Sunday, January 17, 2016

Analyzing a Property's Cash Flow Statement & How to Create a Real Estate Pro Forma (part 5 of pro forma building series)


Coit Tower
(Coit Tower)

In part 4 of the pro forma building series, we finished the income section and were introduced to income adjustments. Part 5 will begin diving into the individual income adjustment line items starting with "Rent Abatements."

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

Part 1 - Overview on how to calculate down to the NOI line item.
Part 2 - Intro to lease structures and calculating the gross potential revenue line item.
Part 3 - A look at reimbursement methods and how to calculate reimbursement income.
Part 4 - How to calculate the other income line item and an intro to income adjustments.
Part 5 - Rent abatements overview and calculation example.
Part 6 - Absorption and turnover vacancy explanation and intro to tenant improvements.
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.

Here's our simple example pro forma spreadsheet to follow along with as well.

Rent Abatements


As part of lease agreements, tenants will negotiate some free rent. These months where they don't pay rent are called months with abated rent. Think of renting apartments. Some complexes will offer a month free rent after signing a year lease. Well, it's the same with commercial real estate.

The actual structure of rent abatements can vary greatly. Some leases might specify the first 3 months are free. Others might say month 1, month 13, and month 25 are free. Just the other day I saw a lease agreement where there were 8 months of abated rent, but only 50% of the rent was abated in those months so that, in reality, there were only 4 months of free rent, but they were spread out over 8.

The lease agreement must also specify what exactly is abated. Is it just the base rent? Is it base rent and reimbursements as well? The point is that rent abatements can be structured in many different ways so it's always important to read the specific language in the lease agreement to fully understand how it impacts the numbers.

Net Effective Rent


This is a good time to bring up the idea of "Net Effective Rent." Net effective rent (NER) is the total rent a tenant pays over their entire lease term, divided by the number of months in the term, and divided again (usually) by the square footage of the suite. NER is then used to compare different lease structures.

For example, let's say we have 2 prospective tenants interested in a 1,000 square foot suite. Tenant #1 is offering to pay $1,000 / month for 2 years, with their rent increasing by 3% at the start of year 2. They aren't asking for any free rent.

Their NER would be calculated as (1,000 * 12 + 1,000 * 1.03 * 12) / 24 / 1,000 = $1.015 NER per month per square foot.

Tenant #2 is offering to pay $1,000 / month for 2 years as well, but with their rent increasing by 10% at the start of year 2. However, they want 1 month of free rent at the start of year 2.

Tenant #2's NER would be calculated as (1,000 * 12 + 1,000 * 1.1 * 11) / 24 / 1,000 = $1.004 NER per month per square foot.

Even though Tenant #2 has a big 10% rent increase in year 2, that month of free rent makes their NER a bit lower than Tenant #1, so you would prefer to do the deal with Tenant #1.

Here's an example spreadsheet of the NER example above.

Pro Forma Rent Abatement Calculation


Our pro forma rent abatement calculation is really easy. We've specified on our general assumptions tab that Tenant #1 will receive 3 months of free rent at the start of their lease. Since their monthly rent in year 1 is $25,000, then the rent abatement line item is calculated as 3 * -$25,000 = -$75,000. It's just that easy!

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