Rebuilt the expense recovery and NOI went up $19k with no rent increase

Bought this one two years ago, 11 apartments over four commercial bays, total ground floor about 5,800 sf. Inherited leases from an owner who had held it since the nineties and had stopped paying attention.

What I found in the files: two of the four commercial leases had expense recovery language and neither had been billed in at least six years. One was a base year stop from 2014 with no reconciliation since. The other said pro rata share of taxes and insurance, no CAM, and the pro rata share was defined against the total building square footage including the apartments upstairs, which meant that tenant had been contractually on the hook for about 14% of a number nobody had ever calculated. The other two bays were flat gross, no recovery at all.

What I did over about 14 months. I hired an accountant to build a proper expense pool with the residential costs carved out, because you cannot bill a retail tenant for the apartment turnover and the residential trash contract and expect it to survive the first argument. Then I reconciled the two recoverable leases going forward only. I did not chase back years. My attorney's read was that pursuing six years of unbilled reconciliations on a lease I bought would cost more in tenant relationship than it would collect, and estoppel and waiver arguments differ by state anyway.

On the two flat gross bays I waited for renewal. One renewed at the same base rent with a tax and insurance stop at the current year. The other renewed with base rent up $1.75/sf and stayed gross, which they preferred and I was fine with.

Result: about $11,400 a year of newly billed recoveries and roughly $7,600 of base rent increase at the two renewals. NOI up around $19k on a building that appraised at a 7.75 cap when I bought, so call it $245k of value if the cap holds, which it may not.

The part that nearly broke it. The base year tenant, the 2014 stop, went through her books with a bookkeeper and came back saying the increase was $4,100 a year and she'd have to cut a stylist. She was right about the number. I gave her a three year deal that phased the recovery in over 24 months and got a personal guarantee I didn't have before. If I'd sent the invoice cold I'd have had an empty bay and a legal bill.

What I'd keep: carve the residential expenses out before you do anything, in writing, with the accountant's workpapers saved. Every conversation after that gets easier because you can show your work.

Answer

1stephen_ok9CO2CPRO6

The number I'd push on is the $245k of value. A 7.75 going-in cap on an eleven-over-four in a market you haven't named doesn't mean the next buyer or the appraiser capitalizes your new recovery income at the same rate, and $11,400 of it is recovery income on leases with terms remaining that I'd want to see. Recoveries that started 14 months ago on leases with three years left get discounted by anyone underwriting carefully, and a lender's appraiser may haircut them further.

The part that actually holds value is the $7,600 of base rent at renewal, because that's contractual and it resets the comp for the other two bays. The recovery work is real cash, it just isn't worth the same multiple.

On the phased deal with the stylist, taking the personal guarantee in exchange for the phase-in was the trade worth making. You converted a soft $4,100 into a hard credit enhancement on a tenant who's clearly the marginal one in the building. If she goes dark in year two you have something to point at. I'd be less comfortable if you'd taken the full $4,100 in year one and kept an unsecured tenant.

One thing I'd add for anyone copying this. The residential carve-out isn't a formality. A commercial tenant's bookkeeper who finds apartment-side costs in the expense pool has a reason to challenge the entire reconciliation, and how far that challenge gets depends on the lease language and on state law. Get the workpapers built the way @thicket did before the first invoice goes out.

2 replies

2nicole_adeyemiPassivePRO5

The pro rata share defined against total building square footage including the apartments is the detail I'd want other people to notice. Whoever drafted that in the nineties either wasn't thinking or was thinking very hard, and either way it's the kind of thing that sits in a file for thirty years. Did you leave that definition alone at renewal or fix it?