1. Real Estate Finance, Spring, 2017
Leasing and Modeling
Real Estate Finance, Spring, 2017

2. Overview Let’s get more comfortable with revenues and expenses.
Imagine you have a fully occupied building with one tenant who pays all expenses. This is easy!
So what are the complications?
Vacancy: Impacts expenses and must forecast expected revenues
Multiple tenants: staggered least start and end dates, with different clauses about what is reimbursable and by how much, how fast rents can increase, etc.
We need a system (software) to keep track of the complications
When we finish, you can do a full “model” on paper or in Excel

3. Complications Expenses Paid Rent Revenue Other Revenue
Current Tenants: Fixed vs Variable
Change in Tenants: Tenant Improvement (TI) and Leasing Commissions (LC)
Capital Expenditures
Rent Revenue
Potential Rent vs Actual Rent
Percentage Rent
Current Tenants: How Rent can Change over Time
What Happens when a Lease Ends?
Other Revenue
Expense Recoveries: What you recover may be different than what you pay (Fixed vs Variable, Gross Ups, Base-Year Stops, etc.)

4. Expenses Paid Current Tenants: Fixed vs Variable
Property owners get a bill in the mail – expense -- and have to pay it
The bill can be forwarded to tenants (net lease), but ARGUS and other software will typically show both the expense and the recovery. The pro-forma is “gross”
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)

5. Expenses Example 1
Common Area Maintenance is $20,000/Year when the building is 100% occupied. 25% of this expenses is fixed. The occupancy of the building is 50%. What is the Operating Expense amount that will appear on the Cash Flow?
How do you do this?

6. Expenses Example 1
Common Area Maintenance is $20,000/Year when the building is 100% occupied. 25% of this expenses is fixed. The occupancy of the building is 50%. What is the Operating Expense amount that will appear on the Cash Flow?
Note that 25% of $20,000 = $5,000. This is the fixed portion. This means that the variable portion when 100% leased is $15,000
We solve for the variable expense at 50% leased as
Cash flow will show $12,500 = $5,000 (fixed) + $7,500 (variable)

7. Expenses Example 2
Calculate the operating expense that will appear on the cash flow from the following assumptions:
Expense amount when 100% occupied: $25,000
% Fixed: 35%
Occupancy: 80%

8. Expenses Example 2
Calculate the operating expense that will appear on the cash flow from the following assumptions:
Expense amount when 100% occupied: $25,000
% Fixed: 35%
Occupancy: 80%
What is fixed and variable when 100% occupied?
Fixed = 0.35*$25,000 = $8,750
Variable = $25,000 - $8,750 = $16,250
Variable at 80% occupancy: 0.80*$16,250 = $13,000
Expense amount: $8,750 (fixed) + $13,000 (variable) = $21,750

9. Expenses Paid
Change in Tenants: Tenant Improvement (TI) and Leasing Commissions (LC)
You have just signed up a new tenant for 20,000 ft2 who is paying you monthly rent of $3.00 per square foot. The tenant demands $6/ft2 in improvements to the property and you have to pay a leasing broker 3% of the first-year rent as commissions. What are your TI and LC expenses for this tenant?

10. Expenses Paid
You have just signed up a new tenant for 20,000 ft2 who is paying you monthly rent of $3.00 per square foot. The tenant demands $6/ft2 in improvements to the property and you have to pay a leasing broker 3% of the first-year rent as commissions. What are your TI and LC expenses for this tenant?
TI: 20,000 * $6 = $120,000
LC: 20,000 * $3.00 * 12 * 0.03 = $21,600

11. Rent Revenue Potential Rent vs Actual Rent
Potential Rent is what you would receive if the building were fully leased. It’s handy to keep track of this for valuation reasons.
Potential Rent = Actual rent collected + Vacant square feet * (market rent / square foot)
Complications arise because vacant space eventually is leased

12. Rent Revenue Example 1
You own a building with 45,000 leasable square feet.
Tenant 1 rents 25,000 square feet at $3/foot per month
Tenant 2 rents 10,000 square feet at $2.50/foot per month
The remaining square feet is vacant for Jan-Jun of the year. The market rate for square feet is $3.75/foot per month
In July, you lease the remaining square feet at $3.50/foot per month (at a discount to the market rate)
On a pro-forma for the year what would you show for
Potential Rent
Vacancy Allowance

13. Rent Revenue Example 1
You own a building with 45,000 leasable square feet.
Tenant 1 rents 25,000 square feet at $3/foot per month
Tenant 2 rents 10,000 square feet at $2.50/foot per month
The remaining square feet is vacant for Jan-Jun of the year. The market rate for square feet is $3.75/foot per month
In July, you lease the remaining square feet at $3.50/foot per month (at a discount to the market rate)
On a pro-forma for the year what would you show for
Potential Rent = $1,635,000 = 12*(25,000*$ ,000*$2.50) + 6*10,000*$ *10,000*$3.50
Vacancy Allowance = $225,000 = 6*10,000*$3.75

14. Rent Revenue
Percentage Rent: This is used for retail leases. It is an “add on” to base rent that is a percent of sales.
Percentage Rent can be
A straight percentage of sales
A percentage of sales past a hurdle, typically the “natural breakpoint”
Examples:
Tenant pays 3% of revenue per year, revenue = $1m tenant pays $30,000
Tenant pays 3% of revenue per year past a natural breakpoint, revenue = $1m, base rent = $21,000.
Solve for natural breakpoint = $21,000/0.03 = $700,000
Solve for percentage rent = 0.03*($1,000,000 – $700,000) = $9,000
Total rent w/ natural breakpoint = $21,000 + $9,000 = $30,000

15. Rent Revenue Current Tenants: How Rent can Change over Time
Some contracts allow base rent per square to change over time
This can be
In fixed steps (i.e. $0.50/foot per year)
In percentages (i.e. the general rate of inflation)

16. Rent Revenue Example 2
You own a building with 45,000 leasable square feet.
Tenant 1 signed a 3-year lease on Jan 1, 2016 for 25,000 square feet with a base rent of $3/foot per month. The rent increases by $0.25/foot each year on Jan 1 each year.
Tenant 2 signed a 5-year lease on Jan 1, 2017 for 10,000 square feet with a base rent of $3.50/foot per month. The rent increases by the overall rate of inflation on Jan 1 each year. Assume the inflation rate is 5% per year.
What is the pro-forma rent paid by tenant 1 and tenant 2 in 2018?

17. Rent Revenue Example 2
You own a building with 45,000 leasable square feet.
Tenant 1 signed a 3-year lease on Jan 1, 2016 for 25,000 square feet with a base rent of $3/foot per month. The rent increases by $0.25/foot each year on Jan 1 each year.
Tenant 2 signed a 5-year lease on Jan 1, 2017 for 10,000 square feet with a base rent of $3.50/foot per month. The rent increases by the overall rate of inflation on Jan 1 each year. Assume the inflation rate is 5% per year.
What is the pro-forma rent paid by tenant 1 and tenant 2 in 2018?
Tenant 1: 25,000 * 12 * ($ ) = $1,050,000
Tenant 2: 10,000 * 12 * ($3.50 * 1.05) = $441,000

18. Rent Revenue What Happens when a Lease Ends?
When a tenant’s lease expires, 2 things may happen:
The tenant may renew. If so, at what rent? Will any free rent be given?
The space may be vacant for a while until a new tenant is found. Complications:
How many months will the unit be vacant?
What will the new tenant pay in rent?
A lease end / new vacancy is also associated with TI and LC costs, but those are expenses and we are focusing on rent revenue now.

19. Rent Revenue Example 3
You own a 30,000 square foot building with a single tenant. The tenant signed a 3-year lease on Jan 1, The tenant agreed to pay $3/foot per month with a 5% per year increase on the 1st of every year. There is a 35% chance the tenant renews the lease and a 65% chance the space becomes vacant. If the space is vacant, it will be vacant for 4 months and will then rent for $3.65/month (market rate). What is the expected rent for 2018? What is potential rent for 2018?

20. Rent Revenue Example 3
You own a 30,000 square foot building with a single tenant. The tenant signed a 3-year lease on Jan 1, The tenant agreed to pay $3/foot per month with a 5% per year increase on the 1st of every year. There is a 35% chance the tenant renews the lease and a 65% chance the space becomes vacant. If the space is vacant, it will be vacant for 4 months and will then rent for $3.65/month (market rate). What is the expected rent for 2018? What is potential rent for 2018?
Rent per square foot in the current lease: = $3.00, 2016 = $3.15, 2017 = $3.31, 2018 = $3.47
Expected rent in 2018: 30,000* [0.35 * $3.47 * * $3.65 * 8] = $1,006,620.00
Potential rent in 2018: 30,000* [0.35 * $3.47 * * $3.65 * 12] = $1,291,320.00

21. Other Revenue
Recoveries are reimbursed expenses, but are confusing because
They do not have to equal expenses
In fact: they can be greater (or less) than expenses paid!
What the landlord can recover is specified in a contract
Common contract language:
Fixed vs variable
Base stop and Gross-ups
Reimbursable vs. non-reimbursable expenses
Side note: “Triple Net” lease means tenant pays all ongoing expenses (taxes, insurance, maintenance) plus normal items like rent

22. Recoveries Fixed vs. Variable
Fixed means that what the tenant pays is pre-determined. The tenant might pay $1,000 per month for cleaning, independent of the number or size of other tenants (also independent of the true building expense)
Variable means that the tenant pays his/her pro-rata share.
No Base Stop: Tenant pays (building reimbursable expense / ft2) * tenant ft2
Base Stop: Tenant pays (building reimbursable expense / ft2 – base stop / ft2) * tenant ft2

23. Recoveries Example 4
No Base Stop Calculate the recovery of a tenant leasing 5,000 square feet when the property size is 40,000 square feet and the expense total for the building is $125,000.

24. Recoveries Example 4
No Base Stop Calculate the recovery of a tenant leasing 5,000 square feet when the property size is 40,000 square feet and the expense total for the building is $125, Building expense per square foot = $125,000 / 40,000 = $ Recovery = $3.125 * 5,000 = $15,625

25. Recoveries Example 5
Base Stop Calculate the recovery of a tenant leasing 5,000 square feet when the property size is 40,000 square feet and the expense total for the building is $125,000. The tenant has a base stop for expenses of $2.50/ft2

26. Recoveries Example 5
Base Stop Calculate the recovery of a tenant leasing 5,000 square feet when the property size is 40,000 square feet and the expense total for the building is $125,000. The tenant has a base stop for expenses of $2.50/ft2 Building expense per square foot = $125,000 / 40,000 = $ Tenant Recovery = ($3.125 – $2.50) * 5,000 = $3,125

27. Recoveries Example 6
In 2016, building utilities of a 40,000 ft2 building were $40,000. $10,000 of this is fixed and the rest represents your usage. You are the sole tenant and you occupy 26,000 ft2. You have a base stop of $1 / ft2. In 2017 the building becomes fully occupied. What are your recoveries for utilities in 2017?

28. Recoveries Example 6
In 2016, building utilities of a 40,000 ft2 building were $40,000. $10,000 of this is fixed and the rest represents your usage. You are the sole tenant and you occupy 26,000 ft2. You have a base stop of $1 / ft2. In 2017 the building becomes fully occupied. What are your recoveries for utilities in 2017? First, compute utilities when 100% occupied $40,000 = $10,000 (fixed) + $30,000 (variable at 65%) $56,154 = $10,000 (fixed) + $46,154 (variable at 100%) = $ per square foot Now compute recoveries: ($ – $1.00) * 26,000 = $10,501.4

29. Gross Ups
Gross Ups are used to adjust base stops to account for the fact that the building might not be fully leased at the time the base stop is signed
This protects tenants from an increase in pro-rata recoveries that might occur if expenses rise simply because building vacancy falls. (as in previous example)

30. Recoveries Example 7
In 2016, building utilities of a 40,000 ft2 building were $40,000. $10,000 of this is fixed and the rest represents your usage. You are the sole tenant and you occupy 26,000 ft2. You gross-up to 95% for computing the base stop. What is the base stop? What are your recoveries for utilities in 2017?

31. Recoveries Example 7
In 2016, building utilities of a 40,000 ft2 building were $40,000. $10,000 of this is fixed and the rest represents your usage. You are the sole tenant and you occupy 26,000 ft2. You gross-up to 95% for computing the base stop. What is the base stop? What are your recoveries for utilities in 2017? First, compute utilities when 95% occupied $40,000 = $10,000 (fixed) + $30,000 (variable at 65%) $53,846 = $10,000 (fixed) + $43,846 (variable at 95%) = $ per square foot  this is the base stop Now compute recoveries in 2017: ($ – $1.3462) * 26,000 = $1,501.5