Written by the fine folks at CREA (Canadian Real Estate Association) Café
Commercial properties may be acquired through land purchases, active commercial development, renovating pre-existing spaces, or owner-occupied commercial spaces. Long before purchasing, it’s important to study the market in which you’re looking to buy.
Different types of commercial real estate properties include:
• industrial;
• retail;
• hospitality;
• office; and
• multifamily.
Types of commercial buildings can include:
• warehouses;
• offices;
• restaurants; or
• retail locations.
BEFORE THE PURCHASE
Here are some initial terms to know before purchasing commercial real estate.
Acquisition Cost—The total cost to the purchaser of a property, such as soft costs and sales costs. These costs recoup the upfront costs of performing due diligence on a potential property.
Appraisal Estimate—The process that leads to an estimate of the value of a property, and can also refer to the report that states the estimate and conclusion of value.
Amenities—The details that factor into the sale price or rent calculations and include features around a property that make it more attractive, useful, desirable, and/or rentable.
Arrears—Money that is due or past due, but has not been paid. A commercial real estate broker can help you determine if there are any arrears owing on potential property.
Capital Improvements—Additions to the property or improvements that enhance or extend the useful life of the property.
Clear Title—A title is one of the two most important documents to the purchase of a commercial property as it grants the owner rights to the property. A deed is the transfer of ownership. A clear title is any property free of any and all competing claims, mortgages, liens, and encumbrances.
Comparables—Refers to area rents or competitive rental properties or area sales that have sold, implying “rent comps” and “sales comps” are comparable in size, location, condition, amenities, etc., to the subject property.
Contingent Offer—An offer to purchase property subject to certain conditions, including the buyer’s approval of income and expense statements, title commitment, physical condition of the property, loan commitment, etc. being met. The specific amount of time allowed to clear these provisions is called the inspection or contingency period.
Free and Clear—When there are no liens or loans against real property.
Interest Only Mortgage—A non-amortizing loan where the lender receives only interest during the term of the loan and recovers the principal in a lump sum at the end of the term.
Letter of Intent—A formal method of stating there’s interest in a property, but it’s not an offer and creates no obligation.
Option—The right to purchase or lease a property at a certain price within a designated period of time for which a consideration is paid.
Unencumbered—A property or land that has no liens, claims, or mortgages against it.
Zoning—The rules of a municipality that detail the allowable uses for the real property in specific areas, and only then on specified conditions.
Leasing
After successfully closing on a purchase, leasing a purchased property is another step of the process. You’ll need to determine how much to charge for rent, utilities, insurance, and your profit. But before all that, you’ll need to understand the players involved.
A lease is a contract where one party (the landlord) agrees to allow another party (tenant) the exclusive, common and/or joint right(s) to use a property for a specific period of time. In this scenario, the landlord is called the lessor, and the tenant, the lessee.
In some contracts, there can be a gross lease where the tenant pays a single base rent and the landlord pays all or part of the expenses of the property, such as taxes, insurance, maintenance, and utilities. In a net lease, the tenant pays taxes, insurance, and maintenance on top of their base rent.
There are also some special scenarios, such as a leaseback, where an investor purchases property and then leases it back to the seller. These are scenarios where a company would like to use the cash they invested in an asset for another purpose.
Here are a couple more important lease terms that relate to leasing a commercial building.
Abandonment—A person or entity that leaves a demised premises before the end of a lease term.
Escalation Clause—A clause in a lease providing for an increase in rent at a future time. This could be a fixed or pre-determined rate increase, a cost-of-living increase that ties the rent to a cost-of-living index, or direct expense—the rent is adjusted according to changes in the expenses of the property such as a tax increase.
First Right of Refusal—An option in a lease provided to a tenant in a lease contract providing first right to occupy space or match an incoming offer on adjacent space that may be required for the tenant’s future expansion.
Graduated Lease—A lease that details changes in the rental rate, usually based on periodic appraisal or time.
Lease Buyout—When a landlord offers to take over the current lease of a tenant.
Net-net Lease—A lease in which the tenant pays a rent to the landlord that includes all real estate taxes only and does not include any portion of the operating expenses.
Net-net-net Lease – Also known as a triple net lease, when the tenant pays rent to the landlord that does not include all property taxes and operating expenses.
Percentage Lease—When the tenant pays a minimum rent then also pays a percentage of the volume of the business done on the premises whichever is greater. The percentage paid differs according to the types of business
Pre-Lease—The leasing of a property or space that has not been developed or constructed.
Radius Clause—In a percentage lease, it’s customary to have a clause that details the distance from the property that a competing store from the same chain may be located. This is usually a distance sufficient so that two stores from the same chain are not in the same trade area.
Determining rent
Determining how much rent to charge your lessee will come before the official lease is signed. These are some important terms to know.
Basic Rent—The rent agreed to through negotiation and does not include adjustments and additions.
Gross Rent Multiplier—Sales price or value divided by annual effective gross income. For example, if the sale price is $325,000 and the effective gross annual income is $50,000 the G.R.M. is 6.5 ($325,000 /$50,000).
Net Rent Multiplier—The factor resulting from dividing the net operating income into the sale or purchase price.
Net Rentable Area—Also known as net rentable square feet. This is the total amount of square feet that can be used for rental income. It typically excludes stairways, elevators, hallways, common areas, etc.
Taxes and financials
Purchasing or selling a commercial real estate property is an exceptionally lengthy process, mainly because there’s a lot of money on the table, therefore lawyers and consultants will need to get involved. Hiring a real estate attorney can also help to make sure proper due diligence is taken. A real estate attorney, like Carson Law, will help you go over all the important documents to check for any encumbrances—liens, charges, or other liabilities attached to a property that can diminish its value.
So, what’s the difference between a lien and an encumbrance? A lien is a monetary claim or hold against a property for payment, whereas an encumbrance refers to any claim, not just a monetary one. Any lien is an encumbrance, but not every encumbrance is a lien. Encumbrances can be brought against a property by someone who is not an owner and can also include property use restrictions such as zoning laws or environment restrictions.
A commercial real estate purchase involves a lot of different types of contracts, taxes, and finances. Below is a list of tax and financial terms you’ll encounter when embarking on your commercial real estate journey.
Accrued Expense—Expenses incurred which are not yet payable, or have not yet been paid.
After Tax Yield—The annual profit remaining after payment of income taxes, or the annual return on equity after payment of income taxes.
After Tax Yield Rate—The annual rate of return on equity after payment of income taxes.
Amortization—The process of paying off a debt, together with interest, usually with equal payments at regular intervals over a period of time.
Assessment—A levy against a property in addition to general taxes, usually applied by a civic authority for improvements such as streets, sewers, etc.
Assignment—The method or manner by which a right, specialty, or contract is transferred from one person to another.
Break-even Point—The point where the effective gross income equals the cost of all operating expenses and debt service payments.
Capitalization—The anticipated stabilized rate of return from an investment, also known as the cap rate.
Cash Flow Analysis—A projection of the buyer’s estimated cash flow over the holding period.
Loan-to-value Ratio—This is the principal amount of a loan as a percent of lending value. For example, if property is purchased for $500,000 and financed by a bank loan for $300,000 the ‘loan-to-value’ ratio is 60% of the property’s lending value to a borrower.
Mill Rate—Equal to one tenth of a cent. Used in expressing a tax rate, ten mills would be the same as ten dollars per thousand.
Negative Cash Flow—When the income from an investment property does not equal the usual expenses. The owner must come up with cash each month to meet these expenses.
Net Income—The difference between effective gross income (property) and the operating expenses including taxes and insurance. The term is qualified as net income before debt service
Net Operating Income—Also known as NOI. This is the annual net income remaining after deducting all fixed and operating variable expenses, but before debt service and income tax. The specific formula is: NOI = Scheduled rental income + other income – vacancy and credit losses – operating expenses.
Payback Period—The time required for the complete recovery of an investment; often used with the concept that all income is considered a return of capital until the entire investment is recaptured and that income received after complete payback is considered profit.
Pro Forma—Means “for form only.” A study prepared to estimate future income, expenses, and potential profit or loss.
Yield—The ratio of income from an investment to the total cost of the investment over a given period of time.
Maintenance and Zoning
The overall space of a building is determined by the floor space ratio. Also known as FSR, this is the maximum floor space of a building relative to its land area. It’s determined by a simple equation and the ratio is often used by local governments to measure density. Considering the FSR is important if you’d like to make any additions to a commercial space, or if you’d like to turn a residential location into a commercial space—if you were running a business out of your home, for instance.
There are a lot of questions to ask yourself when considering opening a business and operating it out of your primary home. How does one rezone a property? What sort of land-use restrictions exist? What type of structures are allowed to be built on the land? Changing the zoning on a residential home is a complicated process.
Educating yourself on local zoning laws is essential. You might also want to connect with your neighbours as they’ll need to approve your rezoning application along with municipal government bodies.
If you’re looking for a very specific commercial space, consider a build to suit property. In a build to suit transaction a property owner will construct a building for sale or lease built to a tenant’s (or buyer’s) needs and wants. This type of lease can be any type of commercial real estate from retail to industrial properties.
Here are some terms that fall into the area of general building maintenance.
Absorption Rate—The net statistical changes in occupied space over a period of time. Positive absorption reflects an increase in occupied space while negative absorption reflects a decrease.
Build to Suit Phase I level Audit—This refers to an initial environmental assessment of a facility by a qualified environmental engineering firm for potential contamination to determine if further investigations are warranted. Phase II level audit investigations would require further subsurface sampling, electromagnetic and hydro-geological study.
Density—This is the amount of total square feet buildable on a set land. For example high density properties feature more floors.
Encroachment—A building, part of a building or obstruction which intrudes on another property.
Non-conforming Use—Property used for purposes that do not conform to the permitted uses in the municipal or provincial zoning by-laws.
On-site Improvements—Work completed on a property that improves its value.
Commercial real estate is a world of its own, but with a commercial lawyer and commercial realtor by your side, you can buy, sell or lease the right property for your business.