Lease Analysis & Income Estimation: Key Lease Clauses & Income Development

Lease Analysis & Income Estimation: Key Lease Clauses & Income Development

Introduction

This chapter delves into the critical aspects of lease analysis and income estimation, essential for accurate❓ real estate appraisal. appraisers must❓ possess a thorough understanding of lease clauses and their impact on property income and value. We will explore key lease provisions, their scientific basis, and practical applications in developing robust income estimations.

1. Lease Data & Key Lease Clauses

The foundation of accurate income estimation lies in a detailed analysis of existing lease agreements. These agreements are contracts dictating the rights and responsibilities of landlords (lessors) and tenants (lessees). Key clauses within these leases significantly influence the property’s income stream and overall value.

1.1 Rent & Rent Concessions

• Rent: The periodic payment (typically monthly or annually) a tenant makes to the landlord for the right to use the property. It’s crucial to understand the specific definition used in each lease.
• Rent Concessions: Incentives offered to attract tenants, such as:
  • Early Occupancy: Allowing tenants to occupy the space before the official lease start date, often without charge. This is a form of delayed payment.
  • Finish Upgrades: Providing upgraded finishes or build-outs as part of the lease agreement.
  • Free Rent: Offering rent-free periods (e.g., the first or last month of the lease). This reduces the effective rent over the lease term.

Practical Application:
Consider two identical office spaces in the same building. Space A has a quoted rent of $30/sq ft/year. Space B has a quoted rent of $28/sq ft/year, but offers the first three months rent-free on a five-year lease. To compare, calculate the effective rent for Space B:

Annual Rent (Space B): $28/sq ft
Total rent for five years (Space B): $28/sq ft/year * 5 years = $140/sq ft
Months free rent = 3
Months total rent paid = 5*12 - 3 = 57
Effective rent for five years (Space B): (57/60) * $140/sq ft = $133/sq ft
Effective rent per year (Space B): $133/sq ft / 5 years = $26.6/sq ft/year
Space B with an advertised rent of $28/sf/year is effectively charging $26.6/sf/year due to the free rent concession.

1.2 Division of Expenses Between Lessor and Lessee

Understanding who is responsible for paying operating expenses is paramount. The extent of tenant versus landlord responsibility defines the lease type (e.g., gross lease, net lease, triple net lease). This division directly impacts the landlord’s net operating income (NOI).

• Gross Lease (Full Service Lease): Landlord pays all operating expenses (taxes, insurance, maintenance). Rent is all-inclusive.
• Net Lease: Tenant pays a portion of the operating expenses in addition to the base rent. There are several variations:
  • Single Net (N): Tenant pays property taxes.
  • Double Net (NN): Tenant pays property taxes and insurance.
  • Triple Net (NNN): Tenant pays property taxes, insurance, and maintenance.
• Modified Gross Lease: A hybrid where the tenant pays a portion of certain expenses (e.g., utilities, janitorial services).

Example:
Consider two identical buildings each with 50,000 rentable square feet. Building A is leased under a gross lease with a rental rate of $25/sq ft. Building B is leased under a triple net (NNN) lease with a rental rate of $20/sq ft. Operating expenses for each building are $8/sq ft (including taxes, insurance and maintenance).

Building A potential gross income❓❓ = 50,000 sq ft * $25/sq ft = $1,250,000
Building A Net Operating Income (NOI) = PGI - Operating Expenses = $1,250,000 - (50,000 sq ft * $8/sq ft) = $850,000

Building B Potential Gross Income = 50,000 sq ft * $20/sq ft = $1,000,000
Building B Net Operating Income (NOI) = PGI - Operating Expenses = $1,000,000 - 0 = $1,000,000

While the initial rental rate of Building A appears greater, the tenant in Building B is directly responsible for operating expenses. In reality, building B has a greater NOI.

1.3 Renewal Options

A tenant’s right to extend the lease for a specified period at a predetermined rent (or a rent to be determined by a defined mechanism) is a renewal option. This can significantly affect property value, particularly if the option rent is below market.

Economic Principle: Renewal options represent a potential future obligation for the landlord. If the option rate is below the projected market rate at the time of renewal, the landlord is effectively sacrificing potential future income.

Analysis:
* Probability of Exercise: Consider the likelihood of the tenant exercising the renewal option. Factors include:
* Cost of relocation for the tenant
* Tenant’s satisfaction with the space
* Market conditions (vacancy rates, rental rate trends)
* Specific needs of the tenant
* Impact on Value: If the renewal option is likely to be exercised at a below-market rate, this caps the property’s potential income stream and lowers the property’s value.

1.4 Expense Stop & Expense Cap Clauses

These clauses define the limits of the landlord’s responsibility for operating expenses.

• Expense Stop: The landlord pays operating expenses up to a specified amount (per square foot or as a total dollar amount). Expenses exceeding this stop are passed through to the tenant, proportionally based on tenant occupancy. This protects the landlord from unexpected expense increases.
• Expense Cap: The opposite of an expense stop; the landlord pays expenses above a specified limit, protecting the tenant. This is less common than expense stops.

Mathematical Representation:

Let:
* E = Total operating expenses
* S = Expense Stop (e.g., $5.00/sq ft)
* R = Rentable area of the property
* T = Tenant’s proportionate share of the building

Tenant’s expense responsibility: T * max(0, (E - S) * R)
In this case, if the tenant only occupies 50% of the building, and is responsible for expenses above the stop, then T = 0.5

Practical Application:

Suppose a building has 100,000 sq ft of rentable area, and the operating expenses are $6.00/sq ft. The lease has an expense stop of $5.00/sq ft.

Total Operating Expenses: $6.00/sq ft * 100,000 sq ft = $600,000
Expense Stop Amount: $5.00/sq ft * 100,000 sq ft = $500,000
Expenses Passed Through: $600,000 - $500,000 = $100,000

Tenants proportionally share the $100,000 difference.

1.5 Escalation Clauses & Expense Recovery Clauses

• Escalation Clauses: Allow the landlord to increase the rental rate over time, typically tied to an index like the Consumer Price Index (CPI) or a fixed percentage increase. This helps maintain the real value of the rent during periods of inflation.
  • Formula: Rent_new = Rent_old * (1 + Escalation_Rate)
• Expense Recovery Clauses: Common in retail leases, require the tenant to reimburse the landlord for their pro-rata share of operating expenses. This shifts the risk of rising expenses to the tenant.

1.6 Purchase Options

A purchase option grants the tenant the right (but not the obligation) to purchase the property at a specified price during a specified period. This can significantly affect the value, especially if the option price is below market value.

Impact on Appraisal:

The existence of a purchase option, particularly at a price below the estimated market value, creates a ceiling on the appraised value. A potential buyer would likely not pay more than the option price, as the tenant could simply exercise their option and purchase the property at the lower price. This is underpinned by the Substitution Principle.

Contingency:

An appraiser might argue for a higher value IF they can convincingly demonstrate that the tenant is unlikely to exercise the option, for example, due to:

• Tenant’s financial instability.
• Specific use of the property, which makes it less desirable to the tenant after lease expiration.
• Contractual restrictions preventing the tenant from exercising the option.

1.7 Escape, Kick-Out, Cotenancy, and Buyout Clauses

These clauses provide flexibility for either the landlord or the tenant to terminate the lease under specific conditions.

• Escape Clause (Kick-Out Clause, Cancellation Clause): Allows the tenant to terminate the lease early, often with a penalty.
• Cotenancy Clause: Common in retail, allows a tenant to terminate or reduce rent if a major anchor tenant leaves the property, significantly impacting traffic and sales.
• Buyout Clause: Allows either the landlord or the tenant to terminate the lease by paying a predetermined fee to the other party.

Risk Assessment:
The presence of these clauses increases the uncertainty surrounding future income streams. The appraiser must assess the likelihood of these clauses being exercised and adjust the income projection accordingly.

1.8 Continued Occupancy Clauses

These clauses are common in retail leases. Most often, smaller tenants stipulate that they will stay in the shopping center only as long as the anchor store remains.

Risk Assessment:
An anchor tenant leaving the property dramatically affects property value. The appraiser must assess the likelihood of such an occurence, and adjust the income projection accordingly.

1.9 Tenant Improvements (TIs) & Tenant Improvement Allowances

• Tenant Improvements (TIs): Alterations or upgrades made to the leased space to suit the tenant’s specific needs.
• Tenant Improvement Allowance (TIA): A financial contribution from the landlord to cover the cost of TIs. TIAs are typically amortized over the lease term and reflected in the rental rate.

Capital Budgeting Perspective:

TIAs represent a capital investment by the landlord. The return on this investment is realized through the rental income generated over the lease term. The appraiser must carefully consider the cost of TIAs and their impact on the effective rental rate.

Depreciation Considerations:
Amortizing the TIA over the lease term is analogous to depreciating a capital asset. The TIA is “consumed” over time as the tenant benefits from the improvements.

1.10 Noncompete, Dark Store, & Exclusive Use Clauses

These clauses restrict the landlord’s ability to lease space to competing businesses or require tenants to maintain active operations.

• Noncompete Clause: Prevents the landlord from leasing space to businesses that directly compete with existing tenants.
• Dark Store Clause: Requires the tenant to continue operating their business in the leased space until the lease expires, even if the business is no longer profitable.
• Exclusive Use Clause: Grants a tenant the exclusive right to operate a particular type of business within the property.

Impact on Lease Rate
These clauses are often part of negotations between lessor and lessee and are not only related to lease rates, but also tenant operations. These clauses can add or subtract value from the lease rate.

1.11 Date of Lease

The date of the lease affects the value of the lease. Older leases have rents set to a previous market, while newer leases are more in line with current market values.

1.12 Description of Leased Premises

Leases are often very descriptive about the exact space they are renting.

1.13 Lease Terms, Rental Rate, and Payment

Lease terms are important to the appraisal, as leases that are soon expiring are much less valuable than leases with many years left to run.

1.14 Tenant-Installed Trade Fixtures

Trade fixtures installed by the tenant in a permanent way for use in the tenant’s specific business. Trade fixtures should generally not be included in the appraisal because the items will not transfer with the real estate.

1.15 Revaluation Clauses

Clauses that allow the landlord to change the rent based on the value of the asset as established by a third party, usually an appraiser.

1.16 Signage

Signage on the exterior of a building can be a valuable asset for a tenant.

2. Developing Reconstructed Operating Statements

An operating statement summarizes the income and expenses of a property over a specific period (typically one year). A reconstructed operating statement is an appraiser’s best estimate of the property’s future performance, based on market data and lease analysis.

2.1 Potential Gross Income (PGI)

PGI represents the total income the property could generate if fully occupied and all tenants paid their rent. It is the starting point for income estimation.

• Estimating PGI from Comparable Leases: Analyze recently signed leases of comparable properties to determine market rental rates. Adjustments may be necessary to account for differences in location, size, amenities, lease terms, and other factors.
• Estimating PGI from Current Subject Property Leases: Analyze Existing leases❓❓ on the subject property, taking into account lease terms, escalation clauses, and renewal options.

Data Collection:

• Obtain rent rolls, lease summaries, and full lease agreements.
• Research market rental rates for comparable properties using commercial real estate databases (e.g., CoStar, Real Capital Analytics), broker surveys, and conversations with local market participants.

Example: Lease Comparison Grid

Conclusion
By closely examining the many clauses within a lease, and performing an in depth analysis, an appraiser can accurately estimate the future income potential of a leased fee interest.