Mastering Income-Producing Properties Leases: Effective Rent and Lease Income Analysis

1. CHAPTER9 Introduction to Income-Producing Properties: Leases, Rents, and the Market for Space

2. Property Types • Residential • Single Family • Multifamily • Nonresidential • Commercial • Office Buildings • Retail • Industrial • Warehouse Space • Manufacturing

3. Property Types • Hotel/Motel • One-night stays • Destination resorts • Recreational • Institutional • Government • Hospital • University

4. Popular Business Choice: Leasing • More cost-effective than owning • Space requirements • Owning is a heavy capital investment • Stay out of the “real estate business” • Maintenance and repair • Maintain operating flexibility • This results in specialized real estate firms.

5. Leases • Lessor-Owner, Lessee-Tenant • Qualify the tenant – underwriting • Financial capacity • Some Lease Content Items • Parties, Dates, Length • Base rent & any adjustments, deposits • Allowable uses & restrictions

6. Lease Income • Base Rent • Initial rent • Flat Rent Leases • No rent change over lease term • Step-up Leases • Specified rent increases at specified times • Indexed Leases • Periodic rent adjustment-CPI Index • Percentage Lease • Rent partially based on sales • Overage Rent

7. Responsibility for Expenses • Gross / full service lease • Owner/landlord pays all expenses • Net lease • tenant pays all operating expenses • Expenses stop • Owner pays up to the “stop” • Expenses in excess of the stop are “passes through” to tenants • The stop is typically the expenses per s.f. in the first year of the lease • There can be a “cap” on the amount passed through

8. Example of Expense Stop • A tenant has an expenses stop of $5 per s.f. based on expenses the first year of the lease • Expenses per s.f. are currently $7 per s.f. and the tenant has 15,000 s.f. of leaseable area • How much does the owner and tenant pay in expenses for this tenant’s space? • A: The owner pays $5 x 15,000= $75,000 The tenant pays ($7-$5) x 15,000= $30,000

9. Pro-Forma Cash Flow Statement Rental Income + Other Income + Recovery of Expenses - Vacancy & Collections - Concessions ______________________ Effective Gross Income (EGI)

10. Pro-Forma Cash Flow Statement EGI - Operating Expenses ______________________ Cash Flow from Operations (NOI) - Lease Commissions - Recurring Capital Outlays - Nonrecurring Capital Outlays ______________________ Net Cash Flow

11. Effective rent • We need a single measure to compare leasing alternatives • To calculate effective rent, we need to: • Calculate the PV of expected net rental stream to the owner of the building • Net of any operating expenses paid by owner • Calculate an equivalent level annuity over the term of lease which has the same PV • This measures the return to the lessor and cost to the lessee.

12. Effective rent - Examples • What are the effective rents for the following 6 5-year leases at 10% discount rate? • 1. net lease with steps • $10 / sf for 1st year and increases by $1 each of the following 4 years • Tenants pay all operating expenses

13. Effective rent - Examples • 2. net lease with one year free rent • Free rent in the 1st year • $14.50 / sf for 2st year and increases by $1 per year thereafter • Tenants pay all operating expenses

14. Effective rent - Examples • 3. net lease with CPI adjustments • $11 / sf for 1st year and increases by CPI in each following 4 years • Tenants pay all operating expenses • CPI is expected to grow at 2% during year 2, 3% year 3, 4% year 4 and 5% year 5

15. Effective rent - Examples • 4. gross lease • $17.50 / sf for 1st year and stays flat • Lessor responsible for all operating expenses • Expenses estimated to be $4 in year1, and increase by $0.50 each year

16. Effective rent - Examples • 5.gross lease with expense stop • Base rent $15.5 / sf for 1st year and stays flat • Lessor responsible for operating expenses up to an expense stop of $4/sf • Expenses expected to be $4 for year 1, and increase by 50 cents each year

17. Effective rent - Examples • 6. gross lease with expense stop and CPI adjustment • $14.5 / sf for 1st year and increases by CPI changes in each of the following 5 years • Expense stop at $4/sf • CPI is expected to be 2% during year 2, 3% year 3, 4% year 4 and 5% year 5 • Expenses expected to be $4 for year 1, and increase by 50 cents each year

18. Office Leases: Load factors • Load factor for floor = Rental area per floor Usable area per floor • Example: a floor has 20K rental area and 2K common area, or 18K usable area. • Q: What is the square footage that a tenant with 4,500 sf usable area need to pay for? • Load factor = 20K/18K = 1.11 • 4,500 * 1.11 = 5,000

19. Office Leases: Load factors • Load factor for building can be calculated similarly • Example: 200K rentable sf over 10 floors and a first floor lobby/common area of 20K. • If $20 per sf base rents, what is total rents for 4,500 sf? • 20K/200K = 10% (building load factor of 1.1) • Revised load factor = 1.11*(1+10%) = 1.222 • Rentable sf = 4,500*1.222 = 5,500 sf • @ $20/sf, the rent is 5,500*20 = $ 110,000

20. Retail Leases • Overage Rents • Assume 1,000 sf of rentable space with a base rent of $35/sf and 8% overage rents at breakpoint of $900K. If the expected sale is $1 million, what is the expected rents?

21. Retail Leases Common area maintenance (CAM) • Anchor vs in-line tenants • CAM /sf for in-line space = total CAM expenses – contribution by anchor Total rentable space by in-line tenants Example: A a million sf mall, of which 1.2 million is rentable, costs $5 million per year for CAM expenses. Of the 1.2 million rentable anchors occupy 700K sf, and pay $2/sf CAM charge. Q: what is CAM charge per sf for in-line tenants?