Commercial Real Estate

How it works

A tenant signs a lease for a term measured in years — often three to ten for retail and office, longer for industrial build-to-suit — agreeing to pay base rent plus some share of operating costs, with escalations built into the contract from day one, either a fixed annual percentage or an index tied to CPI.

Lease structures sit on a spectrum. Gross leases have the landlord paying operating costs out of rent collected. Modified gross splits costs by agreement. Triple net shifts property taxes, insurance and maintenance to the tenant, leaving the landlord's income closer to pure rent. Reimbursements and common area maintenance charges are billed monthly on estimate and reconciled against actual costs after year-end, a process called CAM reconciliation that generates its own disputes and true-up payments.

Net operating income is effective gross income minus operating expenses, calculated before debt service, capital expenditure, tenant improvements and leasing commissions — those come later and consume real cash. Price is set as NOI divided by a market cap rate, so two properties with identical rent rolls can trade at very different prices depending on tenant credit and remaining lease term.

Diligence before a purchase is document-heavy and specific: the rent roll, a lease abstract summarizing key terms for each tenant, tenant estoppel certificates confirming lease terms independently, a subordination, non-disturbance and attornment agreement (SNDA) with the lender, a Phase I environmental report, and a property condition assessment covering structural and mechanical systems.

What it pays

Base rent is quoted per square foot per year in most US markets, with reimbursements layered on top, and the total return on purchase price is described as a cap rate. Weighted average lease term and tenant credit quality determine how bond-like that income is — an investment-grade tenant on a fifteen-year lease trades at a materially lower cap rate than a local operator on a three-year term, because the market is pricing default and rollover risk into the discount rate.

Contractual escalations are what make the income grow without any re-leasing effort: a fixed annual bump of two or three percent, or a CPI-linked adjustment, compounds over the lease term and is baked into the price paid at acquisition.

Leverage changes the arithmetic. Levered returns depend on the spread between the cap rate and the mortgage constant — the all-in annual cost of debt service as a percentage of the loan. When borrowing costs exceed the cap rate, adding debt reduces current cash flow rather than amplifying it, a condition common in periods of rising rates.

Because most underwriting models blend annual cash flow with an assumed sale price years out, the projected internal rate of return is highly sensitive to the exit cap rate assumed — a small change in that single assumption can swing the modeled return more than any change in rent.

Costs and taxes

Below the NOI line sit costs that consume real cash and are easy to underestimate: tenant improvement allowances paid to attract or retain tenants, leasing commissions paid to brokers, and building capital expenditure for roofs, HVAC and parking that arrives in lumps rather than smoothly.

US tax treats non-residential buildings as depreciating over 39 years on a straight-line basis; land itself is never depreciable. Cost segregation studies reclassify components of a building — carpeting, certain electrical and plumbing — into shorter recovery periods, accelerating deductions in early years at the cost of more recapture later.

Interest deductibility for larger businesses is capped under the business interest expense limitation rules, though a real property trade or business election restores full deductibility in exchange for longer, less favorable depreciation schedules on the property.

Sale proceeds trigger depreciation recapture taxed at up to 25%, plus capital gains tax on remaining appreciation. A 1031 exchange defers both taxes if replacement property is identified within 45 days and the purchase closes within 180 days of the sale — deadlines that are strict and unforgiving of delay. Transfer taxes, title insurance, surveys, environmental reports and legal fees add transaction friction well beyond what a securities trade involves.

Liquidity and time commitment

A marketed sale process typically runs several months from listing to closing, and buyers can retrade — renegotiate price downward — during due diligence if an environmental or engineering report turns up something unexpected.

Financing is usually a commercial mortgage with a balloon payment due at five, seven or ten years, often non-recourse to the borrower personally except for carve-outs covering fraud, environmental contamination or unauthorized transfers. That maturity date, not investor preference, frequently dictates when a sale or refinance must happen.

Asset management continues even with a third-party property manager handling day-to-day operations: reviewing and approving leasing proposals, setting and monitoring capital budgets, and managing the lender relationship through covenant compliance and reporting.

Public REITs and private non-traded funds sit over the same underlying rent stream but offer daily or periodic liquidity instead of a multi-month sale process — the trade-off is share price volatility or fund-level redemption gates in place of direct control. Within direct ownership, the lease expiration schedule is the operating calendar that matters most: a year with heavy tenant rollover demands capital and leasing attention well in advance of the actual vacancy.

How it goes wrong

Rollover risk is the most common failure mode: a large tenant vacates at lease expiration, the space sits empty while the owner still pays property taxes, insurance and utilities, and then pays again for tenant improvements to attract a replacement — all while debt service continues unabated.

Cap rate expansion, meaning the market's required yield on that property type rises, cuts the value of an asset even when its rent stream has not changed at all. This is a market-wide repricing risk, distinct from anything the property itself has done wrong.

Refinancing risk arrives at balloon maturity: if rates have risen or property income has softened, a new loan may provide less proceeds than the balance owed on the old one, forcing the owner to contribute fresh capital or sell under pressure.

Tenant bankruptcy compounds rollover risk — a lease can be rejected in bankruptcy proceedings, and the landlord's claim for lost rent is capped by statute and typically paid, if at all, at a fraction of face value.

Environmental contamination discovered after purchase, or structural and ADA compliance costs missed by an inadequate property condition assessment, can impose costs with no tenant or insurer to share them. A related and quieter error in underwriting is assuming an exit cap rate equal to or below the entry cap rate — a convenient assumption that the market will value the asset more richly in the future than it does today, with no basis beyond hope.