Leasing Term Impacts to
Valuation
Lachlan MacQuarrie, Vice President
Oxford Properties Group
Vice President, Real Estate Management – National Programs.
S. Michael Brooks, Partner
Aird & Berlis LLP
Real Estate Practice Group Leader
RealLeasing Conference
October 2nd. 2013
Static Model: Real Estate Finance
Investor
Cap Rates, DCF,
IRR, NPV, FFO,
Financial
Modelling
NER, Discount Rate,
yield, budgeting,
lease vs buy
Tenants
Amortization, Yield
Owner
Real Estate
Lender
Budgeting and financial
modelling
Contractors and suppliers
Retail, Office, Industrial “Net Lease” Income
•Net Effective Rent “NER”
NER is the “effective” net rent to the landlord over the term
of a lease after present valuing leasing commissions,
leasehold improvement allowances, old lease takeovers,
and free rent periods, then amortizing that PV over the fixed
initial term of the lease like an annuity
•Gross Effective Rent “GER”
GER is the “effective” gross (ie inclusive of tax and operating
costs) rent to the landlord over the term of a lease – same
mechanics as above
•NER key metric: owners run NER screens
•Face Rents – that shown on reading the lease rent clause illusory: but buyers buy Face Rent (rent roll)
•Face Rent may be significantly higher than market NER’s
Leasing: NER’s answer the question: which deal best?
Deal 1
10 year term
$14 net psf/yr
$10 LIA
$1 Commission
Right to
terminate yr 5
Deal 2
10 year term
$16
$20
$1
Option to
expand yr 3
6 mos rent free 9 mos
Deal 3
10 year term
$18
$30
$1
First right of
refusal
adjoining space
12 mos
3 Step NER: PV calc then net annuity
Deal 1
f
g
h
i
j
face rent
PV to Yr 1@10%
total PV rent a-e
less LIA
less Commission
Net PV (f-g-h)
re-amortize @10%
therefore NER
a
b
Year 1
2
$
7.00 $ 14.00
$
7.00 $ 12.60
$
50.33
$
10.00
$
1.00
$
39.33
$
9.43 $ 9.43
$
9.43
c
d
e
3
4
5
$ 14.00 $ 14.00 $ 14.00
$ 11.34 $ 10.21 $ 9.18
$
9.43
$ 9.43
Should we do an NER if they don’t terminate yr 5?
$ 9.43
Deal 2: The 3 step approach
Deal 2
k
l
m
n
o
face rent
PV to Yr 1@10%
total PV rent a-j
less LIA
less Commission
Net PV (k-l-m)
re-amortize @10%
Therefore NER
a
Year 1
$
$
$
$
$
$
$
$
b
c
d
e
f
g
h
i
j
2
3
4
5
6
7
8
9
10
4.00 $ 16.00 $ 16.00 $ 16.00 $ 16.00 $ 16.00 $ 16.00 $ 16.00 $ 16.00 $ 16.00
4.00 $ 14.40 $ 12.96 $ 11.66 $ 10.50 $ 9.44 $ 8.48 $ 7.65 $ 6.88 $ 6.19
92.16
20.00
1.00
71.16
10.53 $ 10.53 $ 10.53 $ 10.53 $ 10.53 $ 10.53 $ 10.53 $ 10.53 $ 10.53 $ 10.53
10.53
But what about the option to expand Year 3?
Do we have to hold space off the market?
Should we compute that “opportunity cost”?
Deal 3: The 3 Step Approach
Deal 3
k
l
m
n
n
face rent
PV to year 1@10%
Total PV rent a-j
less LIA
less Commission
Net PV (k-l-m)
re-amortize@10%
Therefore NER
a
Year 1
$
$
$
$
$
$
$
$
b
c
d
e
f
g
h
i
j
2
3
4
5
6
7
8
9
10
$ 18.00 $ 18.00 $ 18.00 $ 18.00 $ 18.00 $ 18.00 $ 18.00 $ 18.00 $ 18.00
$ 16.20 $ 14.58 $ 13.14 $ 11.81 $ 10.62 $ 9.54 $ 8.64 $ 7.74 $ 6.97
99.23
30.00
1.00
68.23
10.09 $ 10.09 $ 10.09 $ 10.09 $ 10.09 $ 10.09 $ 10.09 $ 10.09 $ 10.09 $ 10.09
10.09
What about the First Right of Refusal to Lease
adjoining space? Does that cost us anything?
Leasing: NER’s answer the question: which deal best?
Deal 1
10 year term
$14 net psf/yr
$10 LIA
$1 Commission
Right to
terminate yr 5
Deal 2
10 year term
$16
$20
$1
Option to
expand yr 3
6 mos rent free 9 mos
$9.43 NER
$10.53 NER
Deal 3
10 year term
$18
$30
$1
First right of
refusal
adjoining space
12 mos
$10.09 NER
Approaches to Direct Real Estate
Valuation
•Discounted Cash Flow (Income Capitalization)
•Relative Valuation (Sales or “Direct”
Comparison)
•Replacement Cost
Cost
•Assumes value = cost
•= Land value + (building replacement cost –
accumulated depreciation)
•Land value estimated separately – direct comparison
•Depreciation estimated from observation, age of
building, building condition.
•Useful for specialized properties and as a touchstone
Direct Comparison
•Useful if sufficient comparable sales available
•Sale prices of comparable sale prices indicate a range within subject
property should sell
•But must equalize for differences – subjectivity
•Result is an “equalized” value for each comparable
•typical in residential markets
•but value to unique user may be higher than for investor
•use as touchstone for investment property ($/psf or $/unit)
Income Approach
•PV of future benefits - current income and resale value upon
reversion capitalized into current lump sum value
•2 Methods: Direct capitalization and yield capitalization
•Direct Capitalization: take current income stream and use market
capitalization rate, or market based gross income multiplier
•Yield Capitalization: uses Discounted Cash Flow: PV of income
stream and PV of terminal value
•Current cash flow a reflection of Face Rent NOT NER, and does not
reflect the “investment” the Landlord has made to secure those tenants
Discounted Cash Flow: Example 1
Yield Capitalization Method @ 2% rent increases:
D.C.F Summary
Year
Sale at a 6 cap
(a)
NOI
1
(b)
PVNOI @ 8%
(c)
REV
(d)
PVREV @ 8%
( e ) = (b) + (d)
Total PV
$481,875.86 $ 446,181.35
$
446,181.35
2
$
491,513.38 $ 421,393.50
$
421,393.50
3
$
501,343.64 $ 397,982.75
$
397,982.75
4
$
511,370.52 $ 375,872.60
$
375,872.60
5
$
521,597.93 $ 354,990.79
$
354,990.79
6
$
532,029.89 $ 335,269.08
$
335,269.08
7
$
542,670.48 $ 316,643.02
$
316,643.02
8
$
553,523.89 $ 299,051.74
$
299,051.74
9
$
564,594.37 $ 282,437.75
$
282,437.75
10
$
575,886.26 $ 266,746.77 $ 9,790,066.41 $ 4,534,695.01 $ 4,801,441.77
Total =
$ 8,031,264.33
Direct Capitalization Method @ 6% cap rate = $8,031,250
DCF Example 2.
Yield Capitalization Method @ 2% rent increases
D.C.F Summary
Sale at a 5 cap
(a)
Year
NOI
1
(b)
(c)
(d)
( e ) = (b) + (d)
PVNOI @ 7%
REV
PVREV @ 7%
Total PV
$481,875.86 $ 450,351.27
$
450,351.27
2
$
491,513.38 $ 429,306.82
$
429,306.82
3
$
501,343.64 $ 409,245.75
$
409,245.75
4
$
511,370.52 $ 390,122.12
$
390,122.12
5
$
521,597.93 $ 371,892.11
$
371,892.11
6
$
532,029.89 $ 354,513.98
$
354,513.98
7
$
542,670.48 $ 337,947.90
$
337,947.90
8
$
553,523.89 $ 322,155.95
$
322,155.95
9
$
564,594.37 $ 307,101.93
$
307,101.93
10
$
575,886.26 $ 292,751.37 $ 11,748,079.69 $ 5,972,127.99 $ 6,264,879.37
Total =
$ 9,637,517.20
Direct Capitalization Value @ 5% cap rate= $9,637,500
14
Deal structure impacts the value of leases and the valuation of the asset
•Rate
•Term
•Options / ROFR / Right to Expand
•Tenant Allowances
•Restoration Clauses
•Exclusivity / Restrictions
•Operating Costs
•Termination Options
•Parking
•Commitments to…
•Subletting and Assignments
15
Rate –obviously!
• Flat vs. stepped
• Over market (or under market)
• Last rent paid?
• Same NER can have different valuation impacts
• Favored nations clauses – in particular new builds, or large tenant
deals, can impact valuation
Clear IMPACT to valuation! Sometimes even if over market.
16
Term
• Commitment to rent…
• 10 years is better than 5 in a falling market
• ST is better than LT in a volatile market – it depends
– Ideally consider the market – the more stabilized the longer the term, the
more volatile the shorter (assuming things are going up!)
• Use rent steps to protect
• Standard fit out / uses vs customized
• Staggered terms can help an asset (requiring leasing and AM to
talk)
• ½ of the value of an asset occurs outside of the lease term of the
committed cash flow…the residual value
17
Options / ROFR / Right to Expand etc
•Options give control to the tenant
•ROFR gives control to a tenant, credit worthiness is a concern in
extreme cases
•Right to Expand is like a “melting ice cube” for an asset
•Right to Terminate (LL) can limit securing the best tenants and
introduces risk / cost to valuation models
Control will impact how PV cash flow + residual value is forecasted
18
Tenant Allowances
•Give tenants a market TI, maintain the face rate.
•Analysts capitalize the face rent for residual, and the last rent paid has
an impact on negotiations
•Over market TI’s – analysts will see past the face rent, assume
termination, and then renewal at market – an impact to valuation!
Psychology has an impact, even in valuation!
19
Restoration Clauses
•Can be an unseen cost of a lease deal if waived
•Significant exposure to high tech, excessive partitions, specialty uses
such as libraries can detract value on assets
•The main issue is the impact on valuation if the use / equipment is
unique, non-standard.
Should be a cost in NER if waived, will be considered in valuation
20
Exclusivity / Restrictions / Use Clauses
• Exclusivity may be more common in retail…
• Restrictions limit the pool of possible tenants.
• Use clauses that impact wear / tear on a building can impact asset
value.
Largely these are a qualitative impact on valuation unless the impact is
significant which can be the case in thin markets
21
Operating Costs
•Any restriction on recoverability will impact the valuation
• CAM stops
• Exclusions
• Semi-gross
• Inflationary controls
• Only costs which must be recovered by everyone…
Will get picked up in valuation as an impact to value.
22
Termination Options
• Why not just give a ST deal as opposed to giving a tenant control.
• T. Options give the benefit of a buyout in an over market situation to
the Tenant.
• Analysts look at forecasted rent curves to see market vs. termination
rate.
• Better to give ST deals and a market renewal – avoid the valuation
impact
Avoid analysts assuming a termination will occur, which impacts
valuation.
23
Parking
• Don’t over commit – make sure future tenants can have appropriate
ratios otherwise deals will be impacted
• Impacted deals mean capital (if parking can be added), or loss in face
rent – both impact valuation.
Lack of parking, or overcommitted can’t always be cured!
24
Commitments to…
•Renovations
•Lobbies
•Certifications (such as LEED)
•Control on others
All have an impact on valuation – analyst will assume the commitment
to be met which will require capital!
25
Subletting and Assignment
• No significant impacts unless Tenants end up competing with LL to fill
space
• LL should control the right to “take back” space if necessary, and
consider buy outs
• In a rising market LL should capture any upside Tenant’s secure….
If terms and controls are not strong enough generally then major
impacts on “quality” can impact cap rates.
26
Questions and Discussion?
Lachlan MacQuarrie, Vice President
Oxford Properties Group
Vice President, Real Estate Management – National Programs.
S. Michael Brooks, Partner
Aird & Berlis LLP
Real Estate Practice Group Leader
RealLeasing Conference
October 2nd. 2013