The rental market is the lifeblood of commercial properties. It’s the top line that affects Net Operating Income (NOI) and the main source of annual cashflow to investors. Understanding how rents are priced, why they trend up or down, and how to reasonably predict those trends, is therefore an important when analyzing real estate investments.
Recall, the rental market consists of property owners, on the supply side, and tenants, on the demand side. The dynamics between them result contribute in large part to rent and occupancy levels.
Rent is the price granting the right to occupy or use a space for a predetermined period of time, often quoted on an annual basis in terms of square footage. Knowledge of the rental price for a particular property can give an idea of the supply and demand to which that property is subject.
Rent isn’t fixed. It fluctuates based on market conditions. In general, higher rental prices translate to lower supplies and higher demands. Likewise, lower prices indicate higher supplies and lower demands.
In other words, we can specifically say that vacancy rates are a key determinant in the pricing of rents, and also a measurement of the health of a property. Lower vacancy correlates to higher demand and higher pressure on rents, and vice versa.
When gauging vacancy levels, these rules of thumb are generally true:
- A market vacancy of less than 5% or 10% is generally considered a tight market,
- Between 10% and 15% is a moderate market, and
- Vacancy above 15% signifies a weaker market.
Although each product type’s typical vacancy levels can vary.
Net absorption is another key measurement of market strength. Net absorption is the rate at which available space is rented (or vacated) over time. In other words, it signifies market momentum. When net absorption is positive, more tenants are leasing space than vacating it, and vice versa.
The net absorption rate and vacancy rates also indicate how long it will take to re-release a building if a tenant vacates. If the net absorption is positive and vacancy rates are low, available space leases back up in shorter periods of time.
Lease Structures and Rent Fluctuations
Tenants of commercial properties contractually lease properties for pre-determined periods of time. The typical lease structures for various asset classes are as follows:
- Multi-family – 6 months to 1 year.
- Office – 3 to 5 years for smaller suites and 7 to 10+ years for larger suites.
- Retail – 3 to 5 years for inline space and 10+ years for anchors and pad locations.
- Industrial Distribution – 5 to 10+ years.
The fact that tenants are under contractual obligation to pay rent for fixed periods of time helps to mitigate the impact of market fluctuations on NOI and cashflow.
Contractual obligations notwithstanding, tenant credit is still important in determining the risk of inherent in the income stream of an asset. If a tenant goes out of business and leaves prematurely, this will cut into NOI. Therefore, knowing the quality of tenants’ credit aids in analysing an asset’s risk. For example, leasing to Apple, Inc. carries significantly less risk than leasing to a local “Mom & Pop” venture.
When an asset is acquired, there is the possibility for the rent to either increase or decrease, and for tenants to move in or leave. Investors analyze these probabilities based on vacancy rates, net absorption, and determining the quality of tenant credit, as discussed above.
An additional tool that aids in analysing opportunities or risk is lease comparables(or lease comps), which compares the current rent being paid to market rent. For example, if the current rent being paid is $50 per square foot annually, but market rent for comparable properties is $65 per square foot, could indicate the potential for rental price increases and therefore increased NOI and cashflow to investors (the reverse is also true as well).
Lastly, when analyzing the real estate market, a key fact to keep in mind is that the market is not homogenous. Rents and property value are not the same from one city to the next, or even from one block to the next.
Instead, Real estate is segmented, along property usage type, on the one hand, and location, on the other. Accordingly, supply and demand always correspond to particular types of property in specific locations.
Examples of property types include office, industrial, retail, and multifamily residential. Locations refer not only to metropolitan statistical areas (MSAs), but submarkets attached to MSAs, for instance downtown areas or central business districts (CBDs) and suburban areas.
In effect, rental prices vary according to type and location. 5,000SF (square feet) of Office space in central business district (CBD) of the metropolitan statistical area (MSA) of San Francisco will not be equivalent to 5,000SF of office space in the suburbs of Chicago. Different market and microeconomic forces ensure that demand varies from one segment to another, leading to differing levels of supply, demand, and rental prices.