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Commercial Real Estate Interview Questions

Guide to Commercial Real Estate Interview Questions

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Commercial Real Estate Interview Questions

Q. What happens to the property values in the commercial real estate (CRE) market when interest rates rise?

When interest rates rise, the capitalization rates most often follow suit. Moreover, if cap rates increase, property values tend to decline.

However, there are some economic benefits that can help mitigate the decrease in property values.

Fundamentally, rising cap rates are often a sign of a strong real estate market and economy, signifying that the real estate outlook is likely positive.

Since rising interest rates mean that financing costs are higher, the pace of new supply (i.e. new properties flowing into the market) can slow down while demand remains the same – so rent tends to increase in such times.

Q. Why do higher interest rates cause real estate purchase prices to decline?

If interest rates increase, borrowing becomes more expensive, which directly impacts the returns of real estate investors.

In a higher interest rate environment, investors must offset the higher cost of financing with a reduction to purchase prices – since a lower purchase price increases returns (and enables them to achieve their targeted return).

Therefore, as interest rates climb upward, cap rates are also expected to rise, placing downward pressure on pricing.

Q. What is the net absorption rate?

The net absorption rate is a measure of supply and demand in the commercial real estate market, so the metric attempts to capture the net change in demand relative to supply in the market.

Calculating net absorption involves taking the sum of physically occupied space in square feet and subtracting the sum of square feet that became physically vacant over a specified period, most often a quarter or a year.

Net Absorption Formula
  • Net Absorption = Total Space Leased – Vacated Space – New Space

Q. What is the difference between positive and negative net absorption?

  • Positive Net Absorption: More commercial real estate was leased relative to the amount made available on the market, which suggests there is a relative decline in the supply of commercial space available to the market.
  • Negative Net Absorption: More commercial space has become vacant and placed on the market compared to the amount that was leased, indicating the relative demand for commercial real estate has declined in relation to the total supply.

Q. What is the difference between NOI and EBITDA?

The net operating income (NOI) metric measures the profitability of a real estate firm before any corporate-level expenses such as capital expenditures (Capex), financing payments, and depreciation and amortization (D&A).

Net Operating Income Formula
  • Net Operating Income = Rental and Ancillary Income – Direct Real Estate Expenses

NOI is frequently used among real estate firms because it captures the property-level profitability of the firm prior to the effects of corporate expenses.

In contrast, EBITDA – which stands for “Earnings Before Interest, Taxes, Depreciation, and Amortization” – is most commonly used to measure the operating profitability of traditional companies, meaning that NOI can be thought of as a “levered” variation of the EBITDA metric.

Q. Which is used more in real estate investment banking: NPV or IRR?

Both the net present value (NPV) and internal rate of return (IRR) are important metrics to consider for all real estate investors.

However, the IRR is arguably used more frequently because the IRR represents the discount rate at which the NPV of future cash flows is equal to zero.

In other words, the minimum required return on an investment is based on the implied IRR.

Further, the IRR is more easily used to compare the returns on real estate investments relative to other asset classes such as equities, fixed income, and other types of real estate investments.

Q. What are the different types of leases?

  • Full Service: A lease structure in which the landlord is responsible for paying all of the operating expenses of the property, meaning the rental rate is all-inclusive as it accounts for expenses such as taxes, insurance, and utilities.
  • Triple Net: A lease structure in which the tenant agrees to pay for all of the expenses of the property, including taxes, maintenance, and insurance, all in addition (and separately) to rent and utilities. Because these expenses aren’t left to the landlord to pay, the rent on a triple-net lease is typically lower than in other lease structures.
  • Modified Gross Lease: A lease structure in which the tenant pays the base rent at the beginning of the lease, and then takes on a proportion of other expenses such as property taxes, insurance, and utilities.

Q. What are the three methods for valuing real estate assets?

The three methods to value real estate assets are the cap rate, comparables, and the replacement cost method.

  1. Cap Rate: Property Value = Property NOI / Market Cap Rate
  2. Comparables: The valuation is derived based on the transactional data of comparable properties, specifically based upon metrics such as the price per unit, price per square foot, or current market cap rate.
  3. Replacement Cost Method: Investors analyze the cost of building the property that it is considering purchasing (and in general, most would avoid purchasing an existing property for more than it could be built).

Q. Compare the cap rates and risk profiles for each of the main property types.

  • Hotels: Higher cap rates due to cash flows being driven by extremely short-term stays.
  • Retail: Higher risk due to increasing creditworthiness concerns as a result of the rise of e-commerce.
  • Office: Closely correlated with the broader economy but with longer-term leases, making the risk profile a bit lower.
  • Industrial: Lower risk profile as a result of continued trends in e-commerce and longer-term leases.

Q. Walk me through a basic pro forma cash flow build for a real estate asset.

  1. Revenue: The calculation starts with revenue, which is primarily going to be rental income, but could include other sources of income and will most likely deduct vacancy and leasing incentives.
  2. Net Operating Income (NOI): Next, operating expenses are subtracted from revenue to arrive at the NOI.
  3. Unlevered Free Cash Flow: From NOI, capital expenditures related to the purchase and sale of properties are subtracted to arrive at the unlevered free cash flow metric.
  4. Levered Free Cash Flow: Finally, financing costs are subtracted from unlevered free cash flow to arrive at levered free cash flow.

Q.  If you had two identical buildings in the same condition and right next to each other, what factors would you look at to determine which building is more valuable?

The primary focus here should be on the cash flows, especially around the risk associated with the cash flows (and the creditworthiness of the tenants).

  • Average Rent and Occupancy Rates: Specifically, the average rents and occupancy rates of the buildings must be closely examined, as this sort of analysis can reveal differences in management and leasing (and potential issues).
  • Credit Risk: The riskiness of the cash flows is also a critical consideration, in which the creditworthiness of the existing (and future) tenants and the specific terms of the leases are used to gauge the credit risk.
  • NOI and Cap Rate: The NOI and cap rate of each property must be calculated, too. In summary, the property with a higher cash flow and less risk will be more valuable.

Q. Describe the four main real estate investment strategies.

  1. Core: Of the four strategies, the least risky strategy (and thus, resulting in the lowest potential returns). The strategy typically involves targeting newer properties in locations with higher occupancy rates and tenants that are of higher creditworthiness.
  2. Core-Plus: The most common type of real estate investing strategy, which carries slightly more risk by involving minor leasing upside and small amounts of capital improvements.
  3. Value-Add Investments: A riskier strategy in which the risk can come from less creditworthy tenants, meaningful capital improvements, or a substantial lease-up (i.e. more “hands-on” changes).
  4. Opportunistic Investments: The riskiest strategy that targets the highest returns. The strategy consists of investments in new property development (or redevelopment).
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