Commercial leasing and NOI Real Estate Finance, Spring, 2017

Overview Commercial lease agreements Net Operating Income (NOI) Basic characteristics Revenues, expenses Net Operating Income (NOI) What is NOI? Deriving NOI Examples Multifamily – Pajama Factory Lofts Office – Chilltown Office Plaza

Commercial lease agreements A lease is a contract between the owner of property rights (lessor) and user of property rights (lessee) which conveys the rights and responsibilities associated the use of a given property for some specified period of time Leases are the building blocks of property valuation, determining… Rental income Percentage rent/overage Responsibility for expenses Use of common areas and facilities Responsibilities for maintenance and repair of tenant’s space and common areas Concessions and tenant improvements

Commercial leasing: Space The definition of real estate space varies depending on perspective A building’s gross square footage refers to the total area within the structure A building’s rentable square footage refers to amount of space that would be rented if a single tenant occupied the property Usable square footage refers to the amount of space occupied by a tenant that shares common space with other tenants within a building

Commercial leasing: Space Occupancy: The economic occupancy of a building is the rentable area that is leased and paying rent, whether occupied or not The physical occupancy of a building is the rentable area that is used, regardless of whether rent is paid

Commercial leasing: Rent Leases specify the amount of rent tenants to landlords in exchange for the right to use the property Base rent: Rent payment in the initial lease period Base rent escalation: Changes in rents in future lease periods Graduated rent escalation Proportional rent escalation Fixed percentage increase Increase tied to index Percentage rent/overage: Rent tied to store revenues

Commercial leasing: Expenses Leases specify the manner in which operating expenses are shared In a gross lease, the lessor is responsible for all operating expenses associated with the property In a net lease, the lessee pays all expenses Triple net lease In a hybrid, or modified gross, lease the lessor is responsible for expenses up to some predetermined expense stop and any expenses above that point are paid by the tenant in the form of reimbursements Types of expenses: Common area expenses (CAM): Maintenance and upkeep of areas shared by tenants Tenant-specific expenses: Utilities Property taxes Casualty insurance

Commercial leasing: Maturity Leases specify both the term to maturity and the options available to the lessee and lessor at expiration as well as specifying rights and responsibilities in the event that the tenant wishes to vacate the space Extension options Cancellation options Ability to sublease Recourse Credit rating Security deposit Letter of credit

Commercial leasing: TI and concessions Tenant improvements (TI) Sharing of the expenses incurred when customizing tenant space at initiation of lease term Concessions Free rent Capital expenditures Sharing of expenses on durable improvements to the property

Effective rent Lease agreements for similar space may differ in elements relating to base rents, escalators, expense sharing and concessions Trade-offs in basic terms Rents for a gross lease v. rents for a net lease Risk sharing The risk borne by landlord and tenant during the period in which the lease is in place is determined primarily by the structure of the base rent escalators and expense sharing arrangements Base-rent escalation by steps v. by indexing Net v. gross

Effective rent How can we compare across different leases? Effective rent is the constant annuity payment having the same present value as the expected cash flows associated with the lease Can be considered from either perspective; tenant or owner Evaluating trade-offs in lease negotiations What is the appropriate discount rate? Rules of thumb Risk premium associated with tenant credit quality

Effective rent A building owner is presented with the following two 5-year lease agreements Lease A: $20/sf, net, first year rent free Lease B: $28/sf, net, first two years rent free If rental income is discounted at a 7% rate, what is the effective rent associated with each lease? Based on the given information, which lease will the building owner prefer?

Effective rent *Note: The NPV calculation assumes the first payment is made in one year in the future

Effective rent A building owner is presented with the following two 5-year lease agreements Lease C: 5-year term, $30/sf, gross, first year rent free, expenses $10/sf, increase at 2% annually Lease D: 5-year term, $40/sf, gross, first two years rent free, expenses $10/sf, increase at 2% annually If rental income is discounted at a 7% rate, what is the effective rent associated with each lease? Based on the given information, which lease will the building owner prefer?

Effective rent

Effective rent The effective rent may not adequately reflect all components relating to lease value Time to maturity Re-leasing costs Staggered lease expirations

NOI and financial value Net operating income (NOI) represents the free cash flows generated by an income producing property that is available for distribution among financial claimants The market value of a property is determined by the present value of its NOI discounted at the market return to investment in real estate

NOI and financial value Investing in income-producing property is an exchange of current income for claims on future cash flows Debt: senior claim with priority on free cash flows Less uncertainty, lower required return Equity: residual claim More uncertainty, higher required return

NOI and financial value The primary financial claims on the free cash flows generated by a given property are: Debt Equity Taxes D E D E T

NOI and financial value On a before-tax basis, the value of the equity claim on any given property is given by the present value of the residual cash flows The required return on equity, rE, depends on Dt If Dt = 0, returns are said to be unlevered and the return to equity equals the return on the asset If Dt > 0, returns are said to be levered and, if the return on the asset exceeds the return to debt, the return to equity is strictly greater that the return on the asset

NOI and financial value In practice, the cash flows going to the equity claimant are projected within a pro-forma cash flow statement Combine current lease provisions with expectations about future market conditions and outcomes to project the future cash flows that will be received by investors A tool that is useful for… making clear statements about what and what is not assumed in projections showing how inputs are determined identifying primary sources of value Necessary, but not sufficient, piece of analysis… garbage in, garbage out

NOI NOI is total operating income less total operating expenses Rent Percentage rent Ancillary income Collection losses Expense reimbursements (recoveries) Expenses: Common area expenses (CAM) Utilities Property tax Insurance General and administrative (G&A), property management fees

NOI Derivation of NOI: Potential gross Income - Vacancy adjustment = Effective gross income Effective gross income + Percentage rent + Expense reimbursements + Ancillary income - Collection losses - Concessions = Total operating income Total operating income - Operating expenses = Net operating income (NOI)

NOI: Potential gross income A property’s potential gross income (PGI) is the rental income that would be received if the rentable area within the building was fully occupied For occupied space, rental income is determined by the rent determined by the lease provisions of current tenants For multifamily, PGI is based on current market rent even if it exceeds the actual rent paid by existing tenants – the difference between market and contract rents can be used to estimate future rent growth For vacant space, rental income is determined by the current market rent on comparable space

NOI: Effective gross income Effective gross income (EGI) is the rental income generated by all physically occupied space before adjustments EGI = PGI – vacancy For vacant space, subtract the rental income associated with the amount included in determining PGI For occupied space associated with PGI determined by market rents, adjust for difference in market rent above current lease terms

NOI: Total operating income Total operating income equals EGI plus expense reimbursements, ancillary income, percentage rent and less collection losses and concessions Expense reimbursements (recoveries) represent tenant repayment for expenses paid by the owner on their behalf Ancillary income is income from sources other than the rent generated by the space occupied by tenants - parking, vending, antenna, signage Percentage rents are based on a percent of a tenant’s chargeable sales Percent of sale Breakpoint Collection losses are associated with the non-payment or late payment of rent or other revenues Rent concessions reflect loss of revenue due to free-rent periods

NOI: Total operating income Example: What is the percentage rent paid by a tenant occupying 1500 sf of space with a base rent of $16/sf if they earn $925,000 in total sales for the year and a sales percentage of 3% percent of their chargeable sales? Chargeable sales = Total sales Percentage rent = .03(925,000) = $27,750 Chargeable sales = Total sales above $750,000 Percentage rent = .03(925,000 – 750,000) = $5,250 Chargeable sales = Total sales above the tenant’s natural breakpoint Natural breakpoint = 16(1500)/.03 = 800,000 Percentage rent = .03(925,000 – 800,000) = $3,750

NOI: Expenses Depending on lease terms, tenants may be required to reimburse property owners for operating expenses Total operating expenses equal the sum of reimbursable and non-reimbursable expenses Reimbursable expenses: CAM Utilities Property taxes Insurance Non-reimbursable expenses: Property management fee General and administrative expenses

NOI: Expenses Operating expenses are either fixed or variable Fixed expenses are independent of the occupation rate Property taxes Casualty insurance Variable expenses depend on the building’s physical occupation rate Utilities Common area maintenance (CAM) Property management fee General and administrative (G&A)

NOI: Expenses Example: What is the annual utility expense for a property with 30,000 sf of rentable space and utilities are $1.50/sf and 40% fixed… If the building is 100% occupied? Utility expense = 1.50(30,000) = 45,000 If the building is 85% occupied? Utility expense = 1.50(30,000)(.4 + .6(.85)) = 40,950

NOI: Expenses In a modified gross lease, tenants reimburse property owners on a pro-rata basis for any reimbursable expenses above a tenant’s expense stop A tenant’s base year expense stop is by the reimbursable expense per square foot that sets the reimbursement in the initial year of their lease to zero Example: Total reimbursable operating expenses for a 60,000 sf building were 120,000, or 2.00/sf during the past leasing period A tenant with an expense stop of 1.75/sf occupies 3,000 sf of rentable space, the reimbursement paid by the tenant equals 3000(2.00 – 1.75) = 750 A new or renewing tenant in the building in that year will have an expense stop equal to 2.00/sf for the term of their lease

Example: Multifamily Pajama Factory Lofts is a large residential multifamily property in Neptune, NJ The property offers 85 rental units 40 one-bedroom units, $1050/month 25 two-bedroom units, $1450/month 20 three-bedroom units, $2000/month Ancillary income: On-site laundry facilities generates approximately $130/unit/year, 0% fixed Expenses (0% recoverable) Insurance, $16,500/year Property taxes, $92,000/year Maintenance & repairs, $625/unit/year, 25% fixed Management and administration, $195,000/year Miscellaneous, $12,000/year

Example: Multifamily Pajama Factory Lofts Number of units 85 Asking price 13,250,000 1BR/1BA 40 Market return on asset 9.00% 2BR/2BA 25 Inflation 3.00% 3BR/2BA 20 Terminal capitalization rate 7.75% Rental income Loan-to-Value at origination 60.00% Rent/month: 1BR/1BA 1,050 Debt 7,950,000 Rent/month: 2BR/2BA 1,450 Equity contribution to sale 5,300,000 Rent/month: 3BR/2BA 2,000 Mortgage rate 5.25% Origination fees 2.00% Ancillary income Amortization Laundary facilities/vending ($/unit/Y, 0% fixed) 130 Maturity 10 Cost of sale 3.50% Vacancy rate 5.00% Collection losses Tax information Marginal income tax rate 35.00% Operating expenses Capital gains tax rate 15.00% Insurance 16,500 Depreciation recapture rate 25.00% Property taxes 92,000 Other passive income None Maintenance & repairs ($/unit/Y, 25% fixed) 625 Land value 2,750,000 Management and administration 195,000 Structure and improvements 10,500,000 Miscellaneous expenses 12,000 Economic life - structure 27.5 Economic life - capital expenditures Capital reserves ($/unit/Y, 100% fixed) 250

Example: Multifamily 1 Rent: 1BR 504,000.00 Rent: 2BR 435,000.00 480,000.00 Potential gross income (PGI) 1,419,000.00 Vacancy adjustment (70,950.00) Effective gross income 1,348,050.00 Units occupied 80.75 Ancillary income 10,497.50 Collection losses (26,961.00) Total operating income 1,331,586.50 Expenses: Insurance 16,500.00 Property taxes 92,000.00 Maintenance & repairs 51,132.81 Management and administration 195,000.00 Miscellaneous expenses 12,000.00 Total operating expenses 366,632.81 Net operating income (NOI) 964,953.69

Example: Office Chilltown Plaza is a mid-size office building in Jersey City, NJ 45,000 sf of rentable space Sixth Borough Bank, 30,000 sf, 10-year lease signed 1/2014 Green Leaf Publishing, 10,000 sf, 5-year lease signed 1/2015 Goodman and Associates Law Firm, 5,000 sf, 5-year lease to be signed 1/2018 Ancillary income Roof rental/antenna, $24,000/year Expenses Insurance, $27,500/year, 100% recoverable Property taxes, $105,000/year, 100% recoverable Utilities $1.65/sf/year, 35% fixed, 100% recoverable CAM, 5% of EGI, 100% recoverable Management, 3% of EGI, 0% recoverable

Example: Office Chilltown Plaza General data: Lease renewal: Price 7,700,000.00 Renewal probability 75% 75.00% Market return on asset 10% 10.00% Months vacant 8 months 8.00 Property type Office Expected months 100% occupancy 10.00 Rentable SF 45,000 45,000.00 Tenant improvements - New $15/sf 15.00 Inflation Number of tenants 3 Tenant improvements - Renewal $5/sf 5.00 Lease term Five years Leasing commisions - New 25% of base rent in initial year 25.00% Leasing commisions - Renewal 15% of base rent in initial year 15.00% Market and economic data: Reserves $0.25/sf 0.25 7.7M Market rent $23.50/SF 23.50 Disposition: Market inflation 3% 3.00% Market capitalization rate 7% 7.00% 2% 2.00% Sale commissions 3% of sale price Income: Mortgage financing: Sixth Borough Bank Principal amount borrowed $4.5M 4,500,000.00 SF 30,000 30,000.00 Interest rate 6.00% Base rent $19.50/SF 19.50 Amortization period 25 years 25.00 Rent escalation $.50/SF/YR 0.50 Maturity 10 years Expense stop $4.50/SF 4.50 Payment frequency Annual Remaining lease term 7 years Origination fee 1.5% of initial balance 1.50% Greenleaf Publishing 10,000 10,000.00 $22.00/SF 22.00 $4.75/SF 4.75 3 years Goodman and Associates 5,000 5,000.00 $23.50/SF (beginning Y2) TBD 5 years (beginning Y2) Ancillary Antenna, $24000/YR 24,000.00 Reimbursements Base stop Collection losses 2% of EGI Operating expenses: CAM 5% of EGI 5% Utilities 1.65/sf, 35% fixed 1.65 % fixed 0.35 Real estate taxes $105,000 105,000.00 Insurance $27,500 27,500.00 Management (Non-reimbursable) 3% of EGI

Example: Office 1 Jan-17 Utilities/sf 1.65 TI/sf, New 15.00 TI/sf, Renew 5.00 Market Rent 23.50 SBB 19.50 GL 22.00 G+A -- Potential rental income: 585,000.00 220,000.00 117,500.00 Potential gross income (PGI) 922,500.00 Vacancy allowance: 0.00 Total allowance Occupancy 88.89% Effective gross income (EGI) 805,000.00

Example: Office 1 Jan-17 Effective gross income (EGI) 805,000.00 Reimbursements: SBB Base stop 4.50 Reimbursement 26,091.67 GL 4.75 6,197.22 G+A Total reimbursements 32,288.89 Tenant revenue 837,288.89 Collection losses (16,745.78) Antenna rental 24,000.00 Total operating income 844,543.11 Expense information: CAM 40,250.00 Utilities 68,887.50 Real estate taxes 105,000.00 Insurance 27,500.00 Reimbursable expenses 241,637.50 Reimbursable exp/sf 5.37 Management expenses 24,150.00 Total operating expenses 265,787.50 Net operating income (NOI) 578,755.61