Commercial Real Estate

Revenue Sources

Commercial properties generate income through several sources:

• Base Rent: The primary source of income, typically structured as a fixed amount per square foot
• Additional Rent: Includes expense reimbursements, percentage rent (in retail), and other lease-related income
• Other Income: Parking fees, vending, laundry, amenity fees, application fees, etc.

Factors Affecting Income

• Occupancy Rate: The percentage of leasable space that is occupied
• Lease Terms: Duration, rent escalations, expense structures, and renewal options
• Tenant Quality: Credit ratings, business stability, and historical performance
• Market Conditions: Supply and demand dynamics, competitive properties, and economic factors

Potential Gross Income (PGI)

The total income a property would generate if 100% occupied with all tenants paying contracted rents.

Effective Gross Income (EGI)

The actual income a property generates after accounting for vacancy and credit losses.

Types of Operating Expenses

• Property Taxes: Annual taxes assessed by local governments based on property value
• Insurance: Property and liability coverage
• Utilities: Electricity, water, gas, etc. (may be partially or fully passed through to tenants)
• Repairs and Maintenance: Ongoing upkeep of the property
• Property Management: Typically 3-5% of EGI for professional management services
• Administrative: Accounting, legal, and other administrative costs
• Marketing and Leasing: Costs associated with attracting and retaining tenants
• Reserves for Replacement: Funds set aside for future capital expenditures

Expense Ratios

Operating expenses are often analyzed as a percentage of EGI or on a per square foot basis:

• Operating Expense Ratio: Operating Expenses ÷ EGI
• Expense per Square Foot: Total Operating Expenses ÷ Gross Leasable Area

Expense Structures in Leases

• Gross Lease: Landlord pays all operating expenses
• Modified Gross Lease: Tenant pays some expenses, landlord pays others
• Triple Net (NNN) Lease: Tenant pays all operating expenses

Definition and Calculation

Net Operating Income (NOI) is the income generated by a property after deducting all operating expenses but before debt service, income taxes, and capital expenditures.

Importance of NOI

• Primary metric for evaluating a property's income-generating potential
• Used to calculate capitalization rates and property values
• Basis for determining debt service coverage ratios
• Key component in cash flow analysis
• Allows for comparison between properties regardless of financing structure

Stabilized NOI

Represents the expected NOI once a property reaches normal occupancy and operation, often used for valuation purposes.

NOI Growth

Factors affecting NOI growth include:

• Rent escalations in existing leases
• Market rent growth for new leases
• Improved occupancy
• Expense control and management
• Property improvements that allow for higher rents

Capitalization Rate (Cap Rate)

The cap rate represents the expected annual rate of return on a real estate investment based on the NOI it generates, assuming the property was purchased with all cash.

When the property value is unknown, the formula can be rearranged:

Factors Affecting Cap Rates

• Property Type: Different property types have different risk profiles and expected returns
• Location: Prime locations typically command lower cap rates (higher values)
• Property Quality: Class A properties generally have lower cap rates than Class B or C
• Tenant Quality: Properties with credit tenants on long-term leases have lower cap rates
• Market Conditions: Interest rates, supply/demand dynamics, and investor sentiment
• Growth Prospects: Properties with strong NOI growth potential may trade at lower cap rates

Cap Rate Compression/Expansion

Cap rates can change over time due to market conditions:

• Cap Rate Compression: Decreasing cap rates, resulting in higher property values
• Cap Rate Expansion: Increasing cap rates, resulting in lower property values

Other Valuation Methods

• Sales Comparison Approach: Valuing properties based on recent sales of comparable properties
• Cost Approach: Valuing properties based on the cost to replace the improvements plus land value
• Discounted Cash Flow (DCF) Analysis: Valuing properties based on the present value of expected future cash flows

Before-Tax Cash Flow (BTCF)

The cash flow generated by a property after accounting for debt service but before income taxes.

After-Tax Cash Flow (ATCF)

The cash flow generated by a property after accounting for income taxes.

Cash-on-Cash Return

Measures the annual cash flow relative to the initial equity investment.

Debt Service Coverage Ratio (DSCR)

Measures a property's ability to cover its debt obligations.

Lenders typically require a minimum DSCR of 1.20-1.25, meaning the property generates 20-25% more income than needed to cover debt payments.

Internal Rate of Return (IRR)

The discount rate at which the net present value (NPV) of all cash flows equals zero. IRR represents the annualized effective compounded return rate on an investment.

Calculating IRR

IRR is calculated by solving for the rate (r) in the following equation:

Equity Multiple

The ratio of total cash received from an investment to the total equity invested.

For example, an equity multiple of 2.0x means that for every dollar invested, the investor received two dollars back over the life of the investment.

Average Annual Return

The simple average of annual returns over the investment period.

Return on Investment (ROI)

The percentage gain or loss on an investment relative to the amount invested.

Sources of Capital Appreciation

• NOI Growth: Increasing property income leads to higher values
• Cap Rate Compression: Market-driven decreases in cap rates increase values
• Property Improvements: Renovations and upgrades that enhance property value
• Market Appreciation: General increases in property values due to market conditions

Value-Add Strategies

Approaches to actively increase property value:

• Increasing rents through property improvements
• Reducing expenses through operational efficiencies
• Increasing occupancy through better marketing and property management
• Repositioning properties to attract higher-quality tenants
• Changing property use to higher and better uses

Typical Hold Periods

• Short-term: 1-3 years, often for opportunistic investments
• Medium-term: 3-7 years, common for value-add investments
• Long-term: 7+ years, typical for core investments

Factors Affecting Hold Period Decisions

• Investment strategy and objectives
• Market cycle timing
• Lease expiration schedules
• Debt maturity
• Capital improvement timeline
• Tax considerations

Exit Strategies

• Sale to Another Investor: Selling the property outright to capture appreciation
• Refinancing: Pulling out equity while maintaining ownership
• 1031 Exchange: Tax-deferred exchange into another property
• Conversion: Changing property type or use (e.g., apartment to condominium conversion)
• Recapitalization: Bringing in new equity partners while maintaining some ownership

Exit Valuation

Methods for estimating property value at exit:

• Terminal capitalization rate applied to projected NOI
• Sales comparison based on projected market conditions
• Discounted cash flow analysis