Lease Analysis: Terms, Clauses, and Income Estimation

Chapter Title: Lease Analysis: Terms, Clauses, and Income Estimation

Introduction

This chapter delves into the critical aspects of lease analysis, an indispensable skill for appraisers. A thorough understanding of lease terms, clauses, and their implications on income estimation is fundamental to accurately valuing leased properties❓. We will explore the scientific principles underpinning lease analysis, examine the impact of various lease clauses, and provide practical techniques for estimating potential gross income (PGI) and net operating income (NOI).

1. Lease Data: Understanding the Foundation

Before embarking on income estimation, a detailed understanding of lease data is crucial. This involves scrutinizing the lease agreement for essential information.

• 1.1. Key Lease Terms:

  • Rent: The amount paid by the tenant for the right to use the property for a specified period. This can be expressed as a monthly or annual amount. It’s important to note the difference between contract rent (stipulated in the lease) and market rent (prevailing rate for similar properties).

  • Lease Term: The duration of the lease agreement. Longer lease terms generally provide more stable income streams, but can also limit the landlord’s ability to adjust rents to market levels.

  • Renewal Options: Tenant’s right to extend the lease at a specified rate. These options can significantly affect property value, especially if the option rate is below market. The appraiser should analyze if the option rental rate is less than or close to market rental value.

  • Rent Concessions: Incentives offered to tenants, such as free rent periods, finish upgrades, or other benefits. These concessions effectively reduce the overall rental income and must be carefully considered in income estimation.

  • Division of Expenses: A clear understanding of who pays which expenses (landlord or tenant) is paramount.

  • Lease Date: Provides crucial context. Lease agreements dated significantly in the past may not accurately reflect current market conditions, even if the lease is still active. Brokers may choose to give tenants several months of free rent instead of discounting the rental rate.

  • 1.2. Common Lease Clauses:

  • Escalation Clauses: Allow for rent increases based on predetermined criteria, such as the Consumer Price Index (CPI) or a real estate index. The formula for calculating the adjusted rent is:

    • $Rent_{adjusted} = Rent_{initial} * (CPI_{current} / CPI_{base})$

      Where:
      * $Rent_{adjusted}$ is the new rent amount.
      * $Rent_{initial}$ is the original rent amount.
      * $CPI_{current}$ is the current Consumer Price Index value.
      * $CPI_{base}$ is the Consumer Price Index value at the beginning of the lease.
      * Expense Stop/Cap Clauses: An expense stop protects the landlord by shifting expense increases above a certain point to the tenant. Conversely, an expense cap protects the tenant by limiting the landlord’s ability to pass on expense increases.
      * Expense Recovery Clauses: Common in retail leases, where tenants reimburse the landlord for their pro-rata share of operating expenses. The formula for calculating the tenant’s share of expenses is:

    • $Expense_{tenant} = Expense_{total} * (Area_{tenant} / Area_{total})$

      Where:
      * $Expense_{tenant}$ is the tenant’s share of expenses.
      * $Expense_{total}$ is the total operating expenses.
      * $Area_{tenant}$ is the tenant’s leasable area.
      * $Area_{total}$ is the total leasable area of the property.

  • Purchase Options/Right of First Refusal: Grant the tenant the option to purchase the property or the right to match any proposed purchase price. An option to purchase at a specified price is significant because it is illogical to value the property as higher than the option price.

  • Escape/Kick-Out Clauses: Allow tenants to terminate the lease before the end of the term, often with a penalty.

  • Buyout Clauses: Allow either the landlord or tenant to terminate the lease by making a payment to the other party.

  • Continued Occupancy Clauses: Stipulate that smaller tenants will remain in a shopping center only as long as a key anchor tenant remains.

  • Tenant Improvements (TIs): Specify the landlord’s responsibilities for building out the leased space to meet the tenant’s needs. The cost of TIs, which may be amortized into the lease rate, can significantly impact the overall profitability of the lease.

  • Non-Compete/Exclusive Use Clauses: Restrict the landlord from leasing space to competing businesses.

  • Dark Store Clauses: Require the tenant to occupy the store until the end of the lease term.

  • Revaluation Clauses: Allow the landlord to change the rent based on the value of the asset as established by a third party, usually an appraiser.

  • 1.3. Other Lease Data:
  • Description of the Leased Premises: Confirm the size of the leased premises shown in the lease. The size of the leased premises shown in the lease could be different from the actual size of the occupied space.
  • Tenant-Installed Trade Fixtures: Trade fixtures should generally not be included in the appraisal because the items will not transfer with the real estate.
  • Signage: Some leases stipulate that signs with the names of larger tenants can be installed on the building’s exterior. Signage can generate income for the owners.

2. Estimating Potential Gross Income (PGI)

PGI is the total income a property could generate if fully occupied and collecting 100% of the rent.

• 2.1. Methods for Estimating PGI:

  • Market Comparison: Research recently signed leases of comparable properties. Adjustments may be necessary to account for differences in location, size, amenities, lease terms, and other factors. Use of a lease comparison grid (like Exhibit 22.1 from the provided document) is crucial. The most valid comparable are closed lease agreement.

  • Subject Property Leases: Analyze recently signed leases for the subject property. Requires reading each and every lease for special details to accurately estimate the future income potential. As leases roll over, the market rate can be applied.

• 2.2. Considerations for Market Comparison:

  • Effective Date of Lease: The date the lease was agreed upon, not necessarily the commencement date.
  • Location, Size, and Quality: Adjustments may be needed to account for differences between the comparable properties and the subject property.
  • Lease Terms and Concessions: Compare lease rates, expense responsibilities, and any rent concessions offered.

3. Vacancy and Collection Loss (V&C)

Vacancy and collection loss represent the potential income lost due to vacant space and uncollected rent.

• 3.1. Estimating V&C:

  • Market Analysis: Research vacancy rates and collection losses for similar properties in the same market area.
  • Property-Specific Factors: Consider the property’s location, condition, management, and tenant mix.
  • Economic Conditions: Assess the overall health of the local economy and its impact on the demand for leased space.

  The vacancy rate can be used as follows:

  $Effective\ Gross\ Income = PGI * (1 - Vacancy\ Rate)$
  Where:
  $Effective\ Gross\ Income$ is the estimated income after accounting for vacancy.
  $PGI$ is the Potential Gross Income.
  $Vacancy\ Rate$ is the percentage of total leasable area that is expected to be vacant.
  

4. Operating Expenses

Operating expenses are the costs associated with operating and maintaining the property. They are deducted from Effective Gross Income to arrive at Net Operating Income (NOI).

• 4.1. Types of Operating Expenses:

  • Fixed Expenses: Remain relatively constant regardless of occupancy levels, such as property taxes, insurance, and management fees.

  • Variable Expenses: Fluctuate with occupancy levels, such as utilities, repairs, and maintenance.

  • Replacement Allowance: An annual reserve for replacing short-lived items, such as carpeting, appliances, and roof coverings.

  • Above-the-line expense: are those included in operating expenses when calculating net operating income (NOI).

  • Below-the-line expense: are those excluded from operating expenses when calculating NOI.

  • 4.2. Expense Analysis:

  • Historical Data: Review historical operating expense data for the subject property and comparable properties.

  • Market Data: Research operating expense benchmarks for similar properties in the market area.
  • Expense Ratios: Calculate expense ratios, such as the operating expense ratio (OER), to assess the property’s expense management efficiency.
    • $OER = Total\ Operating\ Expenses / Effective\ Gross\ Income$

5. Net Operating Income (NOI)

NOI is the property’s income after deducting operating expenses from effective gross income. NOI is a crucial metric for property valuation.

• 5.1. Calculating NOI:

  • $NOI = Effective\ Gross\ Income - Total\ Operating\ Expenses$

• 5.2. Importance of Accurate Expense Estimates:

  • Inaccurate expense estimates can significantly distort the NOI and lead to an incorrect property valuation. Appraisers must exercise due diligence in researching and analyzing operating expenses.

  • 5.3. Net Income Ratio (NIR):

  • $NIR = NOI / Potential\ Gross\ Income$

  • The NIR is useful in quickly assessing the profitability of a property relative to its PGI.

6. Practical Applications and Related Experiments:

• 6.1 Experiment Example: Impact of Lease Terms on NOI

  • Scenario: Consider a hypothetical office building with 100,000 square feet of leasable area. The market rent is $25 per square foot per year.
  • Experiment: Compare two different lease scenarios:
    1. All leases are long-term (10 years) with a fixed rate of $25/sq ft.
    2. All leases are short-term (1 year) and reset each year based on a market fluctuation model.
    3. Model a CPI escalation clause and determine its impact on the NOI.
  • Variables:
    • Lease Term Length.
    • Escalation Clause rates.
    • Fluctuations in Market Rate.
  • Analysis:
    • Calculate NOI for both scenarios under different market conditions. Observe how each lease term affect the stability of income.

Conclusion

Lease analysis is a multifaceted process that requires a thorough understanding of lease terms, clauses, and their implications on income estimation. By carefully scrutinizing lease agreements, analyzing market data, and applying appropriate valuation techniques, appraisers can develop accurate and reliable income estimates that underpin sound property valuations. The appraiser should not just rely on a lease synopsis, rent rolls, or a property manager’s income estimate.