Topic 2

Exclusions from NOI

• Debt service

• Depreciation

• Income taxes

• Tenant improvements

• Leasing commissions

• Capital expenditures

Total rent is made up of one or more of these elements:

• Base rent

• Percentage rent

• Expense recovery

• Rent free period

Percentage rent:

• A rental payment that is based on the sale or income earned by the tenant

  • There is therefore a breakpoint (certain level of sales or income) over which percentage rent will begin

Expense participation

• When a tenant pays their proportionate share of certain operating expenses of the property 

  • The proportionate share is calculated as leased area/ total leasable area

  • The expenses they are responsible for is contained in the expense participation clause of the lease

• The more common expense participation clauses can be categorized as:

  • Gross lease

  • Modified lease

  • Single net lease

  • Double net lease

  • Triple net lease

Expense participation

Gross lease

• The rent is all-inclusive. 

• The landlord pays all or most expenses associated with the property, including taxes, insurance and maintenance out of the rents received from tenants.

Modified gross or full service lease

• The landlord pays all expenses up to a lease defined expense stop, and all expenses over the expense stop are passed through to (or paid for by) tenants.

  • These are most commonly found in office leases.

Single net lease

• The tenant pays base rent plus a pro-rata share of the building's property taxes.

Double net lease 

• The tenant is responsible for base rent plus a pro-rata share of property taxes and property insurance.

Triple net lease 

• The tenant is responsible for base rent plus a pro-rata share of property taxes, property insurance and all other property operating expenses.

  • This is the most popular type of net lease for retail space. 

  • Favours the landlord as it protects him against rising expenses

Operating expenses

• Real estate taxes

• Common-area maintenance

• Security

• Utilities

• Insurance

• Management fees

Expenses are estimated at the start of the year and adjusted to actuals at the end of the year

• Referred to as a tru-up or cam adjustment 

Rent Free period

• A landlord will often offer a rent-free period at the beginning of the lease as an incentive to the tenant

  • At the beginning of a lease the tenant often has expenses related to moving or starting-up his business. The rent-free period will help offset these costs

  • Rent-free periods are accounted for on a straight-line basis and must be adjusted for when calculating cash flows

Other Income 

• A property may collect income other than rent derived from the space tenants occupy. This is classified as Other Income, and could include billboard/signage, parking, vending, etc.

Operating Expenses 

• Operating expenses include all expenditures required to operate the property and command market rents. 

Capitalized NOI approach

• Most widely used method to estimate the value of a commercial property 

• This valuation method presumes that a property will generate its stabilized NOI in perpetuity

• The value and cap rate are an inverse relationship

  • The higher the cap rate the lower the value

Potential Rental Income 

• Potential Rental Income is the sum of all rents (including expense participation) under the terms of each lease, assuming the property is 100% occupied. If the property is not 100% occupied, then a market-based rent is used based on lease rates and terms of comparable properties.

Vacancy and Credit Losses 

• Vacancy and credit losses consist of income lost due to tenants vacating the property and/or tenants defaulting (not paying) their lease payments. A historical average or a specific analysis can be used to determine the vacancy and credit losses 

NOI Adjustments

• NOI usually includes management fees.  If no fees are reported because the landlord manages the property himself, a market management fee will be estimated and included in operating expenses.

• In some circumstances NOI will be adjusted for recurring non-revenue generating capital expenditures and leasing commission

  • Institutional investors usually treat these items as “below the NOI” line

Some of the determinants of the Capitalization Rate include the following:

• Other investment yields (especially GOC rate)

  • Real estate competes for investment dollars with other forms of investments

• Perceived risk of asset class

  • Usually seen as a lower risk asset class it is still susceptible to overvaluation

  • Less liquid investment

• The market

  • High growth metropolitan market vs stagnant market

• Property characteristics

  • Type (retail, office, hotel, etc)

  • Quality

  • Size

  • Quality of the rent roll

Cap rates

• In determining the cap rate for a particular property, cap rates on similar properties sold will be examined and adjusted for the factors just listed.

• Cap rates for recent transactions can be obtained from third party service firms

  • See Cushman Wakefield Canadian Cap Rate Report

• The total of the GOC rate and risk premium gives the cap rate. 

• A certain inelasticity in the cap rates is often observed

Discounted Cash Flow

• DCF method values a property by adding together the present value of its future cash flows including its Terminal Value.

Terminal Value 

• The value of the property at the end of the investment period and is calculated based on the NOI at that time.

Discounted Cash Flow

• The discount rate used should reflect the rate of return required by an investor for an investment with this level of risk

  • This can be the same as the capitalization rate but if cash flows are uneven a different rate of return may be required by an investor.

  • The discount rate for the terminal value can be different than the rate used for the cash flows if the condition of the property is expected to change

    • Start-up of operations

    • Age of property when sold

    • Repositioning of the property (competitive position)

    • Business plan to address vacancy issues

Comparable Sales Approach

• Estimates the value of a property by comparing it with the recent selling price of properties that have similar characteristics.

  • Often used for single family houses

  • Sales data for commercial properties are available through third party service companies such as CBRE and Altus.

  • Comparable sales should be for properties of the same or similar

    • Type

    • Location

    • Age

    • Condition

Cost or Replacement Cost Approach

• estimates the current cost of replacing the subject property using industry sourced construction cost data.

  • Comparing the replacement cost to the market value informs the investor of the likelihood of new properties being developed.

  • The replacement cost is artificially depreciated to take into account the age of the property.

Leverage Effect

• Apart from gaining access to funds, many investors add financing to their real estate assets to obtain a higher return.

• Adding leverage (financing) to an asset will act as a multiplier to the return generated by the asset. 

• The greater the amount of leverage the greater the multiplicative effect.

Interest Rates and Fees

• Interest rates reflect both the market and the project risk

  • The higher the perceived risk, the higher the rate

• Interest rates for mortgages are often expressed as the amount of basis points (.0001) above the Government of Canada Bond rate (GOC) for a given term.

  • For example: 5-year term might be GOC 5_yr + 250 bp

  • GOCs are viewed as riskless investments

• Variable rates are usually expressed as the amount of basis points above the bankers’ acceptance rate which is tied to the bank’s credit worthiness

• Lenders may also charge fees that increase the overall cost of the loan

  • Application fees

  • Origination fees

• Standby fees (on undrawn amounts)

• The lender’s expenses in underwriting or documenting the loan may also be charged

• Appraisal fees

• Legal fees

Term Loans

• Mortgage loans

  • Guaranteed by the asset

  • Recourse loans are not only guaranteed by the mortgage on the property but also by a claim over the entity’s other assets.  Depending on the financial strength of the borrower this can greatly reduce the risk of a loan.

  • Non-recourse loans are solely guaranteed by the property.  If the borrower defaults and the value of the property is insufficient to recover the loan amount it is the lender which suffers the additional loss.

• Unsecured or corporate loans

  • Secured only by the corporate credit and not one specific asset. 

Mortgage rates are expressed as annualized semi-annually compounded rates and must be converted to get the monthly interest rate charged.

Underwriting 

• The amount a lender will be willing to lend is dependent on two important metrics:

  • Loan to Value (LTV)

  • Debt Service Coverage Ratio (DSCR)

The Loan To Value Ratio (LTV) measures the value of a loan against the value of the property.

• It is used to ensure that the liquidation of the asset, if necessary, will generate enough cash to repay the loan.

• LTV is calculated by dividing the amount of the loan by the property value.

• Commercial real estate loan LTVs generally fall into the 65% to 80% range depending on the asset category and perceived risk.

The Debt Service Coverage Ration (DSCR) measures the property’s ability to generate enough cash (NOI) to make the required debt payments.

• DSCR is calculated by dividing the NOI by the loan payment amount  (capital and interest) for the year.

• A DSCR of less than 1 indicates a negative cash flow. For example, a DSCR of .92 means that there is only enough NOI to cover 92% of annual debt service.

• In general, commercial lenders look for DSCRs of at least 1.2 to ensure adequate cash flow.

Lenders will also consider non-financial risks:

• Market risk

• Quality of development team

• Operational risks

  • Ability to lease at market rents

  • Security

  • Maintenance

  • HVACC

  • Services offered

• Tenant risk

  • Quality of rent roll

  • Rollover risk