum Loan Size would be $5,398,312 - 0.65 x $8,305,096 - This, of course, subject to other Loan Terms that may LOWER this MAXIMUM AN INVESTMENT QUESTION: Is now a good time to buy Real Estate? Active Real Estate Investment requires excellent working knowledge of underlying Asset Pricing (Valuation) By understanding Value, the Investor can enter the Market at the RIGHT PRICE to create POSITIVE RETURNS

OTHER NEGOTIATED LEASE PROVISIONS: Restrictions on Alterations and Improvements

Landlords will generally not permit Tenants to make Alterations or Improvements to the Leased Premises without Prior Approval. This protects the Landlord against Value-Destroying Improvements, as well as damage to Mechanical, Electrical, Heating, Ventilation, and Air-Conditioning (HVAC) Systems. To the extent, the Tenant is permitted to alter the Leased Premises, the Lease should clearly state when this may be done, and under what circumstances. The Lease must also be clear about the Ownership of such Improvements once completed. The Landlord may require Tenant to restore the Property to the Original Configuration. Trade Fixtures are usually paid for and installed by the Tenant, and may be removed by the tenant at the Termination of the Lease. However, Trade Fixtures should be clearly identified to avoid confusion at Expiration of the Lease.

Negotiated Lease Provisions: Lease Term

Lease Terms are by Product Type: One Year Leases are common in all residential; One night Leases are the mainstay in Hotels, Three to 10+ years are common in Retail; Three to 20+ years are common in Industrial and Office.

FINANCIAL RISK RATIOS: Debt Yield Ratio

Lenders also use the Debt Yield Ratio to help determine the Maximum Amount they are willing to lend to the Borrower. The Debt Yield Ratio (DYR) is defined as the Property's Projected First-Year NOI divided by the amount of the First Mortgage Loan. DYR = Net Operating Income / Loan Amount Centre Point Example: $89,100 / $792,000 = 0.1125 or 11.25% This indicates the Mortgage Lender would earn 11.25% Cash-on-Cash Return on its Invested Capital (i.e., the Loan Amount) if it had to Foreclose on the Centre Point Property immediately after Originating the Loan. The DYR is a Primary Risk Assessment Ratio used by Lender who are Originating Loans that will be Packaged Together and used as Collateral for the Insurance of a CMBS. Unlike the DCR, the DYR is NOT affected by the Interest Rate or Amortization Period of a Loan; the DYR is simply a Measure of how large the NOI is relative to the Loan Amount.

CRE Rent Terminology

MULTIFAMILY: - Tenant: Monthly Total Rent for Specific Unit - Owner: Rent/Sqft/Month on Apartment Unit HOTEL: - Tenant: Nightly Rate for Specific Room - Owner: Two main measures: Average Daily Rate (ADR): Average Rate per Room & RevPAR: Revenue per Available Room RETAIL, OFFICE, INDUSTRIAL: - Tenant & Landlord: Rent/Sqft/Year unique to each Space

WHEN DO WE SEE RECOURSE LOANS IN CRE?

Many Lenders also unwilling to relieve Borrowers of Personal Liability is a "Willful" Act of Borrower causes a Capital Loss for Lender EX: Borrower Fraud, Environmental Problems. Unpaid Property Tax Obligations How is this accomplished? - A "CARVE-OUT" Clause is often included in Note - This Carve-Out, known as a "Bad Boy Clause", holds Borrowers Personally Liable for Lender Losses caused by such Problems

RESTRICTIONS ON PREPAYMENT

Most Fixed-Rate Commercial Mortgages do not allow Borrowers to freely Prepay at Par, as they contain a Lockout Provision, a Prepayment Penalty, or frequently both. A LOCKOUT PROVISION prohibits Prepayment of the Mortgage for any reason for a Period of Time AFTER its Origination. EX: a Commercial Mortgage can have a 10-Year Loan Term, a 25-Year Amortization Schedule, and a 3-Year Lockout Period. Lockout Periods reduce the Risk that Lenders will have to Reinvest the remaining Loan Balance at a Lower rate when Borrowers Prepay Mortgages with Above-Market Rates. Thus, Lockout Provisions reduce Lenders' REINVESTMENT RISK, all else being equal.

MORE ON NET OPERATING INCOME (NOI)

NOI is the Property's Expected "DIVIDEND" Projected Stream of NOI is the Fundamental Determinant of Value NOI MUST be sufficient to: 1. Service the Mortgage Debt and 2. Provide Investor with an Acceptable Return on Equity

Responsibility for Operating Expenses

Note that in a Gross Lease, the EXPECTED level of Operating Expenses over the Lease Term is built into the Rental Rate, assuming the Lease was negotiated by a knowledgeable owner and Tenant in a Competitive Rental Market. However, the Owner still bears all the Risk associated with UNEXPECTED changes in Operating Expenses. In some Leases, the method used to share responsibility for Operating Expenses is a hybrid of the four basic Lease types: Gross Lease, Net Lease, Net-Net Lease, Triple Net Lease. EX: OPERATING EXPENSE ESCALATION CLAUSE, only INCREASES, in one or more Operating Expenses, relative to a Base Year, become the responsibility of the Tenant. The Base Year is usually the first full calendar year after the Tenant moves in.

OTHER NEGOTIATED LEASE PROVISIONS: Responsibility for Maintenance of Space

OFFICE PROPERTIES: Common for Landlord to maintain Space RETIAL & INDUSTRIAL PROPERTIES: Common for Tenants to be Responsible for their Premises - Landlord performs all maintenance outside Tenant's Premises

OPERATING VS. CAPITAL EXPENDITURES

OPERATING EXPENSES (OpEx): - Keep Property Operating & Competitive - Do NOT Increase VALUE or EXTEND Useful Life CAPITAL EXPENDITURES (CapEx): - Increases Market Value of the Property/ Extends Life - EX: Roof Replacement, Air-Conditioner Replacement, Installation of New Landscaping

WHEN DO WE SEE RECOURSE LOANS IN CRE?

On Permanent Financing for Existing Buildings, Nonrecourse Loans dominate Pension Funds, Life Company. & CMBS Loans But . . . Commercial Banks may require some form of Credit "Enhancement" . . . a.k.a. "RECOURSE" - Often a Guarantee by Organizer/Sponsor of Investment to make Lender while in Event Lender suffers Loss Also, almost always "RECOURSE" on Development Loans (Land, Construction Loans)

Responsibility for Operating Expenses

Operating Expenses that are the responsibility of the Tenant can be paid directly by the Tenant or paid by the Landlord and reimbursed by the Tenant. In Multitenant Properties, the Owner will usually pay the Expenses while collecting from each Tenant each Month an estimate of the Tenant's Pro Rate (or negotiated) share of the Property's Operating Expenses. EX: If an Office Tenant occupies 6,000 square feet in a 60,000 square foot Property, her Pro Rata share of Expenses is 10%. At the end of the year, actual Reimbursable Expenses will be reconciled against Projected Expenses for the year. If the Owner has collected more throughout the year than what the Tenant actually owes in Reimbursable expenses, the Landlord generally Credits the overage against what the Tenant owes for the following year. However, if the Landlord has collected too little from the Tenant, according to the Terms of the Lease, the Tenant will usually be required to pay the Owner the amount of the deficit. Sophisticated Tenant will require the right to review Operating Expense details provided by the Owner.

OTHER FORMS OF PERMANENT FINANCING FOR EXISTING PROPERTIES

Other Sources of "Perm" Financing Government Sponsored Entities (Multifamily only) FHA Insured Loans for investment in Low and Moderate Income Multifamily Housing Freddie Mac & Frannie Mae Multifamily Lending Programs - Many targeted to Low and Moderate Income Housing

OTHER COMMON CLAUSES: Advertising & Signage

Owners seek to restrict the Type, Location, and Number of Signs and Graphics Tenants are allowed to display on the Property. Large Shopping Centers, for example, establish a uniform graphic images and work to maintain their quality. These restrictions help keep signs and displays consistent with the Building's image and the Owner's Marketing Strategy. The location of the Tenant's Business Name on a Shopping Center Sign is often a heavily negotiated Lease Clause. Shopping Center Tenants may also be required by their lease to expand a certain portion of their Store's Sales Revenues on Advertising to promote their Business.

FIRST YEAR NOI EQUATION

PGI - VC _____________ EGI - OE -CAPX _____________ = NOI ** For this Class: we will assume "Above-Line Treatment" for Capital Expenditures"

1ST STEP IN INVESTMENT ANALYSIS: Estimating NOI over Next Year

PGI: aka First Year Cash Flow VC: Empty Space (V) and people not paying their Rent (C) MI: vending machines, garage door clickers for Rent, etc. EGI: Actual Revenue you are bringing in OE: Operating Expenses; electricity bill, trash service, maintenance --> what keeps the Building running CAPX: things to elongate/extend the Lifespan of the Property --> what keeps the building running for LONGER, CAPX will ALWAYS be here in this class NOI: number used in the "Cap Rate" Equation --> "NET OPERATING INCOME"

PROS AND CONS OF RATIO MULTIPLIERS

PROS: - Quick & relatively easy to compute - Intuitive - Facilitates comparisons with Similar Properties - No Explicit Assumptions about Future CONS: - No clear Benchmarks for Acceptable Ranges - Only a Partial View of Performance - No Explicit Assumptions about Future

Essential Elements of a Lease

Parties to a Lease must be legally competent, the objective of the Lease must be legal, there must be Mutual Agreement between the Tenant and Landlord to enter into the Lease agreement, and something of Value (i.e., Consideration) must be given or promised by both Parties. The promise to pay rent constitutes the Tenant's Consideration. Allowing the Tenant to occupy the Space or Property constitutes the Landlord's Consideration. Valid and Enforcement Leases also must include the following elements: 1. The names of the Landlord and Tenant 2. An adequate description of the Leased Premises 3. An Agreement to transfer Possession of the Property from the Landlord to the Tenant 4. The Start and End Dates of the Agreement 5. A description of the Rental Payments 6. The Agreement must be in WRITING 7. The Agreement must be signed by all Parties The type of description required upon the nature of the Property, but must be precise about the physical premises being leased. For Residential and small Commercial Properties, a street address and/or apartment number is usually adequate. Descriptions for larger Multitenant Office and Retail Properties are more detailed and may include items such as Site Plans, Floor Plans, the Total Square Footage of the Leased Premises, and Descriptions of Parking Areas

RETAIL PROPERTIES & LEASES: Power Shopping Center

Power Centers typically have Leasable Areas ranging from 250,000 to 600,000 square feet. The Dominating Feature of a Power Center is the high ratio of Anchors to Ancillary Tenants. Typically, Power Centers contain three or more giants in hard goods retailing (e.g., Toy, Electronics, Home Furnishings, Off-Price Stores). Home Depot and Wal-Mart are two prominent "Big Box" Retailers that frequently locate their Stores in Power Centers. These Centers often draw Shoppers from a radius of Five Miles or more.

DECISION MAKING IN REAL ESTATE CENTERS AROUND VALUATION

Professional RE Appraisers are paid to estimate the Market Value of a Property MARKET VALUE: - Is the basis for Economic Transactions - Buyer does not want to pay more than the Market Value of Property - For many Investors, Market Value is NOT the whole story, most Real Estate Decisions are made with an Investment Motive

BORROWER'S DECISION MAKING PROCESS: Loan Size

REASONS FOR USE OF DEBT BY INVESTORS: 1. Limited Financial Resources / Accumulated Wealth 2. Debt alters Risk and Equity Return on Investment - "Magnifies" Rate of Return on Invested Equity - This Magnification known as Positive (or Negative) Leverage 3. Diversity Investment Portfolio

BORROWER'S DECISION MAKING PROCESS: Refinancing

REFINANCING (REFI) involves a NPV Decision Even more focused on NPV than Home Mortgage Refinancing - More sophisticated Borrowers - Fewer Non-Financial Considerations Refinancing (Refi) must account for Lockout Period and/or Prepayment Penalty NPVrefi = PV of Payment Savings - Refi Costs - Prepay Penalty - Regarding "PV", Discount Monthly Savings at Current Market Mortgage Rate - Expected Holding Period after Refinancing is important assumption

OTHER NEGOTIATED LEASE PROVISIONS: CONCESSIONS

RENT CONCESSIONS/ABATEMENTS: Lease Contracts may also contain one or more Concessions that reduce the Lease Cash Flows. Concessions are usually offered to potential Tenants to provide them an Incentive to Lease space in the Owner's Property, but they are not reflected in the quoted Rental Rate. A Concession often granted to new Tenants when the Supply of Space in a Local Market exceeds Demand is a period of free, or perhaps reduced, Rent. The owner also may commit to pay a Tenant's Moving Expenses or Penalties incurred by a Tenant in breaking an existing Lease. A common Concession found in Office, Industrial, and Shopping Center Leases are Tenant Improvement Allowances. TIs are usually stated as a per square foot amount. If a Tenant is moving into an existing Space that has already been finished out by a prior Tenant and requires little in the way of alterations, the negotiated TI Allowance may be $5 per square foot or lower. However, if a Tenant is moving into newly constructed "shell" Space, the Owner may be required to provide significant TI Allowance to permit the Tenant, or the Owner on the behalf of the Tenant, to build out the Space in an appropriate fashion. The magnitude of the Tenant improvement Allowance is often a heavily negotiated Lease item.

NEGOTIATED LEASE PROVISIONS: Retail (Percentage Rent)

RETAIL SPACE PERCENT REVENUE (PERCENTAGE RENT) With Clause, TOTAL RENT = BASE RENT + PERCENTAGE RENT EXAMPLE: - Base Rent: $96,000 per year ($8,000 mth) - 5% of Gross Sales in excess of $160,000 charged as Percentage Rent - Store produces $200k in Monthly Sales; Total Rent is = $8,000 + 0.05($200,000 - $160,000) = $10,000 - Effect of Clause on minimum (Base) Rent? TENANT MUST PROVIDE - Detailed info on Tenant Sales - Financial Statements upon request

USING DISCOUNTED CASH FLOW ANALYSIS FOR VALUATION

Recall that, with the exception of Apartments and Motels, Commercial properties are often subject to Long-Term Leases. These In-Place Leases may carry Rental Rates Above or Below the Current Market Rate. In fact, Multitenant Properties can be subject to Numerous Leases, all with different Rental Rates, remaining Terms, and Rent Escalation Clauses. There also can be significant variation between Owner and the Tenant in the Percentage of Operating Expenses that each pays. In addition to the Heterogenous Nature of Commercial Leases, the complexity of many Transactions also requires Adjustments to Comparable Sales Prices that are difficult to quantify. For these many reasons, the Use of DCF Valuation Models is often a necessity. Moreover, DCF Analysis has become the main Financial Tool used by Investors to evaluate the Merits of Commercial Real Estate Investments. The term DISCOUNTED CASH FLOW ANALYSIS refers to the Process and Procedures for estimating (1) Future Annual Cash Flows from Property Operations, (2) the Net Cash Flow from Disposition of the Property at the End of the Assumed Investment Holding Period, (3) the appropriate Holding Period, and (4) the required Total rate of Return, and then using these inputs to generate an Indicated Value for the Subject Property. PRO FORMA: Cash Flow Forecast (EX: Five-Years)

RETAIL PROPERTIES & LEASES: Regional Shopping Center

Regional Centers (Malls) focus on general Merchandise and usually have at least two Anchor Tenants that are major Department Stores (e.g., Nordstrom and Neiman Marcus). Typical sizes range from 400,000 square feet of Gross Leasable Area to 800,000 square feet of GLA. Major Tenants are National Chains or Well-Established Local Businesses that have High Credit Ratings and significant Net Worth. These Retailers draw people from a Larger Area than the Neighborhood or Community Centers, although 80% of their Sales are typically drawn from within a 5-to 15-Mile Radius. Minor "In-Line" Tenants are located between the Anchor Tenants to capture Customers. Often, Regional Centers contain several Stores of one type (e.g., Shoe Stores). Many include Small Fast-Food Outlets arranged in Food Courts. Many Malls, especially those of lower Quality and Location, have witnessed declining Rents and increased Vacancies, which will require new strategies to combat.

Negotiated Lease Provisions: Rental Payments

Rent for Residential Rental Units is typically stated as a dollar amount per month. In contrast, rents for U.S. Commercial Properties are generally quoted on an annual cost per square foot basis; for example, $15 per square foot per year, even though rent is paid in equal monthly installments Because of the Short-Term nature of most Residential Leases (generally One-Year Terms), Owners have not found it necessary to include Clauses that enable them to adjust Rents as Local and National economic conditions change. In contrast, many Commercial Leases have terms of 5, 10, and, in some cases, 25 years or more. Changing Market Conditions usually may result from shifts in Supply and Demand Conditions in the Local Rental Market, changes in Operating Costs that must eventually be passed on to Tenants, or from Rent pressures that result from National Economic factors such as inflation. To maintain the Market Value of Properties subject to Long-term Leases, Commercial Leases with durations longer than One Year often include Clauses that permit the Owner to adjust Rents over time and/or require the Tenants to reimburse the Owner for all or a portion of Increased Operating Expenses. Clearly, the True Cost of Commercial Lease from the tenant's perspective is a function of both the Rental Rate and the proportion of Property-Level Operating Expenses, if any, that are the responsibility of the Tenant.

NEGOTIATED LEASE PROVISIONS: Retail

Responsibility for Payment of Common Area Maintenance (CAM) Expenses is often heavily negotiated in Retail Leases - Tenant pays to Landlord Estimated Pro Rata Share of CAM & other Pass Through Charges (Property Taxes & Insurance) at the BEGINNING OF EACH MONTH - NOT all Tenants pay Pro Rata Share of CAM - AT YEAR END, Landlord provides CAM Reconciliation to Tenant; who then Pays Deficiency or Receives a Credit - Tenant has Right to Audit Pass-Through Charges & Review Invoices

NEGOTIATED LEASE PROVISIONS: Retail

Restrictions on Operation of Tenant's Business & Landlord's Remedies - Common in Retail - Tenant must be open for business during business hours of center . . . or pay additional rent Cancellation Option for Tenant - May be granted if Tenant sales fall BELOW Pre-Specified Amount - Or if Landlord violates a Tenant's Exclusive Use CO-TENANCY PROVISIONS - Tenant allowed to pay only Percentage Rent or Cancel if one or more Anchor Tenants vacate

COMMON LEASE PROVISIONS OF RETAIL PROVISIONS: Other Clauses

Retail Leases commonly require the Tenant to occupy the Space for the Entire Lease Term (CONTINUOUS OCCUPANCY) and to keep its Business Operating consistently (CONTINUOUS OPERATION). For the Benefit of both the Tenant and the Owner, Retail Leases also require the Tenant to carry an adequate Amount of Liability Insurance. Many sophisticated Tenants insist on Provisions that restrict a Landlord's ability to change access to the Property. They may also require "No-Build" Areas on the Property to preserve the Tenants access, parking, and visibility.

OTHER COMMON CLAUSES: Parking

Shopper access to Parking is critical to the success of Shopping Centers. Thus, Retail Leases may require a Tenant's Employees to park only in designated (and less desriable) Employee Parking Areas. Access to suitable Parking also is important to Office Building Tenants. Tenants often attempt to negotiate exclusive Parking Rights. The Lease should be clear about Tenant access to Parking, both for Customers and Employees. The Lease also must be clear about the responsibilities of Owner and Tenants to pay for the lighting and upkeep of the Parking Area.

COMMON LEASE PROVISIONS OF RETAIL PROVISIONS: Percentage Rent Clause

Shopping Center Leases may include a Clause that ties Total Rent Payments to the Tenant's Sales Revenue. In a Percentage Lease, there is usually a Flat or Fixed component referred to as the BASE RENT. In addition, the PERCENTAGE RENT CLAUSE dictates that the Property Owner receive a prespecified Percentage of Tenant Sales that exceeds some Minimum Threshold Amount. Percentage Rent Clauses are unique to Retail and Service Tenants and offer advantages for both the Owner and the Tenant. For the Tenant, the Percentage Rental offers a way of Leasing Space that she might not otherwise be willing to Rent because of the uncertainty of her future Business success. The Percentage Rental also assures the Tenant that increased Rental Costs will be Conditional upon the success of her Business. The Percentage Rent Clause helps to align the Interests of the Shopping Center Owner of the Shopping Center Owner with those of the Tenant. Because the Owner's Lease Cash Flows are partially determined by the Success of the Tenant's Business, the Owner has an Incentive to keep the Center clean and attractive, maintain adequate Signage, Advertise, and ensure that Stores with complementary Products are located nearby to help drive Customers to the Tenant's Store. From the Landlord's perspective, a Percentage Rental gives the Owner an Equity-Like Interest in a Tenant's Business. In a Competitive Rental Market, however, Tenants do not freely give away a portion of their Firm's upside potential to Property Owners. To be induced to do so, the Base Rent must be Lower than it would be in the Absence of the Percentage Rent Clause. Obviously, a Percentage Rent Clause requires that the Shopping Center Owner have access to the Financial Records of the Tenants.

RESTRICTIONS ON PREPAYMENT: Prepayment Penalties

Some Commercial Mortgages contain Prepayment Penalties instead of, or in addition to, Lockout Provisions. These Penalties may be expressed as a Fixed Percentage of the Remaining Loan Balance, say, 2 - 4 %, or the percentage may decline as the Loan ages. Prepayment Penalties can significantly Increase the Cost of Refinancing and, therefore, Reduce the Benefits to the Borrower. An Alternative Form of Prepayment Penalty is a YIELD-MAINTENANCE AGREEMENT. With such Agreement, the Penalty that Borrowers pay depends on how far Interest Rates have Declined since Origination. Why tie the Penalty to Interest Rate Movements? When Interest Rates Decline and Borrowers Prepay at Par, Lenders must Reinvest the remaining Loan Balance at Current (i.e., Lower) Rates. Effectively, Lenders lose the Present Value of the difference between the Payments on the Old Mortgage and the Payments on a New Mortgage at Current Rates. The Prepayment Penalty can be set to approximate this lost Present Value, or some portion of it. Finally, a Defeasance Clause is typically found in Mortgages that are originated to become Collateral for a Commercial Mortgage-Backed Security (CMBS). With Defeasance, a Borrower who Prepays must, in exchange for extinguishing the Loan, purchase for the Lender a set of U.S. Treasury Securities whose Coupon Payments replace the Mortgage Cash Flows the Lender will lose as a result of the Early Retirement of the Mortgage. Thus, similar to Yield Maintenance Agreements, Defeasance Clauses provide Borrowers with the Flexibility to Prepay (assuming they are not locked out). However, the Clauses are designed such that the Borrower's Cost of purchasing the Treasury Securities for the Lender effectively eliminates any Interest Savings associated with the Mortgage Prepayment. "Defeasing" a Loan is generally more Expensive for the Borrower than providing Yield Maintenance.

OTHER NEGOTIATED LEASE PROVISIONS: Acceptance of Premises

Tenants have Specific Time Period (One Week?) to notify Landlord (in Writing) of any "Defects"

LEASE OPTIONS: Cancellation Option

Tenants may be able to negotiate the Right to Cancel a Lease before Expiration, perhaps with a Termination Fee. Owners may also negotiate a Cancelation Option. Although not common in Commercial Leases, Shopping Center Tenants may negotiate the right to Cancel if their Sales, or those of other Tenants in the Center, do not reach an agreed upon Threshold Level.

NEGOTIATED LEASE PROVISIONS: Retail (CAM CHARGES)

Tenants prefer to pay only for Maintenance & Repair, not Replacement of Items - Ownership Costs vs. Operating Costs? Landlords may agree to cap "Controllable" Expenses, which do NOT include Property Taxes, Insurance, Utilities, & Snow Removal - Caps have become more Common Growing use of Fixed (Instead of Variable) CAM Charge (especially in Malls) - Reduces uncertainty for both Parties - Eliminates costs of Negotiating & Reconciling

OTHER NEGOTIATED LEASE PROVISIONS: Assignment

Tenants, especially those subject to Long-Term Leases, may desire to Assign or Sublet all, or part, of their Leased Space. A Lease ASSIGNMENT occurs when ALL of the Tenant's Rights and Obligations are transferred to another Party. However, the Assignor remains Liable for the promised Rent unless relieved in Writing of this responsibility by the Property Owner or by the Terms of the Lease.

USING DIRECT CAPITALIZATION FOR VALUATION: Understanding Capitalization Rates

The Cap Rate is a Measure of the Relationship between a Property's Current Income Stream and its Price or Value. It is NOT an Interest Rate, Discount Rate, or Internal rate of Return. It DOES NOT measure Total Investment Return because it ignores Future Cash Flows from Operations and Expected Appreciation (or Depreciation) in the Market Value of the Property. Cap Rate is analogous to the Dividend Yield on a Common Stock, defined as the Company's Projected Annual Dividend, divided by the Current Stock Price. All else being the same, Investors prefer Stocked (and Commercial Properties) with the Highest Dividend Yield (Cap Rate). Expected Cash Flows beyond Year 1 and changes in the Value of the Asset can significantly affect Total Rates of Return. CENTRE POINT BUILDING EXAMPLE: If the Property is Purchased by an Investor for the Asking Price of $1,056,000, and the Estimated First-Year NOI is $89,100, the Investor's GOING-IN Capitalization Rate (Dividend Yield) is 8.44%. If the Property is expected to increase in Value to $1,077,120 by the END of Year 1, the Expected Total Rate of Return is 10.44%: Y0 = R0 + g = $89,100 / $1,056,000 + $1,077,120 - $1,056,000 / $1,056,000 = 0.084 + 0.200 = 0.1044 or 10.44% WHERE R0 = NOI1 / Price AND g = P1 - P0 / Price The Expected Total Rate of Return, y0, is often referred to as the INTERNAL RATE OF RETURN (IRR) on the Investment. Note that the y0 for One-Year Holding Period is comprised of TWO PARTS: 8.44% Overall Cap Rate (or "Current" Yield in Year 1), and the 2.00% Rate of Price Appreciation. This Formulation clearly shows that the Investor's Total Rate of Return is expected to be obtained from TWO SOURCES: 1. The Property's Annual Dividend (i.e., NOI) 2. Annual Appreciation (or Depreciation) in the Value of the Property If a LARGER portion of y0 is expected to be obtained from Annualized Price Appreciation (g), then a SMALLER portion of y0 must be provided in the form of Current Yield (i.e., Cap Rates can be Lower). This helps explain why Cap Rates often vary significantly across Property Types and Across the Markets; Expected Appreciation rates can be very different.

FINANCIAL RISK RATIOS: Debt Coverage Ratio

The Debt Coverage Ratio (DCR) indicates the extent to which Net Operating Income (NOI) can DECLINE before it is insufficient to cover the Debt Service (DS). Also known as Debt (Service) Coverage Ratio (DSCR) DCR = Net Operating Income (NOI) / Debt Service Centre Point Example: $89,100 / $60,072 = 1.48 DCR is the Primary Risk Assessment Ratio used by most Lenders. The DCR indicates the amount of "Cushion" above that which is needed to pay Debt Service. The DCR provides an indication of safety from potential Borrower Default in the event Rental Revenues fall and the Mortgage Payment is in jeopardy. Typically, Lenders require this Ratio to be AT LEAST 1.2 to 1.3. This, Centre Point's 1.48 Coverage Ratio would seem to provide the Lender (and Investor) with a satisfactory safety margin. Required DCRs vary over Time and Location and across Property Types.

USING DIRECT CAPITALIZATION FOR VALUATION: Abstracting Cap Rates from the Market

The FIRST STEP in Direct Capitalization is Abstracting Cap Rates from the Market. Appraisers rely on recently completed Transactions of Similar Properties to guide their selection of the Cap Rate to be used to Value the Subject Property. The basic Capitalization Formula can be rearranged so that: R0 = NOI1 / V0 or R0 = NOI1 / Sale Price This allows R0 to be estimated from Comparable Property Sales if the Sale Price and First-Year NOIs for the Comparables are known or can be Estimated. This method of Estimating the Appropriate Valuation Cap Rate is called Direct Market Extraction. The Estimated R0 can then be applied, using the original equation, to Capitalize the Estimated First-Year NOI of the Subject Property into an Estimate of Market Value. Centre Point Building EX: Assume the Appraiser found Five Comparable Properties that sold recently. Comparability is as important here as in the Sales Comparison Approach. Property Location, Size, Age and Condition, and Intensity of Land Use must be similar to the Subject Property. The Appraiser should also examine the Comparable Property's Tenant Mix, the important Terms in each In-Place Lease, the Probability will Default on their Leases, and the Probability Tenants will desire to Renew when their Leases Expire. The extent to which these Risk Factors vary from the Subject Property should affect the Weigh the Appraiser gives to the Comparable Sale in Developing her Value Estimate. The selected Comparables should then be Screened to ensure that only recent Open-Market Sales are used. Unusual Financing or Contractual Terms must be Analyzed. If the appropriate Adjustment can be Quantified, the Comparable may be Used; if not, it must be Excluded. Although Space Limitations do not permit a detailed discussion here, many Appraisers argue that the Selection and Use of Comparable Sales is the most important, and difficult, component of the Appraisal Process. For each Comparable Property, the Appraiser estimated Expected First-Year NOI, making sure that all appropriate Operating Expenses and Capital Expenditures have been Deducted. The NOI of each Comparable Property is then divided by the Sale Price of the Comparable Property. This Calculation provides an Indicated Capitalization rate (NOI / Sale Price) for each Comparable Sale. Assume that each Five selected Comparable Sales in this EXAMPLE are Equally similar to the Subject Property and therefore deserve equal weight. The Simple Average of the Five Comparable Capitalization Rates is 8.4%. Dividing the Subject Property's Expected NOI of $89,100 by 8.4% (or 0.084) produces an Indicated Value for the Subject Property of $1,060,714 ($89,100 / 0.084), which we round to $1,061,000

COMMON LEASE PROVISIONS OF RETAIL PROVISIONS

The Lease Contracts between Retail Owners and Tenants are often extremely complicated and can vary across Properties and Tenants. Many Clauses and Conditions that are Standard in the Leases of Regional Mall Department Stores are not appropriate for a hair salon or gift store in a neighborhood shopping center. Small Retail Businesses often Lease Spaces for Durations as short as One or Two Years, whereas Larger Tenants are often willing and able to commit to Leases of much longer Duration. ANCHOR TENANTS -- The Large and generally Well-Known Retailers who typically draw the majority of Customers to the Shopping Center -- may Sign Leases with Terms of 25 to 30 Years, with one or more Renewal Options. Nonanchor Tenants often make Flat or Indexed Rental Paymetns plus an Additional Payment based on some Percentage of their Gross Sales. All Tenants typically share in Paying the Center's Operating Expenses.

Negotiated Lease Provisions: Lease Term

The Lease Term must be clearly indicated, including the Beginning and Ending Dates. One-Year Terms for Apartment Leases are the Industry Standard. For other Commercial Property Types, however, Lease lengths can vary considerably. Longer Leases provide more stability for both the Tenant and Owner and they delay the Re-Leasing costs faced by Tenants and Owners when a Tenant vacates the Premises. EX: Owners may face an extended period of Vacancy and may incur significant search costs in their attempts to find a new Tenant. With the exception of Apartment Projectsm the Owner will usually need to pay a Leasing Commission to the person responsible for securing a new Tenant. In addition, the Owner may need to provide a Tenant Improvement (TI) Allowance to the new Tenant. The TI Allowance is the amount the Landlord agrees to spend to build out or refurbish the Space to meet the needs of the Tenant's Business. The Owner may take care of the improvements herself, pay the Allowance directly to the Tenant, or pay Contractors on the Tenant's behalf. Sophisticated Tenants often require Landlords to escrow the promised TIs to assure the Funds are available when needed. Both Tenants and Owners are negatively affected by Re-Leasing Costs. As a result, both prefer Longer-Term Leases, all else being the same, in order to minimize such Costs. In general, the more uncertain a Tenant's future space needs, the greater the value associated with Flexibility. Flexibility is also valuable to Owners. EX: Landlords may desire a shorter Lease Term if they believe Market Rents are likely to rise in the near future. In addition, Owners often desire to alter the mix of Tenants to maximize the synergies of the Property. In short, Flexibility considerations suggest Shorter-Term Leases are more valuable to both Tenants and Owners. Therefore, optimal Lease Terms reflect the trade-offs between the desire for the Flexibility inherent in Short-Term Leases and the reduction in risk and Re-Leasing Cots associated with Longer-Term Leases.

OTHER COMMON CLAUSES: Access to Premises

The Lease must give Owners the Right to Enter and Inspect the Leases Space without violating a Tenant's Right to Quiet Enjoyment. Access to the Premises allows the Owner to make needed repairs and to show the space to prospective Tenants near the end of the Current Leased Term. Inspection also allows Owners to monitor whether a Tenant's Use of the Space is allowed under the Terms of the Lease. However, the Lease should specify that, except in emergencies, the Owners may only inspect at reasonable times and with sufficient Prior Notification.

OFFICE PROPERTIES & LEASES

The Real Estate profession commonly refers to Office Buildings in the following way: CLASS A: These Buildings usually Command the Highest Rents because they are the most prestigious in their Tenancy, Location, Amenities, and overall desirability. They are usually Newer Structures located in Major Metropolitan Areas that have Market Values in excess of $10 Million. CLASS B: The Rents in these Buildings are usually less than those in Class A Buildings because of a less desirable Location; fewer Amenities; less impressive Lobbies, elevators, or appearance; or a relatively inefficient layout of the Leasable Space. *ONLY NEED TO KNOW CLASS A & B*

MEASURING RENTABLE & USABLE SPACE IN OFFICE BUILDINGS

The Standard for Measuring Office Space is the one adopted by the Building Owners and Managers Association International (BOMA), although some Property Owners prefer their own method. Under BOMA guidelines, the USABLE AREA is the square footage of the Space bounded by the walls that separate one Tenant's Space from another. Thus, the Usable Area is the amount of Space in Sole Possession of the Tenant. EX: In an Office Floor Plan, Tenant A occupies 4,500 square feet of Usable Space wile the three remaining Tenants control 13,200 square feet. The total Usable Square Footage on the Floor is 17,700. The RENTABLE AREA of a Tenant's Leased Office Space is equal to the Usable Area, plus the Tenant's Prorated Share of any Common Areas. EX: The Common Area is 3,800 square feet, which includes the Open Areas and Walkways that lead to the Elevators, to the Individual Office Suites, and to other Common Areas, such as Restrooms and Storage and Utility Closets. Thus, the TOTAL RENTABLE AREA of the Office Floor is 21,500 square feet (17,700 plus 3,800 Common).

POTENTIAL GROSS INCOME

The Starting Point in Calculating NOI is to estimate Potential Gross Income (PGI). PGI is the Total Annual Rental Income the Property would produce assuming 100% Occupancy and NO Collection Losses (in other words, assuming Tenants always pay their Full Rent on Time). Sometimes referred to as Potential Gross Revenue (PGR) or Gross Rent (GR) Although Rents are generally received from Tenants on a Monthly Basis and Operating Expenses are incurred during each Month, as a matter of practice most Appraisers and Investment Analysts estimate Property Cash Flows for existing Properties on an Annual Basis. PGI is the Estimated Rent per Unit (or per Square Foot) for each YEAR multiplied by the Number of Units (or Square Feet) available for Rent. Of course, different Units in an Apartment Complex or different Spaces in an Office Building or Shopping Center often Rent for different Dollar Amounts. Appraisers estimate PGI by carefully examining Current Market Conditions and by examining the terms of any Existing Leases and the creditworthiness of the Tenant(s). MARKET RENT is the Rental the Property would most probably Command if all the Space were continuously Leased at Market Rental Rates. CONTRACT RENT refers to the Actual Rent being paid under Contractual Commitments between Owners and Tenants. Generally, if some of the Space is subject to Long-Term Leases to financially Reliable Tenants at Rates Above or Below the Market, the Owner is said to have a Leased-Fee Interest in the Property and the Estimation of PGI will include the Contract Rent of these Leases. Said differently, the Rent that will potentially be collected over the Next 12 Months is constrained by In-Place Leases. Only Space that is, or will become, Vacant can potentially be Lease to a Tenant at Market Rental Rates. It should be noted that Office, Retail, and Industrial Tenants often Occupy their Space under Leases ranging from Three to Five Years. However, Tenants of more Specialized Properties such as Restaurants, Department Stores, and Freestanding Drug Stores often sign Leases of 10 Years or More. An additional complication is that Appraisers encounter numerous Lease Types. The Flat Lease is one in which the Monthly Rent remains Fixed over the ENTIRE Lease Term. The Step-Up (or "Graduated") Lease establishes a Schedule of Rental Rate Increases over the Term of the Lease. In some Retail Leases, the existing Lease Structure of the Subject and Comparable Properties can significantly complicate the Appraisal, as can the creditworthiness of Tenants.

DECISION MAKING IN REAL ESTATE CENTERS AROUND VALUATION

The focus is on a set of widely used Single-Year Return Measures, Ratios, and Income Multipliers. These Returns, Ratios, and Multipliers have the Advantage of being relatively easy to calculate and understand. They do not, however, explicitly incorporate Cash Inflows and Outflow beyond the First Year of Analysis -- a potentially serious Limitation in their Use and Interpretation given the Long-Lived nature of Real Estate Assets. To overcome the Shortcomings of Single-Year Decision-Making Metrics, many Investors also perform Multiyear Analyses of the Income-Producing Ability of potential Acquisitions. These Multiyear DISCOUNTED CASH FLOW (DCF) Valuation and Decision-Making Methods, most notable Net Present Value and the Internal Rate of Return.

USING DISCOUNTED CASH FLOW ANALYSIS FOR VALUATION: Estimating Future Sale Proceeds

The second major source of Expected Property Cash Flows comes from the DISPOSITION (typically, the Sale) of the Ownership Interest in a Property at THE END of the Holding Period. With a Sale, the Invested Capital "REVERTS" to the Owner; hence, the Proceeds from the Sale are frequently referred to as the REVERSION. Because Income Properties usually held for a Limited Time Period, the Net Cash Flow from the Eventual Sale of the Property must be estimated in addition to the Cash Flows from Annual Operations. There are numerous methods available for estimating the Sale Price at the END of the Expected Holding Period -- commonly termed the TERMINAL VALUE (Vt, or REVERSION VALUE. For example, an Appraiser may simply assume a Resale Price or assume that the Value of the Subject Property will grow at some Compound Annual Rate. However, Direct Capitalization is the most common method used to estimate Terminal Value. This is because estimating the Sale Price at the End of an Expected Five-Year Holding Period is analogous to estimating the Value of the Property at the Beginning of Year 6. If the Estimated NOI in Year 6 is $103,291 and a TERMINAL CAPITALIZATION RATE (Rt) or GOING-OUT RATE, of 8.75% (0.0875) is deemed appropriate for determining the Future Sale Price (Terminal Value) of Centre Point, then the ESTIMATED SALE PRICE at the END OF YEAR 5 is: V5 = NOI6 / Rt = $103,291 / 0.0875 = $1,180,469 Note that DCF Analysis, as commonly employed, uses a combination of DCF and Direct Capitalization (to find Terminal Value). For fully Leased, Stabilized Properties in a Normal Markets, the GOING-OUT CAP RATE is usually assumed to be approximately 1/4 or 1/3 Percentage Points HIGHER than the GOING-IN CAP RATE -- and HGHER Cap Rates produce Lower Value estimates. The NET SALE PROCEEDS (NSP) at the END of the Expected Holding Period are obtained by Subtracting Estimated Selling Expenses (SE) from the Expected Selling Price. Selling Expenses include Brokerage Fees, Lawyer's Fees, and other Costs associated with the Sale of the Property. Selling Expenses in our example are forecasted to be $47,219 or 4% of the Expected Sales Price. When deducted from the Estimated Selling Price, this leaves an Expected NSP of $1,133,250.

OPERATING EXPENSES

The typical Operating Expenses Owners incur in Maintaining and Operating Rental Properties are termed OPERATING EXPENSES (OE). Operating Expenses include the Ordinary and Necessary Expenditures expected to be incurred during the Next 12 Months (including Incidental Repairs) that do not Materially add Value, but keep the Property Operating and Competitive in its Local Rental Market. They are generally divided into TWO Categories: FIXED and VARIABLE Expenses. FIXED Expensees do not vary directly with the Level of Operation (i.e., Occupancy) of the Property, at least in the Short Run. Common Fixed Expenses are Local Property Taxes, and Hazard and Fire Insurance; Owners pay them whether the Property is Vacant or Fully Occupied. VARIABLE Expenses increase as the Level of Occupancy Rises and Decrease when Occupancy is Reduced. Variable Expenses include items such as Utilities, Maintenance, Repairs, Supplies, or Property Management. The Annual Operating Expense Estimate is based on the Historical Experience of the Subject Property in comparison with Competing Properties, the Appraisers knowledge of Typical Expense Levels, and any Property-Specific Characteristics. In addition to comparing Owner-Reported Expenses for the Subject Property to Similar Properties in the Market, comparisons to Industry Averages are available from the Institute of Real Estate Management, the Building Owners and Managers Association, the International Council of Shopping Centers, and the Urban Land Institute.

TRADITIONAL SINGLE-YEAR INVESTMENT CRITERIA: Profitability Ratios - Capitalization Rate

These Ratios work best when used to compare a "Stabilized" Property to other Stabilized Properties. Such Properties have Vacancy rates and Rental Rates that are at or near Current Market Rates and are not expected to require Abnormal Amounts of Maintenance or Capital Expenditures. PROFITABLE RATIOS: The ultimate determination of Investment's Desirability is its Capacity to produce Income in relation to the Capital required to obtain that Income. Two frequently used Profitability Ratios: the Capitalization Rate and the Equity Dividend rate 1. CAPITALIZATION RATE: The Going-In Capitalization Rate on an Acquired Property -- known as the Overall Cap Rate -- is defined as R0 = NOI1 / Acquisition Price Where NOI1 is the Estimated NOI over the Next Year (12 Months). R0 indicates the (First Year) Cash Flow Return on the Total Investment -- that is, the Return over the next 12 Months on Funds supplied by both Equity Investors and Lenders. It measures the OVERALL Income-Producing Ability of the Property. NOI $ - Represents the "SPACE MARKET" - The HIGHER NOI, the LOWER Price - The LOWER NOI, the LOWER Price CAP RATE % - Represents the "CAPITAL MARKET" - The HIGHER Cap Rate, the LOWER Price - The LOWER Cap Rate, the HIGHER Price EX: Centre Point Office Building - Acquisition Price of $1,056,000 and an Estimated First-Year Net Operating Income (NOI) of$89,100. The Going-In Capitalization Rate therefore is R0 = $89,100 / $1,056,000 = 0.0844 or 8.44% Is 8.44% an Acceptable overall Cap Rate for the Investor? This question can only be addressed by comparisons with Cap Rates on similar Properties in the Market. Investors should rely on CAP RATE information abstracted from Comparable Transactions in the Local Market. However, regularly Published Surveys may also provide useful information on CAP RATE Trends 1. CAP RATES vary Inversely with Quality (i.e., "CLASS") 2. CAP RATES vary by Property Type Risk

RETAIL PROPERTIES & LEASES: Superregional Malls

These centers may have as many as Five or Six Major Tenants and Dozens of Minor Tenants. The typical GLA exceeds 800,000 square feet. The Retail Tenant's primary concerns are the availability of adequate space for its business, Shopper's access to their Space, Shoppers' access to their Space, the Volume of Consumer Traffic generated by the Center, and the Visibility of the Tenant's Location within the Center. Additional challenges are presented by the Special Requirements of some Tenants. For Example, Furniture and Appliance Stores require loading docks, Food Service Providers have garbage disposal requirements, and Supermarkets need an abundance of Close-by Short-Term Parking.

COMMON LEASE PROVISIONS OF RETAIL PROVISIONS: Common Area Maintenance (CAM)

This Lease Clause specifies exactly what the Common Areas of the Shopping Center are, what responsibilities the Owner has to maintain and repair the Common Areas, and what COMMON AREA MAINTENANCE (CAM) CHARGES will be paid by each of the Tenants. In addition to Maintenance and Repair Costs, CAM Charges typically include the Cost of Security Personnel and Alarm Systems, as well as Fees for the management of the Common Area. CAM Charges, which may run from $2.00 to $5.00 per square foot per year, or more, are usually Prorated among Tenants based on the Percentage of the Center's Gross Leasable Area (GLA) occupied by the Tenant. EX: Anchor Tenants are often able to avoid reimbursing the Owner for Center Management Charges.

FINANCIAL RISK RATIOS: Operating Expense Ratio

This Ratio expresses expected Operating Expenses over the Next Year as a Percentage of Effective gross Income (EGI): Thus the Operating Expense Ratio (OER) is OER = Operating Expenses / Effective Gross Income Centre Point Example: OER = $64,800 / $162,000 = 0.40 or 40% The GREATER the OER, the Larger the Portion of Effective Rental Income expected to be consumed by Operating Expenses. If the OER of a Property is HIGHER than Average, it may signal that Expenses are out of control, or perhaps, that Rents are too LOW. This may indicate a "Turnaround" Opportunity for a Buyer. Investors should not simply seek Properties with Low reported OERs because the Seller may be Underreporting Expenses in an effort to Increase Pro Forma NOI and , therefore, Sales Price. The Investor must estimate the OER she would expect if purchasing the Property.

RETAIL PROPERTIES & LEASES: Community Shopping Center

This is a larger version of a Neighborhood Center. This type of Center may be anchored by a Discount Department Store and may include Outlets such as Clothing Stores, Banks, Furniture Stores, Lawn and Garden Stores, Fast-Food Operations, and Professional Offices (e.g., Dentists). The Gross Leasable Area (GLA) is usually three times that of a Neighborhood Center. A Community Center's Trade Area is usually within a three- to six- Mile Radius of the Center.

FINANCIAL RISK RATIOS: Loan-to-Value Ratio

This ratio measures the Percentage of the Acquisition Price (or Current Market Value) encumbered by Mortgage Debt. To protect their invested Capital in the Event that Property Values decline, Lenders who provide Mortgage Financing for the Acquisition of Existing Stabilized Commercial Properties generally require that the Senior Mortgage NOT EXCEED 65 to 75% of the Acquisition Price. LTV = Mortgage Balance / Acquisition Price Centre Point Example: LTV = $792,000 / $1,056,000 = 0.75 or 75% Note that a Second Mortgage would Increase the Borrower's overall LTV

RETAIL PROPERTIES & LEASES: Neighborhood Shopping Center

This type of Center is located for the convenience of a nearby Resident Population. it contains Retail Establishments offering mostly Convenience Goods (e.g., Groceries) and Services (e.g., Barbershop, Coffee Shops and Restaurants and Dry Cleaning). These centers may be anchored by the Grocery Store. The Gross Leasable Area of the Anchor(s) and Nonanchored Tenant Space typically ranges from 30,000 to 125,000 square feet. The Trade Area of a Shopping Center is the Geographic Area from which it draws its Customers. A neighborhood Center's Trade Area is typically within a Two- to Three-Mile radius of the Center.

ADDING MEZZANINE LOAN OR 2ND MORTGAGE TO THE "CAPITAL STACK"

Why does Increased Leverage in this example Increase Expected First Year Return on Equity? Weighted Average Cost of Debt = (6.5 / 8.5) x 0.04 + (2.0 / 8.5) x 0.11 = 0.0564 or 5.6% Which is <7.5% Cap Rate

COMMON LEASE PROVISIONS OF RETAIL PROVISIONS: Use Clauses

To help maintain the best mix of Tenants in a Shopping Center, Owners frequently specify the Merchandise or Services that can be sold or offered by the Tenant (e.g., "Women's Shoes" or "Costume Jewelry"). Conversely, Large Tenants may seek to restrict the way Retail Space close to the Tenant can be used. Such Clauses may be desirable in order to limit the amount of nearby Competition or to help ensure adequate Parking is available for Potential Customers. Some Tenants may demand exclusives; that is, the Right to be the ONLY Tenant in the Center that provides a certain kind of Merchandise or Service. Certain Tenants will also seek to avoid granting such Rights. During Lease Negotiations, Tenants seek to obtain a Use Clause that is as broad as possible; Owners, in contrast, desire narrow and restrictive Use Clauses. The phrase ". . . or any other Lawful Use" is not something Owners are typically willing to accept.

LEASE OPTIONS: Relocation Option

To maintain flexibility, Owners of Shopping Centers and Multitenant Office Buildings may negotiate Relocation Options: the Right to Relocate Tenants within the Property. In New Office Properties, for example, the early Leasing of Space to small Tenants may prevent the Owner from Leasing larger Spaces, or entire floors, to larger Tenants. Also, exiting Office and Shopping Centers may wish to expand into a contiguous Area that is occupied by a small Tenant. If the Owner is unable to accommodate the expansion desires of larger Tenants, these Tenants may move to another Property when their Leases expire. Most major Tenants will not permit a Relocation Clause to enter the Lease. However, smaller Tenants may allow such a Clause if they are guaranteed the new Space will be of similar size and quality and the Owner agrees to pay all reasonable moving costs.

OTHER NEGOTIATED LEASE PROVISIONS:

Use of Common Areas & Facilities (Lobbies, Rest Rooms, Parking Lots) Requirements for obtaining Liability Insurance - Tenant must provide Evidence of Insurance to Landlord upon request Method for handling Late Payments (including Interest Rate on Past Due Payments)

FUNDAMENTALS OF INCOME APPROACH

Using the Income Approach, the Value of Commercial Real Estate is sees as a Function of TWO MARKETS: 1. The Market for Space 2. The Market for Capital The Market for SPACE is one of a Property's Operational Competitiveness; it is often Measured by the Cash Flow result of "Net Operating Income" or NOI - NOI is expressed in Currency ($) The Market for CAPITAL consists of Investors seeking Risk-Adjusted Return. This is often Measured by a Factor called the "Capitalization Rate" (CAP RATE) - The Cap Rate is expressed as a Percentage (%)

FIXED RATE COMMERCIAL MORTGAGE LOANS

Usually a PARTIALLY Amortized "Balloon" Mortgage 25 - 30 Year Amortization of Principle 5 - 10 Year Loan Maturity (Term) - Balance of Loan at Maturity (End of Term) must be 1. Refinanced or 2. Paid off with a "Balloon" Payment

INCOME CAPITALIZATION: Direct Cap Method

Values Properties as Perpetuities - a Steady Stream of Cash Flows with no known End Date (Infinite, theoretically) Accounts for ALL Future NOI Cash Flows, including Market-Rate growth in such Cash Flows Property must be STABILIZED Reliable in Submarkets with many recent Sales and widely Available, accurate Transaction Data Takes far less Time and is less Complex than a DCF Analysis Most COMMON METHOD if the Future Income Stream is Inconsistent or is not DIRECTLY accounted for Real Estate is a Physical Asset, and has a Limited Life, and this is Not Growing at a Stable Rate First Year NOI estimates often DIFFER between Professionals, resulting in multiple variations Value t = NOI t+1 / Cap Rate t

INCOME CAPITALIZATION: DCF Method

Values Properties as a SUM of the Individual Asset's Discounted Cash Flow over a certain Period (usually 5, 7, or 10 Years) Uses a Required Rate of Return, commonly known as a Discount Rate, which included a Growth Factor Expected Cash Flow is forecasted in a Financial Model known as a PRO-FORMA Good for Valuing Properties with fluctuating NOI / Variable Growth Rates Can provide detailed insight into the Individual Factors affecting a Property's Value Requires a Pro-Forma design and Data-Validation Process that can be time consuming Requires the determination of a Discount Rate, the definition of which varies, and is difficult to determine accurately Requires a Forecasted Determination of Terminal Value, which makes up a Large Portion of the Present Value and essentially Values the Property as a Perpetuity at some point Value t = E^n t= 1 (CF t / (1+r) t

BORROWING (LEVERAGE)

WHY DO INVESTORS BORROW? There are three Primary Reasons why Real Estate Investors use Financial Leverage. 1. Limited Financial Resources/Wealth: If an Investor desire to Purchase Real Estate but does not have the sufficient Wealth to pay Cash for the Property, then Borrowing is necessary. The Price the Investor/Borrower must pay is the Periodic Interest Rate on the Borrowed Funds. 2. Alters the Expected Risk & Return of Equity Investments: the Use of Financial Leverage amplifies the Rate of Return Investors earn on their Invested Equity. Positive Magnification of Equity Returns is known as "Positive Financial Leverage", and it may induce Investors to partially Debt-Finance (i.e., use other people's money) even if they have sufficient accumulated Wealth to avoid Borrowing. 3. Also permits more Portfolio Diversification

DEBT FINANCING EXAMPLE: Effect on Initial Equity Investment

When a Mortgage Loan is obtained, the Cash Down Payment (i.e., Equity) required at Property Acquisition, E, is equal to E = Acquisition Price - Net Loan Proceeds Where the NET LOAN PROCEEDS equal the Face (or Stated) amount of the Loan, minus the Total Upfront Financing Costs paid by the Borrower at Closing to the Lender or Third-Party Service Providers to obtain the Loan. (include any charges or fees the Borrower pays to obtain the Mortgage Financing; EX: Attorney Fees, Loan Origination Fees, and Costs associated with having the Property Surveyed or Appraised.) Assume the $1,056,000 Centre Point Acquisition Price is to be Financed with a 30-Year, 6.5% Mortgage Loan. The Face Amount of the Loan will equal 75% of the Purchase Price, or $792,000. Assume the Total Upfront Financial Costs will equal 3% of the $792,000 Loan Amount, or $23,760. Thus, Investor's Requires Equity Down Payment is E = $1,056,000 - ($792,000 -$23,760) = $287,760 The Net Loan Proceeds received by the Investor at closing are equal to $768,240 ($792,000 - $23,760). The Monthly Mortgage Payment, however, is based on $792,000, the Face Amount of the Loan. PAYMENT: $5,005.98 Monthly, or $60,072 per Year

TWO APPROACHES TO INCOME VALUATION: Direct Capitalization (With an "Overall" Cap Rate)

With Direct Capitalization Models, Value estimates are typically based on a Ratio or Multiple of Expected NOI over the next 12 Months; Find Value as a Multiple of First Year Net Income (NOI) It is essential that the Ratios used to Value the Subject Property are based on data from Sales of Comparable Properties, if possible.