It appears that Joe Biden will be the next President of the United States, raising questions about the implications for commercial real estate.
Don’t know the difference between asking rent and actual rent? Can’t figure out CapEx or DSCR?
We’ve broken it down for you with our commercial real estate glossary. Here are some important terms and concepts to get you started.
Absorption is a measure of the health of the market in which a building is located, measured in square footage. Net absorption is measured by subtracting the total commercial space that is occupied during a given timeframe (usually quarterly) as compared to the total occupied space in the prior timeframe. It takes into account new construction. Positive net absorption signals a healthy real estate market.
In the recession of 2008, more commercial real estate square footage came to market than was being leased, leading to negative net absorption. This happened because in 2005, a lot of new buildings were planned. But because they take a couple of years to build, many of them came online in ’08, right when the economy collapsed. Tenants were purging space from the existing buildings while newly constructed buildings were being delivered. That was a double whammy and resulted in negative absorption.
Asking rent is fiction, actual rent is fact.
Every landlord will list their asking prices. The most well-known listing service or database is called Costar. It has a virtual monopoly of databases in the United States for office space leasing. Every office building will list its asking prices in this database.
But the actual rents are not disclosed, only rumored. As a rule of thumb, actual rents may run 5 percent to 10 percent below asking rents when you factor in concessions and the like, including free rent (see rent abatement, below).
Sometimes the so-called “face rate” will equal the asking rent. But when you factor in free rent and extra tenant-improvement dollars and similar concessions, the actual rent is usually lower than the asking rent.
That said, asking rents remain a valid barometer because they provide a relative index.
CapEx refers to the capital improvements to a building. They are distinguished from tenant improvements (see below).
A capital expenditure is part of the landlord’s basis for his entire investment in a project. When a landlord performs radical renovations of lobbies — we call them “lobby-ectomies“ — or improvements to offices (“office-ectomies”), they can cost millions. A lobby renovation can cost anywhere from $1 million to as much as $5 million.
In most cases, CapEx cannot be passed through to the tenant under the operating expense clause in a lease, unless that particular capital improvement reduces the energy or the operations expense for running the building. In that case, it is legally allowed to be passed through to the tenants as an operating expense under the operating expense clause, with the expense attributable to normal operations as opposed to a one-time capital item.
Operating expenses include normal and recurring maintenance. Every month or every year, you have certain minimum expenses. The utility expense for electricity is an operating expense because it’s a recurring expense for the normal operations of the building. The renovation of a lobby is something you don’t do every year; it’s a one-time capital investment.
Operating expense can be a tax write off in the year incurred. CapEx, such as an investment in the lobby, is considered a capital improvement and is depreciated according to a depreciation schedule. Under the most recent tax laws, certain parts of a building may qualify for accelerated depreciation.
There is a gray area about when a particular expense is a repair or when it is a capital improvement. Take an air conditioning system. If you replace the system’s chiller — this big, massive machine that runs a whole building — it’s a capital expenditure. But if you’re just replacing part of the system, that may be considered a repair, which can be a tax deduction for that year.
Let’s discuss reserves for CapEx. Any prudent developer looking at buying a new building or projecting the future cash flow of an existing building they own should be allocating a recurring reserve annually for capital expenditures, almost like it is a recurring expense, though it’s technically not that.
The reserve is usually expressed in cents per square foot. Here at Feldman Equities, we have historically used 15 cents per square foot. Then we used 20 cents per square foot. Now we’re using 25 or 30 cents per square foot because over time these things get increasingly more expensive.
Those amounts should be set aside in a fund to cover the eventuality that they may be needed. Developers don’t always do that. But some lenders — such as lenders that issue Commercial Mortgage Backed Securities, or CMBS — actually require developers each year to post reserves to a lockbox account or a cash collateral account from which they cannot withdraw funds unless they are for a capital expenditure. Each month and each year, money is deposited from cash flow into that account.
CMBS lenders also require tenant-improvement reserves, because in the course of managing an office building, there are always going to be tenant improvements. A lender will negotiate reserves for tenant improvements, separate and apart from CapEx reserves.
DSCR is the net operating income (NOI) divided by the debt service. It’s the most important metric in the commercial real estate business, a measure of a project’s financial productivity. It’s the key metric that a lender wants to see.
Net operating income refers to all the revenue derived from a property — whether it be an office building, a retail shopping center or an industrial building — minus operating expenses.
Revenues include all of the office rents from all of the spaces in a building, plus all of the revenue for ancillary services. If you have a parking garage and charge for parking, that’s also included in the revenue stream.
Operating expenses include such things as utility expenses. If you run a lot of air conditioning, it can be a big number as it is here in Tampa. Operating expenses also include the cost of janitors to clean the building and engineers to operate the building.
Net operating income does not take into account any tenant improvements, which would be below the line of net operating income. Net operating income also does not take into account any capital improvements, nor does it include debt service. All of those things are additional subtractions to net operating income.
Debt service is the annual payment of interest and amortization to a lender.
Here’s an example of DSCR: If your net operating income is $1 million, and your debt service expense — your interest and amortization — is $500,000, your DSCR is 2.0, which is considered a healthy ratio ($1 million divided by $500,000.) Again, we’re not taking out tenant improvements. We’re not taking out capital improvements. We’re just looking at the operations of the building.
Anytime your DSCR reaches or rises above 2.0, you make your lender happy. Lenders get queasy when DSCR falls to 1.25 or lower. That translates to more expensive interest. It can lead a lender to require recourse to the borrower or other types of credit enhancement. If none of those things can be provided, they can charge you an arm and a leg and your first-born in the form of higher interest.
Debt yield is the net operating income divided by the amount of debt. Lenders at the beginning of the recovery wanted a debt yield of 12 percent, which is a crazy number. Soon thereafter, post-recession, that fell to 10 percent, which is still a healthy metric.
If you think about where interest rates are right now — around 4 percent or less — that leaves a huge margin of safety for a lender’s loan.
Debt yields are usually higher than cap rates. If a building is at a 10 percent debt yield, it’s a very safe loan today, because an office building might trade at a 6 or 7 percent cap rate. It means that the lender’s got a lot of cushion. The net operating income could drop a lot, and there’s still a cushion. Or the cap rates could rise a lot for some unexplained reason, and there’s a lot of cushion. It’s a metric of safety.
Leasing commissions are different from the kind of commissions you might experience with a home sale.
A home sale commission is a very simple calculation. Typically, a residential commission, depending on the area, will be 5 percent of the sale price. That might be split up between different brokers, the agent, the listing agent, etc. It could be a little higher; it could be a little bit lower.
In office leasing, we express the commission as a percentage of the gross rent over the entire lease term. If it’s a 10-year lease, and the average annual rent over the 10 years is $30 a square foot, the gross rent is 10 times 30, or $300 per square foot for the entire term of the lease. The leasing commission would be a percentage of that.
If the leasing commission is 4 percent, that’s 0.04 times $300 per square foot, or $12 per square foot. We typically pay that within 30 days of the lease execution. A lot of other landlords pay 50 percent of that at signing and the other 50 percent sometime after the tenant moves in.
We have an in-house team here at Feldman to manage the leasing process, so when an outside broker brings in a tenant, the broker will get that 4 percent commission times the aggregate rent for the entire lease term.
In some cases, a landlord will hire a broker directly to solicit the lease. In this case, the broker who represents the landlord would typically get half of the commission. The landlord pays to his agent a 50 percent override, so another 2 percent would be paid to the landlord’s agent. In these kinds of circumstances, the landlord ends up actually paying 6 percent in commissions.
To be clear, if the procuring broker – the one who brings the tenant – is the same as the one hired to represent the landlord, then the landlord would only pay 4 percent commission. It’s when there is an outside broker involved that the landlord has to pay that outside broker in full, plus 50 percent more, which, in this case, would be an additional 2 percent.
There is a lease term cap on commissions. In most markets, there’s a cap between 10 and 15 years on the lease term for which a commission will be calculated. Even if a landlord negotiates a 20-year lease, for example, the commission (negotiable) will typically only be for 10 years or 15 years at the most.
This is one of the more subjective parts of our business. It is a “buyer beware” item for an office tenant. It’s sometimes an abused area in our business.
A load factor is a methodology that landlords use to compensate the landlord for non-usable space in a building.
In addition to the tenant spaces, a landlord constructs and manages common areas such as circulation corridors, bathrooms, the main lobby of the building, and elevator landings.
In an office building, if the four walls of your office space are 1,000 square feet, it is market for a Tampa landlord to charge for 1,200 square feet. That 20-percent add-on factor — or 1.2 times what we call usable square footage (as defined by the Building Owners and Managers Association, BOMA), the so-called carpetable area inside the four walls of the space — compensates the landlord for the cost of corridors, lobbies and other common areas.
This percentage varies greatly from market to market and by product type. Office buildings use load factors, while retail spaces and industrial buildings generally don’t.
One market where landlords abuse load factors is New York City where they could be almost double those in Tampa. In Tampa, landlords are constrained by a marketplace that is more conservative and transparent.
People don’t necessarily go out of their way to hide load factors, but they don’t go out of their way to advertise them, either. A tenant or a good commercial leasing broker should ask this question: “What is your load factor? How do you compute it?” Not every tenant focuses on this, and they should be more aware of it.
In our view, the industry should go to a usable rental rate. The only argument that landlords have for using a load factor is that buildings vary. Some buildings have beautiful, spacious corridors that you can roller skate through. It’s not always clear how tenants benefit from that, but some landlords will argue that their corridors are more spacious, and beautifully appointed, and therefore that they are entitled to a higher load factor.
Generally speaking, that argument is kind of thin. The industry should go to a price-per-usable-square-foot rate, or a rate based on rentable square footage in a lease that has the load factor already built into it.
This is a fancy word for free rent.
The free rent is usually at the beginning of the lease term. However, in some transactions, you’ll get the 13th month or the 23rd month free, but these are unusual arrangements. When offered, the typical free-rent period is the first three months or the first six months of a 5-year or 10-year term. In recessions, free rent periods can be much higher.
Such rent abatements don’t include the costs of overtime use of electricity or special services or other costs.
This term refers to the extent to which a landlord performs on behalf of the tenant certain interior construction to the office space that’s being leased. Tenant improvements can come in two broad categories in terms of the financial arrangement.
One arrangement is that the landlord provides the tenant with an allowance — a certain amount of dollars per square foot — that the tenant can use to build out his space. The advantage in this scenario is that it caps the landlord’s liability with respect to the interior tenant construction, which, given the recovery in construction markets nationally, is important to landlords. It is a much-preferred route to provide a fixed-dollar limit as opposed to the second broad category of tenant improvements.
The second category is what is called ‘turnkey.’ This is where a landlord agrees to a scope of work which is actually attached to the lease that will lay out, in great detail, the work that is going to look like, including a depiction of the plan. The plans may have all sorts of specifications that may go on for several pages, and these are all attached to the lease. It’s the landlord’s guarantee that they will spend whatever money is necessary to complete the construction depicted on the exhibit attached to the lease.
The turnkey arrangement puts a bigger risk on the landlord. The disadvantage is that it’s potentially a blank check. If the landlord has not had enough time to bid with enough contractors to get a good feel for what the construction is going to actually cost him, the turnkey methodology is a scary scenario. That’s particularly true now, when contractors are the new OPEC and cost of construction has gone as high as it has, late in the cycle.
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It appears that Joe Biden will be the next President of the United States, raising questions about the implications for commercial real estate.
Any investor will tell you: the higher the risk, the higher the reward! Yet, when crafting their own investment portfolios, most will look to create some sort of balance between risk and reward.