class 2: Real Estate Finance

Question 1

Property Cash Flow sheet

Answer 1

Rental Income
- Operating expenses
+ Ancillary Income
= NOI

• Tenant Inducements
• Leasing commissions
• Capital expenditures
  = Cashflow before financing
• Financing costs
  = cash flow after financing

Question 2

Exclusions from NOI

Answer 2

Debt Service

Depreciation

Income Taxes

Tenant Improvements

Leasing Commissions

Capital Expenditures

Question 3

why is Debt Service excluded from NOI

Answer 3

Financing costs are specific to the owner/investor and as such are not included in calculating NOI

Question 4

why is depreciation excluded from NOI

Answer 4

Depreciation is not an actual cash outflow, but rather an accounting entry and is, therefore, not included in the NOI calculation

Question 5

why are Income Taxes excluded from NOI

Answer 5

Since income taxes are specific to the owner/investor they are also excluded from the net operating income calculation

Question 6

why are tenant improvements excluded from NOI

Answer 6

Tenant improvements include construction within a tenant’susable spaceto make the space viable for the tenant’s specific use.

Question 7

why are leasing commissions excluded from NOI

Answer 7

Commissions are the fees paid to real estate agents/brokers involved in leasing the space

Question 8

why are Capital Expenditures excluded from NOI

Answer 8

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

Question 9

rent is generally made up of one or more of which
elements

Answer 9

Base rent

Percentage rent

Expense recovery

Rent free period

Question 10

base rent

Answer 10

is usually expressed as a dollar amount per square foot per year

Question 11

Percentage rent

Answer 11

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

Question 12

The most common formula for percentage rent is:

Answer 12

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑟𝑒𝑛𝑡 = (𝑎𝑐𝑡𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 − 𝑏𝑟𝑒𝑎𝑘𝑝𝑜𝑖𝑛𝑡) ∗ 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑓𝑎𝑐𝑡𝑜𝑟

Question 13

Expense participation

Answer 13

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.

Question 14

The more common expense participation clauses can be categorized as

Answer 14

Gross Lease

Modified Gross Lease

Single Net Lease

Double Net Lease

Triple Net Lease

Question 15

gross lease

Answer 15

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.

Question 16

modified gross or full service lease

Answer 16

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.

Question 17

a single net lease

Answer 17

the tenant pays base rent plus a pro-rata share of the building’s property taxes.

Question 18

a double net lease

Answer 18

the tenant is responsible for base rent plus a pro-rata share of property taxes and property insurance

Question 19

a triple net lease

Answer 19

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

Question 20

most popular operating expenses

Answer 20

Real estate taxes

Common-area maintenance

Security

Utilities

Insurance

Management fees

Question 21

why does a triple net lease favor the landlord

Answer 21

as it protects him against rising expenses

Question 22

True-up or CAM Adjustment

Answer 22

Expenses estimated at the start of the year and adjusted to actuals at the end of the year

Question 23

how are rent-free periods accounted for?

Answer 23

Rent-free periods are accounted for on a straight-line basis and must be adjusted for when calculating cash flows.

Question 24

Operating Expenses

Answer 24

Operating expenses include all expenditures required to operate the property and command market rents

Question 25

The most widely used method to estimate the value of a commercial property?

explain the method

Answer 25

Capitalized NOI

Value = Stabilized NOI / Cap Rate

This valuation method presumes that a property will generate its stabilized NOI in perpetuity

Question 26

in capitalized NOI, how are the value and cap rate an inverse relationship?

Answer 26

The higher the cap rate the lower the value

Question 27

stabilized NOI sheet

Answer 27

Potential Rental Income
- Vacancy and Credit Allowance
= Effective Rental Income

+ Other miscellaneous Income
= Gross Operating Income

• Operating expense
  = NOI

Question 28

Potential Rental Income

Answer 28

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

Question 29

Vacancy and Credit Losses

Answer 29

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

Question 30

NOI Adjustments

Answer 30

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 “below the NOI” line

Question 31

Some of the determinants of the Capitalization Rate include the following

Answer 31

Other investment yields (especially GOC rate)
–> Real estate competes for investment dollars with other forms of investments

Perceived risk of asset class
–> Usually seen as a lower risk asset class it is still –> susceptible to overvaluation
Less liquid investment

Question 32

Some of the determinants of the Capitalization Rate include the following

Answer 32

Other investment yields (especially GOC rate)
–> Real estate competes for investment dollars with other forms of investments

Perceived risk of asset class
–> Usually seen as a lower risk asset class it is still –> susceptible to overvaluation
Less liquid investment

The market
–> High growth metropolitan market vs stagnant market

Property characteristics
–> Type (retail, office, hotel, etc)
–> Quality
–> Size
–> Quality of the rent roll

Question 33

The Discounted Cash Flow (DCF) method

Answer 33

values a property by adding together the present value of its future cash flows including its Terminal Value

Question 34

The Terminal Value (TV)

Answer 34

the value of the property at the end of the investment period and is calculated based on the NOI at that time

Question 35

The discount rate’s role in DCF

Answer 35

should reflect the rate of return required by an investor for an investment with this level of risk

Question 36

when can the discount rate for the terminal value can be different than the rate used for the cash flows?

Answer 36

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

Question 37

The Comparable Sales Approach

Answer 37

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:
–> Type
–> Location
–> Age
–> Condition

Question 38

The Cost or Replacement Cost Approach

Answer 38

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.

Question 39

Leverage Effect

Answer 39

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

Question 40

what do Interest rates reflect?

Answer 40

reflect both the market and the project risk

–> The higher the perceived risk, the higher the rate

Question 41

how are Interest rates for mortgages often expressed as?

Answer 41

often expressed as the amount of basis points (.0001) above the Government of Canada Bond rate (GOC) for a given term.

–> For example: 5-year term might be GOC 5yr + 250 bp

–> GOCs are viewed as riskless investments

Question 42

charge fees that increase the overall cost of the loan that lenders sometimes ask

Answer 42

Application fees

Origination fees

Standby fees (on undrawn amounts)

Question 43

The lender’s expenses in underwriting or documenting the loan may also be charged

which are they?

Answer 43

Appraisal fees

Legal fees

Question 44

Types of Real Estate Loans

Answer 44

all are Term Loans

either mortgage loans or Unsecured or corporate loans

Question 45

mortgage loans

Answer 45

Guaranteed by the asset

either recourse or non-recourse loans

Question 46

recourse loans

Answer 46

not only guaranteed by the mortgage on the property but also by a claim over the entity’s other assets

Depending on the financial strength of the borrower this can greatly reduce the risk of a loan

Question 47

non-recourse loans

Answer 47

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

Question 48

The amount a lender will be willing to lend is dependent on which two important metrics?

Answer 48

Loan to Value (LTV)

Debt Service Coverage Ratio (DSCR)

Question 49

The Loan To Value Ratio (LTV)

Answer 49

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.

Question 50

The Debt Service Coverage Ration (DSCR)

Answer 50

measures the property’s 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.

Question 51

Lenders will also consider which non-financial risks?

Answer 51

Market risk

Quality of development team

Operational risks
–> Ability to lease at market rents
–> Security
–> Maintenance
–> HVACC
–> Services offered

Tenant risk
–> Quality of rent roll
–> Rollover risk

Environmental risk

Legal risk

Physical asset risk

Liquidity risk

Market risk

Geographic risk

Other risks

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