1. Commercial leasing and NOI
Real Estate Finance, Spring, 2017

2. Overview Commercial lease agreements Net Operating Income (NOI)
Basic characteristics
Revenues, expenses
Net Operating Income (NOI)
What is NOI?
Deriving NOI
Examples
Multifamily – Pajama Factory Lofts
Office – Chilltown Office Plaza

3. Commercial lease agreements
A lease is a contract between the owner of property rights (lessor) and user of property rights (lessee) which conveys the rights and responsibilities associated the use of a given property for some specified period of time
Leases are the building blocks of property valuation, determining…
Rental income
Percentage rent/overage
Responsibility for expenses
Use of common areas and facilities
Responsibilities for maintenance and repair of tenant’s space and common areas
Concessions and tenant improvements

4. Commercial leasing: Space
The definition of real estate space varies depending on perspective
A building’s gross square footage refers to the total area within the structure
A building’s rentable square footage refers to amount of space that would be rented if a single tenant occupied the property
Usable square footage refers to the amount of space occupied by a tenant that shares common space with other tenants within a building

5. Commercial leasing: Space
Occupancy:
The economic occupancy of a building is the rentable area that is leased and paying rent, whether occupied or not
The physical occupancy of a building is the rentable area that is used, regardless of whether rent is paid

6. Commercial leasing: Rent
Leases specify the amount of rent tenants to landlords in exchange for the right to use the property
Base rent: Rent payment in the initial lease period
Base rent escalation: Changes in rents in future lease periods
Graduated rent escalation
Proportional rent escalation
Fixed percentage increase
Increase tied to index
Percentage rent/overage:
Rent tied to store revenues

7. Commercial leasing: Expenses
Leases specify the manner in which operating expenses are shared
In a gross lease, the lessor is responsible for all operating expenses associated with the property
In a net lease, the lessee pays all expenses
Triple net lease
In a hybrid, or modified gross, lease the lessor is responsible for expenses up to some predetermined expense stop and any expenses above that point are paid by the tenant in the form of reimbursements
Types of expenses:
Common area expenses (CAM):
Maintenance and upkeep of areas shared by tenants
Tenant-specific expenses:
Utilities
Property taxes
Casualty insurance

8. Commercial leasing: Maturity
Leases specify both the term to maturity and the options available to the lessee and lessor at expiration as well as specifying rights and responsibilities in the event that the tenant wishes to vacate the space
Extension options
Cancellation options
Ability to sublease
Recourse
Credit rating
Security deposit
Letter of credit

9. Commercial leasing: TI and concessions
Tenant improvements (TI)
Sharing of the expenses incurred when customizing tenant space at initiation of lease term
Concessions
Free rent
Capital expenditures
Sharing of expenses on durable improvements to the property

10. Effective rent
Lease agreements for similar space may differ in elements relating to base rents, escalators, expense sharing and concessions
Trade-offs in basic terms
Rents for a gross lease v. rents for a net lease
Risk sharing
The risk borne by landlord and tenant during the period in which the lease is in place is determined primarily by the structure of the base rent escalators and expense sharing arrangements
Base-rent escalation by steps v. by indexing
Net v. gross

11. Effective rent How can we compare across different leases?
Effective rent is the constant annuity payment having the same present value as the expected cash flows associated with the lease
Can be considered from either perspective; tenant or owner
Evaluating trade-offs in lease negotiations
What is the appropriate discount rate?
Rules of thumb
Risk premium associated with tenant credit quality

12. Effective rent
A building owner is presented with the following two 5-year lease agreements
Lease A:
$20/sf, net, first year rent free
Lease B:
$28/sf, net, first two years rent free
If rental income is discounted at a 7% rate, what is the effective rent associated with each lease?
Based on the given information, which lease will the building owner prefer?

13. Effective rent
*Note: The NPV calculation assumes the first payment is made in one year in the future

14. Effective rent
A building owner is presented with the following two 5-year lease agreements
Lease C:
5-year term, $30/sf, gross, first year rent free, expenses $10/sf, increase at 2% annually
Lease D:
5-year term, $40/sf, gross, first two years rent free, expenses $10/sf, increase at 2% annually
If rental income is discounted at a 7% rate, what is the effective rent associated with each lease?
Based on the given information, which lease will the building owner prefer?

15. Effective rent

16. Effective rent
The effective rent may not adequately reflect all components relating to lease value
Time to maturity
Re-leasing costs
Staggered lease expirations

17. NOI and financial value
Net operating income (NOI) represents the free cash flows generated by an income producing property that is available for distribution among financial claimants
The market value of a property is determined by the present value of its NOI discounted at the market return to investment in real estate

18. NOI and financial value
Investing in income-producing property is an exchange of current income for claims on future cash flows
Debt: senior claim with priority on free cash flows
Less uncertainty, lower required return
Equity: residual claim
More uncertainty, higher required return

19. NOI and financial value
The primary financial claims on the free cash flows generated by a given property are:
Debt
Equity
Taxes D E D E T

20. NOI and financial value
On a before-tax basis, the value of the equity claim on any given property is given by the present value of the residual cash flows
The required return on equity, rE, depends on Dt
If Dt = 0, returns are said to be unlevered and the return to equity equals the return on the asset
If Dt > 0, returns are said to be levered and, if the return on the asset exceeds the return to debt, the return to equity is strictly greater that the return on the asset

21. NOI and financial value
In practice, the cash flows going to the equity claimant are projected within a pro-forma cash flow statement
Combine current lease provisions with expectations about future market conditions and outcomes to project the future cash flows that will be received by investors
A tool that is useful for…
making clear statements about what and what is not assumed in projections
showing how inputs are determined
identifying primary sources of value
Necessary, but not sufficient, piece of analysis…
garbage in, garbage out

22. NOI NOI is total operating income less total operating expenses
Rent
Percentage rent
Ancillary income
Collection losses
Expense reimbursements (recoveries)
Expenses:
Common area expenses (CAM)
Utilities
Property tax
Insurance
General and administrative (G&A), property management fees

23. NOI Derivation of NOI: Potential gross Income - Vacancy adjustment
= Effective gross income
Effective gross income
+ Percentage rent
+ Expense reimbursements
+ Ancillary income
- Collection losses
- Concessions
= Total operating income
Total operating income
- Operating expenses
= Net operating income (NOI)

24. NOI: Potential gross income
A property’s potential gross income (PGI) is the rental income that would be received if the rentable area within the building was fully occupied
For occupied space, rental income is determined by the rent determined by the lease provisions of current tenants
For multifamily, PGI is based on current market rent even if it exceeds the actual rent paid by existing tenants – the difference between market and contract rents can be used to estimate future rent growth
For vacant space, rental income is determined by the current market rent on comparable space

25. NOI: Effective gross income
Effective gross income (EGI) is the rental income generated by all physically occupied space before adjustments
EGI = PGI – vacancy
For vacant space, subtract the rental income associated with the amount included in determining PGI
For occupied space associated with PGI determined by market rents, adjust for difference in market rent above current lease terms

26. NOI: Total operating income
Total operating income equals EGI plus expense reimbursements, ancillary income, percentage rent and less collection losses and concessions
Expense reimbursements (recoveries) represent tenant repayment for expenses paid by the owner on their behalf
Ancillary income is income from sources other than the rent generated by the space occupied by tenants - parking, vending, antenna, signage
Percentage rents are based on a percent of a tenant’s chargeable sales
Percent of sale
Breakpoint
Collection losses are associated with the non-payment or late payment of rent or other revenues
Rent concessions reflect loss of revenue due to free-rent periods

27. NOI: Total operating income
Example: What is the percentage rent paid by a tenant occupying 1500 sf of space with a base rent of $16/sf if they earn $925,000 in total sales for the year and a sales percentage of 3% percent of their chargeable sales?
Chargeable sales = Total sales
Percentage rent = .03(925,000) = $27,750
Chargeable sales = Total sales above $750,000
Percentage rent = .03(925,000 – 750,000) = $5,250
Chargeable sales = Total sales above the tenant’s natural breakpoint
Natural breakpoint = 16(1500)/.03 = 800,000
Percentage rent = .03(925,000 – 800,000) = $3,750

28. NOI: Expenses
Depending on lease terms, tenants may be required to reimburse property owners for operating expenses
Total operating expenses equal the sum of reimbursable and non-reimbursable expenses
Reimbursable expenses:
CAM
Utilities
Property taxes
Insurance
Non-reimbursable expenses:
Property management fee
General and administrative expenses

29. NOI: Expenses Operating expenses are either fixed or variable
Fixed expenses are independent of the occupation rate
Property taxes
Casualty insurance
Variable expenses depend on the building’s physical occupation rate
Utilities
Common area maintenance (CAM)
Property management fee
General and administrative (G&A)

30. NOI: Expenses
Example: What is the annual utility expense for a property with 30,000 sf of rentable space and utilities are $1.50/sf and 40% fixed…
If the building is 100% occupied?
Utility expense = 1.50(30,000) = 45,000
If the building is 85% occupied?
Utility expense = 1.50(30,000)( (.85)) = 40,950

31. NOI: Expenses
In a modified gross lease, tenants reimburse property owners on a pro-rata basis for any reimbursable expenses above a tenant’s expense stop
A tenant’s base year expense stop is by the reimbursable expense per square foot that sets the reimbursement in the initial year of their lease to zero
Example:
Total reimbursable operating expenses for a 60,000 sf building were 120,000, or 2.00/sf during the past leasing period
A tenant with an expense stop of 1.75/sf occupies 3,000 sf of rentable space, the reimbursement paid by the tenant equals 3000(2.00 – 1.75) = 750
A new or renewing tenant in the building in that year will have an expense stop equal to 2.00/sf for the term of their lease

32. Example: Multifamily
Pajama Factory Lofts is a large residential multifamily property in Neptune, NJ
The property offers 85 rental units
40 one-bedroom units, $1050/month
25 two-bedroom units, $1450/month
20 three-bedroom units, $2000/month
Ancillary income:
On-site laundry facilities generates approximately $130/unit/year, 0% fixed
Expenses (0% recoverable)
Insurance, $16,500/year
Property taxes, $92,000/year
Maintenance & repairs, $625/unit/year, 25% fixed
Management and administration, $195,000/year
Miscellaneous, $12,000/year

33. Example: Multifamily Pajama Factory Lofts Number of units 85
Asking price
13,250,000
1BR/1BA 40
Market return on asset
9.00%
2BR/2BA 25
Inflation
3.00%
3BR/2BA 20
Terminal capitalization rate
7.75%
Rental income
Loan-to-Value at origination
60.00%
Rent/month: 1BR/1BA
1,050
Debt
7,950,000
Rent/month: 2BR/2BA
1,450
Equity contribution to sale
5,300,000
Rent/month: 3BR/2BA
2,000
Mortgage rate
5.25%
Origination fees
2.00%
Ancillary income
Amortization
Laundary facilities/vending ($/unit/Y, 0% fixed)
130
Maturity 10
Cost of sale
3.50%
Vacancy rate
5.00%
Collection losses
Tax information
Marginal income tax rate
35.00%
Operating expenses
Capital gains tax rate
15.00%
Insurance
16,500
Depreciation recapture rate
25.00%
Property taxes
92,000
Other passive income
None
Maintenance & repairs ($/unit/Y, 25% fixed)
625
Land value
2,750,000
Management and administration
195,000
Structure and improvements
10,500,000
Miscellaneous expenses
12,000
Economic life - structure
27.5
Economic life - capital expenditures
Capital reserves ($/unit/Y, 100% fixed)
250

34. Example: Multifamily 1 Rent: 1BR 504,000.00 Rent: 2BR 435,000.00
480,000.00
Potential gross income (PGI)
1,419,000.00
Vacancy adjustment
(70,950.00)
Effective gross income
1,348,050.00
Units occupied
80.75
Ancillary income
10,497.50
Collection losses
(26,961.00)
Total operating income
1,331,586.50
Expenses:
Insurance
16,500.00
Property taxes
92,000.00
Maintenance & repairs
51,132.81
Management and administration
195,000.00
Miscellaneous expenses
12,000.00
Total operating expenses
366,632.81
Net operating income (NOI)
964,953.69

35. Example: Office
Chilltown Plaza is a mid-size office building in Jersey City, NJ
45,000 sf of rentable space
Sixth Borough Bank, 30,000 sf, 10-year lease signed 1/2014
Green Leaf Publishing, 10,000 sf, 5-year lease signed 1/2015
Goodman and Associates Law Firm, 5,000 sf, 5-year lease to be signed 1/2018
Ancillary income
Roof rental/antenna, $24,000/year
Expenses
Insurance, $27,500/year, 100% recoverable
Property taxes, $105,000/year, 100% recoverable
Utilities $1.65/sf/year, 35% fixed, 100% recoverable
CAM, 5% of EGI, 100% recoverable
Management, 3% of EGI, 0% recoverable

36. Example: Office Chilltown Plaza General data: Lease renewal: Price
7,700,000.00
Renewal probability
75%
75.00%
Market return on asset
10%
10.00%
Months vacant
8 months
8.00
Property type
Office
Expected months 100% occupancy
10.00
Rentable SF
45,000
45,000.00
Tenant improvements - New
$15/sf
15.00
Inflation
Number of tenants 3
Tenant improvements - Renewal
$5/sf
5.00
Lease term
Five years
Leasing commisions - New
25% of base rent in initial year
25.00%
Leasing commisions - Renewal
15% of base rent in initial year
15.00%
Market and economic data:
Reserves
$0.25/sf
0.25
7.7M
Market rent
$23.50/SF
23.50
Disposition:
Market inflation 3%
3.00%
Market capitalization rate 7%
7.00% 2%
2.00%
Sale commissions
3% of sale price
Income:
Mortgage financing:
Sixth Borough Bank
Principal amount borrowed
$4.5M
4,500,000.00 SF
30,000
30,000.00
Interest rate
6.00%
Base rent
$19.50/SF
19.50
Amortization period
25 years
25.00
Rent escalation
$.50/SF/YR
0.50
Maturity
10 years
Expense stop
$4.50/SF
4.50
Payment frequency
Annual
Remaining lease term
7 years
Origination fee
1.5% of initial balance
1.50%
Greenleaf Publishing
10,000
10,000.00
$22.00/SF
22.00
$4.75/SF
4.75
3 years
Goodman and Associates
5,000
5,000.00
$23.50/SF (beginning Y2)
TBD
5 years (beginning Y2)
Ancillary
Antenna, $24000/YR
24,000.00
Reimbursements
Base stop
Collection losses
2% of EGI
Operating expenses:
CAM
5% of EGI 5%
Utilities
1.65/sf, 35% fixed
1.65
% fixed
0.35
Real estate taxes
$105,000
105,000.00
Insurance
$27,500
27,500.00
Management (Non-reimbursable)
3% of EGI

37. Example: Office 1 Jan-17 Utilities/sf 1.65 TI/sf, New 15.00
TI/sf, Renew
5.00
Market Rent
23.50
SBB
19.50 GL
22.00
G+A --
Potential rental income:
585,000.00
220,000.00
117,500.00
Potential gross income (PGI)
922,500.00
Vacancy allowance:
0.00
Total allowance
Occupancy
88.89%
Effective gross income (EGI)
805,000.00

38. Example: Office 1 Jan-17 Effective gross income (EGI) 805,000.00
Reimbursements:
SBB
Base stop
4.50
Reimbursement
26,091.67 GL
4.75
6,197.22
G+A
Total reimbursements
32,288.89
Tenant revenue
837,288.89
Collection losses
(16,745.78)
Antenna rental
24,000.00
Total operating income
844,543.11
Expense information:
CAM
40,250.00
Utilities
68,887.50
Real estate taxes
105,000.00
Insurance
27,500.00
Reimbursable expenses
241,637.50
Reimbursable exp/sf
5.37
Management expenses
24,150.00
Total operating expenses
265,787.50
Net operating income (NOI)
578,755.61