1 Chapter 9 Introduction to Income-Producing Properties: Leases, Rents, and the Market for Space.

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Chapter 9

Introduction to Income-Producing Properties: Leases,

Rents, and the Market for Space

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Overview

Property Types Supply & Demand Short-Run Supply Long-Run Supply Determinants of Supply and Demand

for Major Property Types Location & User-Tenants

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Property Types

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Supply & Demand

Equilibrium Market Rent Determined by the supply and demand for

space In the short-term supply of space is fixed

Equilibrium Vacancy Rate Vacant space because tenants moving and

the time it takes for newly constructed space to be offered for lease

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Short-Run Supply

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Long-Run Supply

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Determinants of Supply and Demand for Major Property Types

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Location & User-Tenants Motivating Factors

Increase sales Business type where success requires a higher

revenue stream and heavy pedestrian traffic Reduce operating costs

Business type where success is based on a lower cost structure and large amount of land

Clustering and submarkets Similar businesses and operating cost

structures locate in similar locations

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The Business of Real Estate

Most real estate used by firms is leased rather than owned

Leasing is more cost-effective than owning Space requirement can be met without

significant capital commitment Stay out of the “real estate business”

Maintenance and repair Maintain operating flexibility

This results in specialized real estate firms

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Real Estate Income Market Rent

Supply & demand for specific property type Population demographics & income level Economic base of the area Economic forecasts

Vacancy Allowance for unused space. It should always

be included in cash flow projections It is more predictable for space already in use It is difficult to estimate for newly constructed

properties

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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 Use of and maintenance responsibility for

common areas Responsibilities for specific expenses

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Lease Income Base Rent

Initial rent or minimum 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 – dollar amount of rent that exceeds

the base rent

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Leases & Expenses Recoveries

Operating expenses are usually shared with tenants

These operating expenses are prorated among tenants

Typical operating expenses: Cleaning, repairs, maintenance, landscaping, water/sewer,

security, management, real estate taxes, insurance

Gross Leases Tenant pays rent only Property owner pays all operating expenses

Modified Full Service Leases Tenant pays rent & specified expenses

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Leases & Expenses – Continued

Leases with Expense Recoveries in Excess of Expense Stops

Tenant pays rent plus some pro-rated “recoverable” operating expenses after an “expense stop” is reached

Pass-Through Leases Expense pass-through leases that require tenant payments

on expenses Net leases – all operating expenses are passed to tenant with

usually no expense stops Net, net leases – all operating expenses plus property taxes and

insurance costs are passed to tenant Net, net, net leases (triple net) – in additions to all above

expenses, tenant pays for maintenance, repairs, and building alterations (tenant improvements)

Combinations Leases can be designed to serve for the best interest of

parties involved and therefore they may have features that are not distinct

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Effective Rent Used to compare different leases

Compute present value of rent stream Convert present value to an equivalent annual

annuity Consider the following rent schedule

Year 1 = $12/square foot Year 2 = $14/square foot Year 3 = $15/square foot

If the interest rate is 12%, what is the effective rent?

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Effective Rent – Continued

Year 1 2 3Rent psf 12.00 14.00 15.00Interest Rate 12.00%PV $32.55Effective Rent $13.55

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Effective Rent – Continued1. Net Lease with StepsYear 1 2 3 4 5Net rent 10.00 11.00 12.00 13.00 14.00Average rent 12.00Interest Rate 10.00%PV $44.77Effective Rent $11.81

2. Net Lease with Free RentYear 1 2 3 4 5Net rent 0.00 14.50 15.50 16.50 17.50Average rent 12.80Interest Rate 10.00%PV $45.76Effective Rent $12.07

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Effective Rent – Continued3. Net Lease with 100% CPI AdjustmentYear 1 2 3 4 5CPI 2.00% 3.00% 4.00% 5.00%Net rent 11.00 11.22 11.56 12.02 12.62Average rent 11.68Interest Rate 10.00%PV $44.00Effective Rent $11.61

4. Gross LeaseYear 1 2 3 4 5Gross rent 17.50 17.50 17.50 17.50 17.50Less expenses 4.00 4.50 5.00 5.50 6.00Net rent 13.50 13.00 12.50 12.00 11.50Average rent 12.50Interest Rate 10.00%PV $47.74Effective Rent $12.59

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Effective Rent – Continued5. Gross Lease with Expense Stop at 4.00Year 1 2 3 4 5Gross rent 15.50 15.50 15.50 15.50 15.50Less expenses 4.00 4.50 5.00 5.50 6.00Plus reimbursement 0.00 0.50 1.00 1.50 2.00Net rent 11.50 11.50 11.50 11.50 11.50Average rent 11.50Interest Rate 10.00%PV $43.59Effective Rent $11.50

6. Gross Lease with Expense Stop at 4.00 and CPI AdjustmentYear 1 2 3 4 5Expected CPI 2.00% 3.00% 4.00% 5.00%Gross rent 14.50 14.79 15.23 15.84 16.64Less expenses 4.00 4.50 5.00 5.50 6.00Plus reimbursement 0.00 0.50 1.00 1.50 2.00Net rent 10.50 10.79 11.23 11.84 12.64Average rent 11.40Interest Rate 10.00%PV $42.84Effective Rent $11.30

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Pro-Forma Cash Flow Statement

Rental Income+ Other Income+ Recoveries- Vacancy and Collection Losses- Concessions

Effective Gross Income- Operating Expenses

Cash Flow From Operations (NOI)- Lease Commissions- Recurring Capital Outlays- Nonrecurring Capital Outlays

Net Cash Flow

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Office Leases Normally 3-7 year terms Renewal option of tenant Premium rents for highly desirable space Rent discounts for space Right of first refusal

Right to rent contiguous space as it becomes available

Right to put back space Purchase option

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Industrial Property Leases

Similar to office leases Individualized and longer Tend to be pass-through or

Net Net, net Net, net, net leases

Premiums & discounts

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Retail Leases Sales per square foot Provisions on operations Limits on other tenants Anchor and in-line tenants

Rent differences Common Area Maintenance (CAM)

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Apartment Leases

Shorter term Consumer protection laws Gross potential rental income

Based on full occupancy Loss to lease - lease difference

between new and old leases times number of old leases/units