The business plan for a commercial property investment is straightforward. An investment property is purchased for a certain amount of money up front and it produces returns from the income earned by renting space to commercial tenants. That income is used to pay for the property’s operating expenses and debt service. If there is anything left over, it is distributed to the owner(s).
To project potential returns from these distributions, commercial real estate investors typically put together a proforma that projects income and expenses over the duration of the planned investment holding period. One of the most important line items on the proforma is Gross Rental Income.
In this article, we discuss Gross Rental Income in commercial property investing. In doing so, we describe what it is, how it is calculated, and why it is important in the creation of a commercial property proforma. By the end, readers will have a thorough understanding of this metric and will be able to incorporate it into their pre-investment due diligence process.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. As part of our own pre-investment due diligence process, we allocate a significant amount of resources into accurately projecting Gross Rental Income for all of our potential acquisitions. If you are an Accredited Investor, click here to learn more about our current investment opportunities.
What is Gross Rental Income?
As its name suggests, Gross Rental Income is the total amount of money produced by rents and rental activity. It is easiest to think about this in two parts: rent and other fees.
How is Gross Rental Income Calculated?
Income derived from rents is the aggregate of tenant monthly rent payments. For example, if a property has five tenants, each of whom pay $2,000 per month, the total rental income is equal to $10,000.
The other portion of gross rental income may be more difficult to calculate. According to the IRS, “…rental income is any payment you receive for the use or occupation of property.” Put another way, Gross Rental Income could also include funds paid by the tenant that aren’t included in the contractual rent. For example, other income could come from parking fees, pet rent, or common area maintenance (CAM) reimbursements like property taxes and insurance.
So, the combination of rental income and other fees sums to Gross Rental Income.
Why is Gross Rental Income Important?
Commercial properties are valued based on the amount of Net Operating Income (NOI) they produce. So, Gross Rental Income is important because it is one of the inputs into the Net Operating Income calculation. The other is operating expenses like taxes, insurance, maintenance, property management, and admin.
Net Operating Income is calculated as Gross Rental Income less operating expenses and it is a key metric evaluated by real estate investors when trying to determine if they would like to proceed with a purchase or not.
There are a number of factors that go into modeling Gross Rental Income/Net Operating Income and one of the most important is the type of lease a tenant signs. This knowledge will help investors determine what amounts are included in Rental Income and which additional expenses are backed out of it.
Gross Rental Income, Net Operating Income, and Lease Structures
In commercial real estate, there are generally two types of commercial leases, gross and net.
In a gross lease agreement, tenants make one monthly rental payment each month and it covers all aspects of the tenant’s share of operating expenses. As a result, it tends to be higher on a per square foot basis because the property owner uses this income to pay for the property’s operating and maintenance expenses. Many tenants prefer this arrangement because it is cleaner, simpler, and easier to budget for. But, much of the administrative responsibility for tracking and paying operating expenses falls on the property owner. For this reason, they may prefer to encourage tenants to sign a net lease.
A net lease is the opposite of a gross lease. In it, a tenant’s monthly rental amount is a bit more complicated. They pay a base rent plus their proportionate share of the operating expenses. The exact amount depends on the type of net lease signed. There are four:
- Single Net Lease: Tenant pays rent plus their share of one major operating expense category – usually property taxes.
- Double Net Lease: Tenant pays base rent plus their share of two major operating expense categories – usually property taxes and insurance.
- Triple Net Lease: Sometimes called an “NNN lease”, the tenant pays base rent plus their share of three major operating cost categories – property taxes, insurance, and maintenance.
- Absolute Net Lease: Tenant pays base rent plus all operating and maintenance costs for the property.
In some ways, the net lease structure is a win/win for both the tenant and the property owner. Tenants like it because their base rent is lower and it gives them some semblance of operational control over the property. Landlords like them because it is far less administratively cumbersome.
How FNRP Uses Gross Rental Income Calculations
As described above, the most important use of the Gross Rental Income calculation is as part of the pre-investment due diligence process because it helps in the construction of a proforma and the calculation of the return metrics that come with it. With this in mind, here is how we use Gross Rental Income as part of our own investment decision making process.
When evaluating a potential commercial property investment, the first thing we do is to review the existing commercial lease agreements for key components like: the lease term, lease rate, the lease type (full service gross lease, modified gross, triple net, etc.), and what the tenant’s pro-rata share of building expenses is. In addition, we will look to see if there are any other payments due under the terms of the lease like those associated with reimbursement for utility costs, parking, or building insurance. In most cases, this extra portion of the payment is either a percentage of rent, a flat fee, or a pro rata share of the total operating expenses.
Next, we use this information to construct our pro forma financial model of the investment. Typically, we try to project income and expenses over a 10-year holding period. So, we use the Gross Income Calculation along with property expenses to get to Net Operating Income for each of the 10 years.
Then, using net operating income and some other figures, we calculate a number of real estate investment return metrics like equity multiple, IRR, and cash on cash return over a range of economic scenarios. Typically, we start with a “base case” which is our initial projection and complement it with cases that incorporate best and worst case scenarios.
Finally, we use these return metrics to work with lenders and potential investors to secure financing for the acquisition.
Summary of Gross Rental Income
Gross Rental Income is a metric that represents all income received in a commercial property. It is calculated as total rental income plus other income received from things like pet rent, parking fees, or CAM reimbursements.
Gross Income is important because it is a key element of a property’s real estate proforma – which is a projection of income and expenses over the investment holding period. The proforma is used to calculate potential returns.
When creating the proforma, it is imperative to understand the commercial real estate lease structure for existing and future leases and there are two, gross and net.
We always calculate Gross Rental Income as part of our pre-investment due diligence process and it is a major factor in our decision to proceed with a purchase or not.
Want To Learn More About Commercial Real Estate?
First National Realty Partners is one of the leading private equity commercial real estate investment firms in the United States. We leverage decades of expertise to find world-class, multi-tenanted assets available 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 investment opportunities, contact FNRP at (800) 605-4966 or info@fnrpusa.com.
