Real Estate Modeling 101: Capital Costs
The Pro-Forma: CapEx, Tenant Improvements, and Commissions
Capital costs refer to long-term investments that provide lasting benefits over multiple years. These costs fall into three primary categories: Capital Expenditures (CapEx), Tenant Improvements (TIs), and Leasing Commissions (LCs).
In simpler pro-formas, these costs are grouped under a single line item (e.g., "CapEx, TIs, and LCs"). However, in more detailed models, each category is calculated and displayed separately.
Capital Expenditures (CapEx)
CapEx covers property-wide improvements not specific to any tenant, such as new roofs, elevators, or HVAC systems. These costs can vary significantly based on the property's age and condition.
Example Calculation:
If CapEx is $5 per gross square foot and the property has 50,000 gross square feet, the total CapEx would be:
50,000 * $5 = $250,000.
Tenant Improvements (TIs)
TIs are customizations made to suit individual tenants, such as building walls or installing doors. These costs occur when tenants move in or renew leases but are not recurring annually.
Example Calculation:
If a tenant is renting 10,000 square feet, and TIs cost $50 per rentable square foot, the total TI cost would be:
10,000 * $50 = $500,000.
Leasing Commissions (LCs)
LCs are payments to brokers or leasing agents for finding tenants or negotiating lease renewals. These commissions are usually a percentage of the total lease value over the lease term.
Example Calculation:
A tenant signs a 5-year lease for 10,000 square feet with annual rents starting at $50 per square foot and increasing by $2 each year. The total lease value would be:
($50 + $52 + $54 + $56 + $58) * 10,000 = $1.35 million.
If the LC is 5% of the lease value, the commission would be:
1,350,000 * 5% = $67,500.
Capital Reserves (Replacement Reserves)
Capital costs tend to be unpredictable and uneven, making cash flows volatile. To smooth out these fluctuations, property owners set aside Reserves—annual allocations that fund future capital costs.
Example:
If the estimated capital costs over the next 5 years total $1.5 million, the owner might allocate $300,000 per year into the Reserves.
Here’s how the Reserve allocation could play out:
Year 1: Allocate $300K; spend $200K → Ending Reserve: $100K
Year 2: Allocate $300K; no spending → Ending Reserve: $400K
Year 3: Allocate $300K; spend $800K → $700K covered by Reserves, $100K from cash flows → Ending Reserve: $0
There is debate over whether Reserve allocations should reduce Net Operating Income (NOI).
One view: Reserves are not real-time cash expenses, so they should be deducted after NOI.
Our approach: Reserves reflect the true cost of ownership, so they should reduce NOI.
Net Operating Income (NOI)
NOI, similar to EBITDA for companies, measures core cash flow before financing costs. If Reserve allocations are deducted, as we do, NOI reflects both operational and capital-related costs.
Why NOI Matters:
Properties are typically valued based on their projected NOI divided by a Capitalization Rate (Cap Rate).
Example Calculation:
If the property’s NOI is $5 million and the market Cap Rate is 5%, the property’s estimated value would be:
5,000,000 / 5% = $100 million.
Capital Costs Paid from Reserves
This line shows how much of the capital costs are funded from Reserves in a given year. If Reserves are insufficient, the shortfall must come from cash flows, reducing the property’s available cash.
Adjusted Net Operating Income (Adjusted NOI)
Adjusted NOI equals NOI minus capital costs not covered by Reserves. It’s comparable to Unlevered Free Cash Flow for companies, representing operational cash flow after reinvestment but before financing costs. However, Adjusted NOI differs from Unlevered FCF since it excludes taxes, changes in working capital, and other elements.
Interest Expense on Debt
Most properties are financed with Debt, so interest expenses are included in the pro-forma. You can calculate this using Excel’s IPMT function or with:
Interest Rate * Outstanding Debt Balance
Debt Principal Repayment
This represents the repayment of the loan principal over time. Use Excel’s PPMT function or a manual calculation based on loan terms.
Cash Flow to Equity Investors
This is the final line in the pro-forma and shows the cash available to distribute to equity investors (the property owners). Unlike corporations that often retain profits, real estate investments typically distribute most or all of their cash flow unless needed for major expenditures.