Friday, January 8, 2016

Analyzing a Property's Cash Flow Statement & How to Create a Real Estate Pro Forma (part 3 of pro forma building series)

(Downtown Provo, Utah)

In part 2 of the series, we looked at how to calculate the gross potential revenue line item. Now we'll look at how to calculate reimbursement income. Here's the link to the spreadsheet to follow along with: Pro Forma Example.

Here's a list of everything we've covered so far:

Part 5 - Rent abatements overview and calculation example.
Part 7 - General vacancy allowance explanation and calculation example.
Part 8 - Operating expenses explanation.
Part 9 - Constructing a sources and uses table.
Part 10 - Building a debt schedule.
Part 11 - Calculating levered IRR.
Part 12 - DCF analysis.
Part 13 - Loan sizing.

Reimbursement Income

As part of their lease agreements, commercial tenants will often pay for a part of the operating expenses on a property. The actual method of calculating how much the tenant reimburses is determined in the lease agreement. Although there are many, many, many different methods and variations on those methods, there are 3 in particular that are the most widely used.

NNN Lease

We already briefly covered what a NNN lease is in a previous post, so I'll just repost what was written:

Retail tenants typically have "Triple Net" (NNN) leases. NNN means the tenant reimburses the landlord their share of all operating expenses. Their share is calculated by their square footage divided by the total property's square footage, also known as the tenant's "Pro Rata Share." Notice in our example we have 2 tenants each occupying 25,000 square feet. Our total property square footage is 50,000 square feet. Each tenant's pro rata share is then 50%. Each tenant then pays 50% of all the operating expenses.

As you can see, the reimbursement income calculation for triple net leases is actually fairly simple and doesn't require much more explanation.

Gross / Full Service Gross / Base Year Lease

Gross leases are most common type of lease for office tenants. A gross lease means the operating expenses are built into the base rent amount. For example, if a tenant's base rent is $2.50 per square foot per month, and the property costs $1.00 per square foot per month to run, then the tenant's base rent is composed of $1.00 per square foot for the operating expenses and an additional $1.50 for rent.

That part is pretty straightforward, Where it starts getting tricky is in future years. As part of gross leases, tenants agree to pay for their share of the increase of operating expenses. For example, if a tenant signs their lease in 2015, then their "Base Year" is 2015. At the end of 2015, the landlord must calculate what the operating expenses were for that year. Let's say 2015 operating expenses are $1,000,000. The tenant's "Base Year Expense" is then $1,000,000.

Let's say in 2016 the landlord budgets operating expenses to increase by 3% to $1,030,000. The tenant will then be responsible to pay for their pro rata share of that $30,000 increase. If their pro rata share is 50%, then they will pay $15,000 in reimbursements throughout 2016. At the end of the year, the landlord calculates what their actual operating expenses were for 2016. If the actual amount is less than $1,030,000, then the tenant has been overpaying for their share of the operating expenses and will be owed money. Vice versa if the actual amount is above $1,030,000.

There are a few wrinkles to be aware of when calculating reimbursement income for gross leases. First, notice that landlords are incentivized to make the operating expenses as low as possible in the tenant's base year. Landlords can play games on what expenses are considered operating expenses and not operating expenses to try and lower that base year expense number. They can then add back in expenses to operating expenses in future years to increase it as much as possible.

Next, the landlord can "Gross Up" expenses. Grossing up expenses means calculating what that expense would be if the building was 95% occupied. For example, utilities will increase or decrease almost 1:1 with the occupancy of the building. An empty suite doesn't use water or electricity. Once it's leased up though, it will start contributing to the electricity and water expense. When calculating a year's expenses for the purpose of billing tenants for their reimbursement income, landlords are often allowed to bill them the expenses as if the building were 95% occupied. Continuing our previous example, let's say in 2017 the building was half empty and operating expenses dropped to $700,000. At first glance it would seem the tenant doesn't owe anything for an increase in operating expenses because $700,000 is less than $1,000,000 (their base year expense). However, if the landlord is able to show that the operating expenses would have been $1,100,000 if the building were 95% occupied, then the tenant still owes their share of the $100,000 increase in operating expenses.

True Full Service Lease

Some leases specify that the tenant doesn't reimburse for any operating expenses. These are often referred to as full service leases, or true gross leases. Tenants don't pay any reimbursements in these agreements.

Pro Forma Reimbursement Income Calculation

In our pro forma we are calculating our reimbursement income by saying if both suites were occupied, what would the reimbursement income be? The answer is since both tenants are on NNN leases, all operating expenses would be reimbursed if both suites were occupied. The calculation then just equals whatever that year's operating expenses are.

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