Posted: Nov 3, 2018 in Education
The Fundamentals of Commercial Real Estate (in 20 minutes)
At the end of the day, the mortgage needs to be paid.
As a tenant in the building, your activities influence the incomes generated from the property and ultimately determine the value of the property. Whether a real estate project is viable depends on whether the income generated is sufficient to justify the cost of buying or building it.
To understand how you, as a tenant, inform the viability of the project, you need to understand just three commercial market terms:
- Triple Net Rent,
- Net Operating Income, and
- Rate of Capitalization.
Triple Net Rent
The market standard lease in commercial real estate is a triple net lease. Triple net basically means that, in addition to base rent and utilities, the tenant is responsible for all other operating costs. The ‘triple’ in triple-net refers to property taxes, insurance, and repairs and maintenance.
In practice, this means you pay two different types of rent.
The first rent is generally called Basic Rent. This is usually a fixed amount calculated on a $ / ft2 / year basis. For example, for a retail space on Whyte Ave or 104 St., a tenant might pay $40-50 per ft2 per year. So if they lease a 2000 ft2 restaurant at $45 psf, they would pay $90,000 in base rent per year. Typical Basic Rent in Edmonton ranges from $10-30 psf for office and $15-55 psf for retail, depending on the location and quality of the building.
The second rent is generally called Additional Rent. This is a variable amount based on the costs incurred to operate the property. The way this works is that, at the beginning of the year, the landlord produces an operating budget including all the operating costs anticipated for that year. That cost is then divided by the total ft2 of the building so it can be calculated like Basic Rent on the basis of $ / ft2 / year. Typical additional rent in Edmonton ranges from $8-20 psf.
The tenants collectively pay 1/12 of the operating budget every month through payment of additional rent. At the end of the year, the landlord conducts an operating cost reconciliation. If the operating costs were less than budgeted, the landlord writes a cheque to the each tenant. If the costs exceeded the budget, the tenants receive an invoice for the difference.
Triple Net Rent = Basic Rent + Additional Rent
Net Operating Income (NOI)
Ultimately, the value of commercial property is almost entirely a function of Net Operating Income, which quite simply, is equal to Operating Income minus Operating Expenses.
Generally, Operating Income consists of rents. In some cases, there may be other revenues from services offered by the building. But for the most part, we can think of Operating Income as equivalent to the total rental income.
Note that Operating Expenses do not include debt servicing. NOI is therefore different than Net Profit. For example, mortgage interest is generally a business expense that you can deduct against income for tax purposes. But costs of servicing debt are not Operating Expenses for the building. General categories of Operating Expenses include property tax, insurance, repairs & maintenance, utilities, and property management.
It’s important to separate debt servicing from NOI because the function of NOI is meant to allow us to compare the financial performance of one building against another on an apples-to-apples basis. Mortgage payments can be highly variable depending on how much has been borrowed and at what interest rate. They are therefore not reliable inputs when evaluating the performance of the building. Another way to think of this is to consider that NOI is more or less equivalent to the Net Profit the property would generate if we were to buy the building cash, with no mortgage.
NOI = Operating Income – Operating Expenses
And here’s another useful observation. Recall that in a Triple Net Lease, all Operating Expenses are charged back to the tenant through Additional Rent.
Operating Income = Basic Rent + Additional Rent
Additional Rent = Operating Expenses
NOI = (Basic Rent + Additional Rent) – (Additional Rent)
Or in other words:
NOI = Basic Rent
This is a reliable rule of thumb. There is some nuance when we get into the details. For example, you’ll probably want to apply a vacancy rate against the Basic Rent, to account for vacancy risk. But for most practical purposes, if you know the Basic Rent a property can generate, then you have an accurate approximation of NOI.
Rate of Capitalization (CAP Rate)
Here’s where it gets interesting. Let’s say you are looking at a property that comprises 10,000 ft2 of retail space. If we know that the fair market Basic Rent for that location is $30 psf, then we can reliably estimate that the NOI will be $300,000.
So what is the building worth if it generates $300,000 of NOI per year? Well, that just depends on what buyers are willing to pay.
It so happens that in Edmonton, buyers will likely pay about $4.3M for an average property in average location that generates $300,000 in NOI. That’s a ratio of about 7%. In other words, for every $1M a buyer spends on a building, They will look for $70,000 in NOI.
This is called the Prevailing CAP Rate. In Edmonton, the Prevailing CAP for retail and office space tends to range from 5.5-8.0%
If a building is in excellent condition and in a neighbourhood with low vacancy risk, a buyer might be happy with just $55,0oo of NOI on a $1M of assets. If the building is in disrepair and located in an undesirable neighbourhood, the buyer may need to see $80,000 or more to justify the risks of the property.
CAP Rates can also become compressed in markets like Toronto and Vancouver. In these markets, buyers are speculating that rapid appreciation in land values will far surpass any losses due to low NOI. In such cases, buyers may accept a 3% CAP Rate and be happy with $30,000 of NOI on $1M of assets. Conversely, in declining markets, like a remote town with a dwindling population, buyers may need to see a 10-15% CAP Rate to offset the perceived risk.
But for our purposes, we can work with CAP Rate assumptions in the range of 6-7%.
CAP Rate = NOI ÷ Property Value (or Project Cost)
Property Value & Viability
And that’s basically it. Property Value is a function of NOI. If NOI goes up, Property Value increases. If vacancy rates go up and rent values go down, Property Value decreases. So the value of the property is measured by its ability to attract quality operators who can afford market rent and whose activities in the building make it even more attractive to other tenants.
Property Value = NOI ÷ CAP Rate
For a project to be viable, it has to make sense to whoever is bringing the capital to make it happen. Real estate projects are capitalized through a combination of debt and equity. The bank will look at the NOI to evaluate whether the project can afford to carry the mortgage. The investors will look at the NOI to determine whether there is likely to be enough profit remaining after the bank is paid to justify putting their equity investment at risk.
In the end, a financially viable project is one where the Project Value, once stabilized, exceeds the Project Cost by a margin that meets the expectations of all the parties to the project, especially the bank and the investors.
Viability = Project Value > Project Cost
The key concepts we wanted to share with you are contained in these three formulas:
Triple Net Rent = Basic Rent + Additional Rent NOI = Operating Income – Operating Expenses Property Value = NOI ÷ CAP Rate
With this perspective, you have 90% of the information you need to understand project viability and speak the language of commercial real estate on market terms.
The only real missing variable is to have a sense of what fair market rents are in various neighbourhoods in Edmonton. But if you are out looking at what’s available in the market, you’ll quickly get perspective on this. Once you know average Basic Rents in a given neighbourhood, you can just look at a building, estimate the ft2 (or measure it on Google Maps), multiply by Basic Rent, and divided by the CAP Rate, and you’ll know what the building is worth.
It’s worth practicing these formulas until you can easily recall them. It’s also worth thinking about what happens to Property Value if, for example, in a 2000 ft2 restaurant Basic Rent increases by $1 psf. Or conversely, how Property Value might be impacted by a chronic 2000 ft2 vacancy. These are good exercises to better understand the concepts. They may also inform your thinking about how your negotiations with landlords can take the form of a collaboration to enhance Property Value.
Hopefully this will be of value to you as a toolset to inform your thinking about renting, buying, or building the commercial space you need to advance your ventures.