Lease Structures and Future Income Analysis

Chapter: Lease Structures and Future Income Analysis

Introduction

This chapter delves into the critical aspects of lease structures and their impact on future income analysis within the context of income capitalization in real estate appraisal. A thorough understanding of these concepts is essential for accurately estimating the income potential of a property, which directly influences its value. We will explore various lease types, their characteristics, and the methods used to project future income streams, considering factors such as market trends, expense projections, and the time value of money.

1.0 Lease Structures: Foundations of Income Projection

A lease is a contractual agreement granting a tenant the right to use a property for a specified period in exchange for rent. The structure of a lease significantly influences the predictability and stability of the income stream generated by a property. Understanding the nuances of different lease types is crucial for accurate income capitalization.

1.1 Types of Leases

• Gross Lease: The landlord pays all operating expenses, including property taxes, insurance, and maintenance. The tenant pays a fixed rent amount.

• Net Lease: The tenant pays a base rent plus a portion or all of the property’s operating expenses. Common variations include:

  • Single Net Lease: Tenant pays base rent plus property taxes.
  • Double Net Lease: Tenant pays base rent plus property taxes and insurance.
  • Triple Net Lease (NNN): Tenant pays base rent plus property taxes, insurance, and maintenance.

• Modified Gross Lease: Landlord and tenant share operating expenses according to a pre-determined agreement.

• Percentage Lease: The tenant pays a base rent plus a percentage of their gross sales. Commonly used in retail properties.

• Ground Lease: A lease of land, often for a long term (e.g., 50-99 years), where the tenant constructs improvements on the land.

• Graduated Lease (Step-Up/Step-Down): Rent increases or decreases at predetermined intervals.

• Index Lease: Rent adjustments are tied to an economic index, such as the Consumer Price Index (CPI).

• Revaluation Lease: Rent is re-evaluated (and usually adjusted to market rate) periodically.

1.2 Lease Provisions and Their Impact on Income

Lease agreements contain numerous provisions that can affect future income. Key provisions to consider include:

• Rent Commencement Date: When rent payments begin.

• Lease Term: The duration of the lease.

• Renewal Options: The tenant’s right to extend the lease.

• Rent Escalation Clauses: Provisions for increasing rent over time.

• Expense Pass-Throughs: How operating expenses are allocated between landlord and tenant.

• Tenant Improvement (TI) Allowances: Funds provided by the landlord for tenant improvements.

• Concessions: Incentives offered to attract tenants (e.g., free rent, reduced rent).

• Use Restrictions: Limitations on how the tenant can use the property.

• Sublease and Assignment Clauses: Tenant’s ability to sublease the property or assign the lease to another party.

Example 1: Impact of Renewal Options. A property has a tenant with a lease expiring in 3 years. The current contract rent is $20/sq.ft./year. Market rent is also $20/sq.ft./year. The lease contains two 5 year renewal options at the greater of 90% of then market rent, or the current contract rent. In this case, the appraiser should consider that the property will likely generate at least the existing rental income during the renewal options.

2.0 Rent: The Building Block of Income Analysis

Rent is the payment made by a tenant for the right to occupy a property. Accurately determining the appropriate rent levels is fundamental to income capitalization.

2.1 Types of Rent

• Market Rent (Economic Rent): The rent a property would command in the open market, given current conditions.

• Contract Rent: The rent stipulated in the lease agreement.

• Effective Rent: The actual rent received by the landlord, considering concessions and expenses.

Effective Rent = (Total Rent Paid Over Lease Term - Concessions) / Lease Term

• Excess Rent: The amount by which contract rent exceeds market rent. This represents a premium paid by the tenant and is less reliable than market rent.

• Deficit Rent: The amount by which market rent exceeds contract rent. The landlord is not receiving the full potential income.

• Overage Rent: The rent paid by a retail tenant based on a percentage of their sales above a specified breakpoint.

2.2 Estimating Market Rent

• Market Surveys: Gather data on comparable properties’ rental rates.

• Lease Comps: Analyze recent lease transactions of similar properties in the same market.

• Industry Data: Utilize reports from commercial real estate firms and industry associations.

3.0 Future Income Analysis: Projecting Cash Flows

Future income analysis involves estimating the income a property is expected to generate over a specified holding period. This analysis forms the basis for determining the present value of the income stream.

3.1 Potential Gross Income (PGI)

PGI is the total potential income a property could generate if fully occupied, based on market rents or contract rents (if higher than market rent for existing leases).

3.2 Vacancy and Collection Loss (V&C)

V&C represents the estimated loss of income due to vacant space and uncollected rent. It is expressed as a percentage of PGI.

• Effective Gross Income (EGI) = PGI - V&C

3.3 Operating Expenses (OE)

OE are the costs associated with operating and maintaining the property. They are categorized as either fixed or variable.

• Fixed Expenses: Relatively constant regardless of occupancy (e.g., property taxes, insurance).
• Variable Expenses: Fluctuate with occupancy levels (e.g., utilities, maintenance).

3.4 Net Operating Income (NOI)

NOI is the income remaining after deducting operating expenses from effective gross income.

• NOI = EGI - OE

3.5 Capital Expenditures (CAPEX)

CAPEX are expenses for significant property improvements or replacements. While not included in operating expenses, CAPEX must be considered in the overall income analysis, as they impact the property’s long-term profitability. In some analysis, a replacement allowance (an annual reserve for future capital expenditures) is deducted when calculating stabilized NOI.

3.6 Reversion Value (Resale Value)

The reversion value is the estimated sale price of the property at the end of the holding period. Accurately estimating the reversion requires considering factors such as market conditions, property condition, and potential future income.

4.0 Forecasting Future Income: Methodologies

Several methods can be used to forecast future income:

• Straight-Line Projection: Assumes a constant growth rate in income.

  • Year n Income = Base Year Income * (1 + Growth Rate)^n

• Percentage Change: Base future income on a percentage change of prior income.

• Step-Up Leases Analysis: Take the rent increases defined in the leases into consideration.

• Market Trend Analysis: Considers broader economic trends, such as inflation and interest rates.

• Sensitivity Analysis: Examines how changes in key variables (e.g., vacancy rate, expense growth) affect the projected income stream.

Example 2: Forecasting using a straight-line projection. Current NOI is $100,000. Assume a 3% annual growth rate. Projected NOI for year 5: $100,000*(1+0.03)^5 = $115,927.41

5.0 Discounting Future Income: Time Value of Money

The time value of money (TVM) is a fundamental concept in income capitalization. It recognizes that money received today is worth more than the same amount received in the future due to its potential earning capacity.

5.1 Discount Rate

The discount rate reflects the required rate of return for an investment, considering its risk profile and opportunity cost. It is used to calculate the present value of future income streams.

5.2 Present Value (PV)

PV is the current value of a future sum of money or stream of cash flows, given a specified discount rate.

• PV = FV / (1 + r)^n

  Where:

  • PV = Present Value
  • FV = Future Value
  • r = Discount Rate
  • n = Number of Periods

5.3 Discounted Cash Flow (DCF) Analysis

DCF is a valuation method that estimates the value of an investment based on the present value of its expected future cash flows.

Example 3: DCF Analysis. Assume an investment is expected to generate the following cash flows: Year 1: $50,000, Year 2: $60,000, Year 3: $70,000, Reversion in Year 3: $800,000. Assume a discount rate of 10%.

Year 1 PV = $50,000 / (1+0.10)^1 = $45,454.55
Year 2 PV = $60,000 / (1+0.10)^2 = $49,586.78
Year 3 PV = ($70,000+$800,000) / (1+0.10)^3 = $650,602.41
Total Value = $45,454.55 + $49,586.78 + $650,602.41 = $745,643.74

6.0 Conclusion

Understanding lease structures and performing thorough future income analysis are essential components of the income capitalization approach in real estate appraisal. By carefully analyzing lease provisions, estimating market rents, projecting future cash flows, and applying the time value of money concepts, appraisers can arrive at accurate and reliable property valuations.