Commercial real estate properties come in many different forms or property types ranging from multi-family apartments to retail shopping center malls, industrial warehouse space, 100-story office buildings, and mixed-use properties with a combination of one or more zoning or usage types. Commercial properties typically derive their value from a combination of income less expenses, cap rates, preferred Debt Service Coverage Rations (DSCR – 1.0 is break-even when the income covers the annual mortgage debt service) used by lenders, comparable sales comps in the region, and location.
We will take a look below in regard to various types of leases used on many commercial properties, value analysis strategies used by lenders, real estate agents, and investors, and more recent sales or leasing trends for these properties. In order to best define a commercial property’s perceived value, we must better understand how lenders and experienced investors look at the deals. First, we will look at some of the most common lease agreements below which are signed prior to the property owners generating any income on the subject property.
Gross and Net Leases
The most basic types of Commercial Real Estate lease agreements may be considered as “Net”, “Gross”, or a hybrid combination of both. These are especially true for Office buildings across the nation.
Full Service Lease or Gross Lease: With a Gross or Full Service Lease, the monthly rent paid is typically all-inclusive. The Landlord usually pays most or all of the expenses which can include property taxes, insurance, maintenance, utilities, and other common area expenses. This type of Commercial lease can be the easiest lease agreement to enter into for the prospective Tenant as well as can be the easiest type of lease for the licensed Agent to work on as well. The Landlord effectively assumes most or all of the responsibility for the property, and the Tenant is free to focus on growing and expanding their business. Rental rate hikes can be built in for each subsequent year of the signed lease agreement, and is tied typically to some type of projected national inflation index percentage rate.
Net Lease: There are various types of Net Leases such as “Single Net”, “Double Net”, “Triple Net”, and other combinations of these Net Lease options. The Landlord may charge a much lower base rent for the building’s space, but the Tenant then pays a higher portion of the monthly expenses such as pro-rated property taxes, insurance, common area maintenance items, sewer, water, trash collection, landscaping, parking lot expenses, and other shared services or fees.
Single Net: With type of Net Lease agreement, the Tenant may pay a base rent plus a pro-rata portion of the property owner’s portion of the property tax bill (the single portion paid out of this Net Lease), utility fees, and janitorial services for the same proportional space in which the Tenant occupies. If the Tenant only occupies 20% of the entire building’s space, then his or her portion of the taxes, utilities, and any other common area expenses represent 20% of the owner’s overall bills. Generally, a Single Net lease agreement is assigned to one single tenant.
Double Net: The Tenant is primarily responsible for the base rent in addition to a pro-rata percentage or share of property insurance and property taxes (these two paid items represent the “Double” portion heading for this Net Lease). If the Tenant occupies 50% of a Medical Office Building, then that same Tenant will pay 50% of the building owner’s insurance and taxes. The Landlord, in turn, will usually cover the expenses for common area maintenance and basic structural repairs. The Tenant will also pay for his or her own utility expenses and janitorial services.
Triple Net (NNN): This is perhaps the most popular and common type of Net Lease for various types of Commercial Real Estate. It is also referred to as the “Net, Net, Net Lease” or “NNN Lease.” The three paid pro-rated items out by the Tenant(s) which represent the word “Triple” in this Net Lease description are property taxes, insurance, and CAMS (Common Area Maintenance Fees). These three main expenses paid directly by the tenant are in addition to the typically flat monthly rental fee which probably has escalation clauses tied to higher projected rates of inflation.
Common area utilities and operating expenses may be included in the requested monthly expenses to be paid by the Tenants also. These common area expenses can include staffing costs for lobby attendants, doormen, or other building personnel. Tenants also have to pay for their own interior utility and insurance fees as well as their own taxes. So, several Tenants are paying multiple payments for separate utility, maintenance, tax, and insurance costs.
Triple Net Leases are favored by Landlords who may own high quality and prime Class A and Class B type Office Buildings and other types of Commercial Real Estate. Triple Net Lease payments can vary monthly and yearly due to fluctuations with the high number of third party and common area costs which may be outside of the control of the Tenant.
Commercial Leases during Good and Bad Economies
Landlords who employ property management firms for prime commercial properties prefer this Triple Net approach with their Tenants during positive economic time periods when the demand for space is much stronger. However, Landlords may also offer as many financial and rent incentives and upgrades to prospective Tenants during the more sluggish economic times which can have relatively high rates of vacancies. When the economic time periods for Commercial Real Estate Tenants and Landlords get really bad, then foreclosure and bankruptcy rates can skyrocket for either party in these transactions. For some Tenants who are financially struggling, a bankruptcy filing (personal or business) may be one of the better options in order to legally break their lease and avoid future liabilities with the property’s owner.
For Tenants who struggle to meet their monthly expense obligations during both good and bad economic time periods, these rapidly increasing monthly and annual expenses can really hurt the Tenant financially. In many Landlord / Tenant situations, the Tenant must break the lease and vacate the building’s premises due to the rapidly increasing and ever changing monthly expenses which the Tenant had not factored within their original budget.
If the Landlord struggles to make their monthly mortgage payments on their buildings which can range from several thousand to tens or even hundreds of thousands of dollars per month, then that same Landlord may be forced to file for Bankruptcy protection in order to try to hold off any impending foreclosures by his or her existing mortgage lender.
Retail Shopping Centers
Sadly, the retail shopping center sector has been in the news many times in recent years in regard to numerous small, medium, and large shopping centers going out of business due to much less demand by their retail customers. Many people prefer to purchase their consumer goods online instead of in person at large outdated shopping malls. As a result, a large number of retail malls have filed for bankruptcy or shutdown altogether. Yet, there are still a reported 114,000 shopping centers nationwide in existence, per the International Council of Shopping Centers (ICSC).
On the other side of the retail shopping center spectrum, there are also many high-end malls and discounted outlet locations doing quite well. Some of the wealthiest REITs (Real Estate Investment Trusts) and Equity Funds are buyers or long-time owners of many of the top shopping center locations in the United States. Let’s take a look below at the Top 10 sales generating malls in the USA in 2014 as based upon sales per square foot.
The Top 10 Sales Generating Malls in the USA in 2014
1. Bal Harbour Shops (Bal Harbour, Florida) – $3,010 sales per square foot
2. The Grove (Los Angeles, California) – $2,100 / sq. ft.
3. Pioneer Place (Portland, Oregon) – $1,855 / sq. ft.
4. Woodbury Common Premium Outlets (Central Valley, N.Y.) – $1,550 / sq. ft.
5. Forum Shops at Caesars (Las Vegas, Nevada) – $1,515 / sq. ft.
6. Aventura Mall (Aventura, Florida) – $1,550 / sq. ft.
7. The Mall at Millenia (Orlando, Florida) – $1,400 / sq. ft.
8. Orlando Premium Outlets (Orlando, Florida) – $1,385 / sq. ft.
9. Ala Moana Center (Honolulu, Hawaii) – $1,360 / sq. ft.
10. The Malls at Short Hills (Short Hills, New Jersey) – $1,245 / sq. ft.
Source: Green Street Advisors, a real estate analysis firm
The most successful part of the commercial real estate sector continues to be multi-family apartment buildings (5+ units). In some of the most prime, coastal metropolitan regions, apartment buildings are selling near or above all-time record high prices. Individuals, REITs, Hedge Funds, and Crowdfunding Platforms for Real Estate are some of the top buyers today for multi-family deals. As a result, the bidding wars are pushing prices higher than ever before.
Vacancy rates have also fallen to near 4% nationally for metropolitan regions in 2015 due to strong demand from tenants. In some of the most populous metropolitan regions, the apartment vacancy rates are closer to the 0% to 3% range. Low vacancies plus increased demand are pushing rents skyward as noted by the Top 10 priciest year-over-year rent increases as of the 1st quarter of 2015:
1. San Francisco, CA (median rents near $3,055): 14.9%
2. San Jose, CA: 13.4%
3. Denver, CO: 10.2%
4. Kansas City, MO: 8.5%
5. Portland, OR: 7.2%
6. Austin, TX: 7%
7. Charlotte, NC: 6.1%
8. Houston, TX: 5.9%
9. Phoenix, AZ: 5.3%
10. Detroit, MI: 5%
Apartments derive much of their value by way of dividing their Net Operating Income (NOI) by a targeted cap (or “capitalization”) rate. Property values and cap rates are inverse to one another like a See Saw. Declining cap rates lead to increasing building values, and increasing cap rates usually lead to falling values. In recent years, we’ve seen cap rates reach near or all-time record lows right along with mortgage rates and vacancy rates.
Between 2002 and 2008, the average national cap rates used for commercial properties nationally fell from 9.3% to 6.75% (250 basis points). This was the largest recorded decline or compression of rates in U.S. history at the time. Yet, cap rates continued their downward descent between 2008 and 2014 as the average cap rates fell from 6.75% down to 4.4% in many of the most populous, coastal regions such as New York City, Boston, Los Angeles, San Francisco, and Seattle.
Let’s take a quick look how building values are calculated by using the exact same apartment building with absolutely no change in Net Operating Income (NOI) as well as significant changes with a lower cap rate:
* Building Value or Market Value = Net Operating Income / Cap Rate
* Building 1: $160,000 NOI divided by an 8% Cap Rate ($160,000 / .08%) = $2,000,000 value
* Building 2: $160,000 NOI divided by a 4.5% Cap Rate ($160,000 / .045%) = $3,555,556 value
The combination of near record or all-time low mortgage rates, vacancy rates, and cap rates plus record high rents should continue to create the exceptional combination of high rental income, long-term tenants, and rapidly escalating building values for many years into the future. Assets that create significant consistent monthly income while you sleep are hard to beat in any boom or bust financial era.
Author: Rick Tobin Look for Rick’s ebook on Amazon Kindle: The Credit Crisis Deals: Finding America’s Best Real Estate Bargains. Rick Tobin has a diversified background in both the Real Estate and Securities fields for the past 25+ years. He has held seven (7) different Real Estate and Securities brokerage licenses to date. Rick has an extensive background in the financing of residential and commercial properties around the U.S with debt, equity, and mezzanine money. His funding sources have included banks, life insurance companies, REITs (Real Estate Investment Trusts), Equity Funds, and foreign money sources. You can visit Rick Tobin at RealLoans.com.