Race to the Finish

Alec J. Pacella

Growing up in the 1970s meant that we had some really cool toys. Among the coolest were electric racing sets. Known as “slot cars,” these sets provided hours of fun, especially when all the neighborhood kids brought over their individual sets to create super tracks.

AFX was considered the king of slot cars, but one day I noticed a new upstart on the shelf: Tyco. And their set was really cool. The grooved channel that ran down the center of each lane was gone. And the hand controller could not only adjust the speed of the cars but also allow them to change lanes. I had to have it so after hoarding up my weekly allowance, and dipping into my birthday money, I finally saved up enough to buy one. And it was great racing, requiring all sorts of new strategies. But it also created a problem. I had a fair bit invested in the AFX products but neither the miles of slotted track nor the stable of cool slot cars were compatible with the Tyco products.

A few months ago, I took us back to school in this column and this month we are starting third period. To discover how slot cars relate to the concept of capital accumulation, read on.

IRR (internal rate of return) is similar to that wiz-bang Tyco racing set of my youth; a terrific concept that can be very useful. But it has some limitations. And to better understand these limitations, we need to first under- stand what IRR is actually measuring. The textbook definition of IRR is the rate of return that each dollar earns in an investment while it’s invested. But this definition underscores a major point of clarification; IRR only con- siders money that is internal or inside of the investment. Once money comes out of the investment, IRR makes no assumptions about what we do with that money. IRR doesn’t care; the only thing IRR cares about money that comes out of an investment is that it is no longer in the investment. But, as an investor, I care because I can do something with that money.

Here’s a simple example to illustrate this point. Suppose I’m considering two different investments. Each are equally attractive and have the same perceived degree of risk. Investment A costs $100,000 to purchase and I expect it to produce $10,000 each of the five years that I plan

to own it. At the end of the fifth year, I anticipate selling it for $100,000. I don’t need a financial calculator to deter- mine that investment A has an IRR of 10%. Investment B will also cost me

$100,000 upfront. But it will produce no cash flows for the five years I will own it and at the end, I expect to sell it for $161,051. I will need a financial cal- culator for this one; PV is ($100,000), FV is $161,051, n is 5, and if I solve for I/YR or in this instance, IRR, I am greeted with 10%.

Great – but even though both invest- ments have an IRR of 10%, which is better for me? And if you are think- ing it doesn’t matter, consider that I was thinking the same thing when I pulled the trigger on that wiz-bang Tyco racing set. Here is why. IRR makes no consideration of what I can do with the

$10,000 that comes out of investment A each year. As I said earlier, the only thing that IRR cares about money that comes out of a deal is that it is no longer in the deal. And let’s assume that I follow along and don’t care either. Each year that the $10,000 comes out of the deal, I simply put it into a mason jar and bury it in the back yard. At the end of five years, I get the $10,000 in cash flow from year five and the $100,000 in sale

proceeds. Then I walk out to the back yard, dig up those four mason jars, still containing $10,000 each, and I dump everything into one big pile. That pile will have $150,000 in it, right? In terms of an annual rate, how much did my original $100,000 investment grow over those five years? PV is ($100,00), FV is

$150,000, n is 5 and when I solve for I/YR, I will see 8.45%. In this instance, the rate is referred to as the Capital Growth Rate, or CGR. More on that in a sec.

The only thing that [internal rate of return] cares about money that comes out of an investment is that it is no longer in the investment. But, as an investor, I care because I can do something with that money.

But first, a question. Why has this happened – why does investment A have an IRR of 10% but a CGR of only 8.45%? For the same reason that, by itself, the Tyco racetrack looked so good, right up until I considered the bigger picture. The money that was in the deal did well, earning 10% over the life of the investment. But the money that came out of the deal didn’t do so well – the mason jar equates to an IRR of exactly zero. As a result, our total pile of cash, which is what most investors really care about, is smaller when compared to investment B. With B, nothing came out; all $100,000 that was originally invested remained in the deal the entire time and earned 10% annually over those five years. The result is a bigger pile of cash. Again, IRR only considers money in the deal. Capital accumulation also considers money that came out of the deal and can be reinvested at a chosen reinvestment rate. And if that reinvestment rate is lower than the native IRR, the pile of cash for that alternative has to be smaller.

Looping back to CGR, in a capital accumulation application, the generic I/YR component is termed the Capital Growth Rate. It measures the annualized rate at which the total original invested capital as well as the reinvested cash flows collectively grows over the holding period. I hesitate to use the term “composite yield,” as the strict academics among us would likely frown. But that’s what it is telling us – how much our total capital is \growing over a given time period. And if you think we are done with this topic, think again!

Now that we have a grip on the concept of capital accumulation, next month we will move on to fourth period and discuss a similar concept called Modified Internal Rate of Return. And don’t worry, there will be more to come on the AFX vs. Tyco story as well!

For Properties Magazine, December 2022


Netting Things Out

Alec J. Pacella

One of my favorite types of cuisine is Thai food. I love the variety, flavors and especially the spiciness. Like many, I have my favorite go-to location but was recently in Scottsdale, came across a Thai restaurant and had to give it a try.

While the curry dish that I ordered was fantastic, I made a classic blunder that rendered it almost inedible. With Thai food, it’s common to be able to select a specific spice level, typically expressed as a range from one to 10. At my Lakewood go-to, I always chose a four, which hits me just right. And of course, I did the same thing at this Scottsdale establishment – after all, a four is a four is a four, right? After almost having my eyeballs melt, I was quickly reminded of the danger of assumptions and how a four in Lakewood, Ohio can mean something very different as compared to a four in Scottsdale, Arizona. I know what you are thinking right about now; how is Pacella ever going to tie red curry to real estate? And by now, you likely know the response – read on!
The next day on that Scottsdale trip, I met with a developer that was building a flex-warehouse project. The discussion soon settled on economics and this developer quoted a figure that was preceded with the phrase “modified gross.” I immediately hit the brakes on the conversation, as the memory of my scorched
tonsils was still very fresh. I needed to understand exactly what the developer’s definition of modified gross was, as this is one of those terms that can mean dramatically different things to different people. This month, we are going to discuss the terminology used to describe the most common lease structures. Along the way, I will point out specific items to be aware of and components that can vary.
Leases generally fall into two camps: net and gross. The term “net” is an indication that, in addition to rent, the tenant is also responsible for a portion of the related occupancy expenses such as real estate taxes, insurance, common area maintenance, repairs, etc. The term “gross” is an indication that the rent
includes landlord contributions to at least some portion of occupancy expenses.

The following is a hierarchy of lease types, ranging from the types with the greatest tenant responsibilities to the types with the greatest landlord responsibilities.

Absolute net lease
This lease structure requires the tenant to pay for any costs related to the premises, including real estate taxes, property insurance, repairs, maintenance, utilities, etc. It also requires tenant to pay for large-scale items such as a roof replacement or new HVAC unit or even rebuilding the structure should it be damaged or destroyed. The best example of this type of lease is a ground lease, where a tenant pays rent associated with the underlying ground and is also responsible for all other types of occupancy cost, including constructing, maintaining, repairing and replacement of any improvements. This type of lease can also be referred to as a bond lease and is most often seen in single-tenant retail properties, especially restaurants.

The term “net” is an indication that, in addition to rent, the tenant is also responsible for a portion of the related occupancy expenses….
The term “gross” is an indication that the rent includes landlord contributions to at least some portion of occupancy expenses.

Triple net lease
This is by far the most widely used lease term and, like the term “cap rate,” it is often thrown around with reckless abandon. While some may assume this type of lease to result in the tenant paying for everything, that’s not usually the case. Let’s talk about what the tenant does pay for – in addition to rent, the three “nets” are real estate taxes, insurance and common area maintenance. These can be paid either directly (the tenant contracts for and pays the snow plowing expense) or indirectly (the landlord contracts for and pays the snow plowing expense and then sends a bill to the tenant for reimbursement). Now let’s talk about what the tenant does not pay for. Top of the list is replacement of major items, such as roof, mechanicals, structure or parking lot. And some gray can creep into this, as the lines between maintenance and replacement can be blurry. For example, an HVAC unit may need the belts replaced and a control unit swapped out. Would that be considered a repair (and thus an expense borne by the tenant) or a replacement (and thus an expense borne by the landlord). Another item is rebuilding expense. Suppose part of the property’s façade is damaged due to high winds – is this the tenant’s responsibility to repair or the landlords? While a well- constructed lease document will make situations like these clearer, one cannot simply rely on the term “triple net” as a catch-all. This type of lease is most often seen among multi-tenant retail properties, as well as single-tenant retail, industrial and office properties.

Modified gross lease
If ever there was a catch-all term, this would be it. Also known as a double net or a hybrid lease, this structure connotes that some of the expense responsibility falls on the tenant and some falls on the landlord. Unfortunately, that’s as clear as things get. Sometimes, it means that the landlord pays for insurance and common area maintenance and the tenant pays for real estate taxes. Other times, it can mean that the landlord pays for real estate taxes and the tenant pays for insurance and common area maintenance. And still other times, it may mean that the landlord pays for maintenance and real estate.

Full service gross lease typically implies that the tenant pays for all operating expenses, such as real estate taxes, insurance, repairs and maintenance of the grounds and building, etc. up to a set threshold. Future increases in these collective expenses that exceed the threshold
are the responsibility of the tenant.

Full-service gross lease

This is a very common structure in multi-tenant office properties in our market. It typically implies that the tenant pays for all operating expenses, such as real estate taxes, insurance, repairs and maintenance of the grounds and building, etc. up to a set threshold. Future increases in these collective expenses that exceed the threshold are the responsibility of the tenant. The tenant is also responsible for electricity usage within their premises, sometimes referred to as “lights and plugs.” But even this common structure has some pitfalls. One is janitorial – sometimes the landlord contracts and pays for cleaning of the tenant’s premises and other times the tenant will be required to contract for cleaning directly. Another is electricity. As electrical usage can be directly metered to the tenant’s premises, it can be sub-metered to the tenant’s premises, or it can be fed via a master meter and then charged on a pro rata basis.

Absolute gross lease
This structure is rarely seen, save for one type of tenant. And if any of you have ever been involved with a lease for the U.S. Government, you know exactly what I’m talking about. In an absolute gross lease, the landlord pays for everything for the entire term of the lease. There are no pass-throughs, escalations or separately metered utilities. The day the lease is signed, the tenant will know exactly what they will be paying each month for the entire duration of the lease. There is not a “one size fits all” lease structure and even when we hear a common term, there can still be nuances. As I was painfully reminded in Scottsdale, assuming you know something based on a commonly used term can be a sure way to get burned!

Alec Pacella, CCIM, president at NAI Pleasant Valley, can be reached by phone at 216-455-0925 or by email at apacella@naipvc.com. You can connect with him at http://www.linkedin.com/in/alecpacellaccim or subscribe to his youtube channel; What I C at PVC.

See Properties Magazine for March 2022

Three “glass-half-full” forecasts for the new year

Despite the ongoing uncertainty of the new virulent Omicron variant of Covid-19, there are a lot of positive signs that we can expect in 2022 for commercial real estate (CRE), according to a round-up of sources.

The case for optimism

First, however, an important caveat: Of course, all of these predictions are opinion. No matter how great the historical data used to inform those opinions, they are still not to be considered “financial advice”. Having said that, after a difficult two years (for global business, not just real estate), a little optimism is a welcome break.

Survey says…

First up, Deloitte’s annual forecast report for the CRE sector is out, and generally reflects a high degree of buoyancy.

“Eighty percent of respondents [to their survey] expect their institution’s revenues in 2022 to be slightly or significantly better than 2021 levels,” writes the report’s authors.

…And so does the data

Meanwhile, Forbes real estate contributor and economic analyst Calvin Schnure has done a list of predictions for the year ahead, starting with this one: “Property transactions will rise further in 2022 as the economic recovery gains momentum, and CRE prices will maintain growth in the mid-single digits. REIT mergers and acquisitions could top 2021 as well,” writes Schnure.

How does he come to this conclusion? It’s a matter of looking at the bigger (data) picture trends, he says – plotting this graph from RCA, Bloomberg and NAREIT data.

Source: https://www.forbes.com/sites/calvinschnure/2021/12/01/top-10-things-to-watch-in-commercial-real-estate-in-2022/?sh=352375d63002

“All in alert”

Finally, in December 2021, investment and commercial analysis publication The Motley Fool issued a “rare ‘all in’ buy alert” for CRE, offering three key points of their bullish positioning:

  • “Industrial and multifamily sectors look the most promising in the new year.”
  • “Retail and office CRE should have its good performers but see more headwinds.”
  • “REITs remain a promising avenue for overall returns.”

For the nitty-gritty in how they came to this conclusion, read the full analysis by author Marc Rappaport here.

As we said above, a prediction isn’t a guarantee, a forecast isn’t fact, but we think these bold analysts make a great case for optimism and a solid-looking year ahead for commercial property and investing.

From us to you, happy new year to our CRE network and peers!

Capital markets news bite: Daily fund indices showing record strength

The National Council of Real Estate Investment Fiduciaries’ (NCREIF) latest report on the performance of daily-priced fund indices (NFI‐DP) indicates remarkable strength in the sphere. The report covers the September 2021 period – the latest at the time of going to print – and the data shows the asset class had its highest monthly returns in a decade.

This would put year-to-date (nine months) returns for this group of daily-priced funds at 13.08%

Performance and make-up

The NFI‐DP at the end of Sept 21 was at 2.36%, up from 1.68% in the preceding month. According to the NCREIF, the index represents “the performance of a group of daily‐priced open‐end funds that invest predominantly in private real estate, generally ranging from 75% to 95% allocation”. The balance of allocation for these funds sits in liquid investments (including cash and securities). This makes for a “small universe of qualifying funds” and returns that are equal-weighted and gross of brokerage fees, as well as advisory and incentive fees.

Industry relevance

NCREIF’s data is used by various media and industry analysts as one element (of many) in the determination of market health. They put together various data products, of which this is one, by collecting property and fund level information drawn directly from members – usually on a quarterly basis. The NFI‐DP however is drawn monthly. They have data from over 35 000 properties and 150 funds on their database, which dates back to 1977.

National property index

The decade-high record for daily-priced fund indices (NFI‐DP) noted above is not the only record-level they have noted this year. The last results from the quarterly NCREIF Property Index (NPI) (published in August 2021, representing Q2 2021) show the highest return in the past ten years, sitting at 3.59% up from 1.72% in the previous quarter. This is the top return result since the second quarter of 2011 (3.94%). NCREIF writes, these “are unleveraged returns for what is primarily ‘core’ real estate held by institutional investors throughout the US”.

SOCIAL: What industry facts and figures do you use to inform your understanding of the state of the market?

NAI Pleasant Valley Announces New Agent- Lorin Schultz CCIM

Lorin Schultz, CCIM Joins NAI Pleasant Valley as Vice President

AKRON, OHIO – October 22, 2021,  NAI Pleasant Valley, a leading global commercial real estate brokerage firm, announced today that Lorin Schultz, CCIM joined the firm as Vice President. “We are excited to welcome Lorin back to the NAI Global family,” said President Alec Pacella.

Lorin has significant experience in commercial real estate, particularly in the office market around Akron. She joins NAI Pleasant Valley after spending several years at Colliers and NAI Cummins, where she secured purchases of substantial properties, including Merriman Valley Parkwood Plazas, and procurement of leases for companies such as Tegron and J.M. Smucker Company. Previous to joining the real estate profession, Lorin was a broadcast journalist for NBC stations in Columbus and Youngstown, Ohio.

Lorin holds a Bachelor of Arts Degree in Mass Media Communications from The University of Akron.  She became a licensed realtor in 2003 and later earned CCIM designation in 2009. Lorin currently belongs to the National Association of Realtors and Leadership Akron NEXT 10.

About NAI Pleasant Valley

NAI Pleasant Valley is the Northern Ohio office of NAI Global, the leading global commercial real estate brokerage firm. NAI Global offices are leaders in their local markets and work in unison to provide clients with exceptional solutions to their commercial real estate needs, locally and globally.

To learn more, visit www.naipvc.com