Week 2

Property Categories (Market)

  • Commercial Property Categories:

    • Land

    • Office

    • Retail

    • Industrial

    • Multi-family (generally five units or more)

    • Special Use

  • Residential Property Categories:

    • Land

    • Single Family

    • Multi-family (generally fewer than four units)

Property Categories (IRS)

  • Residential Properties:

    • Defined as properties where people live for 30 days or more at a time.

    • No substantial services are provided (e.g., no medical care or rehabilitation services).

  • Non-Residential (Commercial):

    • Encompasses everything that is not residential.

    • Mixed-use designation: if residential income constitutes less than 80% of total income, it is considered commercial.

Units of Comparison

  • Definition: Units of comparison are components into which a property may be divided for purposes of comparison, e.g., price per square foot, front foot, cubic foot, room, bed, seat, apartment unit.

  • Purpose: To facilitate analysis even when properties are not exceedingly comparable.

  • Reference: The Dictionary of Real Estate Appraisal, Fifth Edition, Illinois: Appraisal Institute, 2010.

Common Units of Comparison

  • Square Foot (Sq. Ft.): Common for office, retail, industrial, commercial land, occasionally residential.

  • Acres: Used for residential land or large tracts of developmental or agricultural land.

  • Beds: Typically used for assisted living and student housing.

  • Units/Doors: Refers to multi-family apartments/condos and hotels.

  • Lots: Commonly associated with residential and some commercial subdivisions.

    • Mixed-Use Note: Units can also refer to "Development Units" which represent total units approved within a master-planned development.

Units of Comparison (Nuances)

  • Valuation Practices:

    • Most commercial property (office, retail, industrial, land) is valued on a price-per-square-foot basis.

  • Leasing:

    • Most commercial leases (office, retail, land) are quoted on a rate per square foot per year basis.

    • Exceptions:

    • Industrial leases often quoted per square foot per month (nationwide).

    • Commercial leases in California, and some other markets, may quote on a per square foot per month basis.

Gross vs. Net Rentable Area

  • Gross Square Footage:

    • Total area of a building, measured from inner wall to inner wall, with no deductions for obstructions or non-leasable space (as defined by Linneman).

  • Net Rentable Square Footage:

    • The leasable space, equal to the floor area where rent is based, often calculated using local market customs.

    • Reference: The Dictionary of Real Estate Appraisal, Fifth Edition, Illinois: Appraisal Institute, 2010.

Income Statement vs. Proforma

  • Income Statement:

    • A financial report detailing the operating history of a property, providing retrospective insights.

    • Typically prepared by accountants, it deducts depreciation and interest as expenses.

    • Important Note: Depreciation and interest should not be included as expenses for real estate analysis.

  • Proforma (Pro Forma):

    • A forward-looking statement forecasting expected financial performance.

    • Summary of Comparison: Income statement looks backward while Proforma looks forward.

Simple Income Statement Structure

  1. **Potential Rental Income

  2. Less: Vacancy**

  3. Effective Rental Income

  4. Plus: Other Income

  5. Reimbursable Expenses

  6. Effective Gross Income (EGI) or Gross Operating Income

  7. Less: Operating Expenses

Final Value: Net Operating Income (NOI)

Potential Rental Income

  • Defined as the total income attributable to real property at full occupancy before vacancy and operating expenses deductions.

  • Also commonly referred to as:

    • Potential Gross Income (PGI)

    • Gross Potential Rent (GPR)

  • Tip: Look for the keyword "Potential" in property income evaluations.

  • Reference: The Dictionary of Real Estate Appraisal, Fifth Edition, Illinois: Appraisal Institute, 2010.

Potential Gross Income Calculation

  • Calculation Formula:
    PGI=extBaseRentperUnitimesextTotalRentableUnitsPGI = ext{Base Rent per Unit} imes ext{Total Rentable Units}

  • Examples of Calculation:

    1. A 10,000 sq. ft. retail building leased at $18.00 per square foot:
      Annual PGI = 10,000 * 18 = $180,000

    2. A 150,000 sq. ft. industrial building leased at $0.35 per square foot:
      Annual PGI = 150,000 * 0.35 = $630,000

    3. A 60 unit apartment building rents for $600 per unit per month:
      Annual PGI = 60 * 600 * 12 = $432,000

Vacancy Definition

  • Description: Vacant space represents unrented areas within a property.

    • Property-level Vacancy: Specific to an individual property or project.

    • Market Vacancy: Represents the overall rate of vacancy influenced by supply and demand dynamics in a specific region or market.

  • Importance: It serves as a deduction from PGI for revenue lost due to vacant units.

  • Reference: The Dictionary of Real Estate Appraisal, Fifth Edition, Illinois: Appraisal Institute, 2010.

Vacancy Rate Explanation

  • Types of Vacancy Rates:

    1. Physical Vacancy Rate: Ratio of the amount of vacant space to the total space in a building or market, expressed as a percentage (representing the square footage or units that are unoccupied).

    2. Economic Vacancy Rate: Ratio of rent estimated for vacant space versus the total potential rent estimated for the entire building (representing lost rent due to vacancy).

  • Reference: The Dictionary of Real Estate Appraisal, Fifth Edition, Illinois: Appraisal Institute, 2010.

Characteristics of Vacancy

  • Physical Characteristics: Unoccupied dwelling units or spaces.

  • Economic Characteristics: Includes uncollected rent from both physical vacancy and unpaid/delinquent rent.

  • Terminology: Vacancy is often referred to as VACL, indicating vacancy and collection loss.

Property Level Vacancy Rate Calculation

  • Formula:
    extVacancyRate=racextVacantSpaceextTotalSpaceext{Vacancy Rate} = rac{ ext{Vacant Space}}{ ext{Total Space}}

  • Example 1 Calculation:
    Property Size: 100,000 sq. ft.
    Occupied: 92,500 sq. ft.

    • Vacancy Calculation:
      7,500 ext{ sq. ft. (vacant)} igg/ 100,000 ext{ sq. ft. (total)} = 7.5 ext{%}

  • Example 2 Calculation:
    ext{Vacancy Rate Calculation:} rac{9,000}{100,000} = 9.0 ext{%}
    (given $100,000 PGI and $91,000 EGI)

Market Level Vacancy Rate Calculation

  • Weighted Average Method: A more accurate approach.
    extMarketVacancyRate=racextTotalVacancyextTotalInventoryext{Market Vacancy Rate} = rac{ ext{Total Vacancy}}{ ext{Total Inventory}}

  • Simple Average Method: An easier but less precise average of individual building vacancy rates.

Vacancy Rate Calculation: Examples

  1. Vacancy Calculations Table (as of February 28th):

    • Property Name, Total Sq. Ft., Total Vacant Sq. Ft., and Vacancy Rate expressed.

    • Example for Building 1: 53,000 sq. ft. with 4,100 sq. ft. vacant.

    • Aggregated total and average figures provided.

Special Vacancy Rate Calculations

  • Considerations for Calculation:

    • Weight influences and context for each property's market analysis.

  • Data Specifications:

    • Variations among building types and how to best interpret vacancies and their potential impact on income streams.

Frictional Vacancy

  • Definition: The necessary amount of vacant space required in a market for it to operate smoothly.

  • Function: In a balanced, stabilized market, frictional vacancy facilitates tenant turnover (move-ins and move-outs).

  • Importance: Helps manage income losses when leases roll over and expire.

  • Discussion Points: Consider impacts of excessively high or low vacancy rates.

  • Reference: The Dictionary of Real Estate Appraisal, Fifth Edition, Illinois: Appraisal Institute, 2010.

Effective Rental Income Calculation

  • Formula:
    extEffectiveRentalIncome=extPotentialRentalIncome−VACLext{Effective Rental Income} = ext{Potential Rental Income} - VACL

  • Importance: Determines the realistic income expected from properties based on vacancy considerations.

Other Income in Multifamily Properties

  • Definition: Income generated through property operations not directly from space rental.

  • Common Sources:

    • Parking fees

    • Laundry services

    • Billboards

    • Vending machines

    • Can include reimbursable expenses.

  • Discussion Points:

    • The rationale for classifying other income differently than rental income.

    • Position of other income addition in effective gross income computations.

  • Reference: The Dictionary of Real Estate Appraisal, Fifth Edition, Illinois: Appraisal Institute, 2010.

Other Income/CAM Reimbursements

  • Definition: Tenants' share of costs related to common areas (CAM), including:

    • Gym

    • Lobby and amenities

    • Hallways and bathrooms

  • Applications:

    • For NNN leases, tenants cover their share of all operational expenses incurred by the landlord, covering:

    • Taxes

    • Insurance

    • Utilities

    • Repairs & Maintenance

    • Management fees

  • Discussion Points: Who covers CAM for unrented/vacant spaces?

Effective Gross Income (EGI)

  • Definition: The total anticipated income (revenue) from property operations after allowances for vacancy and collection losses but before the deduction of operating expenses.

  • Also Known As: Gross Operating Income.

  • Equation for EGI:
    extEGI=extPotentialRentalIncome−extVACL+extOtherIncomeext{EGI} = ext{Potential Rental Income} - ext{VACL} + ext{Other Income}

Operating Expenses

  • Definition: Regular expenditures required to sustain the property and support effective gross income production, presuming competent management.

  • Typical Operating Expenses Include:

    • Property taxes

    • Insurance

    • Management fees

    • Payroll expenses

    • Repairs and maintenance

    • Utility costs

    • Legal and accounting expenses

    • Licensing and permits

    • Advertising and supplies

    • Contract services like snow removal or landscaping.

Depreciation & Interest Considerations

  • Key Query: Why aren’t depreciation and interest considered operational expenses?

  • Implications: Understanding where they fit within financial analysis and the overall implications for income calculations.

  • Discussion Points: General principles guiding the elegant treatment of these factors under real estate financial analysis.

Reimbursable vs. Non-reimbursable Expenses

  • Reimbursable Expenses: Costs charged to tenants based on lease agreements. ls.

  • Non-Reimbursable Expenses: Costs absorbed by the landlord without recovery from tenants.

  • Discussion Points: Understanding what determines which category expenses fall under.

Common Area Maintenance (CAM)

  • Definition: Expenses related to maintaining the common areas of a property

  • Includes & Important Notes:

    • Management charges may or may not be included.

    • Capital expenditures on tenant improvements are typically excluded.

Net Operating Income (NOI)

  • Definition: Net income calculated after deducting all operational expenses from effective gross income yet before accounting for mortgage payments and book depreciation.

  • Similarity: Aligns with conventions for EBITDA in corporate finance, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.

  • Importance: Shows profitability metrics and how efficiently property management operates.

  • Discussion Points: Understanding why NOI is a focal point in discussions about commercial real estate performance.

Operating Statement Through NOI

Simple Operating Statement Structure:

  1. Potential Rental Income

  2. Less: Vacancy

  3. Effective Rental Income

  4. Plus: Other Income

  5. Plus: Reimbursable Expenses

  6. Gross Operating Income

  7. Less: Operating Expenses

  8. Final Value: Net Operating Income

Cash Flow Before Taxes Definition

  • Description: Portion of net operating income left after mortgage debt service deductions but before taxation on operational earnings.

  • Synonyms: Commonly referred to as:

    • Before-tax cash flow (BTCF)

    • Pre-tax cash flow

  • Purpose: An essential measure of a property's financial viability and potential investor returns.

Exercise Calculations

  • Amortization Schedule: Examples illustrate creation processes for financing structures, covering key factors like interest rates, terms, and monthly payment structures.

  • Importance of Cash Flow: Calculating effective gross income, NOI, and final cash flow metrics indicates overall property performance and fiscal management.

Financing Structures

  • Debt Service: Payments covering mortgage interest and principal repayments.

  • Understanding Metrics: Recognizing how calculations of debt service relate to overall property financing and investment valuations.

Final Thoughts / Discussion Points

  • Clarifications needed on finance terms: Definitions related to operating expenses, capital outlays, and various financial calculations should be retaken for clarity and concept mastery.

  • Application of concepts in real world settings: Consider implications of property management and their financial health in practice, leading into larger discussions about real estate economics.