As the operator of a commercial property, there are expenses that should be properly accounted for in your operating pro forma. In the “setup” (see below), these operating expenses, or, “OpEx,” are subtracted from the Effective Gross Revenue (EGR), which then equals the net operating income (NOI). Operating expenses vary depending on the market. According to Property Metrics, operating expenses include all of the cash expenditures required to operate the property, and command market rents. Common commercial property operating expenses will include real estate and property taxes, insurance, management fees (on or off-site), repairs and maintenance, and other miscellaneous expenses (accounting, legal, etc.).
Information on operating expenses by market can be accessed in reports provided by brokerage firms. CBRE and other large brokers publish market reports with average per square foot (PSF) operating expenses for retail and office properties; however, the best gauge of operating expenses is research of comparable properties. Depending on the terms of the leases at the property, operating expenses can often be “passed through” to tenants. A triple-net lease (denoted as “NNN”) allows an owner to “pass-through” a portion of the operating expenses to the tenant, whereas other types of net leases only allow for certain expenses to be “passed-through” to the tenant. This means that although the landlord’s entity will pay the operating expenses, it is the tenant who is left with the obligation to reimburse the landlord.
Multifamily Apartment Building
|Mgmt Fees||– $8,963|
Real Estate Taxes
Real estate taxes are especially important for an owner of commercial property when one considers their magnitude and implications. To verify real estate taxes for a property in New York City, one can access a building’s tax assessment and tax bills online via the NYC Department of Finance. It should be noted that the formula with which a property is assessed differs depending on the municipality. Without a clear understanding of the real estate taxes, the performance of the asset can be severely affected. Information on tax rates for New York City can also be found online via the NYC Department of Finance.
Administrative expenses often referred to as “general & administrative expenses,” or “G&A,” is defined as “expenditures related to the day-to-day operations of a business.” The role of an admin consists of book keeping and other administrative and organizational duties (i.e. paying bills). Depending on the size and the scale of an owner’s commercial real estate portfolio, the admin duties will often be handled by ownership directly. Regardless of who completes the work, there is a degree of labor that goes into the administration at a commercial property, thus making it an appropriate expense to account for. Leases will often define the operating expenses for which an administrative fee is applicable, and limit the percentage of the expense allowed to be charged as the fee (usually up to 10 percent).
Management fees are the operating expenses attributed to the expense of a property manager. Property owners usually hire property managers when they are unwilling or unable to manage the properties themselves. Multifamily buildings commonly use property managers. The responsibilities of this role range from supervising and coordinating maintenance and other work, light handyman duties, cleaning, and resolving tenant concerns and complaints. The management fee will usually be defined in leases and is often determined based on a percentage (usually ranging from 3-5 percent) of effective gross revenue. To realize the maximum return on investment on a property, one must have effective property management. Some benchmarks that indicate that property management is effective includes whether the property is 90 to 100 percent leased, the tenant’s needs are paramount in the manager’s mind, rents are collected on time, bills are paid in a timely fashion, ongoing preventative maintenance is taking place, the systems are operating efficiently with the forecasted budget, and the cash flow from the property is meeting or exceeding the expectations of the pro forma.
Insurance expenses at a property vary based on a number of factors. If the property is part of a portfolio under an umbrella insurance policy, the cost of insurance at the individual building is likely to be lower than a building under a single insurance policy. Different insurance options are available, but an owner should check with the municipality to see what law requires. Landlord’s insurance will often consist of several types of policies covering different risks, including but not limited to: permanent coverage, liability, rent loss, and riders. Liability insurance covers the loss involved from any accidents that occur on the property. Usually, this coverage will pay for any legal fees associated with lawsuits against the property, the owner, and the property manager. Rent loss insurance covers the loss of rental income for a period during which the property is under reconstruction due to fire or weather. The premium for rent loss insurance is based on the time period in which the rent loss will occur. Additional riders offered as part of many insurance policies to cover areas not covered in the general policy. Some common riders include: flood, glass breakage, earthquake, boiler, and employee theft. One should carefully analyze the deductibility of each type of coverage. The lower the deductible, the higher the annual premium will be. The amount of deductible is a function of ownership’s budget and tolerance for risk. The best pricing available is found with insurance agents who are constantly shopping the market for the best rates. Additionally, the amount of insurance already in place and the amount of claims in the past may affect the price of insurance. Insurance is an expense where a hands-on owner or property manager can find value in a property should they be able to find a better rate than previous ownership.
Repairs and Maintenance
It is important to differentiate between repairs and maintenance, which is an operating expense, and capital expenses, which usually appear “below the line” in the setup, meaning that it is subtracted from the NOI, and don’t adversely affect the direct capitalization value of the property. Maintenance costs are operating expenses for maintenance that is considered routine to keep the building asset’s condition status quo. Capital expenditures and improvements are investments in your property that increase the value of the asset. Capital expenditures will often be financed, and sometimes leases allow for the pass-through of the amortization of the expenses to tenants, as if it were an operating expense. Repairs and maintenance are more likely to come directly out of the owner’s pocket and adversely affects the net operating income.
Capital Expenses and Financing
As briefly discussed above, capital expenditures are improvements to the property that increases its value. The value is increased through increasing the NOI. Improvements to the property will allow an owner or property manager to command market rents. It is crucial that a real estate investor properly plan for capital expenditures that will need to take place in the future. A property owner who does this efficiently is at a strategic advantage over competitors. Often times, these capital expenses will be funded with a loan, as they frequently exceed the before tax cash flow generated by the property. Financing and the capital markets is another crucial element of real estate ownership that owners must have a thorough understanding of. Through the use of leverage, owners can increase their annual cash on cash return. Investors who properly use leverage and plan for the future are always at an advantage over those who do not.
Mortgage interest rates are a function of the 10-year treasury yield. If the bond yield rises, the mortgage rises as well, and the inverse is the same. Most mortgages are calculated in a 30-year time frame; however, after ten years mortgages are often paid off or refinanced for a new rate. The lender is assuming risk when the issue a mortgage, due to the possibility that the customer may default on the loan. When there is a higher perceived risk of default, the higher the interest rate, and the less favorable the terms for the borrower. A higher interest rate ensures that the lander recoups his investment faster. Banks, financial institutions, and private lenders offer commercial mortgages, and information regarding available terms can be easily accessed through consulting with a local mortgage broker. Lenders will also require a borrower using a property as collateral to reach a certain threshold of income that meets their “debt service coverage ratio (DSCR)” to qualify them for a loan. This is determined by taking the ratio of net operating income to annual debt service.
Mortgages are usually amortized over the period of the loan, unless the loan is “interest only.” In this case, there is no pay down of the principal, and monthly interest is paid to the lender. Amortized mortgages are paid down over the course of the loan until it is completely paid off. The longer the amortization period, the lower your monthly payments will be. This results in a more favorable mortgage for the borrower.
The depreciation of commercial property can be used to reduce an owner’s taxable income. The IRS expects depreciation to be calculated from the sale of an investment property in order to increase the amount of taxable gains you had on the property. It is in the owner’s best interest to take advantage of depreciation during ownership. Depreciation can be taken from the building and any additional capital investments made at the property. Some of examples of what can be depreciated besides the actual building itself include: appliances including refrigerators, washing machines, dishwasher, and stoves, furnaces, capital improvements such a remodeling of a kitchen or bathroom, new windows, roof replacement, leasehold improvements such as electrical system overhauls or septic systems, landscaping improvements, legal fees (if carved out separately from the original purchase amount), and equipment used to maintain the property, such as landscaping or cleaning equipment.
There are several types of residential leased-land properties, and the most common type varies by region. When you purchase a property on leased land, you will take out a mortgage on the property as usual. The mortgage will be lower because it is only on the improvements, and not the land; however, you will have to pay the lease on the land every month as well. While it is possible to buy a commercial property on a land-lease, as the lease reaches its expiration the property will be difficult to sell, and this poses a sizable risk.