C H A P T E R 9 Introduction to IncomeProducing Properties: Leases, Rents, and the Market for Space ©2008 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Property Types • Residential Single Family Multifamily • Nonresidential Commercial • Office Buildings • Retail Industrial • Warehouse Space • Manufacturing 9-2 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Property Types Hotel/Motel • One-night stays • Destination resorts Recreational Institutional • Government • Hospital • University 9-3 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 9-4 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 9-5 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 9-6 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 9-7 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 9-8 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Pro-Forma Cash Flow Statement Rental Income + Other Income + Recovery of Expenses - Vacancy & Collections - Concessions ______________________ Effective Gross Income (EGI) 9-9 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Pro-Forma Cash Flow Statement EGI - Operating Expenses ______________________ Cash Flow from Operations (NOI) - Lease Commissions - Recurring Capital Outlays - Nonrecurring Capital Outlays ______________________ Net Cash Flow 9-10 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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. 9-11 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 9-12 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 9-13 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 9-14 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 9-15 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 9-16 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 9-17 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 9-18 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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 9-19 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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? 9-20 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved 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? 9-21 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved