Shopping Center Investing 101: Maximize Value With Multiple Income Streams

  📍 📍 Hey everybody , Joseph Gozlan with Eureka Business Group, and today we’re continuing our series about investing in shopping center.

Our focus today will be understanding and analyzing income stream for the shopping center. In our previous videos, we covered how to determine the value of a shopping center and how to analyze the locations and the markets. And everything about. Now we’re doing a little bit more of a deep dive into the actual shopping center. We’re looking at what do we look for? What are we asking the potential seller?

What are we looking in a package from a broker? And how do we translate that into an underwriting that help us put a value on the shopping center.

When we talk about shopping center investments, we need to understand that not all income is created equal. There are multiple streams of income that contribute to your total revenue, and we’re going to look at all those different ones, and try to figure out how we underwrite that, how do we understand the different income streams, and what’s important to pay attention to.

The first thing obviously we’re going to look at is the base rent. Every lease has a base rent. In shopping centers, it’s usually measured or quoted in a price per square foot per year, which means if I have a space that I’m leasing and the rate is $25 per square foot, let’s say the space is 2000 square foot in size,

that means the tenant is generating $50, 000 in base rent revenue every year for the shopping center. This is the most stable and predictable income revenue stream that you’re going to have in your shopping center.

And this is the first number we’re going to put into our underwriting.

One thing to understand about base rent is that not every space in my shopping center is going to have the exact same rent. Even though they’re right next to each other, it’s the same street address, it’s the same building. What determines the difference in our shopping center’s base rent across the different spaces is a few factors.

The first factor is usually, who’s the tenant? Who are we negotiating with? Am I negotiating with John’s Pizza, which is a local owner, or am I negotiating against McDonald’s? Bigger tenant, National credit, the more leverage they have in the negotiation, that usually means that they’re going to be able to negotiate either a better rate or a better term for their lease in terms of T. I. Budget. We’ll talk about that a little bit later in the expense side of things. So is it a national tenant? Is it a local tenant? Big difference. Another thing that changes the rates within the shopping center would be the location of the space within the shopping center. An end cap unit, a unit that has a drive thru at the end of the building.

It’s going to probably command a higher rent per square foot than the unit that is in line, or worse, the elbow of an L shaped shopping center. We talked about that in previous videos. All of these things are a factor that changes the price per square foot that I’m going to be able to extract from a specific space.

Another factor that kind of helps us with determining price per square foot usually is the length of term. If it’s a local tenant, they usually wouldn’t want to sign a longer lease. They would want like a three year lease. Versus if somebody comes in and takes a five year lease, they expect a little bit of a lower price per square foot because they commit to a longer term with us.

And obviously everything else in real estate, the market conditions are going to determine what we’re looking at in terms of price per square foot. We can’t ask for a million dollars per square foot when everybody else is asking for $15 per square foot. So the market condition around us are going to determine what is the base rent we can charge per square foot for a specific shopping center in a specific area.

Another thing that relates to the market condition and we mentioned that in previous videos before is that we have to compare the in place current rates that the current tenants are paying in the shopping center to what the market conditions are. If we are Looking at a specific shopping center and the rents over there are below market, which means the actual rent base rent is below what the market around us commands.

That’s an opportunity. That’s what we call a value add. We can come in and as those leases get to renewal, we’ll be able to potentially increase the rent to market rate and increase the NOI, which in turn increases the property value. However, the other side of that equation is if the current rents are higher than market rates, that is a potential risk.

It means that when we’re getting to renewal, That tenant might want to back out, might want to leave to a cheaper place, or the tenant might be able to leverage that against you in negotiation during renewal, threatening to leave if they don’t get a lower rent that matches market.

So definitely have to pay attention to what the current market rates are compared to what the actual rates in the shopping centers are.

The next revenue stream We’re gonna look at is percentage rent. Usually more common in malls and big outlets shopping centers.

Some retail leases, particularly common also in restaurants and high volume tenants, include something that’s called a percent range clause. What does that mean? It means that the tenant pays a percentage of their gross sales once they reach a certain threshold. For example, I have a restaurant in my shopping center.

It’s a high volume restaurant. They do a lot of sales. They do a lot of transactions. And I can put a clause in their lease that says, Every dollar that is beyond a million dollars a year, I get 5 percent out of it. That is a great way to add income to your shopping center, especially if your shopping center is a very attractive in terms of location, traffic, and so on.

And that restaurant really wants to be there, then you can put that in the clause. The downside of a percentage rent is you got to make sure that the rent is not heavily relying On that percentage rate. If the market rate in that area is $40 per square foot and the rent is $20 and you get a high percentage, it’s a gamble.

It’s a risk. You can’t assume that this restaurant or this tenant is going to be outperforming the market all the time, that they’re going to be great performance all the time Because economies might shift there might be a downturns people opinions and trends are changing What could be a hot restaurant today could be a dead thing tomorrow just because the trends have changed and the last thing is operational.

Sometimes businesses get into some operational downside. Sometimes there is loss of people, loss of processes, changes in personnel that causes the business to not perform as well as they usually do, and that comes back to hit you. So just the rule of thumb, look at percent rent as a bonus, not as something that you should underwrite as guaranteed.

Another very common income stream is the expense reimbursement. This is where shopping centers and retail really shine as an investment. That’s why we love it so much. We tell all of our investors, you can spell triple net TTR. Transfer the risk.

  📍 📍 Unlike any other real estate classes, retail properties typically pass most of their operational expenses back to the tenant through what we just mentioned, triple net leases.

  📍 📍 Sometimes you will see triple net spelled NNN, and that’s what triple net is: net net net.

  📍 📍 And what does that include? The first N represents property taxes, the second N represents the property insurance, and the third N represents CAM, or common area maintenance.

In a true triple net scenario, these expenses are fully passed on to the tenant based on their proportional rate of square footage. So if I have a 10, 000 square foot building and I have five tenants and each one of them takes 2000 square foot, then they’re each pay a fifth of the total expenses.

So the first in property taxes is pretty easy to understand. The second in insurance also pretty easy to understand. The third one called C.A.M. Common area maintenance is a little bit more complicated. And this is where you have to pay attention to the actual leases and what they say for that particular property you’re underwriting.

Usually we will see. parking lot, maintenance, exterior lights, landscaping, common area utilities. So the parking lot lights the electricity bill for those ,security, if you have in your shopping center security, property management fees, administrative fees, accounting fees, all of these things are typically falling into the common area maintenance.

However, Every landlord might have a different lease and every lease might list different things under what’s considered common area maintenance. So it’s very important to pay attention because you might make a wrong assumption that a certain expense would be passed through, and it’s not in that particular shopping center case.

So always pay attention to these things.

If you’re looking at standard contracts, a lot of them will allow a administrative fee on top of all the other expenses. Normally no more than 10% off of the total cam expenses. So that can be a little add on and a really nice increase to your NOI that does not require a lot of effort on the ownership side of things.

So those were the main income streams that we have in a shopping center. Now let’s talk about additional small ancillary income streams that can be added to your shopping center depending on that specific property.

So things that we commonly see as an additional income streams in shopping centers can be, billboards. That is on the property or a pylon sign lease or a cell tower. If there’s a cell tower at the back of the property, that cell company is paying rent without really consuming a lot of resources. ATM placement fees, vending machine, those big ice and water dispensing machines that you can put in the parking lot.

Those are good money makers because all they need is a little bit of electricity and a water line. And they’re literally selling water, which is cents on a gallon, but they’re charging dollars. So great income stream. Electric vehicle charging station that’s been very common recently, and you can charge for the actual electricity that they’re consuming or what is very common.

Recently, we’ve seen there are third party companies that tell you we will put our machines on your parking lot and you’ll get to participate as a percentage of the income that they generate that saves the landlord from the initial expense of buying the charging machine installing it and all the costs that is involved with that.

But they still get to participate in some of the income that comes from people charging their vehicles on your property. In some urban locations, you can charge parking fees. If you have a parking garage or something like that, you can host events like a farmer’s market on a holiday or on a weekend and charge the vendors , just rent for the day.

A lot of the times we can leverage a vacant space during the holiday season for a popup. Maybe it’s a Halloween store or something like that, that you can leverage a vacant space and make a little bit more money during that time that it’s vacant.

You might be asking yourself, why should I bother myself with all those little things, ancillary income, it might must be more headache than it’s worth the money, but this is where commercial real estate. Is awesome, right? This is where we make most of the value is in picking up all those little things and adding the dollars up.

’cause you have to look at the big picture. Every $1,000 a month that I add to my income, to my net operating income, to my NOI at a six cap,

means I added $20,000 value to my shopping center.

So this is where you have to look at all those little opportunities and make sure that you or your property management company is leveraging all those opportunities to make the most out of your shopping center and get you the highest NOI possible.

So now that we talked about all the potential income streams, let’s talk about underwriting and projecting because when we do an underwriting, usually we’ll project three, five, 10 years forward in order to see When am I going to break even? When am I going to get my money back? And when am I going to start making money and increasing the value of the property?

So let’s review back the income streams we talked about. Base rent was the first one. The current leases in the shopping center that I’m underwriting are going to have rent growth built into them.

Some of them will have annual rent increases. Some of them will have, 10 percent every five years. Some of them will have no rent increases, but a renewal coming up soon that will allow you to increase the rent. So we’ve got to look at those exit points, those turnover points that allows us to increase the NOI, whether it’s through the existing contract or through renewals. We’re also going to look at vacancy and collection losses. What does that mean? No shopping centers that I’ve seen is operating at a hundred percent collection efficiency all the time, every day for decades. There’s going to be some hiccups. There’s going to be some economy downturns. There’s going to be some challenges to the local businesses.

So the smart investors are going to underwrite for some vacancy. And between tenants in retail, you’re going to have at least three to months of vacancy that’s common, especially in secondary markets or in less hot areas. And that’s something that you want to underwrite. Look at your lease renewal dates, and plan for some vacancy if that tenant moves out. Another thing that we’re looking at is collection losses. Sometimes we have tenants that are small business owners, or even big retailers sometimes have little struggles, and they need extensions, or they need deference of some rent, and that is going to be a collection loss that you’re going to have to account for.

And then the last thing we have to account for in the concession losses and so on is renewal concessions. Sometimes I get into a renewal negotiation and in order to keep a tenant for another period, I might have to give them some concession. It could be in the form of a drop in rent. It could be a free rent.

It could be some TI budget to refresh the store. Could be a lot of things. And that would be counted is as a loss of income or as a concession in my underwriting.

So overall to be conservative in your underwriting, I would put anywhere between five and 10 percent of the vacancy and collection loss bucket. And it really depends on the market, right? If you’re in a super hot, super urban high end area and everything is a hundred percent occupied all the time, can go on the lower end of things.

If it’s an area where Everybody’s about six, seven, 8 percent vacant. Then I would go on the higher end towards the 10 percent really understanding the market and working with a professional that can help you really know what everybody else is doing is going to be very beneficial for your underwriting. Another thing to look at when you’re underwriting is the potential tenant turnover. When a tenant moves out, you’re most likely going to look at some loss of rent during that period. Remember, we said six to eight months. the market you’re in, you’re looking at commission to brokers that are going to come in and lease the property for you.

You’re looking at a potential TI budget that you’re going to have to offer to the next tenant and obviously some legal fees for the contract negotiation and when it’s done. If it’s a smaller space, local tenant, probably you can get away with a standard form. If it’s a bigger tenant or a national brand, then you’re going to have to probably have an attorney help you out through the contract They’re gonna have an army of attorneys running the contract.

So very important to look at these things and budget for tenant turnover. A good rule of thumb for the T. I. Budget because a lot of people ask me about what should I budget for T. I.

It’s a big

range, but normally, at least in the D. F. W. Market, what we see is about $10 to $50 per square foot of a T. I. Budget depending on the condition of the space and the kind of tenant you’re working with. If it’s a tenant that need a very complicated structure inside, It’s going to cost a lot to build the space for them. The TI budget is going to probably going to be on the higher end.

If it’s a very simple thing, probably on the lower end, but most of the time we see somewhere between $10-$50 per square foot.

So now let’s talk about common pitfalls. We see when people do underwriting and analysis of a shopping center. This happens a lot with first time owners, and it happens a lot with inexperienced underwriters but even the most sophisticated underwriters might miss something. So let’s talk about those common mistakes. The first thing is overestimating occupancy. We talked about what the average occupancy is going to be in the market. But remember that the broker that created that package for the property for sale.

He’s going to be very optimistic. He’s going to put those proforma numbers that represent best case scenarios. So even if the entire market is at a hundred percent occupancy, I wouldn’t underwrite for a hundred percent occupancy ever. Make sure that you don’t fall into those things and look for what is the right thing for you.

What is the right number to put for vacancy for that shopping center, but that area at that time. Another mistake we see is ignoring the tenant health. Your shopping center that you’re looking and underwriting might be 95 percent occupied on paper, but if several of the tenants are struggling, if they’re behind on rent, if the effective economic occupancy of the property is lower than what the paper says, this is things that we have to look for.

What are those signs that can help us understand that? Consistently late on payments, and we can see that during due diligence, looking at bank statement, looking at the records of the property management company, declining store conditions. Is it run down? Is it chaotic? Is it messy inside?

Looking for reduced operating hours. If they usually open nine to five or nine to seven, and now they’re only opening until 2 p. m. or 3 p. m., that could be a red flag. Employee turnover, a constant employee turnover, is a red flag. Some industries have a natural higher turnover in their employees, but you can always tell when it’s more than average.

Another mistake people do in their underwriting is assuming that all the expenses are going to be recoverable. Remember what I said earlier, the details are in the leases. We have to actually read the lease and read the terms and understand what is recoverable and what is not going to be recoverable.

And read every single lease because just because I saw one or two leases doesn’t mean all the tenants in the shopping center have the same lease. They had leases during different periods. If I signed a lease with a tenant eight years ago and they’re on their second five year extension period, they still Have the original lease from 10 years ago or eight years ago, and it might not be the same lease that was signed six years ago or two years ago or yesterday with the new tenant.

So read every single lease for every single space and understand what is recoverable and what is not recoverable. Sometimes, especially with the larger tenants, we will see a cap on cam charges increases, which means you cannot increase the cam to the full extent.

You can only increase it to that level, that threshold that is in the least, let’s say 5%, 10 percent increase. We’ve seen that you’ve got to know that you’ve got to understand that. And you’ve got to put it into your underwriting. Another mistake, which I already mentioned earlier, is relying too heavily on a percent rent.

Just because you have a percent rent tenant doesn’t mean that this is a guaranteed income. It’s a bonus. It should not be counted for your stress testing on the shopping center underwriting. Another huge mistake we see is ignoring the tenant mix. Sometimes landlords, especially as they gear up for a sale, they will put anybody that will take the space and they’ll put them in there, ignoring the tenant mix. A good shopping center is going to have a Even tenant mix.

They’re going to have a symbiotic tenant mix, which means having two pizza shops at the shopping center is not a good idea. Having two sandwich shops is not a good idea. Having two barbershops, not a good idea. Why? Because all these businesses are going to compete with each other, going to cannibalize on each other, and they’re both going to end up losing, and the bigger loser is going to be the shopping center owner.

So finding the right tenant mix. Symbiotic relationships, if I have a couple of restaurants, having a dessert place is great. This is the kind of things that we want to see, we want to see. Tenants in the shopping center that have the same kind of clientele because if I come over here, I can go to the next door in the next door because they all cater to my needs as a client and that’s a great tenant mix.

So ignoring the tenant mix is a mistake that we see happening often.

So most retail owners are going to look for opportunities for value add, right? How can I take this asset that I’m buying and make it better? How can I increase the value of my property so I can get more money? I can get more cashflow or I can get more equity built into my property. The first and most obvious one is the rental rate increase. Can I increase rent? Whether I have month to month leases whether I have nearby renewals like they’re gonna renew in a few months at the end of the year next year and so on and that’s going to help me understand. Can I increase the value of the property over the next few years?

The next opportunity to increase the value of your shopping center is by optimizing your tenant mix. I know you heard me talk about that multiple times in multiple videos, but it’s really important.

Putting the right mixture of tenants in the shopping center is critical for not only longevity, but also increasing value and making your shopping center more attractive. If your shopping center is more attractive. Then people will pay more per square foot for rent because they want to be in that environment. If I can get a national brand tenant that drives a lot of traffic into the corner unit, then I can charge more rent for the inline from a local tenant that want to be next to that national retail brand. So it’s very important to pay attention to the tenant mix so you can maximize your shopping center attractiveness and thus increase the value of the shopping center and the rents you can get for every space.

Sometimes I have to remind people that NOI net operating income has two sides. It’s not just about increasing rent.

Sometimes it’s about decreasing our expenses and doing a tighter expense management. There’s a lot of ways to decrease your expenses at the shopping center. And I hear people tell me, I don’t care what my expenses are. I got triple net leases. I pass it on all to the tenant. Two things about that. One, remember not everything gets passed on to the tenant. And two, if I can decrease my expenses, And the triple net portion of the lease is lower.

My tenants have better chances of being successful. They have more margin in their business because they pay less for their rent. And it turns my vacant spaces more attractive because if everybody pays the same base rent of, let’s say, $20 per square foot, But the other shopping center is charging $12 for triple net and I’m charging $6 for triple net.

My shopping center is a lot more attractive than the other one with everything else being the same. So how do we decrease expenses in a shopping center? We’re looking at. Energy efficient lighting. We’re looking at water conservation. We’re looking at renegotiating the waste management contract, the cleaning, the landscaping smarter irrigation systems, smarter lighting that are photocell and not timer based and so on.

There’s a lot of ways to look at how can I decrease the expenses in order to make my shopping center more stable, my shopping center tenants more successful. And my shopping center vacancy more attractive because the triple net charges are lower on my shopping center that also include, by the way, renegotiating your insurance policy or shopping it around every year and protesting your taxes in a state in states like Texas, where it’s a nondisclosure state and we can protest the taxes every year. Another interesting way to look at value add opportunities in a shopping center is space reconfiguration. Space reconfiguration basically means I can take a large space and cut it into two. I can take two small spaces and put it into one. Maybe I can add a drive through at the end of the building so that corner unit is going to be more attractive.

There’s going to be a lot of ways to reconfigure space To find the optimized size and the optimized amenities to a potential tenant and make more money. Remember, two smaller spaces, just like in apartments, two one bedroom apartments can make more rent a month than one two bedroom apartment. Same thing with retail.

If I can have two smaller spaces, I can make more per square foot for those spaces than a bigger unit. Cases where your shopping center have extra land or A lot of parking spaces, you might be able to leverage that into adding an out parcel and out parcel is, let’s say I have a grocery store anchored shopping center. A lot of land, a lot of space. I can put a another building at the corner with a McDonald’s or a Starbucks or something like that.

That is a small footprint with a drive through At the corner of the shopping center.

Okay. So we covered a lot of ground today. So just to recap, right? Understanding the income stream is fundamental to a good underwriting. You got to know what you’re buying into and what it can and cannot become. And that’s why we’re focused on these things. In the near future. We’re going to create a template for underwriting shopping centers, and we’re going to share that with everybody.

So stay tuned, subscribe to our channel so you can get that.

And like I said, it’s super important to thoroughly analyze and each revenue source and each potential expense that you’re going to have and how to optimize the combination off. So you know why will increase.

In our next video. We’re going to dive a little bit deeper into understanding and analyzing the expense side of things, the expenses of a shopping center and how we can really optimize that as well. So let’s go. Make sure to stay tuned and look at our next videos in the series. So if you have any questions about the video today or any questions about underwriting shopping centers, feel free to reach out to us.

You can email us so you can leave a comment below and we’ll be happy to answer your questions. I’m Joseph Gozlan from Eureka Business Group, your Retail Navigator for the Dallas Fort Worth market, and we’ll be seeing you in the next video.