PREVNEXTSUBMITTable of ContentsResourcesGlossaryTranscriptClear and return to MenuSearch ResultsFilterSlide TextTranscriptSearch in:Check to includeSearch...TermsDefinitionFINISHfinishdefinitionresourcessearchpauseplayreplaysubmitnextpreviousvolumeSUBMIT ALLsubmit allQuestion ListMore infoSend an emailCloseBioExit part 2 – market cycles expanding the cf model dr. greg smersh introduction we will discuss:lease terminologyrent concessionspercentage rentclauses common to commercial contractsexpand cash flow model to include multiple tenants with different lease terms introduction percentage rent - common in multi-tenant propertiescan increase effective rentbasis: if owners promote their property and tenants do well, owner should be compensatedcommon for retail shopping centerstenants pay a base rent, and additional rent based on sales percentage rent percentage rent base rent / percentage rate = breakpoint in sales lease on 2,000 sq. ft, base rent of $20/sq. ft, and percentage rent clause of 4%. with sales of 1.2 million, how much percentage rent will they pay? ? lease on 2,000 sq. ft, base rent of $20/sq. ft, and percentage rent clause of 4%. with sales of 1.2 million, how much percentage rent will they pay? ? base rent: 2,000 sq. ft. x $20 = $40,000breakpoint: $40,000 / 4% = $1 millionpercentage rate: $200,000 x 4% = $8,000 total rent: $1.2 million x 4% = $48,000ortotal rent: $40,000 + $8,000 = $48,000 (base rent) (percentage rent) percentage rate between 3% and 5% $1 million $8,000 rent concessions rent concessions rent concessions: “free rent”decreases effective renthigher base rent – pgi appear largerexclusive clause:maintains exclusivity against other potential tenantsdo not decrease effective rent, but may limit to whom owner may rent $10,000 / 12 month = $833/mo tenant improvements tenant improvements “white box”most companies have standard design they will implementowners often give allowance to make improvements$5 or $10 dollars per square footleasing costs are referred to as below line itemsnot included in noi because they are not an annually recurring expensenot included in calculation of effective rent absorption & turnover vacancy 90-100% leased at purchaseput additional vacancy allowance into cash flow –absorption and turnover vacancyassumes some probability of tenants renewing their lease absorption & turnover vacancy sqft space x market rent =vacancy allowance $ base rental revenue – absorption & turnover vacancy – rent abatement + expense reimbursements + percentage rent & other adjustments + miscellaneous revenue potential gross income – general vacancy effective gross income – operating expenses net operating income (noi) cash flow model cash flow model cherry creek example cherry creek example consider this:6,000 sf shopping centerpurchased on january 1, 2015assume 5% general vacancyreimbursable operating expenses:taxes, insurance, cam = $33,000 (increase at 3% / year)non-reimbursable operating expenses:management fee = 4% of egi 2015 2016 2017 2018 2019 5.50 5.67 5.83 6.01 6.19 2015 2016 2017 2018 2019 5.50 5.67 5.83 6.01 6.19 see course manual for more detailed calculations pgi calculation pgi calculation tenant size start rent increase reimburse verizon 2,000 sf 01/14 $27 fixed $5.35 stop liberty tax 3,000 sf 01/12 $23 3% year $5.00 stop marco’s pizza 1,000 sf 01/13 $20 $0.50 year nnn tenant size start rent increase reimburse verizon 2,000 sf 01/14 $27 fixed $5.35 stop liberty tax 3,000 sf 01/12 $23 3% year $5.00 stop marco’s pizza 1,000 sf 01/13 $20 $0.50 year nnn cf model calculations cf model calculations in 2015: base rent reimburseverizon $ 54,000 300liberty tax $ 75,398 $1,500marco's pizza $ 21,000 $5,500total $150,398 $7,300 150,398 + 7,300 = pgi $157,698 157,698 – 7,885 = egi $149,813 noi = $110,820 effective rent effective rent reimbursable expenses - $5.50increase 3% per year, $6.01 in 2018 verizon verizon $27.00 + ($6.01 - $5.35) = $27.66 verizon verizon $27.00 + ($6.01 - $5.35) = $27.66 verizon liberty tax $23 x 1.036 = $27.46 + ($6.01 - $5.00) = $28.47 verizon liberty tax $23 x 1.036 = $27.46 + ($6.01 - $5.00) = $28.47 verizon marcos pizza $20 + (5 x $0.50) = $22.50 + $6.01 = $28.51 verizon marcos pizza $20 + (5 x $0.50) = $22.50 + $6.01 = $28.51 conclusion conclusion we discussed:leasingexpanding cash flow modelvital to success in commercial real estate you have reached the end of this presentation.<html><textformat leading='1' tabstops='[48, 96]' leftmargin='0' indent='0'>In this presentation we will continue to discuss lease terminology such as rent concessions, percentage rent, and other clauses that are common to commercial lease contracts. We will also expand the cash flow model to include multiple tenants with different lease terms to demonstrate both the NOI calculation as well as the calculation of effective rent for individual tenants. </textformat></html><html><textformat leading='1' tabstops='[48, 96]' leftmargin='0' indent='0'>Percentage rent is a relatively common stipulation in most multi-tenant retail properties, such as shopping centers. Also referred to as overage rent, this can increase effective rent. The basis for percentage rent is that if owners promote their property - if they keep it well-maintained so as to attract customers, and tenants do well financially, that the owner should be compensated. Traditionally, this has been the norm for shopping malls where owners advertise and make a concerted effort to attract shoppers, but is now very common for even neighborhood shopping centers. Essentially, tenants pay base rent and then additional rent once they have sales over a certain dollar amount. The breakpoint in sales - at which tenants begin to pay additional rent - can be calculated by dividing their base rent by the percentage rate. In this situation the lease contract will include a specific percentage rate, typically between 3 and 5 percent. As an example, let’s assume that the tenant has a lease on 2,000 square feet with a base rent of $20 per foot, and percentage rent clause of 4 percent. If they have sales of $1.2 million, how much percentage rent will they pay? Their base rent is 2,000 square feet times $20 per foot or $40,000. That divided by 4% equals a breakpoint of $1 million. If they have sales of $1.2 million, then they will pay percentage rent of 4% on the $200,000 over the breakpoint, or $8000. Another way to look at this is that 4% of the $1.2 million in sales is $48,000 - the total that the tenant would pay in rent - $40,000 in base rent, plus an additional $8,000 in percentage rent. <tab></tab> </textformat></html><html><textformat leading='1' tabstops='[48, 96]' leftmargin='0' indent='0'>Rent concessions - also referred to as rent abatement - is just another word for free rent. It is common for landlords to offer several months of free rent to entice tenants to sign a lease. This is particularly common for multi-family residential properties. Rent concessions decrease effective rents. For example if a landlord offers rent of $1,000 per month with two months of free rent on a one year lease for an apartment, then the effective rent is 10 months times $1,000 or $10,000 divided by 12 which equals an effective monthly rent of $833. Even though the total rent on a one year lease is $10,000 most owners would prefer to give 2 months free rent and then get $1,000 per month for the remaining 10 months rather than get $833 per month for 12 months because they are seeking to maximize the value of their property, especially if they are thinking about selling. Higher base rent looks better on the rent rolls because it makes PGI appear to be larger than it really is. This is one thing that potential buyers should be aware of when analyzing a property. An analysis of market rents from nearby properties is likely to reveal the true asking rent, which in this case is probably more in the $800 to $850 per month range. Another concession that owners may give to commercial tenants in a shopping center is an exclusive. An exclusive clause in a lease contract indicates that other potential tenants in the same business would not be allowed to lease space in the shopping center. For example, an exclusive might guarantee a tenant that they will be the only dry cleaner, fitness center, or liquor store in the shopping center. Exclusives do not increase or decrease effective rents, but they do limit the owner in who they can rent to in the future.<tab></tab> </textformat></html><html><textformat leading='1' tabstops='[48, 96]' leftmargin='0' indent='0'>When a tenant leases space in a shopping center; that space is commonly referred to as a “white box.” Regardless of whether it is a new center or an old center where another tenant has vacated, the shop space is initially little more than a concrete floor with sheet-rock on the walls and ceiling. Most national and regional tenants have a standard design and layout for their space. Think about a Subway, Starbucks, Firehouse Subs, or UPS Store - these tenants all have a theme that is common to their franchise, and it takes a significant investment to put in the dropped ceilings, electrical and plumbing fixtures, counter space, and other finishes before the tenant can open for business. It is common for owners to give new tenants an allowance to do these things, which are referred to as tenant improvements. Often, tenants get $5 or $10 dollars per square foot in tenant improvements, but it really depends on the market and how badly the owner wants the tenant. Leasing costs, which include tenant improvements and leasing commissions are referred to as below line items, and are not included in NOI because they are not an annually recurring expense. Similarly, they are not included in the calculation of effective rents.<tab></tab> </textformat></html><html><textformat leading='1' tabstops='[48, 96]' leftmargin='0' indent='0'>Typically, when commercial properties such as shopping centers are purchased, they are 90% to 100% leased up. Many of the existing leases were signed years ago, but may expire during the holding period. In multi-tenant properties which have leases due to expire, it is not uncommon to put an additional vacancy allowance into the estimated cash flows, due to the uncertainty involved. This is referred to as absorption and turnover vacancy. If the tenant does move out, the space may sit vacant for some time. To estimate the appropriate allowance, an analyst would make some assumptions about the probability of the tenant either staying or leaving, and how long it would take to put a new tenant in place. For example, let's say that the analyst assumes that there is a 50-50 chance that the tenant will leave, and if so - that it will take six months to lease out the space. In that case a vacancy allowance for three months might be included. The dollar amount for the turnover vacancy allowance would be the square footage of space times the market rent. Typically, the general vacancy allowance would be reduced by the same amount although it is certainly possible for the absorption and turnover vacancy allowance to be greater than the general vacancy allowance in a particular year.<tab></tab> </textformat></html><html><textformat leading='1' tabstops='[48, 96]' leftmargin='0' indent='0'>Let's now go back to the cash flow model, and look at how various leasing adjustments affect potential gross income. PGI now starts with base rental income, but is reduced by any absorption and turnover vacancy, as well as by any rent abatement. It is increased by expense reimbursements, percentage rent, and any miscellaneous income from items such as parking or vending. Operating expenses are the same as they always were. That is, expense reimbursements do not reduce operating expenses but rather increase potential gross income. The net effect is that the owner will pay less of the operating expenses if tenants are paying expense reimbursements, but operating expenses should always be for the exact amount. Typically, reimbursable operating expenses will include taxes, insurance, and CAM, while non-reimbursable operating expenses will include items such as a management fees and security.<tab></tab> </textformat></html><html><textformat leading='1' tabstops='[48, 96]' leftmargin='0' indent='0'>To illustrate, let's consider a 6,000 square foot property with three tenants. We will start our analysis as of January 1, 2015 and assume a 5% general vacancy. Reimbursable operating expenses for taxes, insurance, and CAM are expected to be $33,000 in the first year of operations, and to increase by 3% per year. Thus reimbursable operating expenses are $5.50 per square foot in the first year and will increase to $5.67 per square foot in the second year, $5.83 per square foot in the third year, and so forth. There is also the non-reimbursable operating expense of a management fee which is 4% of EGI. Typically tenants in the same property will have similar leases - that is, all the tenants will have either gross leases or net leases. However, in this example, for the sake of illustration we will consider different types of leases.<tab></tab> </textformat></html><html><textformat leading='1' tabstops='[48, 96]' leftmargin='0' indent='0'>This property has three tenants, Verizon, Liberty Tax, and Marco’s Pizza. Verizon occupies 2,000 square feet with a lease that started in 2014, Liberty Tax occupies 3,000 square feet with a lease that started in 2012, and Marco’s Pizza occupies 1,000 square feet with a lease that started in 2013. In calculating base rent and reimbursements, it is important to pay attention to the year that the lease started. The Verizon lease is fixed at $27 per square foot, so in 2015 they will pay 2,000 square feet times $27 or $54,000. They will reimburse operating expenses over $5.35 per foot and in 2015 will reimburse 2,000 square feet times $0.15 or $300. The Liberty Tax lease started in 2012 at $23 per foot with a 3% annual increase, so in 2015, their base rent will be $25.13 per foot times 3,000 square feet, or $75,398. They will reimburse operating expenses over $5 per foot and in 2015 will reimburse 3,000 square feet times $0.50 or $1,500. The Marco’s Pizza lease started in 2013 at $20 per foot with a $.50 annual increase, so in 2015, their base rent will be $21 per foot times 1,000 square feet, or $21,000. They have a triple-net lease, and so in 2015 will reimburse $5.50 per foot or $5,500.<tab></tab> </textformat></html><html><textformat leading='1' tabstops='[48, 96]' leftmargin='0' indent='0'>Calculations for the cash flow model are now expanded from what we worked with initially. In this example, base rent totals to $150,398, reimbursable expenses total to $7,300, and PGI is the combination of the two, or $157,698. The general vacancy allowance is 5%, or $7,885, which gives us EGI of $149,813. Operating expenses will always be the same, regardless of the amount that is being reimbursed, since expense reimbursements have been added to PGI. In this example operating expenses in 2015 are $33,000 plus 4% of EGI, or $5,993 for a total of $38,993. This gives us first year NOI of $110,820.<tab></tab> </textformat></html><html><textformat leading='1' tabstops='[48, 96]' leftmargin='0' indent='0'>Now let’s calculate effective rents in the year 2018 for these three tenants. Recall that reimbursable operating expenses were $33,000 for the 6,000 square foot property or $5.50 per foot in 2015. These expenses were assumed to increase at 3% per year and therefore are expected to be $36,060 divided by 6,000 square feet, or $6.01 in 2018. The Verizon lease started in 2014 with base rent of $27 per foot and no increase. Their expense stop is $5.35, so they will reimburse $0.51 and their effective rent would be $27.66 per square foot in 2018. Liberty Tax lease started in 2012 at $23 with a 3% annual increase, so base rent is $23 times 1.03 to the sixth power, or $27.46 per foot. Their expense stop is $5.00, so they will reimburse $1.01 and their effective rent would be $28.47 per square foot in 2018. The Marco's Pizza lease started in 2013 at $20 and increases $0.50 per year, so base rent in 2018 would be $22.50. They have a net lease and will reimburse the full $6.01 per square foot, so their effective rent is $28.51 per square foot in 2018.<tab></tab> </textformat></html><html><textformat leading='1' tabstops='[48, 96]' leftmargin='0' indent='0'>In this presentation, we’ve continued our discussion of leasing, and expanded the cash flow model to include multiple tenants with different lease terms. The analysis of commercial real estate can become very complicated with large multi-tenant properties such as a grocery-anchored shopping center with 20 or more leases. The analysis can be complicated even further by the fact that lease terms are of different lengths and often expire during the holding period. For this reason, many real estate professional use programs such as ARGUS, a software package that allows for various leasing assumptions, which can be weighted for items such as the probability of lease renewal to more accurately measure cash flows. Regardless, this relatively simple introduction to leases should help to emphasize that a strong understanding of leasing is vital to success in commercial real estate.<tab></tab></textformat></html>