Understanding Investments

Commercial and InvestmentCommercial and InvestmentReal Estate OpportunitiesReal Estate Opportunities

Types of Properties

Diversity of Clients

® Dearborn Real Estate Education, 2002

Primary Classifications ofPrimary Classifications ofCommercial PropertiesCommercial Properties

OfficeRetailIndustrialApartmentsOther Commercial Properties

Commercial PropertyCommercial PropertyAs anAs an

InvestmentInvestment

Almost every type of commercial property can be an investment!

Investment CustomersInvestment Customers

UsersSpace Driven

DevelopersBuild-to-Suit

Pure InvestorsProfit Driven

Commercial and InvestmentCommercial and InvestmentReal Estate OpportunitiesReal Estate Opportunities

Residential Real Estate– One Client

– One House

– One Time

Commercial and Investment Real Estate

– Many Types of Properties

– Several Kinds ofCustomers

– UnlimitedOpportunities

– Redundant BusinessToo!

““Taxpayer”Taxpayer”Small Multiuse BuildingsSmall Multiuse Buildings

Typically, a store or office on the ground floor with two to six apartments above.

Advantages of PurchasingAdvantages of Purchasinga Small Multiuse Buildinga Small Multiuse Building

Which type of customer would buy a small multiuse building?

Net Operating Income (NOI)Net Operating Income (NOI)

Gross Operating Income

Less Owner’s Operating Expenses

Equals Net Operating Income

Case Study:Case Study:Main Street Multiuse BuildingMain Street Multiuse Building

The Advantages of PurchaseThe Advantages of Purchase

Often the cost to buy is equal to or less than the cost to rent.

Purchase price is affordable.Tax benefits of ownership, i.e., depreciation

Often the Cost to Buy Is EqualOften the Cost to Buy Is Equalto or Less Than the Cost to to or Less Than the Cost to

Rent.Rent.Store rent (from problem)$15 PSF X 1,000 SF = $15,000 annual rent

Rental income (apartments) $12,000Owner’s Operating Expenses 10,000“Profit” $ 2,000Effective new rent $13,000

Affordable Purchase PriceAffordable Purchase Price

Financing the Main Street Building

Building Price $160,000

Down Payment – 32,000

Mortgage $128,000

15-Year Term, 7.5% Interest Rate

Annual Debt Service $ 14,239

Cost to “Carry” theCost to “Carry” theMain Street BuildingMain Street Building

Debt Service (per year) $14,239

Operating Expenses 10,000

Total Expenses $24,239

New Store RentNew Store Rent

Cost to “carry” the building $24,239

Less income from apartments –12,000

Effective New Store Rent $12,239

A savings of $2,761 over the original rent ($15,000) due as a tenant.

Tax Advantages of OwnershipTax Advantages of Ownership

Depreciation or

Cost Recovery

Required by IRS Code

Buildings depreciate, but

land does not

Depreciation Time

Commercial Buildings

over 39 years

Apartment Buildings

over 27.5 years

Tax Advantage of OwnershipTax Advantage of Ownership

Purchase Price $160,000

Less Land Value – 20,000

Depreciable Building Value $140,000

Building value divided by 39 years equals the annual tax depreciation.

$140,000 divided by 39 = 3,590 Tax Benefit

Buy vs. RentBuy vs. Rent

User-investor saves $2,761 in rentGains tax advantage of $3,590

Real estate agents should discuss the advantages of purchasing with their clients.

The Concept of VacancyThe Concept of Vacancy

Vacancy is defined as a portion of, or entire space without, tenancy, measured for a period of time.

NeighborhoodNeighborhoodStrip CenterStrip Center

Considerations of aConsiderations of aUser CustomerUser Customer

The cost to buy may be equal to or less than the cost to rent.

Tax advantages of ownership.However, “Purchase price is affordable”

may no longer be true.

Considerations of anConsiderations of anInvestor ClientInvestor Client

Quality of TenantsTurnover ConcernsRate of Return on the Investment

Case Study:Case Study:Neighborhood Strip CenterNeighborhood Strip Center

Step 2:Step 2:Adjusting for VacancyAdjusting for Vacancy

Adjusting for vacancy requires a reality examination.

Vacancy is usually calculated as a percentage of the Potential Rental Income (PRI).

DetermineDetermineGross Operating IncomeGross Operating Income

Step 3:Step 3:Calculating the Total Calculating the Total Operating ExpensesOperating Expenses

Step 4: Calculating NOIStep 4: Calculating NOINet Operating IncomeNet Operating Income

Gross Operating Income

minus Operating Expenses

equals Net Operating Income

Repair and MaintenanceRepair and MaintenanceContingency ExpensesContingency Expenses

Contingency expenses are best thought of as irregular, unexpected or emergency events. There is an important distinction between normal regular expenses and contingency repair and maintenance expenses.

Repair and MaintenanceRepair and Maintenance

Guidelines Age of the building Condition of the

property Under the lease terms,

what are the landlord’s responsibilities?

Calculation Percentage of PRI

or Percentage of GOI

or Fixed Dollar Figure

Repair and MaintenanceRepair and MaintenanceProblemProblem

Effect ofEffect ofRepair and MaintenanceRepair and Maintenance

on Expenseson Expenses

Operating Expenses Taxes $20,000 Insurance

2,500 Repair &

3,750Maintenance

Total $26,250

Revised NOI

Income$67,500

Expenses –26,250

NOI $41,250

Market ValueMarket Value

Market Conditions Market Conditions Affecting PriceAffecting Price

Supply and DemandLocation, location, location!Available FinancingInsurance Value

Commercial ValuesCommercial Values

Retail– Location– Traffic

Industrial– Cost of Labor– Transportation

Investment– Upside Potential

Highest and Best UseHighest and Best Use

The best use of a property will create the highest financial return on the investment.

Triple Net Lease (NNN)Triple Net Lease (NNN)

Tenant pays all

Floor Area Ratio (FAR)Floor Area Ratio (FAR)a.k.a Land Coverage Ratioa.k.a Land Coverage Ratio

The ratio of the bulk area of a building to the land on which it is situated.

Problem A

Conversion CostsConversion Costs

Variance–Legal Costs

Construction Costs

Down Time

Problem B

Comparing NOIComparing NOI

Current Tenant

GOI $75,000 TOE 15,000 NOI $60,000

Proposed Tenant

GOI $60,000 TOE (NNN) 0 NOI $60,000

Good Deal for Owner?Good Deal for Owner?

Rent IncreasesNo Conversion ExpensesNo Down TimeBigger BuildingSale versus Land Lease

Capitalization RateCapitalization Rate(CAP Rate)(CAP Rate)

The CAP rate can be looked at as a desired

“profit percentage” for an investor.

CAP Rate FormulasCAP Rate Formulas

Solve for Market Value

NOI $50,000

CAP Rate 10%

Market Value ?

Solve for CAP Rate

NOI $60,000

Offer $500,000

CAP Rate ?

CAP Rate ProblemsCAP Rate Problems

A property is priced at $750,000 and has a NOI of $67,000. What is the CAP rate being offered?

An investor wants to sell her building. She advises you that she has an NOI of $48,000 and will offer the property at an 11% CAP. At what price do you market the building?

Retail TermsRetail Terms

Anchor TenantsAnchor Tenants

Do not sell anchors!Large department stores or supermarketsDo their own advertising

CAM ChargesCAM Charges

Common Area Maintenance

GLAGLA

Gross Leasable Area

Tax Escalation ClauseTax Escalation Clause

a.k.a Real Estate Taxes over Base

a.k.a Tax Stops

Annual Property Annual Property Operating DataOperating Data

(APOD)(APOD)

Case Study:Case Study:Mountain View Mini MallMountain View Mini Mall

Base Rent Roll CalculationBase Rent Roll Calculation

$167,000Total

$32,000$162,000Real estate

$36,000$182,000Stationery

$54,000$183,000Video store

$22,500$151,500Dry cleaner

$22,500$151,500Restaurant

Annual RentBase RentSquare FeetStore

Step 2Step 2

Analyze all other income and adjustments to income.

Solve for Gross Operating Income.

Vacancy and Credit LossesVacancy and Credit Losses

In this problem, 5% is used for vacancy contingency.

Potential Rental Income $177,000

Multiplied by 5% X .05

Vacancy & Credit Losses $8,850

Step 3 ExpensesStep 3 Expenses

Only the Owner’s Operating Expenses

Reminder: All figures are annual.

Step 4: Solve for NOIStep 4: Solve for NOI

Net Operating Income (NOI)

Gross Operating Income $168,150

Less: Operating Expenses – 81,000

Net Operating Income $87,150

What Is My Building Worth?What Is My Building Worth?

Step 5: Calculating Market Value

NOI ÷ CAP Rate = Value

$87,150 ÷ .12 (12%) = $726,250

The Value of InvestmentsThe Value of Investments

Key Investment TermsKey Investment Terms

Rate of ReturnLeverageInitial InvestmentCash Flow Before Taxes (CFBT)EquityCash on Cash ReturnInternal Rate of Return (IRR)

Leveraged PurchaseLeveraged PurchaseCash on Cash ReturnCash on Cash Return

CFBT = NOI – Annual Debt Service

Cash on Cash = CFBT ÷ Initial Investment

Investment StrategiesInvestment Strategies

StabilityPotentialFlippingUpside PotentialHolder

What Is the What Is the Property Worth?Property Worth?

Components of ValueComponents of Value

Current year analysisFive-year forecastOwner’s perspectiveBuyer’s perspective

Case StudyCase Study

Office

Building

DetermineDetermineCurrent Rent RollCurrent Rent Roll

andandPotential Rental IncomePotential Rental Income

Complete the IncomeComplete the Incomeportion of the APOD.portion of the APOD.

Operating Operating ExpensesExpenses

Net Operating IncomeNet Operating Income

Cash Flow Before TaxesCash Flow Before Taxes(CFBT)(CFBT)

Cash on Cash ReturnCash on Cash Return

Cash on Cash = CFBT ÷ Initial Investment

$15,294 (CFBT) ÷ $125,000 (II) = .1224

12.24% is the Cash on Cash Return

All Cash PurchaseAll Cash Purchase

Capitalization Rate Formula:

NOI ÷ Value (Purchase Price) = CAP Rate

$60,936 ÷ $500,000 = .1219

12.19% CAP Rate

SpreadsheetsSpreadsheets

Cash Flow ForecastsCash Flow Forecasts

The UpsideThe Upside

44,84441,64233,52428,02215,294CFBT

90,48687,28479,16673,64460,936NOI

Year 5Year 4Year 3Year 2Current

Cash on Cash ReturnsCash on Cash Returns

.1224 (12%)$125,000$15,2941

.3588 (36%)$125,000$44,8445

.3331 (33%)$125,000$41,6424

.2682 (27%)$125,000$33,5243

.2242 (22%)$125,000$28,0222

Cash on Cash Return

Initial Investment

CFBTYear

Market ValueMarket Value

Does the potential buyer care about the present owner’s return on his/her investment?

Potential Market ValuePotential Market Value

90,48687,28479,16673,66460,936NOI

Year 5Year 4Year 3Year 2Current Year

Potential Market ValuePotential Market Value

754,050727,367659,717613,867507,80012%

904,860872,840791,660736,640609,36010%

90,48687,28479,16673,66460,936NOI

Year 5Year 4Year 3Year 2Current Year

What Is My Property Worth?What Is My Property Worth?

Considerations Considerations Regarding ValueRegarding Value

What the current owner paid is irrelevant.

Test the assumptions used in the forecast.

How much upside potential will a buyer pay for?

Methods of ValuationMethods of Valuation

Income Approach

Comparable Sales Method

Cost Approach

The Buyer’s PerspectiveThe Buyer’s Perspective

Challenges

Incorrectly Stated FactsQuestionable AssumptionsBusiness Style

Applied to the last problemApplied to the last problem

Basement Rent?Vacancy Rate 7%?Repairs and Maintenance 5%?Off Site Management 5%

Compare the Market ValuesCompare the Market Values

None of the “facts” changed.

What did change were the assumptions.

Commercial AgentsCommercial Agents

Validate the facts and evaluate the assumptions.

To make a dealTo make a deal

Negotiate the assumptions firstThen the price

Future BusinessFuture Business

Develop relationships with commercial and investment customers for life.

Understanding Investments

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