So you’re interested in finding, acquiring, controlling, and financing stabilized commercial assets?
I don’t blame you. Stabilized properties are the safest and most sought after, in-demand commercial assets in any market. No matter how big or small.
Well, you’ve come to the right place. In this guide, you won’t find fluff and hand-holding, but the content and formulas you need to know to get started on your way to becoming successful.
A few weeks ago, The Commercial Investor Launched our first (of many) Mastery programs: Stabilized Transactions Mastery. While hundreds of students have already enrolled, many sitting on the fence have asked if this was a good place to start. The answer?
But it also dawned me that a concise guide on The Commercial Investor Blog would be helpful for our students and their peers.
So here we are.
Let’s get right into it.
Analyzing Stabilized Properties
What you need to know:
The first step in underwriting any stabilized transaction is to understand the project’s NOI.
The formula for calculating NOI is as follows…
NOI = Revenues – Operating Expenses
Understanding the NOI; Is it stabilized?
Building Occupancy: needs to be at market, today at least 90% leased.
Building Leases: rates need to be at current market rate (not below or above).
Tenant Rollover: the property should not have a significant amount of tenant rollover (expiring leases) in the short term or at the same time.
Once the NOI is established, the investor will evaluate. The unleveraged cash flow is the money available after load principal and interest is paid at the project’s “unleveraged cash flow.”
Net Cash Flow
Net cash flow is the real money that can be distributed to the owners. The investor should always understand the project net cash flow.
The formula for calculating the Net Cash Flow is as follows…
NOI = Total Revenue – Operating Expenses
Cash Flow = NOI – Debt Service, including P & I
Net Cash Flow to Owners = Cash Flow – Reserves
Stabilized Property Financing
How much leverage will the property support?
You’ll want to pay attention here—the key to income property value is capitalization rate (‘cap rate’ to those in the business). This is the key factor in determining the value of a commercial real estate project.
They’re influenced by 5 major forces:
- The rate of return on the 10-year treasury bill.
- The availability of debt in the market (the more debt, the lower the cap rates).
- The overall health of the real estate market.
- The rent roll of the property (tenant quality, lease term, etc.)
- Local market factors.
Keep this in mind: cap rates are set by the market and is the rate or yield that the buyers and sellers will accept on an unleveraged basis to own the building.
There are 5 different cap rates and different asset classes will typically have different cap rates:
- Multifamily: this is the lowest cap rate, and the lowest perceived risk.
- Anchored Retail: this a low cap rate, and generally has a strong “credit tenant”.
- Class A Office: this is a low cap rate, that is location and market driven.
- Hotel: this is a higher cap rate, leases roll every night.
- Unanchored Retail: this is a high cap rate, credit of the tenants is the weakest.
The formula for valuing assets and cap rate are as follows…
Asset Value = Stabilized NOI / Market Cap Rate
Example: $950,000 / 9.5% = $10,000,000
Cap Rate Analysis = Stabilized NOI / Acquisition Price
Example: $950,000 / $10,000,000 = 9.5%
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The Rent Roll
Stabilized properties are driven by their rent rolls.
All rent rolls are not created equal, the rent roll is the summary of the tenants in the building and their rental terms. This is important, as the rents paid by the tenants drive the cash flow of the property.
Rent roll analysis will include…
- Percentage of the building currently leased.
- Rate of lease (monthly payments).
- Lease terms: how long is the lease?
- Lease expiration dates.
Renewal clause analysis will include…
- Extension options.
- Contract rate increases.
- Owner requirements over the lease term (i.e. improvements to space, building, storage, etc.)
Credit quality of tenants’ analysis will include…
- Credit tenants: “A rated” company by Moody’s or S&P.
- Strong Credit: A company with a good balance sheet and income statement.
- Poor Credit: A “Mom-and-Pop” business.
The investor/underwriter will spend significant time in order to understand the “project roll schedule”, which means knowing which tenant’s leases mature and when leaders and investors seek out properties that have a “balanced” roll schedule.
They don’t want the risk of all the tenant’s leases expiring at the same time.
Types of Leases
Most office buildings are full service, while most retail and industrial buildings are leased trip net (NNN).
There are two basic types of leases:
- Full Service: landlord pays all expenses such as maintenance, taxes, and insurance.
- Triple Net Leases: typical charges to triple net include—taxes paid by tenant, insurance paid by tenant, maintenance paid by tenant.
Operating statements are the profit and loss statements of the commercial real estate asset (i.e. the building).
This is the single most important piece of documentation when analyzing stabilized real estate investments.
Operating statements show two things:
- The detail behind the cash flow formulas.
- If the building is operating at profit or a loss.
Now we’ll get into the fun stuff.
Let’s be clear—only stabilized properties can qualify for permanent financing.
What does one look like?
Let’s look at an example of a typical permanent financing structure:
- Term: 10 years
- Loan to Value: 65-80%
- Rate: A “spread” over the 10-Year Treasury, typically a fixed rate.
- Debt Service Coverage: The difference between the property cash flow (NOI) and debt service payment. Typically 1.20-1.40%.
- Amortization: Typically 30 years, but is negotiable. In recent years, amortization has been dropped and loads have become interest only.
- Recourse: Typically not required.
- Loan Constant: This is the true rate of interest. This rate includes the load spread and the amortization.
- Bells & Whistles: Lock out periods, reserve requirements, prepayment options.
Permanent loads are repaid by another permanent load or by a sale, in which case another permanent loan is obtained. The permanent lender that is underwriting the property will underwrite the load to make sure it qualifies for another permanent load at the end term.
Types of Permanent Financing
Life Company or Portfolio Loans
Life companies are large providers of permanent loans.
They view stabilized real estate assets as an “investment class” for their portfolio, like stocks and bonds.
Typically, life companies provide the lowest rates.
They are also the most “picky” about the asset quality and market.
In general, life companies make profit on the spread between the rate and their cost funds.
Examples of active life company leaders include:
- New York Life
Bank have been traditional providers of real estate loans, but they have not been prolific in the long term, fixed-rate market.
Many banks have started “conduit desks” or syndication desks, where the bank originates and hold the loan for a short period of time, then sells the loan to other lenders while keeping a fee.
Banks will generally write loans for 3-5 years, but not 10 years.
Agency lenders are quasi-government entities that provide permanent financing on stabilized multifamily properties.
Agency lenders are excellent alternatives to life companies and conduit lenders.
They also must be assessed by approved mortgaged companies that represent the agency lenders.
- Freddie Mac (FHLMC): Some mortgage firms have Freddie Mac licenses. These mortgage banks originate loans for Freddie Mac directly.
- Fannie Mae (FNMA): Mortgage companies aligned with Fannie Mae are known as DUS Lenders (Delegated Underwriting and Servicing). In this model, the mortgage lender shares some of the first loss risk.
- FHA/HUD: Also known as HUD. They provide the most proceeds, 40-year amortizations, and will do business with different levels of sponsorship. This is a government subsidized lending program. FHA deals typically take a long time to close. (Note: HUD will also finance nursing home and assisted living facilities.)
How much leverage will the property support?
Another key lender metric you need to be aware of is debt service coverage ratio (DSCR).
Known as the “coverage ratio”, this is one of the key formulas that drives loan size.
If debt service coverage ratio is over 1.0x, it means that monthly property cash flow is equal to the principal and interest payments.
Permanent lenders typically look for a 1.20 to 1.25x coverage ratio as the benchmark for a safe loan.
The formula for calculating the DSCR is as follows…
Stabilized DSC Ratio = Conduit Underwritten NOI/ Debt Service
Example: $779,375 / $622,400 = 1.25x
Amortization or Loan Constant
Simply put, the constant is the loan “pay rate” when amortization is included.
The loan constant (“K”) is the implied interest rate when amortization is considered. For example, a loan with an 8% rate, with a 30-year amortization has a loan constant of 8.81%.
This means the constant or continuous rate the property must service to meet its debt obligation. Interest only loans have the same constants as the rate. The interest rate (pay rate) and the constant are the same.
Amortizing loans have a constant different from the pay rate. It is the “constant” rate of interest when amortization is taken into account.
And that’s that! Still with me? Good.
Knowing this information like the back of your hand is all well and good, but it’s not going to be enough. You need to specialize.
That’s where our Mastery course comes back into the conversation. It has everything you need to learn—and master—to help your clients identify great stabilized commercial opportunities (and avoid horrible deals), place capital, structure deals, and increase the value of their assets.
Learn more here, or by click the image below.
Until next time.