class 2: Real Estate Finance Flashcards
Property Cash Flow sheet
Rental Income
- Operating expenses
+ Ancillary Income
= NOI
- Tenant Inducements
- Leasing commissions
- Capital expenditures
= Cashflow before financing - Financing costs
= cash flow after financing
Exclusions from NOI
Debt Service
Depreciation
Income Taxes
Tenant Improvements
Leasing Commissions
Capital Expenditures
why is Debt Service excluded from NOI
Financing costs are specific to the owner/investor and as such are not included in calculating NOI
why is depreciation excluded from NOI
Depreciation is not an actual cash outflow, but rather an accounting entry and is, therefore, not included in the NOI calculation
why are Income Taxes excluded from NOI
Since income taxes are specific to the owner/investor they are also excluded from the net operating income calculation
why are tenant improvements excluded from NOI
Tenant improvements include construction within a tenantβsusable spaceto make the space viable for the tenantβs specific use.
why are leasing commissions excluded from NOI
Commissions are the fees paid to real estate agents/brokers involved in leasing the space
why are Capital Expenditures excluded from NOI
Capital expenditures are expenses that occur irregularly for major repairs and replacements, which are usually funded by a reserve for replacement.
This does not include minor repairs and maintenance which are considered an operating expense
rent is generally made up of one or more of which
elements
Base rent
Percentage rent
Expense recovery
Rent free period
base rent
is usually expressed as a dollar amount per square foot per year
Percentage rent
a rental payment that is based on the sales or income earned by the tenant
There is often a breakpoint (certain level of sales or income) over which percentage rent will begin
The most common formula for percentage rent is:
πππππππ‘πππ ππππ‘ = (πππ‘π’ππ π ππππ β ππππππππππ‘) β πππππππ‘πππ ππππ‘ππ
Expense participation
when a tenant pays their proportionate share of certain operating expenses of the property.
The proportionate share is calculated as leased area/total leasable area
The expenses they are responsible for is contained in the expense participation clause of the lease.
The more common expense participation clauses can be categorized as
Gross Lease
Modified Gross Lease
Single Net Lease
Double Net Lease
Triple Net Lease
gross lease
the rent is all-inclusive
The landlord pays all or most expenses associated with the property, including taxes, insurance and maintenance out of the rents received from tenants.
modified gross or full service lease
the landlord pays all expenses up to a lease defined expense stop, and all expenses over the expense stop are passed through to (or paid for by) tenants.
These are most commonly found in office leases.
a single net lease
the tenant pays base rent plus a pro-rata share of the buildingβs property taxes.
a double net lease
the tenant is responsible for base rent plus a pro-rata share of property taxes and property insurance
a triple net lease
tenant is responsible for base rent plus a pro-rata share of property taxes, property insurance and all other property operating expenses
This is the most popular type of net lease for retail space
most popular operating expenses
Real estate taxes
Common-area maintenance
Security
Utilities
Insurance
Management fees
why does a triple net lease favor the landlord
as it protects him against rising expenses
True-up or CAM Adjustment
Expenses estimated at the start of the year and adjusted to actuals at the end of the year
how are rent-free periods accounted for?
Rent-free periods are accounted for on a straight-line basis and must be adjusted for when calculating cash flows.
Operating Expenses
Operating expenses include all expenditures required to operate the property and command market rents
The most widely used method to estimate the value of a commercial property?
explain the method
Capitalized NOI
Value = Stabilized NOI / Cap Rate
This valuation method presumes that a property will generate its stabilized NOI in perpetuity
in capitalized NOI, how are the value and cap rate an inverse relationship?
The higher the cap rate the lower the value
stabilized NOI sheet
Potential Rental Income
- Vacancy and Credit Allowance
= Effective Rental Income
+ Other miscellaneous Income
= Gross Operating Income
- Operating expense
= NOI
Potential Rental Income
the sum of all rents (including expense participation) under the terms of each lease, assuming the property is 100% occupied
If the property is not 100% occupied, then a market-based rent is used based on lease rates and terms of comparable properties
Vacancy and Credit Losses
consist of income lost due to tenants vacating the property and/or tenants defaulting (not paying) their lease payments
A historical average or a specific analysis can be used to determine the vacancy and credit losses
NOI Adjustments
NOI usually includes management fees. If no fees are reported because the landlord manages the property himself, a market management fee will be estimated and included in operating expenses.
In some circumstances NOI will be adjusted for recurring non-revenue generating capital expenditures and leasing commission
Institutional investors usually treat these items as βbelow the NOIβ line
Some of the determinants of the Capitalization Rate include the following
Other investment yields (especially GOC rate)
β> Real estate competes for investment dollars with other forms of investments
Perceived risk of asset class
β> Usually seen as a lower risk asset class it is still β> susceptible to overvaluation
Less liquid investment
Some of the determinants of the Capitalization Rate include the following
Other investment yields (especially GOC rate)
β> Real estate competes for investment dollars with other forms of investments
Perceived risk of asset class
β> Usually seen as a lower risk asset class it is still β> susceptible to overvaluation
Less liquid investment
The market
β> High growth metropolitan market vs stagnant market
Property characteristics
β> Type (retail, office, hotel, etc)
β> Quality
β> Size
β> Quality of the rent roll
The Discounted Cash Flow (DCF) method
values a property by adding together the present value of its future cash flows including its Terminal Value
The Terminal Value (TV)
the value of the property at the end of the investment period and is calculated based on the NOI at that time
The discount rateβs role in DCF
should reflect the rate of return required by an investor for an investment with this level of risk
when can the discount rate for the terminal value can be different than the rate used for the cash flows?
if the condition of the property is expected to change:
Start-up of operations
Age of property when sold
Repositioning of the property (competitive position)
Business plan to address vacancy issues
The Comparable Sales Approach
estimates the value of a property by comparing it with the recent selling price of properties that have similar characteristics.
Often used for single family houses
Sales data for commercial properties are available through third party service companies such as CBRE and Altus.
Comparable sales should be for properties of the same or similar:
β> Type
β> Location
β> Age
β> Condition
The Cost or Replacement Cost Approach
estimates the current cost of replacing the subject property using industry sourced construction cost data.
Comparing the replacement cost to the market value informs the investor of the likelihood of new properties being developed.
The replacement cost is artificially depreciated to take into account the age of the property.
Leverage Effect
Apart from gaining access to funds, many investors add financing to their real estate assets to obtain a higher return
Adding leverage (financing) to an asset will act as a multiplier to the return generated by the asset
The greater the amount of leverage the greater the multiplicative effect
what do Interest rates reflect?
reflect both the market and the project risk
β> The higher the perceived risk, the higher the rate
how are Interest rates for mortgages often expressed as?
often expressed as the amount of basis points (.0001) above the Government of Canada Bond rate (GOC) for a given term.
β> For example: 5-year term might be GOC 5yr + 250 bp
β> GOCs are viewed as riskless investments
charge fees that increase the overall cost of the loan that lenders sometimes ask
Application fees
Origination fees
Standby fees (on undrawn amounts)
The lenderβs expenses in underwriting or documenting the loan may also be charged
which are they?
Appraisal fees
Legal fees
Types of Real Estate Loans
all are Term Loans
either mortgage loans or Unsecured or corporate loans
mortgage loans
Guaranteed by the asset
either recourse or non-recourse loans
recourse loans
not only guaranteed by the mortgage on the property but also by a claim over the entityβs other assets
Depending on the financial strength of the borrower this can greatly reduce the risk of a loan
non-recourse loans
solely guaranteed by the property
If the borrower defaults and the value of the property is insufficient to recover the loan amount it is the lender which suffers the additional loss
The amount a lender will be willing to lend is dependent on which two important metrics?
Loan to Value (LTV)
Debt Service Coverage Ratio (DSCR)
The Loan To Value Ratio (LTV)
measures the value of a loan against the value of the property.
It is used to ensure that the liquidation of the asset, if necessary, will generate enough cash to repay the loan.
LTV is calculated by dividing the amount of the loan by the property value.
Commercial real estate loan LTVs generally fall into the 65% to 80% range depending on the asset category and perceived risk.
The Debt Service Coverage Ration (DSCR)
measures the propertyβs ability to generate enough cash (NOI) to make the required debt payments.
DSCR is calculated by dividing the NOI by the loan payment amount (capital and interest) for the year.
A DSCR of less than 1 indicates a negative cash flow. For example, a DSCR of .92 means that there is only enough NOI to cover 92% of annual debt service.
In general, commercial lenders look for DSCRs of at least 1.2 to ensure adequate cash flow.
Lenders will also consider which non-financial risks?
Market risk
Quality of development team
Operational risks
β> Ability to lease at market rents
β> Security
β> Maintenance
β> HVACC
β> Services offered
Tenant risk
β> Quality of rent roll
β> Rollover risk
Environmental risk
Legal risk
Physical asset risk
Liquidity risk
Market risk
Geographic risk
Other risks
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