Archive for the 'Commercial Real Estate' Category
A clear understanding of expenses and revenues is needed by a commercial real estate investor to make an informed decision to purchase a property. The investor must comprehend which expenses are the responsibilities of the landlord and which expenses are paid by the tenants. Commercial property expenses include taxes, insurance, utilities, maintenance, and other expenses associated with the operation of the building.
What are Common Area Maintenance (CAM) charges?
Commercial leases often provide that tenants agree to pay a monthly lump sum base rent, and also their proportionate (pro-rata) share of other expenses. Under the provisions of many types of leases, a landlord typically passes through to the tenants such expenses as overhead and administrative fees, and also building repair, maintenance, and operating costs for “common areas” of the property, including driveways, parking lots, lobbies, thoroughfares, hallways and public restrooms. These expenses are collectively called CAM charges.
The CAM fees charged to the tenants are often an important component of the commercial property’s income, and must be collected and accounted for properly to cover the associated expenses of the building. CAM fees may be a flat fixed amount, or may be variable, based upon expense increases or escalation calculations, and may be “capped” for individual tenants at a certain amount. The CAM fees are paid by tenants on a monthly, quarterly or annual basis, and also may be charged on a supplemental basis in the event of major repairs to the property.
An investor (buyer) typically obtains the necessary financial information to understand CAM charges by requesting it from the seller or the seller’s agent. It is customary that the sale transaction purchase contract sets forth the details by which the buyer and his agent verifies or determines important components of his financial analysis by his own due diligence work, while in escrow.
Commercial real estate investment requires the careful review of an asset’s financial performance. Revenues and expenses must be clearly understood for an investor to make an informed decision. Documents obtained from the seller commonly include prior years’ financial statements, setups and proforma income statements, rent rolls, and estoppel certificates.
What is an Estoppel Certificate?
In a purchase transaction, a commercial real estate investor requests documentation from the seller that exhibits income and expenses from the current year and prior years. The historic information from prior years demonstrates stabilized income and expenses. The current information is used by the investor to understand the asset’s performance relative to the market. Current rental income is critical to the investor’s purchase price decision for the asset, and therefore verifying the rent paid by each tenant is an important step in the due diligence process. An estoppel certificate is a document signed by a tenant that confirms to the buyer the rent paid and other important details of the tenant’s lease agreement with the landlord.
Estoppel certificates commonly request from the tenant information about rental amount, lease terms and provisions, details about payment of utilities, oral agreements and promises made by the landlord, and protected tenancy status. A tenant must sign an estoppel certificate when the written lease contains a lease provision requiring it.
It is customary in a commercial real estate sales transaction that the purchase contract sets forth the details by which the investor and his agent verifies the financial performance of the asset and the provisions in each lease, by his own due diligence work while in escrow.
The decision by an investor to purchase a commercial real estate property requires a clear understanding of revenues and expenses. Leases must properly detail which expenses are paid by the tenants and which expenses are the responsibility of the landlord. Lease types include gross, modified, modified gross, percentage, net, modified net, double net, and triple net (NNN).
What is a Triple Net (NNN) Lease?
A triple net lease provides that a tenant agrees to pay a monthly lump sum base rent, and also his proportionate (pro-rata) share of real property taxes, property and liability insurance, and maintenance (repairs, common operating expenses and common area utilities). Each tenant is further responsible for all costs associated with their own occupancy, including personal property taxes, personal property and liability insurance, utility costs and janitorial services.
The responsibility for maintenance and capital expenses must be well-defined and fully understood by both the tenants and the landlord. Typically, capital expenses are borne by the property owner, including the exterior and structural elements of the building. It is customary that the plumbing, electrical, and HVAC maintenance is the responsibility of the tenants.
Each tenant’s prorated share of property taxes, insurance and operating expenses are generally estimated on an annual basis, and paid monthly. It is customary in a commercial real estate sales transaction that the purchase contract sets forth the details by which the investor and his agent verifies the provisions of each NNN Lease by his own due diligence work while in escrow.
Net Operating Income is one of the most important components of financial analysis for commercial real estate investors. A few months ago we discussed another important financial index, CAP Rates, which are determined directly from the NOI.
What is the NOI?
The NOI is calculated as follows:
NOI = GOI – Expenses, where GOI is the Gross Operating Income of the commercial real estate asset. Expenses include property taxes, insurance, maintenance, utilities, capital reserves, management fees and incidental expenses. NOI is analogous to a simple profit calculation for a business.
Of course, the commercial property’s Gross Operating Income (GOI) is needed for the NOI calculation. The GOI is determined by subtracting the vacancy rate reserve from the Scheduled Gross Income (SGI). This is done to adjust the SGI for tenant vacancies. The SGI is simply the total amount of rents scheduled to be collected annually.
An investor (buyer) typically obtains the necessary financial information by requesting it from the seller or the seller’s agent prior to executing a commercial real estate sale transaction.
It is customary that the sale transaction purchase contract sets forth the details by which the buyer and his agent verifies or determines a NOI and other important components of his financial analysis by his own due diligence work, while in escrow.
According to the California Department of Consumer Affairs, the biggest disagreement between landlords and tenants come after the tenant vacates the property, and it is often centered on the refund of the security deposit. Knowing what the law will and won’t allow will go a long way to help you and your tenant avoid any misunderstandings at the end of the lease.
As outlined in California Civil Code 1950.5, landlords are allowed to use a tenant’s security deposit for one of four reasons:
- Unpaid rent.
- Cleaning – but only to return the unit to the condition the property was in on move-in.
- Repair of damages caused by the tenant or the tenant’s guests beyond normal wear and tear.
- And for restoration or replacement of furniture, furnishings, or other items (e.g. keys) beyond normal wear and tear (but only if the lease or rental agreement specifically stipulates).
Furthermore, the landlord is allowed up to 21 calendar days after the tenant’s departure to refund the tenant’s security deposit or to provide an itemized list of deductions from the original deposit amount, accompanied by a refund for what remains. If deductions have been made from the tenant’s deposit, the law requires that the landlord provide copies of receipts (or good-faith estimates) for repairs or cleaning needed to bring the rental property back to “original” move-in condition. Receipts must describe work performed, time spent, and hourly rate (it must be reasonable). If estimates were provided initially, within 14 calendar days, a final statement should be provided to the tenant, detailing final costs, accompanied by a check for the remainder of the security deposit.
If a former tenant disputes the deduction(s), the best thing for the landlord to do is to objectively and expeditiously review the facts and reply. Oftentimes, an open dialogue will help both parties avoid unnecessary stress and anxiety while also allowing them to resolve any differences quickly.
For more information about this and other landlord/tenant subjects, visit the California Department of Consumer Affairs website at http://www.dca.ca.gov.
A fundamental component of the financial performance of commercial investment real estate is the rent (rental income). Depending on the type of lease agreement (gross, modified, NNN, percentage, etc), rental income may include tenant base rent payments, liability insurance, common area maintenance (CAM), property taxes, percentage rent, gross-up and other charges. Also, there may be tenant deposits, which include security (damage) deposits and last-month rent deposits.
How are rents handled in escrow?
The document commonly used in commercial real estate to itemize the collection of rents is called the Rent Roll. This document is provided to the escrow officer by the seller or property manager, and is approved by the buyer and seller prior to the close of escrow.
Rents are customarily prorated at closing by one of two methods:
- Accrual method – All rents as if collected (this is the usual practice)
- Actual method – Rents that have actually been collected (with this method, the buyer assumes any delinquent rents
Tenant deposits are normally itemized on the rent roll, but these are not prorated. Instead, the total amount of the deposits is transferred to the buyer from the seller at closing. The seller is normally charged for the deposit total, and the buyer is credited. In some cases, the seller may be charged for the total, and a check may be issued to the buyer. Special instructions for this require approval by both parties.
The manner in which rents are prorated and deposits are transferred should be stated in the purchase agreement. Otherwise, the escrow officer will require approved special instructions from the seller and buyer.
Because most commercial real estate properties are for investment, the decision by an investor to purchase the commercial property is primarily based upon a financial performance analysis of the asset. A couple months ago, we discussed CAP rates, one of the fundamental components of the financial analysis. Another primary component is the Gross Rent Multiplier.
What is the Gross Rent Multiplier (GRM)?
The GRM is calculated as follows:
GRM = Price/SGI, where SGI is the Scheduled Gross Income of the asset and Price is the price of the property. The GRM is a function of Price and Income. To better understand the GRM, we can use algebra to change the calculation so that Price = GRM X SGI. This formula demonstrates that the Price is expressed by the GRM in relative “multiples” or “orders of magnitude” of the annual income.
For example, if an investor purchases a commercial property for $1,000,000 and the Scheduled Gross Income is $95,000, then the GRM = $1,000,000/$95,000 = 10.5. Therefore, in this case the $1,000,000 Price is 10.5 times the Scheduled Gross Income of $95,000.
GRMs may vary substantially by geographic submarket for investment products within the same asset class, and may also vary over time throughout a real estate economic cycle. GRMs are identified as “current” or “market” (proforma) rates.
Of course, the commercial property’s Scheduled Gross Income (SGI) is needed for the GRM calculation. The SGI is determined from the asset’s rental income (Rent Roll). An investor (buyer) typically obtains the necessary financial information by requesting it from the seller or the seller’s agent prior to executing a commercial real estate sales transaction.
It is customary that the sale transaction purchase contract sets forth the details by which the buyer and his agent verifies or determines a GRM and other important components of his financial analysis by his own due diligence work while in escrow.