Commercial Real Estate Investing For Dummies. Peter Harris
deal into its three simple components of income, expenses, and debt. Here’s the income breakdown:
Gross income = $1,575 × 20 units × 12 months = $378,000 per year
Vacancy rate = $378,000 per year × 10 percent (assumption) = $37,800
Effective gross income = $378,000 – $37,800 = $359,100 per year
Here’s the expense breakdown:
Total operating expenses = $171,510
To figure out the debt breakdown, assume that the interest rate is 5.5 percent today with a 25-year amortization period:
Asking price = $1,650,000
Down payment = 20 percent of asking price, which is $330,000
Loan amount (principal) = $1,650,000 – $330,000 = $1,320,000
Loan payment per month = $18,106 (we used a mortgage calculator for this figure)
Loan payments per year (debt service) = $8,106 × 12 months = $97,272
Now, you have everything you need to figure out whether this deal makes money or not, using these four easy steps:
1 Calculate the net operating income (NOI).Net operating income = effective gross income – operating expenses$359,100 – $171,510 = $187,590
2 Calculate the annual cash flow.Annual cash flow = net operating income – debt service$187,590 – $97,272 = $90,318
3 Calculate the cash-on-cash return.Cash-on-cash return = annual cash flow ÷ down payment$90318 ÷ $330,000 = 27.41 percent
4 Calculate the cap rate.Cap rate = net operating income ÷ sales price$187,590 ÷ $1,650,000= 11.4 percent
So, in a nutshell, you’re putting down $330,000 to earn $90,318 per year in cash flow, or approximately 27 percent return on your $330,000. That’s pretty darn good.
Analyzing a retail shopping center
One of the most important items to understand when analyzing retail investments is the lease. A lease is a written legal agreement between the landlord (called the lessor) and the tenant (called the lessee) that establishes how much the tenant will pay in rent; how long the tenant is legally committed to stay; any additional payments by the tenant for taxes, insurance, or maintenance; rent increases; renewal clauses and options; and all rights, privileges, and responsibilities of the tenant and landlord.
Following are types of leases you’ll run into in the course of looking into investing in retail shopping centers. Each has its own wrinkles and stipulations, so pay attention to the small differences:
Gross lease: The landlord agrees to pay all operating expenses and charges the tenant a rent that’s over and above the operating expenses. The types of expenses covered include taxes, insurance, management, maintenance, and any other costs associated with operating the property.
Modified gross lease: This lease is slightly different from the standard gross lease in that some of the operating expenses — such as maintenance, insurance, or utilities — aren’t paid for by the landlord and are passed on to the tenant. These expenses are called pass-through expenses because they’re passed through to the tenant. Many office-type buildings use a modified gross lease.
Net lease: In a net lease, the tenants pay the operating expenses of the property, and the landlord gets to net a certain amount every month by charging rent over and above the total operating expenses. This lease is favorable in many ways: It’s favorable to landlords because they aren’t responsible for any operational expenses of the property. It’s favorable to tenants because they get to fix up their stores as they see fit and do their own maintenance and cleaning. Net leases typically are customized to fit tenant needs.This type of lease is used mainly by retailers. The landlord takes care of the common area maintenance, and the expense of that is spread among the tenants and billed back to them.Here are the several different levels and types of net leases:Single net lease (N): In a single net lease, the tenant agrees to pay property taxes. The landlord pays for all other expenses in the operation.Double net lease (NN): In a double net lease, the tenant agrees to pay property taxes and insurance. The landlord pays for all other expenses in the operation.Triple net lease (NNN): A triple net lease is most favorable for landlords and is one of the most popular today. The tenants agree to pay the landlord rent plus all other property-related expenses including taxes, insurance, and maintenance. The landlord gets a true net payment. Banks, fast-food restaurants, and anchor tenants typically use triple net leases.Anchor tenants are major tenants, usually the tenant occupying the most space. Anchor tenants are critical in giving value and security to a retail shopping center investor. Their signs are usually the largest and stand out. Major retail chain stores typically are anchor tenants and are called so because they attract other businesses to the shopping center location. They “anchor” the shopping center so to speak.A common clause used in net leases is the expense stop clause, which states that any amount over a certain fixed expense will be charged to the tenant. The fixed expense is a dollar amount agreed on by the tenant and landlord.
Even though retail leases are long term — say, 5 to 15 years in length — it’s common for leases to have rental increases or rent escalations in the middle of the leasing years. For example, you could have a rent escalation of 5 percent once every five years until the lease expires.
Now that you have all that info on leases down, it’s time to analyze a deal. Here’s the deal: Kimo’s Landing, a 36,000-square-foot retail center anchored by a major chain pharmacy is in the center of town, right in the path of progress. It’s on 3 acres of land. The retail center is composed of eight stores of various types, ranging from a bagel shop to a U.S. post office. Table 3-3 provides the square footage and yearly rent of each unit.
TABLE 3-3 Square Footage and Yearly Rent for Kimo’s Landing
| Lessees | Square Footage | Rent Per Square Foot | Yearly Rent |
|---|---|---|---|
| Pharmacy | 10,000 | $10 | $100,000 |
| Bank | 8,000 | $8 | $64,000 |
| Bagel shop | 1,500 | $5 | $7,500 |
| Express photo shop | 1,500 | $5 | $7,500 |
| Electronics shop | 1,000 | $6 | $6,000 |
| Beauty store |
|