REU/Chapter 16 - Commercial & Investment Properties

Lease Escalation Clause

- A contract provision allowing for one to pass an increase in costs to another party. Escalation clauses are usually related to influences beyond both parties control, such as inflation.

Percentage Lease

- A lease of property in which the rental is based upon the percentage of the volume of sales made upon the leased premises, usually provides for minimal rental.

Gross Lease

- A lease of property whereby the lessor is to meet all property charges regularly incurred through ownership.

Cash on Cash Return

- A percentage return on money invested in a property by an investor. Ratio of annual before-tax cash flow to the total amount of cash invested: Cash-on-Cash Return = Down Payment ÷ Cash Flow Cash-on-Cash Return = Annual Pre-cash Tax Flow ÷ Actual Cash Invested It should really only be utilized to evaluate the first year's performance or project a property's first year performance. After that, the cash-on-cash return begins to lose its value. The reason being that your denominator (actual cash invested) will be constantly changing as you pay down the loan and make improvements and repairs to the property. A better metric to use in this case is the IRR.

Rate of Return

- A profit on an investment over a period of time, expressed as a proportion of the original investment.

Pro-forma Statement

- An accounting statement that forecasts income and expenses for a period of time, typically five or more years. Pro-forma statements are typically used by investors to estimate their rate of return for a particular property.

Estoppel

- An instrument executed by the mortgagor setting forth the present status and the balance due on the mortgage as of the date of the execution of the certificate.

Debt Service

- Annual amount to be paid by a debtor on an obligation to repay borrowed money.

Tax Shelter

- Any method of reducing taxable income resulting in a reduction of the payments to tax collecting entities, including state and federal governments.

Investment Property Types

- Apartment buildings - Office buildings - Shopping centers - Industrial properties

Net Operating Income (NOI)

- Equal to the Gross income minus expenses (and sometimes debt service). Also referred to as cash flow. It is a before tax figure.

Commercial Lease Clauses:

- Lease duration clause - Free rent clause - Landlord work clause - Tenant's future work clause - Notice clauses - Tenant options (to continue lease) - Restrictions on who the landlord can rent the other spaces to (competition) - Management level provided tenant (on/off-site) - Utility hours (aircon/heat) - Building access - Amenities provided - Use clauses - Estoppel agreement - Sublease or assignment - Electric Service clause - Lease escalation clause

Characteristics of Real Property Investments

- Risk << your primary focus! - Liquidity - Leveraging

Property types

- Single family - Multi-family - Commercial (5+ units) - Mixed-use buildings

Usable Square Footage

- Space that can be used or occupied by a tenant. Typically does not include elevators, stairs, mechanical spaces, etc.

Common Areas

- Spaces in a commercial building shared by the tenants or residents of the building. Common areas include lobbies, corridors, stairs, elevators, etc.

Retail Property Types

- Strip Centers (8-30K sq ft) - Neighborhood Centers (30-100K sq ft) - Malls: regional or mega mall - Outlet Centers (100-300K sq ft)

Liquid

- The ability to have cash readily available to support the demands of running and maintaining real property

Time Value of Money (TVM)

- The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity.

Before Tax Cash Flow

- The net profit/loss calculated by subtracting expenses from income before taxes are paid.

After Tax Cash Flow

- The net profit/loss realized after taxes are deducted.

Gross Income (Multi-family)

- The total amount collected from rents and other income producing opportunities (washing machines, storage, etc.).

Leverage

- The use or borrowed capital (mortgage) to increase the potential return of an investment.

Office Buildings

-Advent of technology: -Changed the office space requirements for employees. -Easy for tenants to pick-up and leave at the end of a lease. Classes: - Class A, new w/good amenities - Class B, older, OK amenities - Class C, close to failing - Low-rise (1-3 stories) - Mid-rise (3-15) - High-rise (=>20) *** & 16-19??? GAAP - Generally Accepted Accounting Principles

Net Lease - Commercial RE

A net lease requires the tenant to pay in addition to rent some or all of the property expenses that would normally be paid by the property owner: real estate taxes, insurance, maintenance, repairs, utilities and other items. Protects the landlord in long term leases.

Retail Property Anchor Tenant

Anchor - retail store which pulls in customers, draws in traffic, delivers convenience

Capitalization Rate (CAP Rate)

CAP Rate% = (next year's) Adjusted NOI ÷ Purchase Price Valuation Multiple == CAP reciprocal, i.e. CAP 5% = 5/100 Val.Mult. = 100/5 == 20x (20 NOI multiple) Purchase price = Valuation Mult. X Stabilized NOI Purchasing a property with a CAP 5 essentially means that you're paying 5x that estimated next years stabilized NOI. Higher CAP Rate -> Lower the multiple ..... and visa versa ..... Lower CAP Rate -> Higher the multiple Does not take debt service into consideration. "Compression of CAP rates" means that each subsequent year the CAP rate gets smaller. Which in turn means that the Valuation Multiple becomes larger, and the cash flow stream is perceived to be more valuable at a lower CAP rate. High cap rate means high income & low purchase price. Low cap rate means low income & high purchase price. For a given property the higher the cap rate the better. So if you are buying, a High cap rate is better. Or is it? In general better properties, or properties that would be considered safer investments will have lower cap rates. The riskier properties in poor neighborhoods will have high cap rates. "Expansion of Multiples" means that at a high CAP rate the Valuation Multiple is low. CAP rate composition EX: - Risk free rate 1.5% - Occupancy level 1% - Quality 1% - Age 1% - Location 1% - Tenant Mix & Credit 2% TOTAL: 7.5% All but Risk are subjective, Risk is based on U.S. Treasury Bonds CAP rate in essence is the weighted average of: -return to debt -return to equity Cap rate = Cash on Cash Rate when it's an all cash transaction. NOI ends up paying both debt service and equity returns (on a residual basis after debt service is paid)

Commercial RE value?

Commercial Real Estate is valued on Net Income that it produces.

Loss Factor

Difference between the Rentable area and the Usable area.

Effective Gross Income (EGI)

Effective gross income is the relationship or ratio between the sale price of the value of a property and its effective gross rental income. The anticipated income from all operations of the real property after an allowance is made for a vacancy and collection losses.

Underwriting Adjustment

Ex: 5% Vacancy, which may not be the case at the moment but will most probably be incident some time in the future.

Outparcel

Individual retail sites in a shopping center.

Cap Rates / Cash on Cash / Property Value Relationship

Interest Rates Low == Property Investment can be higher to realize the same Cash on Cash Return, Cap Rates driven down Cap Rates go down, Cash on Cash also goes down. If interest rates go down it will compensate for that and then there will be increasing values of property. Cap Rates go up, prices go down. If interest rate goes up, cash on cash goes down Check following: Rising interest Rates == Property Investment will be lower, Cap Rates start moving up Lower Cap Rate == Higher Prices Higher Cap Rates == Higher Property Prices

Commercial vs. Residential

Intrinsic cash flow vs. emotional attachment

Capital Improvements

Investment back into a building, replacement or repair. Not an itemized non-taxable expense, can be accounted for within the scope of replacement reserves. Banks with loans out on a particular building will often ask an owner to put money in an escrow account for capital reserves.

Net Lease Types

N (Net Lease) - Tenant pays real estate taxes only, owner the rest. NN (Double Net Lease) - Tenant pays property taxes and premiums for insuring the building. NNN (Triple Net Lease) - Tenant is responsible for all expenses. **Building structure is always the responsibility of the owner

Negative leverage

Negative leverage occurs when the cost of borrowing money is greater than the return a party makes on an equity investment.This could occur with an adjustablerate mortgage on a commercial investment during a time of rapidly rising interest rates.

Positive Leverage

Positive Leverage occurs when the investment property produces a return GREATER than the cost of borrowing the money (i.e. the interest rate I'm charged to borrow the money). Positive leverage increases the borrowers rate of return.

Loft Lease

Rental of entire floor.

Usable Square Footage

Space that can be used or occupied by a tenant. Typically does not include elevators, stairs, mechanical spaces, etc.

SNDA

Subordination - Tenant subordinates lease to the mortgage. Non-Disturbance - Protects tenant from being thrown out of the property. Attornment Agreement - Tenant commitment to allow for ownership to change.

Add-on Factor

The add-on factor is the number of usable square feet in a commercial property divided by the number of rentable square feet. It is added for the use of Common Spaces in the building.

Rentable Square Footage

The useable area that can be leased or rented to a tenant.

Carpetable Area

Usable Space Excludes areas that do not have a floor you can stand on.