Commercial and Investment Properties

Exam rule

An investment is judged by the return it may produce and the risk taken to earn it. Risk means uncertainty about income, expenses, value and the ability to sell. Real estate faces market risk, vacancy and credit risk, interest-rate risk, physical and environmental risk, legal risk and liquidity risk. Liquidity is the ability to sell an asset promptly without accepting a major loss or heavy transaction cost. Real property is usually less liquid than a publicly traded security. Rate of return compares an investment's gain or cash flow with the amount invested. Leverage means using borrowed money to control a larger asset with less cash. Equity is the owner's value after debt. Positive leverage occurs when the property earns enough to make the return on equity higher after debt service. Negative leverage occurs when the debt burden pushes that return lower. Debt can also magnify a loss, and the payment remains due during vacancy. Time value of money means a dollar today is worth more than a dollar received later because today's dollar can be invested. Future cash flows must be discounted to compare them with cash paid today. A sound analysis never chooses the highest projected return by itself. It asks what assumptions, debt, timing and risk produced that number.

Exam rule

Begin with the property type because it shapes the tenants, leases, expenses, financing and valuation. Unimproved land has no building income and may depend on zoning, access, utilities, approvals and future demand. Office buildings may be described as low-rise, mid-rise or high-rise. Residential investments include single-family and multifamily property. Mixed-use property combines uses, such as stores below apartments, and each use may have a different rent, expense pattern and risk. Retail includes strip and neighborhood centers, malls, regional malls, mega malls and outlet centers. An anchor tenant is a major store or other draw that helps bring customers and may support smaller tenants. Its departure can hurt traffic, rent and financing. Manufacturing and industrial property include plants, warehouses and loft buildings. Ceiling height, floor load, loading access, power, layout and transportation may matter more than finishes. A special-purpose property has a design suited to a narrow use, so adaptation and resale can be difficult. Ownership also matters. Fee simple ownership is the broad ownership interest in the land and improvements, subject to government powers and private limits. A leasehold is the tenant's right to possess and use property for the lease term. Under a long-term ground lease, the landowner keeps the fee and the tenant holds a leasehold in the land, often with rights and duties involving improvements.

Exam rule

A pro forma is a forecast. A reconstructed income and expense statement tests how an informed buyer expects the property to run. Start with the rent roll, leases, amendments, operating statements and tax bills. Then test the figures. Contract rent is the rent stated in a lease. Market rent, also called economic rent, is what similar space would bring in the current market. A below-market lease may be fully collectible and still hold income down. An above-market lease may not last after renewal. Rebuild rent, vacancy, collection loss and expenses from the leases, property history and market data. Check the site and building. Check title, survey, zoning, legal use and permits. Review environmental conditions, utilities and insurance. Review financing, service contracts and planned capital work. Study tenant credit, lease expiration dates and renewal options. Find concessions, deposits, transfer rights and expense payments. Estoppel certificates can confirm key lease facts with tenants. Market analysis asks whether buyers and tenants want this product at the proposed price or rent. Feasibility asks whether the plan is legally allowed, physically possible and financially worthwhile. A sound forecast uses realistic time, cost and reserve estimates. A licensee should spot issues and call the right expert. That may be an attorney, engineer, environmental professional or accountant.

Exam rule

Build the income statement from the top. Potential gross income, or PGI, is the income the property could produce for the period if rentable space were occupied and scheduled amounts were collected. Include rent from every unit or space and other recurring property income named in the facts, such as parking, laundry, storage or vending. Keep the time period consistent. Vacancy loss covers space that is not rented. Collection or credit loss covers amounts that are due but not collected. Subtract the supported vacancy and collection allowance from potential income to reach effective gross income, or EGI. In a simple exam problem: vacancy and collection loss equals PGI times the stated loss rate, and EGI equals PGI minus that loss. If other income is listed separately, follow the problem's layout and add it at the stated step. A current full building can still need a stabilized vacancy allowance because leases expire, tenants default and space turns over. A reconstructed statement should use a rate supported by the property and its market rather than a convenient zero. Do not subtract operating expenses yet. They come after EGI.

Exam rule

Net operating income, or NOI, is the income left after normal operating expenses come out of effective gross income. Use this order. Find EGI. Then subtract operating costs. The basic formula is NOI equals EGI minus operating expenses. Fixed expenses do not change directly with occupancy. Property taxes and many insurance costs are common examples. Variable expenses tend to move with use or occupancy. Some utilities, cleaning, management and repairs may fit here. A reserve for replacements sets aside an annual amount for parts that wear out, such as a roof, pavement, appliances or building equipment. It spreads a future need across the years that benefit. Follow the problem's treatment of reserves. NOI is a property result before financing and income taxes. Do not deduct mortgage principal, mortgage interest, total debt service, book depreciation or the owner's income tax when finding NOI. A major improvement is not a normal one-year operating cost. It is usually a capital item, though the analysis may include a reserve. Rebuild each line instead of trusting the seller's label. A personal owner bill does not become a building cost just because the owner paid it. The same is true for a one-time loan cost.

Exam rule

Debt service is the required principal and interest payment on borrowed money. Before-tax cash flow, or BTCF, equals NOI minus annual debt service in the basic exam model. Cash-on-cash return, also called the equity dividend rate, equals annual BTCF divided by the investor's cash equity. Use the cash actually invested when the problem gives acquisition costs or other initial cash. After-tax cash flow, or ATCF, equals BTCF minus the income tax generated by the operation. The tax calculation does not follow cash flow line for line. A simplified classroom model may begin with NOI, subtract deductible mortgage interest and tax depreciation, make any stated tax adjustments, and multiply taxable income by the supplied tax rate. Mortgage principal reduces cash but is not an interest deduction. Depreciation can reduce taxable income without using current cash. This can create a tax shelter, meaning deductions reduce taxable income, but it does not guarantee spendable cash or a usable current loss. Federal passive-activity and at-risk rules can limit whether and when an investor uses a rental loss. Tax rates and taxpayer facts vary, so use the assumptions in the question and refer an actual investor to a qualified tax professional.

Exam rule

Direct capitalization converts one year's stabilized NOI into value. Use the IRV relationship: income divided by rate equals value. Rearranged, rate equals income divided by value, and income equals value times rate. Write the rate as a decimal before calculating. At an 8 percent cap rate, divide NOI by 0.08. A cap rate may be extracted from comparable sales by dividing each comparable's stabilized NOI by its sale price. The selected rate should reflect market evidence and the property's income risk, growth outlook, condition, location and lease profile. New York's assessment glossary also describes a capitalization rate through components such as a discount rate, effective tax rate and recapture rate. Use the method the question supplies. The cap rate is not the mortgage interest rate. It is not the cash-on-cash return. It uses NOI before debt service and the property value or price, while cash-on-cash uses BTCF and investor equity. For the same NOI, a higher cap rate produces a lower indicated value because the investor demands more return for each dollar paid.

Exam rule

A gross rent multiplier, or GRM, compares sale price with gross rent. GRM equals sale price divided by gross rent. Indicated value equals the subject's gross rent times a supported GRM. A gross income multiplier, or GIM, follows the same idea using the stated gross income figure. Read the problem carefully to see whether it uses monthly rent, annual rent, potential gross income or effective gross income. Keep the numerator and denominator consistent across the comparable and subject. If a comparable sold for $600,000 and its monthly gross rent was $5,000, its monthly GRM is 120. If annual rent is used instead, the annual GRM is 10. Both describe the same sale with different periods. A multiplier is a quick comparison, not a full operating analysis. It does not directly account for different vacancy, taxes, utilities, repairs, management, reserves or lease terms. Use comparable properties with similar expense patterns and confirm the result with a method that considers NOI when the facts permit.

Exam rule

Commercial space can carry several area figures. Gross building area describes the building under the stated method. It is not always the area a tenant uses or pays rent on. Usable area is the space available for the tenant's people and work under the lease standard. Carpetable area is an exam term. It means the floor area where carpet or furniture can be placed after major columns and similar blocks come out. Rentable area is used to calculate rent. It usually includes usable area plus a share of common areas. Common areas may include halls, elevator lobbies, restrooms and shared service areas. Stairs, elevator shafts and major ducts are vertical penetrations. The chosen standard tells how to treat them and their walls. Do not guess. Rentable area is usually larger than usable area. These terms are not fixed facts for every building. The lease must name the method, limits, excluded space and any right to measure again. Compare both the rentable cost and the usable space delivered. Never promise an area from a brochure without checking the documents and method.

Exam rule

The same gap between rentable and usable area can be stated three ways. Load factor, also called the rentable-to-usable or R/U factor, equals rentable area divided by usable area. It is a multiplier, such as 1.15. Add-on factor, also called common area factor in some systems, equals rentable area minus usable area, divided by usable area. It is a percentage, such as 15 percent. Loss factor equals rentable area minus usable area, divided by rentable area. It uses a different base, so it will be a smaller percentage than the add-on factor for the same space. To find rentable area from usable area, multiply usable area by the load factor. To find usable area from rentable area, divide by the load factor. With 10,000 usable square feet and 11,500 rentable square feet, the load factor is 1.15, the add-on factor is 15 percent and the loss factor is about 13.04 percent. The names used in a market can vary, so the safest method is to read the formula in the lease or question. A high factor is not automatically unfair. It may pay for useful common facilities, but it does mean the tenant receives less usable space for each rentable foot.

Exam rule

A lease label is only a starting point. The written lease decides who pays each cost. In a gross lease, the landlord generally pays stated building operating costs from the rent. A modified gross lease changes that allocation. In a net lease, the tenant pays base rent plus one or more named property costs. The shorthand single net, double net and triple net is common, but the lease must still say whether the tenant pays taxes, insurance, maintenance, structure, utilities or other items. Office, retail and loft leases describe the type of space and business setting, not one automatic expense plan. A retail lease may include percentage rent. The tenant pays minimum or base rent plus a stated percentage of sales above a breakpoint. The natural breakpoint equals annual base rent divided by the percentage rate. Annual base rent of $120,000 divided by 6 percent gives a $2,000,000 natural breakpoint. An artificial breakpoint is negotiated rather than produced by that formula. A ground lease gives the tenant a long-term leasehold in land while the owner keeps the fee. The agreement must address improvements, financing, taxes, insurance, maintenance, use and what happens to improvements at the end. New York transfer-tax law can treat creation of a leasehold as a taxable conveyance when the statutory conditions occur together, including a term plus options exceeding 49 years, substantial premises and required capital improvements.

Exam rule

A lease escalation clause adjusts rent or reimbursements during the term. Its purpose is to allocate inflation and rising ownership costs instead of fixing every charge for many years. A fixed increase states the amount or percentage and timing in advance. A CPI clause ties an adjustment to a named Consumer Price Index, base month, comparison month and formula. An expense clause passes through some increase in operating costs. A base-year clause gives the tenant the benefit of operating costs or taxes for a stated year within rent, then charges a proportionate share of increases above that base. An operating or tax stop states a dollar allowance, often per rentable square foot. The tenant pays its share above the stop. A real property tax clause should identify the taxes, base, share, billing evidence, refunds and treatment of assessments. Direct operating may charge a tenant for a cost serving its space. A porter's wage escalation is a traditional office clause tied to changes in a named building-service wage rate or agreement, not necessarily the landlord's exact payroll increase. Proportionate share is commonly the tenant's rentable area divided by the defined building rentable area, but the lease controls the denominator and adjustments. Read exclusions, gross-up rules, caps, floors, audit rights, management fees and whether decreases or refunds produce a credit. Never assume a stop protects the tenant. It usually marks the landlord's included amount, with excess passed through as written.

Exam rule

Tenant improvements, or TIs, are the work needed to make leased space usable for the tenant. The building shell is the base structure and systems defined by the lease. A work letter or improvement exhibit should state the plans, approvals, schedule, contractor process, allowance, change orders, payment and completion standard. A TI allowance is money the landlord agrees to provide for covered work. The tenant may pay an overage, and the landlord may recover an amortized allowance through rent. The lease should address ownership, removal and restoration at the end. A concession is an economic benefit such as free rent, reduced rent, moving money or extra improvement dollars. Free rent does not always remove every charge. Confirm whether operating costs, taxes, utilities, parking or TI rent continue. Compare offers by total occupancy cost, not face rent alone. Include base rent, rentable area, escalation, expense pass-throughs, utilities, improvement costs, concessions, commissions, options and likely restoration. Effective rent spreads the net economic rent over the comparison term. Present value discounts payments and benefits to one comparison date because later dollars have a lower present value. Use the discount rate and timing given in the problem. Also test what happens if the tenant leaves early or an allowance remains unused.

Exam rule

A use clause states what business or activity is allowed. An exclusive-use clause may limit a competing use elsewhere in the property. New York courts read a use limit narrowly. The exact words, parties, dates and notice matter. An assignment generally transfers the tenant's whole remaining lease interest to another party. A sublease transfers less than the whole interest. It may cover part of the space or a shorter term. The first tenant keeps a lease position. Consent and later liability depend on the lease. Subordination places the lease behind a mortgage or other stated lien in priority. Non-disturbance protects a tenant's possession after foreclosure if the tenant meets its duties. Attornment means the tenant accepts the buyer at foreclosure or another successor as the new landlord. An SNDA combines these ideas. New York Real Property Law section 248 says attornment is not needed to make a sale valid. A lease may still require the tenant to sign papers and accept the new owner. An estoppel certificate states lease facts for a buyer or lender. It may cover the term, rent, changes and defaults. A signer may be barred from denying a statement on which the other party relied, so check it with care. Electric service may be direct metered. The utility then measures and bills the tenant. It may be submetered through the owner's master account. It may also be included in rent. The lease must explain the rate, meter, unusual use and later changes.