Investing in Retail and Office Property

Abstract

During the height of the “Yes Era”, retail and office property was constructed based on the growth in new housing starts in various markets across the United States. Speculative home construction may have led to speculative retail and office properties being constructed nearby. While the level of speculative construction was not as prevalent during the “Yes Era” as was the case in prior real estate-led recessions, the “if you build it, they will come” philosophy is an alluring concept during economic expansion.

Keep thy shop and thy shop will keep thee. Light gains make heavy purses.

George Chapman

Appendices

Retail Case Study #1

Strip Center Properties, LLC is looking to purchase a five bay retail strip center for $900,000.00. The investors plan to inject equity of $100,000.00 and seek bank financing for a loan of $800,000.00. The property is a typical retail strip center that contains local small businesses. The property has 12,000 sq. ft. of leasable space, and the strip center was constructed in 1989. It is in fair condition, but it looks its age based on your recent inspection of the property. Professional inspectors could not find any deferred maintenance at the property. The property would be considered average when compared to similar properties in the surrounding area. All leases are on a gross basis, but each call for common area maintenance (CAM) expense reimbursements of $1.50 per square foot leased for each tenant which also covers taxes and insurance for the property. The property is located near the area mall and has had a historical vacancy rate of from 8% to 10%, though it is currently fully leased. The market vacancy rate is 10% for the local area. Based on local averages, standard management fees for this type of space are 5% of the effective gross income (EGI).

The investors have provided a current rent roll for the subject property as follows:

Unit	Tenants	Monthly rent	Size	Lease maturity
1	Nails are us	$1,650.00	1,800	1 Year
2	Hardware plus	$2,625.00	3,000	MTM
3	Junior’s Deli	$2,500.00	2,500	2 Years
4	Hospital florists	$2,083.33	2,000	Next month
5	Mike’s hobbies	$2,362.50	2,700	3 Years

Also included in the financial package submitted to the bank for financing consideration was the following breakdown of the annual operating expenses for the subject property:

Taxes	$8,000
Insurance	$2,000
CAM	$8,000
Recurring repairs	$9,000
Utilities	$2,000

• 1. Determine the net operating income for this property using the direct capitalization spreadsheet.

• 2. Determine the first year debt service coverage ratio for a loan of $800,000.00, at an interest rate of 8%, for 20 years.

• 3. Using a cap rate of 9%, what is the estimated value for this property?

• 4. Determine the breakeven occupancy rate and interest rate for this property.

• 5. What questions would you ask concerning the rent roll information?

• 6. Given the tenant mix, what would be some ideas for replacement tenants that would be comparable to those currently in the property?

Retail Case Study #2

Safin Properties has an opportunity to purchase a mixed use retail property located in the City Market section of Charleston, SC. The property is located on North Market Street, in a neighborhood bound by Meeting Street to the west and Concord Street to the east, and is generally known as the most active tourist district in Charleston, SC. The investors feel that this property would make an excellent investment as Charleston attracts over five million visitors per year and the properties in this submarket have some of the highest rents found anywhere on the peninsula. The property was originally constructed in 1880, but was completely renovated over the last 3 years. The building is constructed on a concrete foundation and has solid masonry and frame exterior with painted stucco and wood side covering. The interior consists of a wood frame structural system, with one main masonry wall, and a built-up roof. The building is two stories, with a currently vacant loft apartment on the second floor, along with a small portion leased to Joe’s Bar and Grill (also a first floor tenant) and 4,099 sq. ft. of space currently vacant that was previously occupied by the Port City Inn. The buyers (who also owned the Port City Inn) feel that there is an opportunity to convert this space to mixed use retail, with a Market Street front entrance. The buyers have stated that they are willing to sign a master lease of $25.00 per square foot for 5 years if this is required to make the deal viable.

The purchase price of the property is $6,000,000, and Safin properties and its owners are seeking financing in the amount of $3,000,000. The remaining proceeds are to come from a 1031 Exchange. The property has the following rent roll:

Tenants	Sq. ft.	Annual rent/sq. ft.	Lease expiration
Joe’s Bar and Grill	4,559	58.13	1 Year
Praline Candy Company	1,772	44.02	10 Years
Trinkets and Baubles	724	93.73	2 Years
Port City Inn	4,099	25.00
Spender’s Coffee	1,915	49.21	3 Years
Loft Apartment	900	29.33

You have market intelligence that rental rates in the area are between $45 and $55 per square foot, with vacancies in the area typically falling between 5% and 10%. The leases are structured as triple net. The only expenses incurred by the prior owners for the last 3 years are shown below.

	Year 1	Year 2	Year 3
Taxes	$ -	$ -	$8,000
Insurance	$ -	$ -	$2,000
Repairs and maintenance	$3,000	$5,000	$7,500
Management	$12,000	$15,000	$17,000
Other	$10,000	$15,000	$25,000

Questions for Discussion

• 1. Determine the net operating income for this property using a direct capitalization framework. Be sure to justify what annual rental rates you are using in your analysis.

• 2. What is a master lease? Does the property underwrite without the master lease? What issues do you have with the proposed master lease?

• 3. Why were there expenses for taxes and insurance in year three?

• 4. Using a cap rate of 8%, what is the value for this property? Prepare a DCF for this property to determine its value on a multi-period basis.

• 5. What questions would you ask about the rent roll and property historical performance?

• 6. Determine the debt service coverage ratio for the first year, assuming loan terms of 8% interest for 20 years.

Office Case Study #1

Office Investors, Inc. completed the construction of an office building in 2003, and achieved 100% occupancy in the subject property by late 2004. They would like to refinance the existing $2,500,000.00 note, and would like another $500,000.00 to replenish their personal cash holdings. The building is housed on 3.1 acres of land in a favorable location in Good Sized Town, Ga. The building size is 52,000 sq. ft. gross, but has only 45,000 sq. ft. of rentable space. The building consists of three stories of net rentable area, 15,000 sq. ft. each. All leases are on a gross basis. Market vacancy rates are between 10% and 15%.

The current rent roll is as follows:

Unit	Tenants	Monthly rent	Size	Lease maturity
1A	Doctor	$10,000	7,500	2 Years
1B	Insurance	$5,000	5,000	Next month
1C	Temp staffing	$2,708	2,500	6 Months
2A	Court reporter	$4,583	5,000	MTM
2B	Vacant		10,000
3	Attorney	$18,750	15,000	5 Years

The location of the subject property is on a busy street in the downtown section of Good Sized Town, GA. The market rents for medical space are in the $15.00–$16.50 per square foot range, while the market rents for standard office space is $10.50 per square foot. The standard management fee in the market for this type of space is 5% of effective gross income (EGI).

The owners of the property have supplied the following information regarding historical operating expenses at the subject property:

	Year 1	Year 2	Year 3
Taxes	$12,500	$14,750	$16,000
Insurance	$2,500	$3,250	$4,000
Janitorial	$8,455	$10,152	$12,000
Utilities	$6,500	$7,250	$8,000
Automobile	$4,000	$5,000	$5,000
Leasing commissions	$7,500	$8,500	$9,000
Landscaping	$9,875	$11,530	$11,000
Repairs and maintenance	$8,000	$14,000	$12,000

• 1. Determine the net operating income for this property using the direct capitalization spreadsheet.

• 2. Determine the first year debt service coverage ratio for a loan of $3,000,000.00, at an interest rate of 8%, for 20 years.

• 3. Using a cap rate of 9%, what is the estimated value for this property?

• 4. Determine the breakeven occupancy rate and interest rate for this property.

• 5. What questions would you ask concerning the rent roll and expense information?

• 6. Given the tenant mix, what would be some questions concerning the property’s location?

Office Case #2

You have been presented with an opportunity to finance a purchase of an existing office building in Irvine, CA. The property is located in Old Town Irvine, located in Orange County California, one of the most heavily urban counties in California today. The property is a six tenant office building and is currently on the market for $5,000,000. The applicants are currently banking at Bank of America and live in Hasbrouck Heights, NJ. They have recently created a real estate holding company, California Dreamin’, LLC, which will borrow the funds, while the principals will guarantee the debt. They have requested a loan amount of $3,000,000 from your organization, which is a primary competitor to B of A. The prospects have over $10 million in personal liquidity, primarily in the form of small cap stocks less than $10 a share (as a side note, when meeting with the prospects they mentioned that they prefer high risk and high return investments, and that this is their first foray into investment real estate.) Given the recent drop in property values in California, they felt that now was a good time to venture into real estate investment on the west coast.

The property rent roll is as follows:

Tenants	Sq. ft.	Annual rent	Lease expiry
Interactive communication	12,500	168,316	6 Months
Jung architecture	1,500	38,160	2 Years
Tong and Lang management	7,500	92,700	2 Years
The learning center	3,500	68,291	5 Years
Alliance Francaise	5,000	117,000	10 Years
AT&T wireless (ground lease)		39,700	9 Years
Totals	30,000	524,167

The property was constructed in 1925, and was renovated from its original use as a grain storage building, into an office building in 1985. The property has a wood exterior, but was completely renovated in 1985 for office space. Given its prior use, the property sits on 2.73 acres. The building is listed in the California Register of Historic Places, and the area has vacancy rates of 15%, which is up from 10% last year due primarily to the problem in the mortgage industry in California. Office rental rates in the area are between $2.25 and $2.50 per month.

Property operating expenses for the last 3 years are as follows:

	Year 1	Year 2	Year 3
Taxes	35,000	35,000	35,000
Insurance	14,000	14,000	15,000
Repairs and maintenance	24,250	35,685	27,500
Management	13,250	14,000	14,153
Utilities	17,750	18,000	18,250
Janitorial	6,800	7,200	7,500
Other	7,500	2,500	3,500
Totals	120,555	128,391	122,910

A few of the selling points for the investors were the consistency of the operating expenses, and historical nature of the property. Since this is your first opportunity to speak to these potential clients, you want to make a good impression, prove that you can be a valued advisor for their financial portfolio, and hopefully to win their entire banking relationship.

Questions for Discussion

• 1. What are some issues that you have with the management situation in the case?

• 2. What are some issues that you see with the rent roll?

• 3. Assuming an interest rate of 8% and a 20 year amortization, what is the debt coverage ratio? What is the value of property assuming a cap rate of 7%?

• 4. Does this property support 20 year financing? What questions would you ask to better understand this issue?

• 5. Is there a gap between the loan request and what the property supports for traditional bank financing? How far would you stretch to win this business, and to possibly win the relationship of these clients?

• 6. What financial advice would you offer these potential customers?

DCF Mini-Case

9.5.1 Construction Project in Heidelberg, Germany

You have recently joined an investment team that operates a well-diversified portfolio of investment properties located in tourist destinations throughout the world. The group’s portfolio of assets consists of office, retail, and residential properties located primarily in North America and Europe. The group is considering the construction of a mixed use office-apartment building located in Heidelberg, Germany. The site has recently been razed, and the prior usage was two residential properties that were owned by professors from Heidelberg University. The site is located on Neuenheim Landstrasse, a primary corridor in the city which has a scenic view of the Neckar River. The site is on the opposite side of the river from the famous castle in Heidelberg, and is near “Philosopher’s Way”, a trail made famous by German philosophers such as Hegel and Nietzsche. In years past, philosophers such as these would traverse the trail, contemplating philosophical questions. Now the path is occupied primarily by tourists, hoping for similar deep insights.

Given the scenic view from the proposed new mixed use property, the project will be known as “King’s View Park”, and will consist of a two story building on site where the two residential houses once stood. The top floor of the building will contain three apartment units (two bedroom, one bath), while the bottom floor will consist of four office units.

Based on your firm’s market research in conjunction with local real estate professionals, it has been determined that the apartment vacancy in the city of Heidelberg is essentially zero at the present time. Some competing units are being constructed currently, but none with the scenic view of the subject property. Your firm has also determined that the existing office market vacancy rate in the Rhein-Neckar metropolitan region is approximately 10%.

Given the strong level of occupancy in the Heidelberg apartment market, you have been able to obtain letters of intent for each of the three apartments, as well as three of the four office units.

Each apartment is 1,400 sq. ft., and will rent for $4,250 per month. The letters of intent have been signed for 1 year, which will begin once construction is complete and the property is ready for occupancy.

The rent roll for the office spaces is shown below:

Tenants	Sq. ft.	Term	Monthly rent
Prof. Dr. Raffeisen	750	2 Years	2,500
Heidelberg Univ.	1,000	4 Years	4,000
Heidelberg Univ.	1,225	4 Years	6,000
Vacant	1,225

One of the office units will be occupied by a retired professor, who will use the space as his personal office while he writes his memoirs and updates his previously published textbooks which are in various stages of completion. He has signed a pre-lease agreement for a 2 year term. Two other office suites will be occupied by Heidelberg University. Since the University has grown in recent years, these offices will be occupied by university staff. They have signed a letter of intent for 4 years. The final office space has yet to be leased, but given that 85% of the total square footage of the property has been pre-leased prior to commencement of construction, your firm believes that this property will be fully and quickly absorbed by the market prior to completion.

Your firm typically assigns a replacement reserve of 1% of EGI annually for projects of this age and condition. Additionally, you have contracted with Dahler & Co. GmbH, a well known real estate brokerage and management firm, for a management contract of 3 years, with compensation equal to 3% of the effective gross income of the property.

Additionally, you have estimated the following expenses for the first 3 years for the project:

Operating expenses	Year 1	Year 2	Year 3
Taxes	25,000	25,500	26,000
Insurance	12,500	13,000	13,500
Repairs and maintenance	8,575	9,900	12,375
Utilities	10,125	11,600	14,500
Other	–	2,500	1,500

Total project construction costs are estimated at $3,500,000, and you have requested a loan to cost of 75%. Your firm already owns the land. A local bank has offered 25 year financing at 7% interest.

Your assignment is to develop a discounted cash flow analysis (DCF) for this property. Assume a 10 year holding period, which is consistent with your firm’s investment horizon for this project. Given the strong location, a 5% annual appreciation rate is expected for this property, and selling costs run 3.5% in this market. Your projections should include a most likely case which assumes annual GPI increases of 2.5%, and a best case which assumes annual GPI increases of 5%. Assume a 9% discount rate, and a terminal cap rate of 8%. Your DCF should take the market intelligence, your projections of income and expense associated with this project, and lease rollover risk into account.