Lease Analysis and Income Estimation

Introduction

This chapter delves into the critical aspects of lease analysis and income estimation, essential skills for real estate appraisers. Understanding lease terms, expense structures, and market dynamics allows appraisers to accurately project income streams, ultimately impacting property valuation.

1. Lease Fundamentals

1.1 Defining Rent

Rent, at its core, represents the consideration paid by a tenant (lessee) to a landlord (lessor) for the right to possess and use a specific property over a defined period. While often expressed as a monthly figure, it can also be quoted on an annual basis.

• Gross Rent: The total rent paid before any deductions or allowances.
• Net Rent: The rent remaining after deducting any concessions or allowances.

1.2 Lease Components

• Lease Term: The duration of the lease agreement. A longer lease term may provide more stable income for the lessor but also limits the flexibility to adjust rent based on market changes.
• Rental Rate: The amount of rent charged per unit of area (e.g., per square foot) or as a fixed sum.
• Payment Schedule: The frequency and method of rent payments (e.g., monthly, quarterly, annually).

1.3 Rent Concessions

Rent concessions are incentives offered to tenants to attract or retain them, particularly in competitive markets. These concessions effectively reduce the actual rental income received by the landlord.

• Examples:
  • Free rent periods (e.g., first month free).
  • Tenant improvement allowances (TIAs).
  • Early occupancy provisions (allowing occupancy before the lease officially starts without rent).
  • Moving expense reimbursements.

1.4 Division of Expenses Between Lessor and Lessee

The allocation of operating expenses between the landlord and tenant significantly affects the net operating income (NOI) attributable to the property. Different lease structures define these responsibilities.

• Gross Lease: The landlord pays all operating expenses (property taxes, insurance, maintenance). The tenant pays a single, inclusive rent amount.

• Net Lease: The tenant pays a base rent plus a share or all of the operating expenses. There are various types of net leases:

  • Single Net Lease (N): Tenant pays base rent plus property taxes.
  • Double Net Lease (NN): Tenant pays base rent plus property taxes and insurance.
  • Triple Net Lease (NNN): Tenant pays base rent plus property taxes, insurance, and maintenance.
  • Absolute Net Lease: Tenant pays all expenses, including significant repairs, potentially even rebuilding after a disaster.

• Expense Stops: Landlord pays expenses up to a specified amount (the “stop”). The tenant is responsible for expenses exceeding this amount. Protects landlords from increases in taxes, insurance, and other expenses.

• Expense Caps: Landlord pays expenses above a certain point. Protects the tenant from unpredictable expense hikes.

2. Lease Clauses and Their Impact

Lease clauses dictate rights and obligations of the landlord and tenant, directly influencing the property’s income potential and risk profile.

2.1 Renewal Options

A renewal option grants the tenant the right, but not the obligation, to extend the lease for a specified period at a predetermined rent or a rent to be determined according to a specific formula. A below-market renewal option can depress the property’s market value.

2.2 Escalation Clauses and Expense Recovery Clauses

• Escalation Clauses: Allow the landlord to increase the rental rate during the lease term based on a predetermined index or schedule.
  • Consumer Price Index (CPI) Escalation: Rent increases are tied to changes in the CPI, reflecting inflation.
    • Example: Rent increases annually by the percentage change in the CPI.
  • Fixed Percentage Escalation: Rent increases by a fixed percentage at specified intervals.
    • Example: Rent increases by 3% every year.
  • Step-Up Rent: Rent increases by a set dollar amount at specified intervals.
    • Example: Rent increases by $1.00 per square foot every 5 years.
• Expense Recovery Clauses: (Common in retail) The tenant reimburses the landlord for a pro rata share of operating expenses. These clauses make the lease similar to a net lease, with the landlord responsible for fewer expenses.

2.3 Purchase Options

A purchase option gives the tenant the right, but not the obligation, to purchase the property at a specified price within a specified timeframe.

• Right of First Refusal (ROFR): The tenant has the right to match any offer the landlord receives from a third party. This provides control over who becomes the landlord but doesn’t guarantee a specific purchase price.
• Option to Purchase: Grants the tenant the right to purchase the property at a pre-determined price. This can cap the property’s market value.
  • Example: If a property’s market value rises to \$2,000,000, but the tenant holds an option to purchase it for \$1,500,000, the market value may be constrained by the option price.

2.4 Escape (Kick-Out), Cotenancy, and Buyout Clauses

• Escape/Kick-Out Clauses (Cancellation Clauses): Allow tenants to terminate the lease before its expiration date, often subject to penalties.
• Cotenancy Clauses: Common in retail leases, allow tenants to reduce rent or terminate the lease if a major anchor tenant leaves the property, significantly reducing customer traffic.
• Buyout Clauses: Allow either the landlord or the tenant to terminate the lease by paying a pre-determined fee to the other party.

2.5 Continued Occupancy Clauses

Common in retail, stipulate that smaller tenants will stay in the shopping center only as long as the anchor store remains.

2.6 Non-Compete, Dark Store, and Exclusive Use Clauses

• Non-Compete Clauses: Prohibit the landlord from leasing space to businesses that directly compete with existing tenants.
• Dark Store Clauses: Require a tenant to maintain a functioning business in the leased space until the end of the lease term, preventing the space from becoming vacant (going “dark”).
• Exclusive Use Clauses: Grant a tenant the exclusive right to operate a specific type of business within the property, preventing the landlord from leasing to similar businesses.

3. Analyzing Lease Data

3.1 Essential Lease Information

• Date of Lease: Indicates the market conditions at the time the lease was executed. A lease signed several years ago may not reflect current market rents.
• Description of Leased Premises: Detailed specifications of the space being leased, including its size, location, and any special features. Important because the property manager’s data and data in the lease could be different.
• Lease Terms, Rental Rate, and Payment: Details the lease duration, rental rate per square foot or unit, and payment schedule.
• Tenant-Installed Trade Fixtures: Items installed by the tenant for use in their specific business. These are typically not included in the appraisal.
• Revaluation Clauses: Allow the landlord to adjust the rent based on periodic appraisals of the property’s value.
• Signage: Stipulations regarding signage rights, including the size, location, and visibility of tenant signage.

3.2 Tenant Improvements (TIs)

TIs represent the costs incurred to customize leased space to meet a tenant’s specific requirements.

• Tenant Improvement Allowance (TIA): A sum of money provided by the landlord to the tenant to cover the cost of TIs.
• Amortization: Landlords typically amortize TI expenses over the lease term, incorporating the cost into the rental rate.
• Impact on Market Rent: TIs paid by the landlord are usually reflected in the lease rate. Tenant-paid TIs may create a discrepancy between contract rent❓ (based on unimproved space) and market rent (based on the improved space).

4. Income Estimation

4.1 Developing Reconstructed Operating Statements

Appraisers use reconstructed operating statements to estimate a property’s potential net operating income (NOI).

4.2 Potential Gross Income (PGI)

PGI represents the total income a property could generate if all units were occupied and rented at market rates, with no vacancy or collection losses.

4.3 Estimating PGI from Comparable Leases

Analyzing comparable leases is crucial for determining market rental rates.

• Lease Comparison Grid: A table summarizing key lease terms and characteristics of comparable properties, allowing for direct comparison and adjustments.
• Adjustments: Adjustments are made to comparable rental rates to account for differences between the subject property and the comparables.
  • Examples: Location, size, condition, amenities, lease terms, and date of the lease.
• Effective Date: The date of the lease agreement is crucial. Older leases may not reflect current market conditions.

4.4 Estimating PGI from Subject Property Leases

• Analyze Existing Leases: Review all existing leases on the subject property to determine contract rents, expense responsibilities, and any unique lease provisions.
• Market Rate Considerations: Leased fee value is often limited by the existing lease terms. Over time, as leases expire, income may be able to increase to market rates.
• Rent Steps and Escalation Clauses: Carefully examine leases for rent step-ups, step-downs, and escalation clauses to accurately project future income.

5. Mathematical Formulas and Equations

5.1 Net Operating Income (NOI)

NOI = Potential Gross Income (PGI) - Vacancy & Collection Loss (V&C) + Other Income - Operating Expenses (OE)

5.2 Operating Expense Ratio (OER)

OER = Operating Expenses / Effective Gross Income

5.3 Net Income Ratio (NIR)

NIR = Net Operating Income / Effective Gross Income

5.4 Present Value

PV = FV / (1 + r)^n

Where:

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