Utilities in Real Estate

What are Utilities?

Utilities are additional essential services needed for a property to be fully functional and are usually paid on a monthly basis. They include electricity, air conditioning, natural gas, water, sewage, trash, and sometimes internet and cable. 

Why are they important?

When determining the amount of rent to charge a tenant, it is important to consider carrying costs such as utilities, insurance, and management fees. These fees play a large role in determining your return on investment, cap rate, and cash flow. 

Even more importantly, it is necessary to decide who is going to be paying these utilities. Because an owner can choose to offload the responsibility of paying for utilities to the tenant as specified in the lease, in doing so, he risks the tenant exceeding normal usage of the service, or worse, service interruption resulting in frozen pipes or a broken AC unit. 

When an owner chooses to front the utilities, he can make sure the utilities always get paid and, therefore, the power always stays on and his property never runs the risk of damage. 

Gross Lease vs. Triple Net Lease

A Gross Lease is where the tenant pays a fixed amount, and the owner pays all regularly incurred expenses (e.g. utilities, taxes, insurance, maintenance).  The owner usually takes into consideration the cost to cover estimated operating expenses when generating a rental rate and should make sure it is in line with expected expense inflation.

On the other hand, a Triple net, or NNN. Lease is where the tenant is responsible for a proportionate share of all operating expenses associated with their occupancy. This shifts the burden of operating expenses from the owner to the tenant. Said another way, the owner is fully reimbursed by tenants for the operating expenses, including utilities, incurred at the property.

How are Utilities relevant to Commercial Real Estate?

When valuing commercial real estate properties, it is important to account for operating expenses as they are out-of-pocket costs and can impact the Net Operating Income (NOI). Operating expenses include utilities and are assessed pro rata on top of the base rent. Click to read more about the importance of NOI in real estate.

Triple net leases are the most common in commercial real estate. In this type of lease, the tenant is responsible for the base rent and all operating expenses. That is, the landowner is fully reimbursed for all operating expenses incurred at the property, including utilities. For more detail on Gross and NNN leases, see our blog.

Conclusion

Utilities should be accounted for accurately as they can significantly affect the cash flow projections of a property and skew decisions when determining if a project is feasible or not.

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About the Author

Eric Bergin is the founder of TSM. He realized that there was a need for real estate financial models that were more than just generic templates. He wanted to create a personalized product for his customers that would ensure success for them and their company. Please reach out to him if you have any questions regarding gross sales proceeds or if he can help you with your modeling needs.