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Commercial Real Estate Terms for Investors DECODED: Part 2

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Commercial Real Estate Terms for Investors DECODED: Part 2

By: Steve Sadler, CEO, Allegiancy

April 15, 2015

At Allegiancy, we know that many of our commercial property owners don’t claim to be financial experts. Many made a good investment, or perhaps inherited one, and now they simply would like it to perform well and/or gain value.

As asset managers, we also understand that an informed investor is a better investor. In that spirit, we present our decoder’s guide (part 2) to key financial terms for commercial real estate ownership.

Loan Covenants

Most commercial properties have mortgages as part of their capital structure. These loans have certain criteria, called covenants, that must be met for owners to retain operating control. Lenders monitor these criteria to protect their investors. The asset manager is also supposed to monitor them to protect their property owners.

Technical Default

Occurs if the lender notices that you’re not doing something required by the loan documents. Generally, these are smaller, less significant items like failure to provide financial reports to the lender at the required intervals, or allowing a vendor to place a mechanic’s lien on the property due to non-payment of his bill. These are items for which the lender usually gives you plenty of time to address.

Monetary Default

Occurs if the property fails to make a mortgage payment to the lender. Most lenders will then move quickly to take control of the property if a monetary default occurs. A monetary default is not quickly remedied.

A property can quickly become in danger of monetary default if a few key tenants don’t renew, and/or capital and maintenance expenses escalate. An experienced asset manager will pay careful attention to the early warning signs to keep your property out of trouble by anticipating and addressing these issues.

Loan Maturity

As a commercial property mortgage agreement nears the end of its term, it’s time for owners to decide of they will try to refinance or sell their property.

In order to refinance, owners need to have 25 to 40 percent in equity. If the building is now appraised lower than when it was acquired, owners may be required to invest additional capital in order to refinance. Raising new equity under these circumstances can be very challenging, and the process should be undertaken with maximum lead time.

Owners can choose to sell, but it is important to have a high occupancy rate and a generous amount of time left on most leases in order to sell at the highest price. Buyers will always assume worst case scenarios — that many tenants will not renew at lease expiration — and will reduce their offers accordingly. Here too, an experienced asset manager will be working to maximize value years ahead of a possible sale or refinancing window.

Capitalization Rate (Cap Rate)

This term is industry shorthand that’s part of valuing any commercial property. The Cap Rate is a percent derived by arms’ length market transactions among buyers and sellers.  The Cap Rate is influenced by the market interest rates and is an approximation of what an investor can expect to receive as a return on his or her capital investment in any given property. Currently, market Cap Rates range from 6 to 8 percent for quality commercial office properties.

Net Operating Income (NOI)

After all the rent is collected and the bills are paid on a building (utilities, janitorial, landscaping, etc.), the amount of money that is left — before the mortgage is paid.

This is a key metric for a commercial building, and it determines the value of the property. Many aspects of NOI are heavily influenced by your asset manager, or lack of an asset manager. In other words, the asset manager can impact the rent that comes in, and we can exercise a lot of control over operating costs.

As an asset manager, we can be aggressive on the topline through marketing and leasing efforts as well as proactive tenant retention campaigns.   And we can be aggressive in controlling expenses, while maintaining building quality with proactive decision-making and by investing wisely in improvements to ensure maximum impact for any expenditure.

NOI is extremely important to investors because the formula for determining a building’s value is:

NOI / Cap Rate = $$$$ Property Value

And of course Property Value is key to any effort to refinance or sell.

At Allegiancy, we are always watching net operating income: We realize that if we can keep the space leased above 90 percent, we can keep a strong top line. And we realize that if we can save a property $100,000 per year in utilities, for example, we have just increased the value of that property by $1 million, using the formula above.

BOMA

Building Owners and Managers Association – a good source of information about how other commercial buildings are doing across the United States. BOMA reports on building operations, efficiency rates, leasing rates, operating costs, energy consumption, and much more.

Allegiancy uses BOMA data, along with other information from various public and private sources, to compare our buildings’ performance with that of our peers. We use it as a benchmark for our operations and levels of efficiency. Through this data, we see opportunities and where we are different.

We always want to be in the top quartile of BOMA numbers — meaning that we are outperforming 75 percent of our peers. Doing this can mean 200 basis point of additional yield for our investors.

In summary

Every commercial office building needs a leader – we like to say they need a CEO running the asset. We also believe that every owner and investor should have direct access to the person managing their building. Asset managers should be extremely responsive to clients.

If you are an owner or investor in commercial real estate and have questions or concerns about your commercial property, contact Allegiancy today.

Steve Sadler manages commercial properties that have outperformed their peers by 45 percent since 2006. The company has approximately $300 million in assets under management and delivers clients attractive returns and profitable, hassle-free investments in commercial real estate. Allegiancy grew by 62 percent last year, largely due to referrals from satisfied clients.

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