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What Does the Future Hold for Commercial Real Estate?

Inflation, interest rates, concerns about recession, pandemic-inspired work-style changes, taxes. There are enough wild cards in the deck to give any economic forecaster vertigo.

Not all real estate markets or all sectors are created equal, so to paraphrase an old TV auto ad, your mileage may vary. Nonetheless, we think it’s possible to make at least some reasonable and general forecasts about the near-term prospects for commercial real estate. Here is some of what we’re hearing, and thinking.

Multifamily

The multifamily sector seems likely to continue showing positive revenue growth. Freddie Mac predicts 3.5% increase in gross income nationally from apartment rentals in 2023, and a 5.1% vacancy rate. The multifamily market was outrageously strong in 2021, has cooled off somewhat since then, but still looks like a propitious place for investor dollars. With mortgage rates at their highest level in years, and the inventory of single-family homes for sale in short supply in many areas, there should be a lot of folks who must opt for apartments — hence, continued strong demand. Globest suggests that “multifamily remains a front-running investment choice.”

Office

The office market seems a bit harder to get a handle on. Many office workers have become very comfortable with working from home and are reluctant to go back into the office. They’ve been saving on commuting costs, especially in a time of high gas prices, on child care, and sometimes even on the cost of business attire. Some employers are demanding that workers return full time, but many are agreeing to a hybrid model, a few days a week in the office and a few at home. For many businesses, this means they need less office space. An in-depth interview on Co-Star with three industry analysts concurs that hybrid work is here for the long term and that demand for space is likely to decrease.

These analysts also noted that the suburban office market has been more resilient than the central business districts, and that suburban vacancies have actually been lower than those in CBDs. Finally, they note that while office leasing appears to be stabilizing, rising interest rates have been putting a damper on sales.

Industrial

If there is one clear winner right now, it would appear to be the industrial sector. In an article on trends in industrial real estate, commercialsearch.com says, “Onshoring efforts, coupled with a continuation of last year’s e-commerce boom, have only added to the already sky-high demand for industrial real estate.” It further quotes an analyst who believes this sector will be “among top performers across the commercial real estate sector in 2023.”

Similarly, NAIOP’s Industrial Space Demand Forecast says, ”Despite rising interest rates and growth in the supply of new space entering the market, the outlook for industrial real estate remains bright as supply chain conditions steadily improve. Low vacancy rates will continue to support growth in rents and property values.”

Retail

Retail, like politics, tends to be hyper-local. A recent article in the Wall Street Journal, The Decline of the Five-Day Commute Is a Boon to Suburban Retail, puts this in the context of the post-pandemic environment. The trend of businesses moving their office out of the central business district has led to fewer people shopping in downtown locations; but on the flip side, the suburbs have generally been the beneficiaries. “In the second half of last year, urban retail availability surpassed suburban availability for the first time since at least 2013, according to real-estate firm CBRE. Asking rent growth in the suburbs also outpaced urban areas last year.”

Overall — Sustainability

One phenomenon that looks like it will cut across all sectors is the growing interest in sustainability. It seems very likely that this will drive demand for green buildings. As we all become more aware of the impact that buildings can have on the environment, there is a growing demand for green buildings that are designed to be energy-efficient and environmentally friendly. This is creating opportunities for developers who can build green buildings. There are also financial incentives to commercial property owners, including reduced operating costs, increased asset value, and higher rents. We’ll be having a follow-up post with more on this soon, so stay tuned.

Frank Gallinelli



         


Copyright 2022,  Frank Gallinelli and RealData® Inc. All Rights Reserved
The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.  Building photo by John Unwin on Unsplash Solar array photo by Trinh Trần on pexels.com

The Case of the Mysterious Sinking IRR

Users of our Real Estate Investment Analysis program sometimes call us with questions that are not about the software but about the underlying analysis. If we had a “greatest hits” list for those questions the all-time winner would be this: “My cash flow goes up each year; the value of the property goes up each year; but when I look at the Internal Rate of Return, it goes down almost every year. What’s up with that?” To see how this can happen, let’s take a look at two very simple examples.

Example #1: We purchase a property for $100,000 all cash. It has a Net Operating Income of $10,000, so the capitalization rate is 10%. We are going to assume that 10% is the right cap rate for this market (primarily because it make the math in our example easy to follow). Because we bought the property for cash there is no debt service and so we can also assume that the cash flow is the same as the Net Operating Income. For those who require an instant (and very abbreviated) refresher course on these concepts, use the following:

  • Gross Income less Operating Expenses equals Net Operating Income
  • Net Operating Income less Debt Service equals Cash Flow
  • Net Operating Income divided by Capitalization Rate equals the property’s Present Value

The property is in good shape and is running well when we buy it. Our initial cash flow occurs on Day One when we spend $100,000 in cash to make the purchase. We project that we can raise the rent 4% during the first year to $10,400. The property is well-located, so we believe we can get a bit more aggressive over time. We’ll project that we can increase the revenue 5% in the second year, 6% in the third, 7% in the fourth and 8% in the fifth. Here is what our projections look like:

 

Notice that, if we sell the property at the end of one year for its full value (i.e., with no selling costs, to keep matters simple), our Internal Rate of Return (IRR) is a pleasing 14.4%. If we sell at the end of year two, our IRR for that holding period is even better, 14.92%. If we hang on to the property for five years, we see that we can expect a 16.38% IRR. The rents go up each year, the value goes up and so does the IRR. All is right with the world.

Example #2: At the same time we buy another property, also for $100,000 cash. It too has a $10,000 NOI, but this property needs immediate management improvements to control expenses and to get rents in line with the market. We feel sure that we can get the NOI (and hence the cash flow) to $12,000 in the first year. That should get it on a stable footing, from which we expect a more modest 3% increase in rent each year thereafter. The rents go up each year, the value goes up each year, but what about the IRR?

 

At the end of the first year, we’re thrilled by a robust IRR of 32%. We worked hard; we deserve it. But if we hold the property for a second year the Internal Rate of Return drops to 22.76% — still not shabby but significantly lower than at the end of the prior year. Indeed, the longer we hold the property, the lower the IRR becomes. What, to coin a phrase, is wrong with this picture? Nothing is wrong, actually. The numbers are correct. Remember that Internal Rate of Return is a time-sensitive measurement. The biggest jump in cash flow and in the property’s value came early. The earlier it arrives, the less severely it gets discounted — it’s the “time value of money” concept. The increases that occur in years two through five are smaller to begin with and they get discounted over a greater number of years, shrinking their worth to us today even more.

Simply put, if we hold the property two years instead of one, then that second year dilutes the overall rate of return because it didn’t contribute as much (especially after an extra year of discounting) as the first year did. If we hold the property for three years, the return gets diluted still further.

At this point, someone in the back of the room is surely asking the insightful question, “So what?” Here’s what: The first property is telling us that it will perform better as an investment if we hold onto it for a while. Its rent increases are accelerating each year. Even though the increases have to be discounted — it’s that time value of money again — they’re growing at a pace that makes them worth waiting for. Hence the IRR gets higher with each year we hold on. The second property, however, has a bit more of a roman candle quality to its performance. The big flash comes early; after that, it just sputters along.

Does this mean you should immediately sell such a property? If you’re happy with the long-term IRR and could not find a replacement property with a greater yield, it might make sense to hold. Or you might be more comfortable following the words of immortal Janis Joplin: Get it while you can. To put that in more businesslike terms, you might decide to sell the property when the IRR peaks; then take the proceeds and reinvest them. Whichever way you go, the important thing is that you’ll be making an informed decision.

Better than being like this guy.


If you found this example helpful, I have a lot more educational material for real estate investors and developers. For example, check out these video lessons…

Real Estate Investment Case Studies where I take you step-by-step through the evaluation of five different property types: apartment, mixed-use, triple-net leased, retail strip center, and single-family property

Value-Add Real Estate Investments where I show how you might do something tangible or intangible to a property, but in either case, something that increases how much a person would pay to acquire that asset from you when you’re done.

Or if you’re ready for a complete training series in real estate investment, development, finance, partnerships, and more, consider Mastering Real Estate Investing.

—— Frank Gallinelli  

 

Copyright 2023,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.


Return on Equity — What a Non-Traditional Approach Can Reveal

We usually think of Return on Equity (ROE) as a straightforward investment measure. That’s understandable, because the traditional method of calculating ROE is pretty clear cut: Take your cash flow after taxes and divide it by your initial cash investment.

This in fact is just a hop-and-a-step away from another popular measure, Cash-on-Cash Return (aka Equity Dividend Rate). The only difference is that Cash-on-Cash uses the cash flow before taxes.

Whichever of the two appeals to you more – and we’ll stick with ROE for simplicity here – the measurement will give you a quick sense of how your cash flow measures up to its cost.

There is a non-traditional approach, however, that we use in our Real Estate Investment Analysis software – an approach that can tell you something quite different about your income-property investment. This not-so-standard method differs in its definition of “equity.” Instead of looking at the actual dollars invested, you look instead at potential equity at a particular point in time. That equity is not what you invested, but rather the difference between what you believe the property is worth at that time and what you still owe in mortgage financing. So, if you look at the equity after one year (or two or three), you’ll be taking into account the growth or decline in the property’s value as well as the amortization of your mortgage.

Our non-standard formula now looks like this:

This measurement becomes interesting if you apply it in a multi-year projection. Let’s assume that you make projections about a property’s performance over a number of years and that you include in those projections the potential resale value and mortgage balances for each year (as we do in our REIA software). Whether or not you actually sell the property in any particular year, you accept the idea that your equity at a given time is the difference between what your property is worth and what you owe on your mortgages. By this reasoning, your return on equity measures not how your cash flow performs in relation to how much you originally invested, but rather how it performs in relation to how much you currently have “tied up” in this property.

What difference does it make? Consider this situation; you project that your property’s cash flow and resale value will increase each year but when you calculate the ROE you find the following:

You observe that your ROE starts going down at some point even though the value of the property and the Cash Flow After Taxes continue to go up. Is this a mistake? No, it can occur if the equity grows at a rate that is faster than the growth in cash flow. With our non-standard definition, your equity can grow when the value of the property increases or the mortgage balance decreases – or both. Mortgage amortization typically accelerates over time, so that alone can accelerate the growth in your potential equity. ROE is a simple ratio, so if the equity grows faster than the cash flow, then the Return on Equity will decline over time.

What does this decline mean to you as an investor? It means you have more and more potentially usable, investable cash tied up in this property and that the return on that cash is declining. Is that a bad thing? Not absolutely – it depends on your alternative uses for the money. If you were to refinance and extract some of that equity, could you purchase another property and earn a greater overall return? If you sold, could you use the funds realized to move up to a larger or better property, one with a better long-term upside?

If the answer to any of these questions is yes, or even maybe, then being tuned into to the message from this alternative method calculating ROE can give you the heads-up you need to maximize your investment dollars.

Frank Gallinelli

To make this kind of ROE projection – and to analyze all facets of your income-property investment – use our Real Estate Investment Analysis software with its numerous rate-of-return, cash flow and resale metrics

Copyright 2022,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services. Photo by Giorgio Trovato on Unsplash 

 

 


What Happened to Your Property Management?

If you’ve taken my video course, read any of my books, listened to some of the podcasts I’ve been on, then you’re very aware that I often rant about how important it is for you to account for just the real operating operating expenses when you evaluate the worth of a property — no more and no fewer.

There is one mistake I see really often, and I want to call it out here in this video blog.

 

Copyright 2021,  Frank Gallinelli and RealData® Inc. All Rights Reserved
The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

Love Your Hat! What is Your Lender Really Looking at When You Apply for a Commercial Mortgage?

If you’re not an all cash buyer, then when you purchase a piece of income-producing real estate you’ll probably need to secure mortgage financing to complete the deal. It’s essential for you to understand what your lender is looking at when underwriting that loan.

And — If you guessed that he or she is not admiring your millinery —  ok then, stick with me here. I’m going to discuss briefly a couple of key yardsticks.

Of course, this short video blog post is just the tip of the iceberg when it comes to evaluating, financing, and acquiring a successful real estate investment.

For in-depth insight into on all the key metrics and methods, check out https://realestateeducation.net/

And you’ll find the software that will do all the heavy lifting for your analysis and presentation at https://realdata.com

 

Copyright 2021,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.


Video post: Understanding Net Operating Income, Part 2

In Part 1 this post, we looked at the revenue side of our NOI calculation. Now let’s look at the expense side, and how the end result – the NOI itself, is typically used when evaluating a potential real estate investment. Click the image below.

 

If you missed Part 1, you can watch it here.

Copyright 2021,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.


Sharpening Your Pencil – Create Better Analyses With Published Real Estate Data

It’s tempting to rush through a property analysis by simply reviewing the broker’s sell sheet, plugging the data into your favorite software program and printing the results. You’re done, right?

Think again.

We’re not saying the seller isn’t providing accurate income and expense data, but is he or she giving you a complete picture of all the issues? Consider such questions as:

  • What is an appropriate cap rate for the market in which the property is located; and more specifically, what’s the prevailing cap rate for the particular sector, such as multi-family or self-storage?
  • What seems like a realistic assumption for revenue and expense growth over time?
  • How have vacancy rates been trending for the area, and what might those trends say about future leases, renewals, and demand for space?

You’ll probably need to look beyond the owner’s statement to build your best property analysis and thus create your best chance at a successful investment. Thankfully, you can find a number of sources online to help you achieve accuracy, and along with it, some peace of mind.  You can find data on:

  • Metropolitan and submarket area cap rates
  • Average rents by market sector
  • Vacancy rates
  • Number of units available and sold
  • Sales and rental comps
  • Custom reports based on your subject property

The following are some of the best-known sources of data:

 

Zillow

https://www.zillow.com/research/data/

You’re probably already familiar with this site, at least in regard to its home value estimates. The focus here is residential but investors can benefit from their extensive rental information, which is provided by county, metro area, city, zip code, and even neighborhood.  You download data in Excel format. We found their series of 5 to 7 years of data particularly useful for evaluating rental trends.

You can also learn about their methodology here.

 

Moody’s Analytics (formerly Reis)

https://cre.moodysanalytics.com/

Reis has been a source of commercial real estate data for nearly four decades, and say they are a “…source for property and market intelligence, including vacancy rates, rent levels, cap rates, new construction, rent comparables, sales comparables, valuation estimates, and capital market trends across eight major commercial real estate sectors.

You can get more info about their data products at https://cre.moodysanalytics.com/products/

 

Costar

http://www.costar.com

Really big data commercial real estate here, for owners, brokers, appraisers, lenders, even institutional investors

They say you can search up to 1 million sales records, across all property types at https://www.costar.com/products/costar-comps or access property-level data, including vacancy, rents, sales comps for multifamily, office, industrial, or retail property at https://www.costar.com/products/analytics.

 

Compstak

https://compstak.com/enterprise

Compstak serves up office, retail and industrial lease data for “leading institutional investors, lenders, and owners across the US and UK.”  Subscribe to their entire database or, if you are broker, appraiser or researcher, trade your own data for theirs and gain access to Compstak data for free.

Real Capital Analytics

https://www.rcanalytics.com/solutions-for/investors-owners/

From macro trends to extensive data on individual properties, Real Capital Analytics offers data on “$18 trillion of sales, recapitalizations and financings.”  Contact them for pricing.

 

Redfin

https://www.redfin.com/blog/data-center

Redfin is a residential brokerage firm but offers a wide variety of property sales and trend data.  Of particular note is their annual report of the “Hottest Neighborhoods in the US.”

While you may not be an investor in single family homes, consider that the market for your commercial property is linked to the health of the local residential market.

 

LoopNet

http://www.loopnet.com/salescomps/
Gain access to their database of 1.6 million sales listings.  Cost is $175 per month.  They also offer, at no charge, sales and lease trends for hundreds of localities across the US.  See http://www.loopnet.com/markettrends/

 

What data sources do you use? Share your thoughts by commenting below.


What is Your Marginal Tax Rate, and Why is It Important to You?

marginal tax rateUnless you make your living by helping people complete their returns, you probably prefer to spend as little time as possible thinking about income taxes. The rules and forms are generally opaque and the process is often stressful. However, there is at least one concept in the U.S. tax system that is both very simple and really important, and yet I find that it is unfamiliar to many. That concept is the Marginal Tax Rate, and the short version goes  like this:

Your marginal tax rate is the rate at which your next dollar of income will be taxed.

Now let’s see just how that works and why it matters to you.

Tax Brackets

If the U.S. had a so-called “flat tax,” then each person would pay a fixed percentage of his or her income. For the sake of example (and putting all political agendas aside), let’s say the flat rate were 10%:

$10,000 income x 10% = $1,000 tax

$1,000,000 income x 10% = $100,000 tax

Simple enough, and the person with the higher income would pay a proportionally higher tax.

However, the U.S. has instead what is called a “progressive” tax system. It’s like a layer cake. The bottom layer is taxed at a certain rate; the next layer is taxed at a higher rate; the next at a still higher rate. We call these layers “tax brackets.” Here is what the brackets for a married couple filing jointly looked like in 2015:

Screenshot 2016-02-03 10.37.06

The logic here is that the higher your income, the higher the rate at which that income will be taxed. The tax rate becomes progressively higher as income increases, hence the name.

What Is Marginal Tax Rate?

Your marginal tax rate is simply the rate at which your next dollar of income will be taxed. Let’s say that our married-filing-jointly couple, Jack and Jill, had income only from their jobs in 2015. After deductions, they had a taxable income of $74,900. They are at the top of what we would call the “15% tax bracket.”

Then Jill received a one-time year-end bonus of $1,000, raising their total family income to $75,900. How much of that bonus will be lost to federal tax? Recall our table:

Screenshot 2016-02-03 10.47.12

Every dollar earned starting with dollar # 74,901 (and continuing until 151,200) is going to be taxed at 25%. So she will pay $250 of that bonus in federal tax.

$1,000 x 25% = $250

What Marginal Tax Rate Isn’t

If someone were to ask our couple what tax bracket they were in, they would say, correctly, “25%.” Many people assume, incorrectly, that this would mean they are paying 25% of their total income in taxes. But that is not the case. This couple is paying 10% of their first $18,450 of income, 15% of the next $56,450, and 25% of the last $1,000.

And so, they are actually paying an effective rate that is just a bit less than 14%.

Screenshot 2016-02-03 10.32.27$75,900 income / $10,562.50 tax = 13.92% effective tax rate

Why Does It Matter to You?

Now that you understand how it works, you ask the obvious existential questions: So what? Why do I care?

Knowing your marginal tax rate is essential to anticipating the tax consequences of new income or new deductions. Consider some examples:

Our couple knows that their effective tax rate is currently around 14% but their marginal rate is 25%. What if they decide to acquire a profitable new investment property? They need to recognize that the additional income, which is layered on top of their employment income, is going to be taxed at their marginal rate of 25%. That information may factor into their decision as to whether the income from that property, after-taxes, is attractive enough to justify the cost and the effort.

What if they were thinking about making a $1,000 donation to charity at the end of 2015, or possibly waiting until next year to do so? If Jill’s bonus is indeed a one-time event, she would save $250 on their joint taxes if she makes that donation this year, while she is in the 25% bracket; but she would save only $150 if she waits until next year when she expects to drop back under the 25% marginal rate and into the 15% bracket.

Perhaps in 2016 this couple encounters a fantastic real estate opportunity where they make a quick $85,000 profit. Short-term gains are treated as ordinary income, so add this profit to the $74,900 taxable income they had expected from their jobs and you can see that they will catapult across two tax brackets. At $159,900, assuming the bracket table remains the same, their marginal rate is going to jump to 28%.

Screenshot 2016-02-03 10.47.32

By being aware of their new marginal rate and where it is that they may fall within that 28% tax bracket, they can do some sensible tax planning. It looks like $8,700 of their income (i.e., the amount that their 2016 income is over $151,200), will be taxed at 28%. Are there some 2017 deductions that they could accelerate into 2016? Perhaps they could pre-pay the property taxes on their home. All or part of that deduction would save 28% if they took it the year of atypically high income, versus 15% in a year where their income returned to the 15% bracket.

One word of caution to so-called high-income investors (and that could mean folks with income as low as about $200,000 for individuals or $250,000 for joint filers): There are a variety of potential gotchas lurking for you in the ever-changing tax code. Certain deductions or exemptions may phase out, and the Net Investment Income Tax may kick in. Don’t try parsing this at home; consult a professional tax advisor.

For most people, however, awareness of your marginal tax rate and where you fall in the tax-bracket chart can be a big help in understanding the consequences of changes in income and making informed tax-planning decisions.

—-Frank Gallinelli

Want to learn more about real estate investing? Visit learn.realdata.com

Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Find out more at www.realdata.com.

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Copyright 2016,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles and blog posts that appear on realdata.com is provided as general information and is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

 


Real Estate Expense Recoveries—What are they, how do they work? (part 3)

In Part 2 of our discussion of real estate expense recoveries, we looked at several different methods that property owners use to recover some of their operating costs from tenants:

  • Simple pass-throughs — These typically work well in single-tenant properties, or in properties with no common area. The expenses chosen for reimbursement are billed to the single tenant; or if there are multiple tenants, then the charge is divided according to each tenant’s share of the total space.
  • Expense-stop pass-throughs — Some pass-through arrangements require the tenants to pay a just portion of the recoverable expenses. The landlord pays up to a certain amount, called an “expense stop,” and the rest is passed through to the tenants. The “stop” can be a dollar amount defined in the lease, or it can be a “base-year stop,” where the landlord pays whatever amount comes due in the first year of the lease and the tenants pay any increase in subsequent years.
  • CAM — In larger properties, where there is common space for the benefit of all tenants as well as for the public, the landlord my collect CAM (Common Area Maintenance) charges—expenses related to the maintenance of these common areas.

We left off at sticking point, however, regarding larger properties. If there is a significant amount common area, then the landlord will surely be thinking about the fact that this space accrues to the benefit of the tenants but doesn’t earn anything for the landlord. There must be a way to remedy this apparent inequity.

 

The Load Factor

Enter the “load factor.”

Fotolia_42618982_XSload factor

Recall two definitions near the end of the previous article:

usable square feet (usf): The amount of space physically occupied by a tenant.

rentable square feet (rsf): The amount of space on which the tenant pays rent.

The load factor represents a percentage of the common area, which is then added onto a tenant’s usable square footage to determine the tenant’s rentable square footage.

Let’s say a shopping center has a total area of 100,000 square feet. 90,000 is the usable area, occupied by tenants, and 10,000 is common area.

Load Factor = total area / usable area

Load Factor = 100,000 / 90,000

Load Factor = 1.11

What this means is that each tenant’s usable square footage will be multiplied by 1.11—in other words, bumped up by 11%—to determine its rentable square footage, the amount on which it pays rent.

Say for example that you operate a 2,000 square foot boutique in this 100,000 center, and have contracted to pay $40 per rentable square foot.

2,000 usable sf x 1.11 load factor = 2,220 rentable sf

2,220 rsf x $40 = $88,800 per year rent

Unlike what you did in the earlier pass-through models, you’re not paying an additional charge on top of your base rent here. Your base rental rate remains the same, but now it is applied to a greater number of square feet—the space you actually occupy plus a proportional share of the common area. This combination of your private space plus a pro-rata portion of the common space is what we now call your rentable square feet.

You and the other tenants are paying rent for your proportional shares of the common area from which you all benefit, and the landlord is receiving rent for all the space in the property. Cosmic equilibrium is restored.

 

 

Is It More Income or Less Expense?

Regardless of the name we give it—reimbursement, recovery, or pass-through—the end result is the same. The bottom line of our Annual Property Operating Data (APOD) form, Net Operating Income, is increased. The final issue to confront is how do we account for this additional money when we assemble a presentation or analysis?

more lessOne way that I see often, and which I believe to be incorrect, is to treat the reimbursement as if it were a negative expense—in other words, to show the expense reduced by the amount reimbursed. For example, if the actual property tax bill were $10,000 and the amount reimbursed were $9,000, then by this method the property tax expense would be shown as $1,000. Why do I say this is incorrect?

The purpose of an APOD, or of any income-and-expense statement, is to convey information that is both accurate and useful. The taxes for this property are $10,000. If you were a broker or property owner and handed me a report that showed taxes of $1,000, I would…

a) suspect you were trying to con me

b) doubt all of the rest of the numbers on your report

c) be denied essential information I need to evaluate the property (e.g., the true cost of property taxes and the lease terms regarding expense reimbursement)

d) find another broker or owner to work with

e) all of the above

The correct answer, of course, is “e.” You’ve missed a key ingredient of successful business discourse: clarity. You should convey your analysis of a property in terms that are unambiguous, accurate, and relevant to your audience.

If you don’t treat the reimbursement as a negative expense, then how should you handle it?

You should treat it as revenue, the same as rent.

  • It is rent. The amount may be based on a calculation involving one or more operating expenses, but it is still money paid by a tenant to a landlord under a lease agreement. If it walks like a duck, etc.
  • Many lease agreements will in fact describe the reimbursement as additional rent.
  • You can then apply a vacancy allowance to the total of base rent plus recoveries to account for the loss of both from a vacant unit. The top portion of your APOD might look like this:

(One side note on the interplay of vacancy on expense recoveries: Some leases will contain a gross-up clause. In such a lease, if there is less than full occupancy (which is defined in the lease, and is often pegged at 90 or 95%), then the landlord may take certain variable expenses that would be directly affected by the level of occupancy, such as janitorial cost, and “gross them up” to the amount they would be at full occupancy.)

In these three articles I’ve given you the abridged version of simple, single-tenant pass-throughs; pro-rated multi-tenant pass-throughs; expense stops; base-year stops; CAM charges; load factors; and even presentation issues. But there is no limit to the creativity of landlords and tenants in their pursuit of successful dealmaking. If you’ve been part of novel expense-recovery design, please share it with us.

—-Frank Gallinelli

Want to learn more? Visit learn.realdata.com

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Find out more at www.realdata.com.

Copyright 2016-2023,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

Real Estate Expense Recoveries—What are they, how do they work? (part 2)

Expense recoveries (aka reimbursements or pass-throughs) serve as a customary ingredient in leases for non-residential property. In part 1 of this article, I discussed some of the typical ways such an arrangement might play out.


The Simple Pass-Through

Fotolia_84790892_XS_split_costsIn a single-tenant property the tenant may be expected to pay all or a portion of certain operating expenses, such as property taxes and insurance, in addition to its base rent. If the tenant is obliged to pay just a portion of the expense, that amount is the excess over what is called an “expense stop.” Let’s say the property taxes are $12,000 and the lease requires the tenant to pay the excess over an expense stop of $4,000. The tenant would have to pay $8,000.

property tax expense — expense stop = expense reimbursement

$12,000 — $4,000 = $8,000 expense reimbursement

If this were a multi-tenant property, the recoverable amount would typically be pro-rated among the tenants—that is, it would be divided up according to the square footage of each tenant’s space in relation to the whole.


Base-Year Expense Stop

A variation on the expense-stop theme is the “base year expense stop.” In this scenario, the parties agree that the landlord will pay the full amount of the recoverable expenses for the first year, and in future years the tenant will pay any increase over that base.

An arrangement like this certainly seems straightforward enough, but prospective tenants sometimes view it with a jaundiced eye. What if the landlord tries to maneuver the timing of base year expenses in order to minimize them? Then the excess in subsequent years would be artificially inflated. If that’s a concern, then perhaps the tenant would prefer a pre-defined expense stop, as in the earlier example.

Keep in mind that the tenant does not pay these expenses directly to the original source of the bill. The landlord pays the tab and passes the appropriate charge through to the tenant, hence the term “expense recovery” or “reimbursement.”


Common Area Maintenance

furniture in small spaceNot every property will fit into a nice, neat, divisible mold. Take, for example, an office building or a larger shopping center. Properties like these may include areas such as lobbies, hallways, elevators, escalators, rest rooms, and parking lots—areas provided for the benefit of all the tenants, as well as for the public served by those tenants (i.e., their customers or clients). In addition, there may be services that the landlord provides for everyone’s benefit, such as security, trash removal, and janitorial. How does the property owner pass these costs through to tenants?

One approach is to bundle up the cost of common services into an item called CAM— Common Area Maintenance charges— and to pass that charge through based on square footage, just as one might pass through a property’s tax expense. Let’s take a tenant who occupies 2,000 square feet out of a total of 10,000; and let’s also say that we have identified $1,000 in total CAM charges for a given time period.

pro rata share of space x CAM charge
= expense reimbursement

20% x $1,000 = expense reimbursement

= $200 expense reimbursement

This method may be fine in situations where the CAM charges are based mainly on services, but the property owner might be less than satisfied with this approach if the property has a significant amount of physical area devoted to common use. Why?


Usable vs. Rentable

Perhaps the answer lies in that we mean by “space.” Let’s pause for two definitions:

usable square feet (usf): The amount of space physically occupied by a tenant.

rentable square feet (rsf): The amount of space on which the tenant pays rent.

The common area represents space from which the tenants benefit, but that space is not part of their private, usable square footage. The common space is being used for lobbies and hallways and rest rooms, so it’s not available to lease out and earn rental income. This would not appear to be an ideal business plan for the landlord. Should the landlord absorb the loss? Is there an alternative?

The answer, and more, in our final installment about expense reimbursements.

—-Frank Gallinelli

Want to learn more? Visit learn.realdata.com

####

Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Find out more at www.realdata.com.

Copyright 2016,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

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