1. Real Estate Finance Analysis of income-producing property Part I: Commercial leasing and NOI

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

3. Property characteristics according to use:  Residential Multifamily  Nonresidential Office Retail Industrial Hotel Recreational Institutional Hospital Universities Government  Mixed use Property types

4. 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 lease agreements

5. 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

6. 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: Space

7. 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: Rent

8.  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: Expenses

9.  Leases specify both the term to maturity and the options available to the lessee and lessor at expiration Extension options  Leases also specify rights and responsibilities in the event that the tenant wishes to vacate the space Cancellation options Ability to sublease Recourse Credit rating Security deposit Letter of credit Lease terms are subject to bankruptcy law Commercial leasing: Maturity

10.  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 Commercial leasing: TI and concessions

11. 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

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

13. 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

14. 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, r E, depends on D t If D t = 0, returns are said to be unlevered and the return to equity equals the return on the asset If D t > 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

15. 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 and financial value

16. NOI is total operating income less total operating expenses  Income: 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

17. 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

18. 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: Potential gross income

19. 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: Effective gross income

20. 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

21. 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: Total operating income

22. 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

23. 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

24. 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

25. 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 NOI: Expenses

26. 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  Expenses (0% recoverable) Insurance, $16,500/year Property taxes, $92,000/year Maintenance & repairs, $625/unit/year Management and administration, $195,000/year Miscellaneous, $12,000/year Example: Multifamily

27. Pajama Factory Lofts Number of units85Asking price13,250,000 1BR/1BA40Market return on asset9.00% 2BR/2BA25Inflation3.00% 3BR/2BA20Terminal capitalization rate7.75% Rental incomeLoan-to-Value at origination60.00% Rent/month: 1BR/1BA1,050Debt7,950,000 Rent/month: 2BR/2BA1,450Equity contribution to sale5,300,000 Rent/month: 3BR/2BA2,000Mortgage rate5.25% Origination fees2.00% Ancillary incomeAmortization20 Laundary facilities/vending ($130/unit/Y)11,050Maturity10 Cost of sale3.50% Vacancy rate5.00% Collection losses2.00% Operating expenses Insurance16,500 Property taxes92,000 Maintenance & repairs ($625/unit/Y)53,125 Management and administration195,000 Miscellaneous expenses12,000 Capital reserves ($250/unit/Y)21,250

28. 1 Rent: 1BR504,000.00 Rent: 2BR435,000.00 Rent: 3BR480,000.00 Total rental income1,419,000.00 Vacancy adjustment(70,950.00) Effective gross income1,348,050.00 Ancillary income11,050.00 Collection losses(26,961.00) Total operating income1,332,139.00 Expenses: Insurance16,500.00 Property taxes92,000.00 Maintenance & repairs53,125.00 Management and administration195,000.00 Miscellaneous expenses12,000.00 Total operating expenses368,625.00 Net operating income (NOI)963,514.00 Example: Multifamily

29. 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

30. Example: Office Chilltown Plaza General data:Lease renewal: Price$9.5M9,500,000.00 Renewal probability75%75.00% Required return (unlevered)10%10.00% Months vacant8 months8.00 Property typeOffice Expected months 100% occupancy10.00 Rentable SF45,00045,000.00 Tenant improvements - New$15/sf15.00Inflation Number of tenants3 Tenant improvements - Renewal$5/sf5.00Inflation Lease termFive years5.00 Leasing commisions - New25% of base rent in initial year25.00% Leasing commisions - Renewal15% of base rent in initial year15.00% Market and economic data: Reserves$0.25/sf0.25Inflation Market rent$23.50/SF23.50 Market inflation3%3.00%Disposition: Inflation2%2.00% Market capitalization rate7%7.00% Sale commissions3% of sale price3.00% Income: Sixth Borough BankMortgage financing: SF30,00030,000.00 Principal amount borrowed$6.0M6,000,000.00 Base rent$19.50/SF19.50 Interest rate6.00% Rent escalation$.50/SF/YR0.50 Amortization period25 years25.00 Expense stop$4.50/SF4.50 Maturity10 years10.00 Remaining lease term7 years Payment frequencyAnnual Greenleaf Publishing Origination fee1.5% of initial balance1.50% SF10,00010,000.00 Base rent$22.00/SF22.00 Rent escalation$.50/SF/YR0.50 Expense stop$4.75/SF4.75 Remaining lease term3 years Goodman and Associates SF5,0005,000.00 Base rent$23.50/SF (beginning Y2)23.50 Rent escalation$.50/SF/YR0.50 Expense stopTBD Remaining lease term5 years (beginning Y2) AncillaryAntenna, $24,000/YR24,000.00Inflation ReimbursementsBase stop Collection losses2% of tenant revenue2.00% Operating expenses: CAM5% of EGI5% Utilities1.65/sf, 35% fixed1.65Inflation % fixed0.35 Real estate taxes$105,000105,000.00Inflation Insurance$27,50027,500.00Inflation Management (Non-reimbursable)3% of EGI3%

31. Example: Office 1 Jan-17 Utilities/sf1.65 TI/sf, New15.00 TI/sf, Renew5.00 Market Rent23.50 SBB19.50 GL22.00 G+A-- Potential rental income: SBB585,000.00 GL220,000.00 G+A117,500.00 Potential gross income (PGI)922,500.00 Vacancy allowance: SBB0.00 GL0.00 G+A117,500.00 Total allowance117,500.00 Occupancy88.89% Effective gross income (EGI)805,000.00

32. Example: Office 1 Jan-17 Effective gross income (EGI)805,000.00 Reimbursements: SBB Base stop4.50 Reimbursement26,091.67 GL Base stop4.75 Reimbursement6,197.22 G+A Base stop Reimbursement Total reimbursements32,288.89 Tenant revenue837,288.89 Collection losses(16,745.78) Antenna rental24,000.00 Total operating income844,543.11 Expense information: CAM40,250.00 Utilities68,887.50 Real estate taxes105,000.00 Insurance27,500.00 Reimbursable expenses241,637.50 Reimbursable exp/sf5.37 Management expenses24,150.00 Total operating expenses265,787.50 Net operating income (NOI)578,755.61