Commercial real estate assets are not just something that can be purchased, ignored, and then sold at a later date for a higher value. In order to keep the property in good condition and to preserve its value for future buyers, they must be attended to and maintained. The costs to complete these activities are commonly referred to as “carrying costs.”
In this article, we will discuss carrying costs. We will describe what they are, why they matter in commercial real estate, and provide some examples of common carrying costs. By the end, readers will have a greater understanding of the costs needed to carry a commercial property and they will be able to use this information as part of their pre-investment due diligence process.
At First National Realty Partners, we leverage our experience and expertise to model the carrying costs for all of our properties prior to purchase. Doing so allows us to provide a more realistic picture of the potential returns for our investors. If you are an accredited investor and would like to learn more about our current commercial real estate investment opportunities, click here.
What are Carrying Costs?
Carrying costs are the ongoing expenses that it takes to operate and maintain a commercial investment property.
To think about it another way, there are three major capital events in the lifecycle of a commercial real estate investment. The first is the purchase, which requires a large upfront outlay of capital (the exact amount depends on the purchase price & financing costs). The second is the ongoing costs necessary to carry the property, which also requires cash outlay. The third is the sale of the property, which results in a significant capital inflow.
The important point here is that the payment carrying costs is not a one-time event. Is it ongoing for the entire investment holding period and can have a major impact on the returns generated by an asset.
Types of Carrying Costs
The type and amount of carrying costs can vary by property, but the major categories are described below:
- Property Taxes: Cities and municipalities charge taxes for the benefit of using their land and services, like trash pickup and water. Property taxes are charged on an annual basis and can grow slowly over time.
- Insurance: Depending on the commercial property’s type and location, owners may need to carry several different types of rental property insurance policies. Most carry some sort of general liability to protect against financial loss from accidents on site. Others may carry specialized policies for things like wind/fire damage, floods, or business interruption. There are premiums that must be paid for each of these policies, usually on an annual or semi-annual basis.
- Property Management: There is a lot of work that goes into the upkeep of commercial real estate on a day to day basis. Typical tasks include: rent collection, landscaping, basic maintenance, and providing tours for new tenants. In most cases, these tasks are performed by a third-party property management company, who charge property management fees equivalent to a percentage of a property’s gross income. In some cases, like ours, these tasks are handled by an in-house property management team, which saves money in the long run.
- Maintenance: Routine maintenance activities include things like: changing air filters, cleaning windows, snow removal, tree trimming, cleaning common areas, and power washing. It should also be noted that larger (meaning more expensive) maintenance activities may need to be handled on a less frequent basis. These could include things like replacing a roof or resurfacing a parking lot. These activities are designed to keep a property in good operating order and to preserve its value over time.
- Other Costs: This bucket includes costs that are necessary to maintain high occupancy levels. They are unique to each property and may occur infrequently, but they could include things like admin expenses or legal and collection costs.
- Debt Service: Most commercial real estate is financed with some amount of debt that has to be repaid to the lender over time. The exact amount of the commercial mortgage payment depends on the borrower requested amount, interest rate, closing costs, sale price, and loan term. This is a cost that is typically incurred monthly.
In most cases, these costs are paid by the property owner and, depending on the lease arrangement with their tenants, some or all may be reimbursed as part of the tenant’s monthly payment.
Calculating Carrying Costs
When performing pre-investment due diligence, there are two ways that carrying costs can be calculated.
The first is by examining a property’s historical operating statements. They can provide important context for what a property’s carrying costs look like, but it doesn’t mean they are necessarily right. For example, property taxes usually go up when a property is sold or a new owner may choose to invest more heavily in routine maintenance activities. Historical performance can point investors in the right direction for carrying costs, but they shouldn’t be relied upon alone.
The second method is through experience, best practices, and comparable properties in the market. Each of the above holding costs typically fall within a somewhat normalized range, which can be used to make an educated estimate of each line item. For example, property management fees are usually 3% – 10% of gross income. If an operating statement shows something significantly different than this, say 15%, the final calculation may be “normalized” to bring this item in line with industry standards.
The big takeaway here is that there is no “right” way to calculate carrying costs when creating a commercial rental property proforma. Instead, potential investors should review historical operating statements, comparable properties, and industry standards and use all of these sources as inputs into the final calculation for each line item.
Why Carrying Costs Matter
Commercial property values are based on the amount of net operating income produced. Net operating income is calculated as gross income less operating expenses/carrying costs. So, carrying costs matter because they can have a material impact on a property’s value.
To illustrate this point, suppose that an investor is considering the purchase of a retail center. Based on their calculations, they believe the property produces $100,000 in gross income and will have $40,000 in operating expenses. As a result, the calculated net operating income is $60,000. At a 8% cap rate, this property has an estimated value of $750,000.
Now assume that this same investor purchases the property on the belief that operating expenses are $40,000. But, after they have operated it for a year, they come to realize that actual operating expenses are $50,000, which means that net operating income is reduced to $50,000. At the same 8% cap rate, the property’s value is reduced to $625,000.
So, the bottom line on this point is that carrying costs play an important role in determining a property’s market value. Getting them wrong in the real estate due diligence process can result in lower than expected return on investment after a property is purchased.
Carrying Costs & Private Equity Real Estate
Calculating the carrying costs of a commercial property prior to purchase is both an art and a science. Doing it accurately requires years of experience, specialized expertise, and dozens of deal repetitions. It also requires detailed knowledge of local markets and the software tools to identify costs for comparable properties. For individual investors, it can be tough to have all of these.
As a result, it can be beneficial for individual investors to partner with a private equity firm when making a commercial real estate investment. Doing so means that the private equity firm will do all of the hard work of finding a property and calculating its carrying costs while all the investor has to do is to provide capital.
This type of partnership can be beneficial for both parties because it allows investors to gain a fractional ownership of institutional grade assets while the private equity firm is able to gain capital to close deals.
Summary & Conclusion
Carrying costs are the post-purchase expenses required to fund the day to day operations of a commercial property.
Examples of common carrying costs include things like: property taxes, insurance, maintenance, property management, and admin costs.
A property’s carrying costs are a major component in the calculation of its net operating income / cash flow, which guides a property’s value.
As such, an inaccurate estimate of a property’s carrying costs can add up over time and cause lower than expected investment returns.
For individual commercial real estate investors, it can be helpful to partner with a private equity firm because they can bring their experience, expertise, and resources to the carrying cost calculation, which can maximize the chances for a positive return.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
