Commercial Real Estate is About the Numbers Part II

A couple of days ago I wrote about the value of a commercial property as it relates to the income it generates.  Recall, if a tenant is able to get a $6,000 reduction in the annual lease payment, that can reduce the value of the property by about $75,000.  ($6,000 / 8% cap rate = $75,000)  A contrast with a residential rental and a commercial lease is the addition of NNN charges to the tenant of the commercial building.  So how does this work?  In a residential lease, typically the tenant pays a flat monthly fee and the landlord picks up the property taxes, property insurance and most of the maintenance costs.  This is a gross lease.  If the rent is $1,000 per month, then the expenses could look like this; $125 a month for property taxes, $60 for insurance and on average, $65 a month for maintenance, that leaves the landlord with $750 of taxable income. $1,000 - ($125 + $60 + $65 =$250) = $750.

In a commercial lease, many times the tenant is charged for the expenses listed above.  If so, it is called a NNN lease.  This equates to the tenant paying their proportionate share of the property taxes, property insurance and a negotiated charge for maintenance items, i.e. landscaping, parking lot cleanup and re-stripping as well snow removal.  On the tenants share, it means that if the tenant leases 40% of the building, they pay 40% of the NNN. As you can see, the landlord of the commercial building has a much more predictable income compared to the landlord with the gross lease.  Additionally, since the NNN's are paid by the tenant, there is a larger amount of income for the landlord and consequently, the higher income translates into a higher value for the property.  For example, if the property taxes are $5,000, the insurance is $1,500 and the maintenance costs are $2,500, and all of these charges are paid by the tenants, the net operating income is NOT reduced by $9,000.  $9,000 of income with a 9% cap rate equates to $100,000.