Preparing and analyzing the proforma cash flow for income producing commercial real estate is an important part of the underwriting process to determine the property’s projected ability to service debt. A basic NOI analysis of a commercial property includes gross rental income and operating expenses (e.g. property taxes, utilities, insurance), but prudent business loan underwriting practices suggest it should also include a vacancy factor, management fee, and replacement reserves. So why should you include these additional deductions in a CRE analysis, and can they be excluded if they have not been incurred in the past or are not expected going forward?
CUBG’s expert staff provided this tip in response to these questions and others we hear frequently from our clients.
Q: Why should a vacancy factor be included in the CRE Analysis?
A: Vacancy can be unavoidable, particularly in residential properties or other property types with short-term leases. However, it can also be seen in properties with long-term leases due to a variety of business-specific or market factors. Therefore, it is prudent to include a vacancy factor in the cash flow analysis to account for a potential loss of rental income associated with unoccupied unit(s), rent concessions, or non-payment. Typical vacancy factors range from 3% to 10% of gross rental income and can be estimated from internal underwriting procedures, an appraisal, and/or other market data. A vacancy factor will also be applied by an appraiser and a potential investor to stress the cash flow in order to determine the property’s income potential and ultimately its market value.
Q: Why should a management fee be included in the CRE Analysis?
A: A management fee is a recurring operating expense that should be accounted for in cash flow. The fee is paid to a third-party management company who ensures rent is collected, tenant’s repair requests are handled, and much more. The actual fee should be included in the NOI when the management agreement and/or cost is available. However, in many cases, the fee is unknown at the time of underwriting and can be estimated based on market rates and/or internal underwriting procedures. Management fees typically range from 4% to 5% of Effective Gross Income (EGI) and depend on property type; refer to CUBG’s recommendations below.
What if the borrower will self-manage the property and will not incur a fee from a third-party property management company? It is still prudent to include a management fee as it is an industry standard expense that an appraiser or potential investor would include in a proforma and directly effects the property’s income and value. Additionally, this considers the possibility that in the event of foreclosure the credit union would need to employ a property manager while the property is marketed for sale or liquidation. The potential purchaser would also likely analyze the property’s cash flow with a management fee included. Thus, it is important that the credit union analyze the property’s ability to support a potential management fee and continue to service the debt.
Q: Why should replacement reserves be included in the CRE Analysis?
A: Capital improvements are inevitable costs that investors must plan for as a property ages. These expenditures are an important, and necessary, part of maintaining an attractive, fully occupied property that is free of deferred maintenance issues that may adversely affect the property’s market value over time. Accordingly, it is prudent to include reserves in the cash flow analysis to ensure the property can support repairs without relying on additional outside capital injections, additional indebtedness, or guarantor support. Replacement reserves should even be included when a property has a strong triple-net (NNN) lease(s) in place, as there are certain replacements that are typically still the responsibility of the property owner (e.g. structural repairs). Consistent with the other two deductions, an appraiser, and a potential investor alike, would consider replacement reserves in the calculation of the property’s NOI. Replacement reserves vary based on property type; refer to CUBG’s recommendations below.
CUBG Recommendations and Example:
The examples below were developed by CUBG’s staff based on industry standard underwriting practices and an analysis of market appraisal standards. An example of an office property proforma cash flow follows.
Please contact firstname.lastname@example.org for any additional questions or clarifications on this topic.