In commercial real estate properties, tenants typically pay rent based on the price per square foot of space they are allotted. But, not all square footage is the same. Tenants often pay rent on space that they cannot use for normal occupancy, such as common areas, bathrooms, and shared storage spaces. A real estate concept known as “load factor” helps real estate investors and property management companies understand how much of the rent is allocated to square footage that can be used for normal occupancy versus how much cannot.
In this article, we’ll explain what is load factor in commercial real estate, how it affects CRE investments, how to calculate load factor, and other helpful information for investors to understand.
What is Load Factor in Commercial Real Estate?
In commercial real estate (CRE), load factor is defined as the ratio of total rentable space in a commercial property to the total amount of usable space. Regardless of asset class, load factor helps tenants understand how much space they are paying rent on versus how much space they can actually use in the course of daily business. Load factor also helps real estate investors evaluate investment property, and it often comes into play during the due diligence process before a transaction closes.
How Does Load Factor Affect CRE Investments?
Before purchasing an investment property, real estate investors typically perform due diligence and analyze the expected cash flow to estimate the value of the property and the cap rate. Calculating the load factor helps investors understand how much square footage will produce rental income.
It is important to understand that rental income is calculated on a per square foot basis in commercial real estate. For instance, if an office building has 10,000 square feet of rentable space and if the space rents at $3.00 per square foot per month, then the property would be expected to generate monthly rental income of $30,000. It is fair to say that the square footage has a direct correlation to the property valuation.
How to Calculate Load Factor
The load factor is calculated as the amount of rentable square feet divided by the amount of usable square feet. For example, if an office building has 10,000 square feet of rentable space but only 8,000 square feet of usable office space, the load factor would be 1.25 (10,000/8,000).
A higher load factor ratio means that the tenant is paying rent on more space that they cannot use solely for their occupancy. Instead, a higher portion of their rent is being allocated to space shared with other tenants – things like common areas, shared bathrooms, and shared storage space.
Rentable vs. Usable Square Footage
For purposes of commercial real estate investments, it is important to understand the difference between rentable space and usable space. These terms, which we explore in more detail below, apply to all commercial real estate property types, including office buildings, shopping centers, other retail space, and even apartment buildings or multifamily properties in residential real estate.
Rentable Square Footage
Rentable space includes the square footage that the tenant can use for normal occupancy purposes as well as shared space that is not used strictly by any one tenant. It is important for property owners to understand that lease terms, especially the per square foot rental rate, are based on the rentable square footage. In other words, tenants pay for the space they occupy plus space they share with other tenants.
Usable Square Footage
Usable square footage includes only the portion of the space that is dedicated entirely to one tenant. Prospective tenants should be careful to do due diligence to understand how much of the space they are paying rent on is actually usable solely by them. Also, tenants may benefit from doing market research to understand how much usable square footage they might be allotted across different types of commercial real estate because this is ultimately what they are able to use to run their business, hold employees, or entertain clients.
An Example of Rentable vs. Usable Square Footage
Let’s assume that we are an investor looking at two investment options in the local real estate market. The first investment opportunity is a class A commercial rental property with 10,000 square feet of rentable space. The common area is relatively small at 1,000 square feet, so that leaves 9,000 square feet of usable space. The second commercial real estate investment opportunity is another Class A property that happens to also have 10,000 square feet of rentable space. The difference is that the second property has a large common area of 4,000 square feet, leaving only 6,000 square feet of usable space for tenants. From market research we know that the going rent in the area is $7.00 per square foot per month.
Both properties command the same monthly rental income of $70,000 ($10,000 x $7.00). However, the important consideration is that the first property offers much more usable space (9,000 square feet) compared to the second (only 4,000 square feet). Because of this difference, our investor should think about the real estate investment strategy from the tenant’s standpoint. The tenants in the second property will pay considerably more per square foot of usable space ($11.67 per square foot) than the tenants in the first property ($7.78 per square foot). The second property is not necessarily a worse investment, but when building an investment portfolio it is important to consider whether the load factors will attract the right tenants.
Loss Factor vs. Load Factor
Loss factor and load factor are related concepts in commercial real estate. Loss factor is defined as the percentage difference between rentable space and usable space. Loss factor is calculated as rentable square footage minus usable square footage divided by rentable square footage.
For example, imagine a property with 10,000 square feet of rentable space and 8,000 square feet of usable space has a loss factor of 20% ((10,000 – 8,000)/10,000). This means that 20% of the square footage that the tenant pays rent on is some sort of shared space or common area and cannot be used solely by the tenant.
It is worth noting that many landlords do not disclose loss factors, so it falls on the tenant or prospective real estate investor to estimate this figure as part of the due diligence process.
Load Factor & Private Equity Real Estate Investments
The private equity real estate investment space is made up of real estate investment trusts (REITs) and real estate partnerships that seek to generate passive income for their investors. Along with other factors like vacancy rates, zoning, and depreciation, these real estate investment firms consider the load factor of each property they purchase.
In certain applications, a high load factor might be beneficial, while in other scenarios it might be viewed as a negative. This depends on how the property will be used and what types of tenants rent the space.
It is also important for these investment firms to consider flexibility to allow for future changes in tenant preferences. For example, in the short-term tenants might prefer a property with lots of common space to allow customers to gather in a public setting. Over time, this might change and customers and tenants might not value the shared space. Sophisticated investors are good at considering options for future changes to the property that would alter the load factor to better accommodate market preferences.
Summary of Load Factor in Commercial Real Estate
Load factor is defined as the ratio of total rentable space in a commercial property to the total amount of usable space. This concept is important because it helps tenants, landlords, and property management firms understand how much of the total space in a property is usable only by the tenants paying the rent and how much of the space is shared.
Load factor is considered and estimated by tenants before signing a lease and by investors before purchasing a property. Both are trying to figure out where the rent payments are allocated. They are also considering whether the property is a good fit for the use they envision. Sometimes shared space or common area is viewed as a positive and other times it is viewed as a negative. Load factor helps to quantify where a property stands in this regard.
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