CCIM NEW DESIGN TION CURRICULUM Enhance your career, deepen your knowledge, and be better equipped for today’s market with CCIM’s new, evolved courses.CI 101–Financial Analysis for Commercial Investment Real EstateMake better investment decisions by using the CCIM Cash Flow Model as a framework for real estate analysis. Apply state-of-the-art real estate analysis tools to quantify investment return. Measure the impact of federal taxation and financial leverage on the cash flow from acquisition, ownership, and disposition phases of real estate investment. CI 102–Market Analysisfor Commercial Investment Real EstateApply the CCIM Strategic Analysis Model to make a “go” or “no -go” investment decision.Use state-of-the-art geospatial technology for strategic analyses. Examine real-world case studies of comprehensive strategic analyses for each of the four major property types: office, industrial, multifamily, and retail. Preparing to Negotiate (online, self-paced course) Apply the CCIM Interest-Based Communications/Negotiations Model to your negotiations and presentations. Interpret CCIM Interest Analysis Chart elements, and consider creative solutions for identified interests and issues. Assess risks and action plans for potential conflicts. CI 103–User Decision Analysis for Commercial Investment Real EstateApply key occupancy decision-making skills such as comparative lease analysis, lease vs. purchase analysis, lease buyout analysis, and sale-leaseback analysis to optimize user space decisions. Determine how financial reporting requirements for real estate influences user decisions. Integrate negotiation skills with financial analysis skills to maximize user outcomes. CI 104–Investment Analysis for Commercial Investment Real Estate Apply key investor decision-making analyses to optimize investment returns. More effectively forecast investment performance by quantifying real estate risk. Leverage CCIM analytical tools to improve decision-making. For the most up to date course schedule and to register for a course, visit www.ccim.com/course/catalog or call (800) 621-7027, ext. 3100.
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CCIM NEW DESIGN TION CURRICULUM
Enhance your career, deepen your knowledge, and be better equipped for today’smarket with CCIM’s new, evolved courses.
CI 101 – Financial Analysis
for Commercial Investment Real Estate Make better investment decisions by using the CCIM Cash Flow Model as a framework for real estate
analysis.
Apply state-of-the-art real estate analysis tools to quantify investment return.
Measure the impact of federal taxation and financial leverage on the cash flow from acquisition,
ownership, and disposition phases of real estate investment.
CI 102 – Market Analysis
for Commercial Investment Real Estate Apply the CCIM Strategic Analysis Model to make a “go” or “no -go” investment decision.
Use state-of-the-art geospatial technology for strategic analyses.
Examine real-world case studies of comprehensive strategic analyses for each of the four
major property types: office, industrial, multifamily, and retail.
Preparing to Negotiate (online, self-paced course) Apply the CCIM Interest-Based Communications/Negotiations Model to your negotiations
and presentations.
Interpret CCIM Interest Analysis Chart elements, and consider creative solutions for identified
interests and issues.
Assess risks and action plans for potential conflicts.
CI 103 – User Decision Analysisfor Commercial Investment Real Estate
Apply key occupancy decision-making skills such as comparative lease analysis, lease vs. purchase
analysis, lease buyout analysis, and sale-leaseback analysis to optimize user space decisions.
Determine how financial reporting requirements for real estate influences user decisions.
Integrate negotiation skills with financial analysis skills to maximize user outcomes.
CI 104 – Investment Analysis
for Commercial Investment Real Estate
Apply key investor decision-making analyses to optimize investment returns.
More effectively forecast investment performance by quantifying real estate risk.
Leverage CCIM analytical tools to improve decision-making.
For the most up to date course schedule and to register for a course,visit www.ccim.com/course/catalog or call (800) 621-7027, ext. 3100.
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CCIM DESIGN TION ND INSTITUTE MEMBERSHIP
Joining the CCIM Institute and earning the coveted CCIM Designation equips you toface the challenges of the commercial real estate market.
CCIM Institute Member Benefits
Commercial Investment Real Estate (CIRE) Magazine CCIM’s award-winning magazine is your bi-monthly source for the latest articles,
analysis, and insight into all facets of commercial investment real estate.
Free Web ConferencesCCIM offers free monthly web conferences addressing the latest industry developmentsand trends.
Discounts on Education As a CCIM Institute member, you receive discounts on all of CCIM’s education courses and events.
CCIMREDEXResearch, analyze, and market your property all at once using CCIMREDEX.CCIMREDEX is integrated with the industry’s top marketing, analytical, and financial products,allowing you to save time and money.
Site To Do BusinessSite To Do Business integrated online resource center provides comprehensive site analysis,mapping and demographic data, aerial viewing of properties, flood zone determinations,financial analysis tools, customized reports, and a broad spectrum of other business services.
For a complete list of CCIM Institute member benefits and to join, visit www.ccim.com/membership.
Earning the CCIM Designation To earn the coveted CCIM Designation you must:
Become a Candidate of the Institute
Successfully complete the designation courses
Successfully complete the CCIM Online Ethics Course
Earn elective credits
Submit the Portfolio of Qualifying Experience
Successfully pass the Comprehensive Exam
For complete details and updated information on earning the CCIM designation,visit www.ccim.com/membership or call (800) 621-7027, ext. 3100.
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User Decision Analysis for Commercial Investment Real Estate
In This Section Welcome Letter ....................................................... i
Course Material ...................................................... ii
Table of Icons ......................................................... ii
User Decision for Commercial Investment Real Estate• i
C o n t e n t s
Welcome
Dear Student:
The CCIM Institute welcomes you to the CI 103 course, User Decision
Analysis for Commercial Investment Real Estate .
This course is designed to give you a thorough understanding of financialanalysis tools, concepts, and calculations. It provides you with the foundation
you will need to take subsequent CCIM courses. The course material consists
of three components—a reference manual, CD-ROM, and an in-class exam.
Each component is described later in this section.
To receive the maximum benefit from this course, students are advised to
complete all practice problems and actively participate in classroom activities.
This course is designed to be interactive, so student discussion and questions
are welcomed.
Students seeking the Certified Commercial Investment Member (CCIM)designation are required to successfully complete the final exam under the
supervision of the instructor(s).
Students seeking only continuing education credit are required to complete the
State Continuing Education Request Form (available from the instructor) and
may be required to successfully complete the exam, depending on their state’s
regulations.
Please remember that the classroom is a nonsmoking environment. Also,
inappropriate behavior will not be tolerated. Offenders will be asked to leave
the course immediately and will forfeit their tuition.
If you have any questions during the course regarding the CCIM program or
courses, do not hesitate to ask either an instructor or the Institute’s on-site
administrator. Enjoy the course.
CCIM Institute
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ii• User Decision Analysis for Commercial Investment Real Estate
Course Material
All Institute courses are designed to ensure a highly effective learning
experience. This course consists of the following components:
Reference Manual
The reference manual is designed to be used as an in-class textbook and an
after-class reference tool. This manual includes conceptual material,
calculations, examples, and activities. The activities are real-life real estate
scenarios that require application of the skills, calculations, and theories
presented in each course module.
CD-ROM
The CD-ROM contains Excel spreadsheets and other tools that students can
use to solve course activities and tasks.
In-Class Exam
The course ends with an in-class exam to test particular skills taught throughout
the course. It is multiple-choice and open-book. The exam is formatted in the
same manner as the self-assessment questions at the end of each module.
Information from the reference manual will be on the exam. (Students taking
the course for continuing education credit in Illinois also must take a closed-
book exam.)
Table of Icons
Included throughout the reference manual are the following icons to help you
identify particular sections or concepts in the course material:
Activity Instructor
Demonstration /
Sample Problem
Material found on
the CD ROM
Summary Case Study
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User Decision Analysis for Commercial Investment Real Estate • TOC i
Summary ......................................................................................... 2.16 Activity 2-1: After-tax Weighted Average Cost of Capital ................................. 2.17
User Decision Analysis for Commercial Investment Real Estate • TOC ix
T a b l e o f C o n t e n t s
Step 3: What Happens if No Agreement Is Reached? Determine
Fighting Alternatives (The Consequences of No Solution)............................... 8.19
Implementing the Optimal Strategy ................................................................... 8.20
Case Study 1: Comparative Lease AnalysisCase Study Overview ............................................................................................ 9.1
Case Objectives ..................................................................................................... 9.1
Case Study 1: Comparative Lease Analysis .......................................... 9.3Case Setup ............................................................................................................. 9.3
Task 1-2: Complete an Economic Comparison of the Leases ........................ 9.12
Case Study 2: Lease versus Purchase AnalysisCase Study Overview .......................................................................................... 10.1
Case Objectives ................................................................................................... 10.1
Lease versus Purchase Analysis ........................................................ 10.3Case Setup ........................................................................................................... 10.3
Task 2-1: Initial Interests and Economic Analyses ........................................... 10.6
Task 2-2: Update Your Interests and Financial Analyses ............................... 10.10
Task 2-3: Determine Actions and Make a Recommendation ........................ 10.13
Task 2-2: Update Your Interests and Financial Analyses ............................... 10.21
Case Study 3: Lease BuyoutCase Study Overview .......................................................................................... 11.1
Case Objectives ................................................................................................... 11.1
Case Study 3: Lease Buyout .............................................................. 11.3Case Setup ........................................................................................................... 11.3
Case Study 4: Sale LeasebackCase Study Overview .......................................................................................... 12.1
Case Objectives ................................................................................................... 12.1
Case Study 4: Sale Leaseback .......................................................... 12.2Case Setup ........................................................................................................... 12.2
Task 4-1: User Analysis ..................................................................................... 12.5
User Decision Analysis for Commercial Investment Real Estate • 1.1
Introduction to User Decision
Analysis Module Snapshot
Module Goal
The material contained in this course addresses occupancy costs from the
user’s perspective. Users of real estate are organizations that use property such
as office and warehouse space, retail stores, or industrial plants for a businesspurpose. The material and case studies in this course cover information about
a variety of user scenarios. By the end of the course, students should be able to
assess occupancy economics from various perspectives, weigh those economics
against any pertinent qualitative factors, and then make decisions that result in
the best overall occupancy decision.
Objectives
Identify the major decisions users face concerning the acquisition, holding
period, and disposition of space.
Explain the interaction of supply and demand in the space market.
Explain the interaction of net operating income (NOI), capitalization rate,
and value in the capital market.
Demonstrate the interaction between the space and capital markets.
Quantify developer profit as determined by the interaction between the
space and capital markets.
Identify the major sources of debt and equity capital.
1.6 • User Decision Analysis for Commercial Investment Real Estate
supply to be created is to make some of the existing vacant space available to
tenants. Property owners may not be leasing some of this space in anticipation
of higher rents. However, if the price is right, they will make it available. At the
highest rent level, all of the vacant space might be made available, although in
practice this probably never occurs as frictions in the market always result in
vacancy.The demand curve (D) reflects the willingness of tenants to lease more space at
lower rents (such as to make more space available for each employee of an
office building). The intersection of supply and demand results in market rents
and determines the current occupancy of space (quantity occupied). The
difference between this and the available supply is the vacancy.
Capital Market
Just as users are interested in acquiring space in the space market, investors aredeciding whether to acquire buildings that can be leased to these users.
Investors will consider what return they can expect from their investment in real
estate, which depends to a large extent on current market rents and how
investors think those rents will change over time due to fluctuations in the
supply and demand for space in the space market.
Depending on how the expected return on the property compares to other
investment alternatives with similar risk, or, depending on how the expected
risk-weighted return on the property compares to other investment alternatives,
real estate as an investment will be in demand—that is, a demand for capital to
flow into the real estate asset class. This demand must be met by the existing
supply of buildings available for investment, which might include owner-
occupied space since those users could decide to sell their buildings and lease
them back. The interaction between the demand for real estate as an
investment and the existing supply of space results in the value of space in what
is referred to as the capital market. The value for space often is expressed
relative to the NOI that would be expected during the first year of property
ownership. The ratio of NOI to the price investors are willing to pay for the
property is referred to as the capitalization rate, or cap rate . The cap rate is
what investors are willing to pay for a dollar of NOI. The value of the propertyis found as follows:
Value =NOI
Cap Rate
The cap rate provides an important gauge for what investors are willing to pay.
We could say that the cap rate implicitly reflects investors’ expectations of the
NOI and/or value growth, as well as leverage and tax benefits. For example,
investors will be more willing to purchase a property at a lower cap rate (higher
1.8 • User Decision Analysis for Commercial Investment Real Estate
Figure 1.3 Relationship between Space and Capital Markets
An increase in office space demand due to an improvement in the economy, which leads to job growth and more demand for space in office buildings,
would shift the demand curve in Figure 1.2 to the right. This would result in
higher market rents with the same supply curve, which in turn would lead to
higher values with the same cap rate. Profit to developers also would increase
since the gap between value and cost increased. Ultimately, this should lead to
an increase in supply that would shift the supply curve to the right, decreasing
rents and bringing developer profits back to a normal level.
The above discussion illustrates what might happen if demand for space in the
space market increases. A decrease in cap rates in the capital market also could
occur (as a result of a decrease in mortgage rates, for example). This would
cause the slope of the cap rate line to decrease (indicating a lower cap rate).
Note that this would result in higher values for the same NOI and also would
increase developer profits and the incentive for additional development, purely
as a result of changes in capital market conditions.
The main point of this discussion about the space and capital markets is that
although market rents and lease terms are primarily determined in the space
market, and although cap rates and property values are primarily determined in
the capital market, these are two distinct but interrelated markets that are
important to understanding real estate. Real estate values can change becauseof events that impact either market. For example, job growth could increase the
demand for office space, which would increase rent levels, resulting in higher
values at the same cap rate. That is, the increase in values is driven by the space
market. On the other hand, interest rates and the cost of debt capital might
decline; thus, investors might be willing to accept a lower cap rate for the same
NOI. They would bid up the price for real estate, and values would rise
because of the actions of investors in the capital market.
1.12 • User Decision Analysis for Commercial Investment Real Estate
Sources of Debt and Equity Capital
The Equity Component of Commercial Real Estate
Several categories of equity investors target commercial real estate in the United
States, primarily private investors, public real estate investment trusts (REITs),
pension funds, foreign investors, and life insurance companies.
Private Investors and Private Institutions
Private investors are the most significant influence in the equity market. Unlike
stocks and bonds, real estate is a visible and tangible asset. For individuals, the
decision to own property can be based on pride as much as profitability. Real
estate also has the benefit of being more transparent than stocks and bonds,
especially with respect to investment returns and the investment decisionprocess. Individuals can invest in commercial real estate in a variety of ways,
including purchasing individual pieces of property alone or with other private
investors. Some individuals control billions of dollars in capital and invest a
significant amount of that wealth in commercial real estate. Private institutions
include investment banks, mutual funds, mortgage brokers, venture capital
companies, and other private institutions that may provide equity capital for real
estate.
Public REITs
Publicly traded REITs offer an easy way for the average person to invest in
commercial real estate. REITs are companies traded on the stock exchanges
that invest the majority of their assets in real estate. Many retirement plans
include REITs among their fund offerings. A REIT is a means by which many
investors can invest a small amount of capital in a portfolio of real estate
properties. The income generated by a REIT is not subject to corporate
income taxes because REITs are required to distribute a large majority of their
incomes to the shareholders (currently 90 percent).
Although some REITs invest in mortgages, the majority invest equity capital in
commercial real estate. They typically specialize in a particular property type,
but hold a fairly well diversified portfolio of properties in different geographic
areas. Thus, investors in REITs get diversification benefits as well as liquidity.
User Decision Analysis for Commercial Investment Real Estate • 1.15
1
•
I n t r o d u c t i o n
Commercial Mortgage-backed Securities and Commercial Real Estate
Collateralized Debt Obligations
CMBS are financial assets that are securitized by mortgages made on
commercial real estate. Commonly issued in the U.S., CMBS work like bonds.
One benefit of CMBS as compared to residential mortgage-backed securities
(MBS or RMBS) is that CMBS more often are protected from prepayment by
prepayment penalties, yield maintenance, or defeasance.
In a CMBS, first mortgages, usually from several different properties diversified
by property type and location, are pooled and held by a trust, which serves as a
pass-through entity for bondholders. Securities with different investment
characteristics are created from the same pool of mortgages. The securities are
given bond ratings (typically AAA through BBB-) based on their priority for
receiving principal payments and payments in the event of default on any of the
mortgages underlying the pool. Some securities are unrated and are the ―first
loss‖ piece, meaning that they are the first to lose money (the last to be paid anyprincipal) in the event of default. Investors can choose their preferred
combination of risk, yield, and duration. The AAA-rated securities have the
lowest risk, but also the lowest expected return. The unrated securities have the
highest risk, but offer the highest expected return.
Commercial real estate collateralized debt obligations (CRE CDOs) are
somewhat similar to CMBS, except they typically have many different types of
mortgages as assets and also may have other securities as part of their asset
pool. For example, they may include mezzanine debt and low-rated CMBS
securities as part of the assets against which new securities are issued.Unfortunately, CDOs were the vehicle used to securitize many of the subprime
mortgages on residential real estate that were made to homeowners with poor
credit ratings. Falling home prices and increasing interest rates in the late 2000s
triggered resets on the adjustable-interest-rate mortgages. Many of these
securities had high credit ratings under the theory that they were diversified,
backed by many residential mortgages, but the drop in home prices and rise in
interest rates affected virtually all of the mortgages. It remains to be seen if the
CDO market will recover as investors have become skeptical of these types of
securities, whether they are backed by residential or commercial mortgages.
Life Insurance Companies
Typically serving as the lender for large loans, life insurance companies provide
billions of dollars in real estate mortgages each year. Most companies utilize
various mortgage brokers throughout the country to originate loans. Life
insurance companies are more interested in holding positions in the
commercial real estate debt market than the equity market, due to the
1.16 • User Decision Analysis for Commercial Investment Real Estate
regulatory requirements on risk-based capital and the companies’ liability
structures.
Savings Institutions
Originally thought of as home mortgage lenders, savings institutions held long-
term savings deposits, which enabled them to make long-term loans. However,in the early 1980s when real estate values dropped drastically as a result of
significantly increasing interest rates, savings institutions were forced to decrease
their mortgage holdings by more than $25 billion. Lender, or debt, positions
increased from around $1 billion in 1994 to more than $2.5 billion in 2006.
Government-Sponsored Enterprises
GSEs such as the Federal National Mortgage Association (Fannie Mae) and the
Federal Home Loan Mortgage Corporation (Freddie Mac) also play an
important role in mortgage lending and issuing MBS. Both Fannie Mae andFreddie Mac provide multifamily financing for affordable and market-rate
rental housing. GSEs provide financing for apartment buildings,
condominiums, or cooperatives with five or more individual units.
User Decision Analysis for Commercial Investment Real Estate • 2.1
Special Considerations for
Cost of Occupancy Module Snapshot
Module Goal
This module introduces the special considerations that must be taken into
account when determining the cost of occupancy, specifically financial reporting
requirements and user discount rates. The financial reporting section coversthe fundamental concepts of corporate financial reporting and how they should
be incorporated in any real estate transaction analysis. The section also
explains how real estate transactions can affect a company‘s financial reports
and the importance of accurate and appropriate reporting of these transactions.
The second section of the module addresses user discount rates. Users of real
estate use discount rates for a variety of analyses, such as choosing between
different lease alternatives or deciding whether to own a building rather than
lease space.
Objectives
Explain the general concepts of financial reporting.
List the various ways financial statements are used.
Give a brief overview of the impact of financial reporting on lease, sublease,and sale-leaseback transactions.
Explain the basic reporting components of commercial real estate.
List the rule setting and governing entities for financial reporting.
Identify the financial accounting standard (FAS) regulations that apply to various types of real estate transactions.
Explain the key components of the income statement.
Explain the key components of the balance sheet.
Define opportunity cost.
Calculate the historic and marginal after-tax weighted average costs of capitalfor a corporation.
2.2 • User Decision Analysis for Commercial Investment Real Estate
Concepts of Financial ReportingThe reporting of an organization‘s overall financial performance is one of the
most important measures of its success. Operations, service, staffing, sales, and
other metrics are important, but financial reporting plots an organization‘s
ultimate health and longevity. The information it contains can drive strategic,investment, purchase, sale, and other key decisions. This holds true for private
and public companies, not-for-profits, and government organizations—basically
any large or small entity doing business.
In general, all organizations adhere to a consistent set of parameters and
guidelines/principles for reporting their financial status and performance results.
That said, in recent history, most notably since 2001, the validity of and
variations in financial reporting have been frequently scrutinized and closely
questioned, in some cases even leading to the demise of organizations. To
bring organizations back to more consistency and validity in reporting, rules andlaws have been revised or overhauled to avoid the issues and/or
misrepresentations that have cost taxpayers and company shareholders billions
of dollars.
The lesson learned from organizations taken to task over their financial
reporting practices is simple: it is absolutely vital to ensure the accuracy and
validity of financial statements and reporting, which should be a clear and
consistent reflection of a company‘s overall health.
It should be noted that the drive to consistency and transparency in financialreporting is a global movement, and is not limited to the U.S. Domestic and
international rule making authorities have been working together, merging
concepts, and collaborating on rulings designed to provide accuracy and validity
in financial reporting.
The role of real estate and real estate transactions within the context of financial
reporting often can be one of the most important for organizations when you
consider that many have extensive real estate holdings. Headquarters,
distribution centers, sales offices, telemarketing and call centers, and
manufacturing plants quickly add up to large real estate holdings, yet real estate
practitioners often misunderstand or overlook the impact of real estate and real
estate transactions on financial statements.
While the practitioner often times strictly views real estate for its investment and
income-generating purposes, the senior management of most organizations sees
real estate as a factor of production—the place where the business happens, not
the business itself. Airplane manufacturers are focused on building airplanes
more than on the large plants in which they are built. Oil refineries are focused
User Decision Analysis for Commercial Investment Real Estate•
2.3
2 •
S p e c i a l C o n s i d e r a t i o n s
on oil production more than on the physical plant; telecommunications
companies are focused on the service from their representatives rather than on
the centers in which they reside. Given the production factor necessity, real
estate holdings can be one of a company‘s largest asset classes and highest
annual expenses. Thus, the role of the real estate practitioner in accurate
financial reporting can become very important and strategic to his or her clients.
This module is designed to incorporate financial reporting information and
activities to verse students in the mechanics and generalities of reporting so they
understand the role real estate plays and its effect on financials. The
information is targeted to external real estate practitioners—those who represent
companies or businesses—and internal corporate real estate executives advising
senior management. Given the analyses a real estate practitioner routinely
conducts, it is easier to provide the practitioner with a working knowledge of
financial reporting and how to overlay it on his or her analyses than it is to
provide a working knowledge of real estate with its complexities regarding
corporate financial clients. Once educated, the practitioner will be in the
position to look at real estate from an overall financial perspective and to make
decisions or recommendations with that complete perspective.
How Financial Statements Are Used
At a very basic level, financial reporting acts as a common financial language of
business. It ensures that all companies play by the same rules and use the same
units of success. Although different industries may vary, when a company
reports earnings of $1 per share or a certain dollar amount of net equity, by andlarge everyone understands exactly what each metric means. This is the
information investors, lenders, regulators and others use to determine a
company‘s value and to make buying, selling , and other decisions.
For a company, financial reporting is a valuable tool in monitoring and
measuring performance. By using the information, management can see what
strategies may be working and those that may need to be re-evaluated. Financial
performance also is used to set reward targets for management and employees.
The real estate practitioner (whether internal to the company or retained as aconsultant) can play a key role by first understanding the financial drivers and
targets and then accurately planning and executing real estate activities to help
achieve those goals.
Real estate can be one of the most important and largest items on a company‘s
financial re ort et real estate ractitioners fre uentl misunderstand its im act.
2.4 • User Decision Analysis for Commercial Investment Real Estate
Financial Reporting Goals of the Course After completing this course, students should be able to better assist clients by
Ensuring that the goals of real estate transactions are aligned with the client‘s
overall financial goals. Understanding and communicating the impact of common real estate
transactions on an organization‘s financials and reports.
Understanding how to overlay financial reporting considerations on top of
real estate economic analyses to drive the best decisions and timing for
common transactions: leases, subleases, sale leasebacks, and conventional
purchases and sales.
Why Care About Financial Reporting?
Corporate real estate tenants or owners (users) occupy the vast majority of all
real estate. As mentioned above, that real estate is often a substantial line item
on financial reports. Wall Street, regulators and the broader investment
community (lenders, banks, and shareholders) judge company leaders based on
the financial data in these reports. Regardless of a company‘s size, these
stakeholders dislike surprises, good or bad.
Typically, a public company issues its quarterly earnings about 15–45 days into
the quarter following the one they are issuing. That process provides a look at
the past and signals what the next quarter or rest of the year may look like.Often at this time, a company will adjust its projected annual earnings or
provide guidance. When companies miss these projections—in either a positive
or negative way —questions arise about management oversight, abilities, and
intent. How can you prevent this from the real estate perspective? You can
understand the impact of a transaction. The more you understand, the easier it
is to structure a transaction that achieves a company‘s goals.
Consider that one of the most egregious examples of failure or issues in
financial reporting occurred when a Fortune 10 company virtually collapsed in
2001. At a high level, it could be said that the company collapsed due to off-balance-sheet transactions. (Balance sheets are covered in depth in the next
section.) How does this relate to real estate transactions? Negotiating lease
agreements—one of the most common real estate transactions—generally
constitutes an off-balance-sheet transaction, so the link becomes clear. As will
be further explained in the leasing activities of this module, an off-balance-sheet
transaction is neither bad nor incorrect. In fact, it generally is the preferred
2.6 • User Decision Analysis for Commercial Investment Real Estate
prosecutions for those who attest to a company‘s incorrect financials. The
Sarbanes-Oxley Act of 2002, known as ―SOX,‖ was enacted for publicly held
companies in response to high-profile financial scandals. It is designed to
protect shareholders and the public from accounting errors, inconsistencies and
fraudulent financial practices in companies. It also dictates a level of culpability
and responsibility for executives at both a personal and professional level.
Note that financial reporting rules are not only for public companies. Many
small and medium sized companies are obligated to prepare audited financial
statements for various reasons. For example, a closely held company may
prepare audited financial statements for its investors, or likely would be
required to submit audited financial statements to its lenders in order to comply
with loan covenants. A privately held school may be required to provided
audited financial statements to the state and federal accreditation entities. A
company working in a regulated field (say, insurance or banking), may be
required to prepare audited financial statements. A not-for-profit organizationmight be obligated to prepare audited financial statements to comply with their
charter or funding entities.
Financial reporting rules require that you report bad news when you know itand good news when you benefit from it.
User Decision Analysis for Commercial Investment Real Estate•
2.7
2 •
S p e c i a l C o n s i d e r a t i o n s
The Basics of Financial Reporting for Real
EstateFinancial reporting consists of various reports detailing different aspects of a
company‘s financial performance. Collectively, these should reflect the overallfinancial position of the organization. This section addresses the reports most
relevant to real estate and its impact on a compan y‘s reporting.
Income Statement
This document presents the results of an organization‘s operations for a specific
period. It details the revenue, expenses, and net income. The income
statement can be compared to an individual tax return—how much money you
brought in minus deductions equals net income. Obviously, different rules
apply, but the premise is similar.
Balance Sheet
This document presents the status of a company at a specific point in time. It
details a company‘s assets, liabilities, and net equity. It can be compared to a
personal statement of net worth— what you own minus how much you owe.
Cash Flow Statement
This document presents the sources and uses of cash for a specific period. It
details cash flows from operations, as well as investing and financing activities.
It can be compared on a personal level to a checkbook record. The cash flow
statement‘s relevance to real estate lies only in how transactions impact the
income statement and the balance sheet, which then are captured or recorded
on the cash flow statement. There are no stand-alone cash flow impacts.
SEC Filings
Public companies must provide financial reporting to the SEC through filings,
generally on both a quarterly and an annual basis. The most important filings
for this module are the 10-K and the 10-Q.
The 10-K is an annual SEC filing that includes:
Income statement, balance sheet, and cash flow statement as discussed
2.10 • User Decision Analysis for Commercial Investment Real Estate
Income StatementThe income statement consists of two main parts: revenue and expenses.
Revenue is the dollar inflow (money coming into the company) from the
operations of the company (sale of goods and services, dispositions, real estateor property sales, etc.). Expenses are dollar outflow (money going out) for
operations (costs to run the business). From a real estate standpoint, the
building a company purchased does not appear on the income statement;
rather, the purchase is recorded as an asset on the balance sheet (to be
discussed later). However, the expenses related to that building (depreciation,
maintenance, utilities, interest expenses, etc.) do appear on the income
statement. If your client rents rather than owns, then rent as well as
depreciation on his or her tenant improvements (TIs) show up as expenses.
Revenue – expenses = net income*
(*also called net profit, bottom line, net earnings, and profit and loss)
Whether renting or owning, the associated costs — rent payments when leasing orinterest and depreciation costs for owning — all appear as expenses on theincome statement. Purchases appear as assets on the balance sheet.
Key Concepts of the Income Statement
Accrual Versus Cash
As individuals, we are cash-basis taxpayers. If money comes in on January 1,
2011, it is not taxable for 2010. Companies, however, must accrue. When they
earn money, regardless of whether payment is in hand, it must be recorded on
the income statement as revenue. The balance sheet would show a receivable if
payment has not yet been received. Essentially, revenue is recorded when fully
earned, not when the contract is signed or when it is paid.
Conversely, expenses (such as in the form of an electric utility bill) also should
be accrued, assuming an actual check has not yet been written.
Matching Principle
Revenue and expenses must be recorded in the appropriate period. Expenses
must be recorded as they happen, and revenues must be recorded when fully
earned, not before. This prevents companies from using potential future
revenues to bolster current performance, a misrepresentation of the true
User Decision Analysis for Commercial Investment Real Estate•
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Application to Corporate Real Estate
The Importance of Quarterly Earnings
Given the rules governing when real estate transaction expenses and revenue
are recorded, a company‘s quarterly earnings can drive when a transactionoccurs. If a company must close a transaction to benefit the current period,
management often is prepared to sacrifice ancillary dollars to ensure that the
transaction happens in the period they want.
Free Rent Periods (Early Occupancy) Aren’t Free
For financial reporting, rent expenses are recognized in a manner similar to
total effective net rent (the amount of rent after deductions for landlord
concessions and any tenant-paid build-outs or allowances which is further
defined and explained later in this course). It is recognized straight-line over the
entire term, including any free rent period.
For example, your company or client signs a lease paying a teaser rate of $2 per
square foot (psf), which then increases dramatically to $10 psf. Financial
accounting rules dictate that the company cannot reflect the lower rent expenses
at the beginning of the lease, as this would provide an artificially low view of
expenses in the early portion of the lease. The company must average or
straight-line the rent expense consistently across the life of the lease.
It is important to remember when negotiating on behalf of certain clients that
they may not gain any benefit on their financial statements from a free rentperiod (a consequence of not clearly understanding this is incurring double rent
expense). For instance, your client wants to move, understanding they will be
paying on the old lease, but they think they are getting two or three months free
in the new space. They will be actually recording expenses for both locations.
Sale Transactions Can Create a Gain or Loss Depending on the Book
Value (Adjusted Basis)
When selling a property on behalf of a client, it is important to know the book
value (adjusted basis). For example, your client wants to sell a building for$5,000,000. If the book value is $3,000,000, they will record a gain of
$2,000,000. However, if the book value is $6,000,000, they will record a loss of
$1,000,000. The selling price is the same, but the difference lies in the book
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a cost of doing business on financial statements—listing the book value for that
property as an asset on the balance sheet and correspondingly treating
depreciation and related costs as business expenses on the income statement.
Conservatism Principle
Reporting rules require gains to be recorded when they are earned, while lossesmust be recorded when they are known. Factors such as increases in market
value cannot be recorded as gains; however, known liabilities should be
recorded. For example, signing a contract to deliver professional services for
five years is not realized as an immediate gain, but rather over the five years
when earned. Conversely, settling a lawsuit for $5,000,000 must be reported
immediately upon settlement, even if you will pay it off over time.
Substance Prevails Over Form
A transaction will be classed according to its substance. For example, leases are
largely off balance sheet. However, if certain financial attributes are present, a
lease must appear on the balance sheet. The fact that it is called a lease for real
estate becomes immaterial if the substance of the terms deems its classification
as a capital lease (defined and explained later), or an on-balance-sheet
2.14 • User Decision Analysis for Commercial Investment Real Estate
Selection of Discount Rate for the UserUsers of real estate utilize discount rates for a variety of analyses, such as
choosing between different lease alternatives or deciding whether to own a
building rather than lease space. The discount rate depends on the risk factor
of the cash flows, but it also may depend to some extent on the nature of theuser and their cost of capital.
By users of real estate, we mean companies that are using property for some
business purpose. Their core business is not real estate, and their motivation
for using the real estate is to serve a purpose for their business. They are using
the real estate either as real estate tenants leasing space from an investor or as
real estate owners occupying the space.
Choosing the appropriate discount rate is mandatory to make prudent decisions
during discounted cash flow (DCF) analysis, as well as to quantify occupancycosts for users. Users usually fall into two categories—corporate and non-
corporate (individuals, partnerships, or sole proprietors)—and the process for
selecting the discount rate is different for the two. This section briefly explores
the process for each.
Individuals, Partnerships, and Sole Proprietors
Users who fall into this category usually use opportunity cost as the discount
rate for decision making. In the case of users quantifying occupancy costs, the
following questions are asked: ―If I were not using these funds for occupancy
costs, what alternative uses for these funds would I have? What could I earn on
those funds?‖ For instance, one alternative use of the funds is the user‘s
business. The user must decide if it is worth it to give up the opportunity of this
alternative use for occupancy costs.
Corporate Entities
Corporations sometimes use the after-tax weighted average cost of capital as the
discount rate to make financial decisions. Corporations don‘t have any capitalof their own. All of a corporation‘s capital is raised from two sources—debt and
equity —and each of these sources has an associated after-tax cost. The ratio of
debt to equity and the associated after-tax cost of each component are blended
to calculate the after-tax weighted average cost of capital. This rate sometimes is
referred to as a hurdle rate or a threshold rate. A corporation has to earn at
least this hurdle or threshold rate on investments to pay for the capital provided
User Decision Analysis for Commercial Investment Real Estate•
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Assumptions
Marginal tax bracket: 33 percent
Real estate purchase price: $1,255,000
Conventional loan terms:
o
75 percent LTV ratio
o 25-year amortization
o Five year term
o 6.25 percent interest
o No fees
‗ Angel investor‘ loan terms:
o
25 percent of real estate purchase price
o
Unsecured
o
13 percent interest
o
Interest-only payments (monthly)
a.
Before-tax weighted average cost of capital:
b.
After-tax weighted average cost of capital:
3. Calculate the user's discount rate based on the following scenario and
assumptions using your handheld calculator or by using Excel.
Pam and Ted Zinc own the Discovery Preschool and Learning Center. They
purchased the business about seven years ago from the prior operator and have
been leasing the school facility from the prior operator since the purchase. Pamand Ted were approached by the prior operator with an invitation to purchase
the property, or to extend the lease. They contacted you as well as their banker
with this news. You offered to provide an analysis that will allow them to
compare the costs of occupancy of owning versus leasing. To do so, you
explain, you'll use their effective cost of capital (cost of borrowed funds) to
derive the present cost of occupancy of owning and of leasing.
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Module 2: Self-Assessment Review
To test your understanding of the key concepts in this module, answer the
following questions.
1.
Which of the following is not considered a valid rationale for financialreporting?
a. Consistent set of financial status and performance parameters
b. Validity and reliability in financial reporting
c. Income opportunity for accounting and audit firms
d. Avoid cost to taxpayers and company shareholders due tomisrepresentation
2.
An organization using Generally Accepted Accounting Principles (GAAP) isconsidering a lease on a retail center that begins on January 1st that includes
six months of free rent on a lease of five years (a total of 66 months) with
monthly rent of
Year 1: $5,000.00 (months 7-18)
Year 2: $5,150.00
Year 3: $5,305.00
Year 4: $5,465.00
Year 5: $5,630.00
What amount of rent will the company recognize as an expense in year
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Interests in Real Estate
A lease is a legal agreement between a tenant and a landlord for the possession
and use of real estate. The lease agreement defines the contractual relationship
between the real estate owner and the user of the space. The lease document
specifies the rights and obligations of both the owner and user and legally
divides the bundle of rights in real estate into two interests.
The owner‘s group of rights and obligations is called the leased-fee interest, and
the tenant‘s group is called the leasehold interest. The owner‘s interest in a
property, without consideration of leases, is called the fee-simple interest.
Owner’s Leased-Fee Interest
In return for permitting the tenant to use the property, the owner receives:
Rental payments
The right to repossess the space when the lease ends
The conveyance of some of the owner‘s rights to tenant(s) affects the property‘s
value. The value of the periodic rental payments plus the value of the property
at the end of the lease term (the reversion) constitute the leased-fee interest,
which can be sold or mortgaged depending on the lease terms.
(Note:
The terms Interest and Estate are synonymous. For example, Leased-
Fee Interest has the same meaning as Leased-Fee Estate).
Tenant’s Leasehold Estate
The primary value of the lease to the tenant is the right to occupy and use the
space. However, because the tenant must pay rent according to the lease, the
leasehold estate has additional value to the tenant if the contract rent is less than
the current market rent for similar space elsewhere. (Contract rent is the actual
amount required under the existing lease. Market rent is the rent being paid for
comparable space over time periods comparable to the contract rent.)
The value of this leasehold interest is equal to the present value (PV) of thelease payments if the tenant were paying a market rental rate minus the PV of
the below-market lease payment the tenant actually is paying. (The process for
quantifying the value of the difference between market rent and contract rent is
covered in detail in a subsequent module.)
PV of contract rent – PV of market rent = leasehold value
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The Potential Parties in the Space
Acquisition ProcessMany participants are involved in the space acquisition process, and all of them
ultimately support either the tenant/purchaser or the landlord/seller. Thenumber and roles of participants many times will depend on the size and scale
of the transaction. Large companies may have on-staff space planners, or they
may engage a third-party architectural, construction, and/or construction
management firm as they move through the process. Small companies may rely
on a landlord‘s resources to help them define and construct what they need.
In a general sense, the following participants are involved in the process.
Tenant/Purchaser
The tenant/purchaser can be considered a buyer or shopper because they are
in the market for something specific—office, industrial, or retail space—for their
business. To make a sound user decision, the tenant/purchaser and those
representing the tenant/purchaser‘s interest should
Understand the budget set by the user prior to looking for space.
Know the geographic area that best serves the user‘s needs.
Understand how the proposed space integrates with the user‘s business
objectives.
Be able to clearly articulate the user‘s needs for the space.
Be knowledgeable about the necessary infrastructure any building must
have in order to be considered.
Negotiate terms that meet the user‘s needs with the best price and
maximum flexibility possible.
A number of factors can affect the ability of the tenant/purchaser to negotiate
successfully or from a position of strength, including market conditions,
availability of space in a geographic area, company credit rating, size, timing and
so on.
The tenant/purchaser should begin the initial outreach and search for space
well in advance of when they will need the space. Those embarking on a space
acquisition project within a compressed timeframe likely will find themselves at
a disadvantage, driven by the short-term need to get into a space quickly rather
than having time to methodically and intelligently locate the best possible space
and to negotiate advantageous terms. The tenant/purchaser must understand
User Decision Analysis for Commercial Investment Real Estate • 3.7
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addition, this real estate professional must stay on top of the marketplace to
advise the landlord on the rental rates and terms of transactions being done by
the building‘s competition.
The seller‘s representative is engaged by the seller to market the seller‘s
building. This also requires an in-depth knowledge of the product to know if it
will match a prospective purchaser‘s needs. In addition, this real estateprofessional must stay on top of the marketplace to advise the owner on the sale
prices and terms of transactions being done by other sellers in the area.
Space Planner
The space planner is engaged to help plan and lay out how the space should be
designed, constructed and finished in order to best meet the needs of the
tenant/purchaser, while at the same time ensuring that the construction does not
adversely affect existing building systems.
It is typical for the landlord to engage an architectural firm for the space
planning purpose. If the user has very specific needs, then the user might
engage a separate architectural firm to help determine their unique
requirements, calculate the user‘s square footage needs and help identify which
prospective building‘s floor plate and internal systems will best accommodate
those needs. Most users purchasing space to occupy do their final space
planning during the due diligence contingency period.
Attorney Attorney involvement becomes appropriate when the landlord and tenant enter
lease negotiations. Landlords typically have a standard lease for their properties
that is designed to protect their interests; therefore, the tenant should engage
their own legal counsel when lease negotiations begin to protect the user‘s
interests. The tenant rep should work with tenant‘s counsel regarding the cause
and effect of certain clauses in the lease document. Users must remember that
a lease is a legal, binding contract; thus, it is important that the user engage legal
counsel.
When users are purchasing space to occupy, attorney involvement usuallycommences during the purchase agreement negotiation phase. The attorney
usually stays involved through the closing and transfer of title.
User Decision Analysis for Commercial Investment Real Estate • 3.9
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User Needs Analysis
A user needs analysis is a critical first step once the need for space has been
determined. The needs analysis captures such details as the user‘s physical,
geographic, budget, timing and various subjective requirements. The needs
analysis represents the user‘s must-have requirements, as well as its wish list.These criteria subsequently are integrated with the financial analysis in order to
make the final space acquisition decision.
A thorough needs analysis can take a considerable amount of upfront planning
and work, but this advance investment typically will save time and dollars later
in the process. The needs assessment is the opportunity for the user to detail
everything that will be important in making the final occupancy decision. An in-
depth needs analysis forces the user to think through various aspects of their
future space usage and articulate pertinent information about their operational
requirements, and ultimately, this information will help define the type of spacethat is most suitable for the user.
The information that should be included in a needs analysis is as follows:
An overview of the business, its history as well as the business plans and
objectives of the tenant‘s/purchaser‘s company
◘ A short paragraph about the type of business can assist a
tenant/purchaser rep or landlord/seller to better craft an agreement
suited to the type of business and its potential future needs.
Space requirements◘
How much space does the business need?
◘
How will the space be used?
◘
Does the space need to be contiguous, or can different work groups be
on different floors or even different locations?
◘ How many offices and of what sizes are needed for executives and
middle managers? Who gets a window office?
◘ For industrial users, what kind of power, clear height, bay depth,
proximity to freeways, railways, etc. is required?
◘
Do any corporate required standards or color schemes exist?◘
Are open work areas required, and if so what sizes are the cubicles?
◘
Taking into consideration the length of the lease term being
contemplated, what is the projected growth for office space, open space,
and conference room space?
◘ Regarding employee placement, which departments need to be near
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Client Description. This brief description of the tenant‘s business establishes
credibility and gives potential landlords an understanding of the potential use
for the space. This is a good place to reference the company‘s website, so the
landlords can do further research.
Space Requirement. This section sets forth the estimated space that the tenant
needs. Additionally, it could include a breakout of the interior workings of thespace by function. For instance, such information for an office user could be:
Reception area: 10 × 12 feet
Executive offices: Three at 15 × 20 feet each
Open area: Large enough to house 18 cubicles that are 8 × 8 each
Break room: Must have a minimum 8-foot counter, hot/cold water sink,
dishwasher, automatic plumbing line to the refrigerator, icemaker,
automatic-fill coffee maker, upper and lower cabinets
Purpose of Space. This section includes detailed and specific usage
information. For example, if the space is to be used for a call center, the
business‘s hours of operation probably won‘t match the building‘s hours of
operation or parking requirements will be significant. Landlords need to
understand the space use in order to properly respond, similarly, tenants need
to know if the building can accommodate the business use. If the building
cannot or will not accommodate the use, it is eliminated from consideration.
Load Factor. This section requests that the landlord state the multi-floor load
or add-on factor. If the tenant can utilize at least one full floor and part of
another, ask for both the multi-floor and the single-floor load factors.
Location Within the Building.
This section requests information about which
suites or floors can accommodate their space requirements. For instance, if
multiple floors are available in the prospective building, the tenant may prefer
the highest floor if it offers the best views. However, the landlord may not
propose the highest floor because the floor below is also available, or, the
landlord may not want to break up a large block of contiguous space on a
certain floor for the tenant‘s smaller square footage requirement. The
landlord‘s reluctance to give the tenant the desired floor can become a
negotiation point.
Primary Lease Term.
This section details the tenant‘s desired timing and lease
duration needs. For example, the tenant wishes to sign a five-year lease and take
occupancy on a certain date.
Rental Rate. This section asks the landlord to set forth their most competitive
rental terms. The section also clarifies they type of lease, such as a full-service
lease, or a gross lease. The RFP asks for the estimated cost of expenses And
3.14 •User Decision Analysis for Commercial Investment Real Estate
may ask for a breakdown of operating expenses for the last three years and the
building‘s occupancy during each of those y ears.
Existing Lease Assumption. If the tenant is locked into an existing lease, the
RFP may inquire if the landlord is willing to pick up the user‘s existing lease
obligation. The existing lease obligation could be handled a number of ways,
including asking the landlord for a specific dollar amount to be paid to thetenant to cover the current lease, or requesting a free rent period for the
overlapping time while the tenant is still paying rent on the existing space. In an
overdeveloped market, landlords are more likely to grant this than when space
is at a premium. Other factors playing into this decision include the tenant‘s
credit rating and company size, as well as the length of time the tenant is willing
to lease the space. (Note:
This section would not be included in the RFP if the
tenant does not have an existing lease.)
Beneficial Occupancy. The beneficial occupancy period, sometimes known as
early occupancy or fit-up period is the time period the tenant needs to installsystems, set up furniture, or accomplish other tasks before the business can
operate. The RFP should request stipulating the time period allowed, and what
amount of rent, if any, would be charged for this time, and, depending on the
type of lease, what amount of operating expense, if any, would be charged.
Tenant Improvements.
The TI section is one of the most important sections of
the RFP. It requests the amount of money (or allowance) the landlord will
provide for the tenant to build out the space to meet the user‘s specifications
and needs. The negotiations in this section also force the user to balance their
construction needs with the dollars the landlord will allow.
To clearly negotiate the TI allowance, the RFP should request the TI allowance
dollar amount, as well as a description of the existing conditions (sometimes
called shell condition) in the space prior to the application of any TI dollars.
The RFP also should state what is to be excluded from the TI allowance. For
example, ―the cost of initial space plans, construction documents, and
construction management shall not be a deduction from the TI allowance.‖
The RFP also should request a preliminary space planning meeting with either
the tenant‘s space planner or those employed by the landlord. The space
planner will design the space to the tenant‘s specifications, and the sketches
then may be sent for preliminary construction bids to contractors of the
landlord‘s and/or tenant‘s choosing. The responding bids will let the tenant
know if the TI allowance will cover the necessary build-out. This information
may direct the tenant to prioritize another building or attempt to negotiate a
greater TI allowance.
When comparing the landlord‘s proposals, the tenant must determine which
landlord is offering the best overall TI allowance. A simple comparison
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between dollar amounts may not be sufficient. Other factors, such as the
existing space conditions and how given allowances are to be applied are also
important determining factors.
Options to Renew. This section of the RFP lays out the user‘s desired options
for renewing the lease, including the rent that will be paid upon renewal, or how
the rent will be determined at renewal as well as the terms of the renewal noticethat the landlord requires.
Refurbishment Allowance/Improvement Package.
This section requests
clarification of an allowance (if any) for space improvements at some point later
in the lease or at renewal time. Items for refurbishment could include new
carpet, paint, or other basic enhancements.
Expansion Options.
Expansion options, like renewal options, are for the
benefit of the tenant and can be detrimental to the landlord. Such options
essentially ask the landlord to hold space off the market to accommodate the
tenant‘s future expansion, or, if space becomes available, an option mightprovide the tenant the first right to the expansion space. Generally speaking,
3.16 •User Decision Analysis for Commercial Investment Real Estate
Technology Requirements. This section describes the user‘s technology needs
such as for server rooms, a satellite on the roof, raised floors, antennas, etc.
Construction. Assuming that some construction is needed to ready the space
for occupancy and that the tenant is paying for part of it, the tenant may wish to
reserve the right to bid out the work. Some landlords have the benefit of
construction managers on staff, even so the tenant should have the right toensure that the work is being done to a quality and price that‘s fair to both
landlord and tenant.
Space Planning. This section addresses who pays for the space planning and
who actually serves in that role. Often a landlord will want their own staff, while
the tenant may want a third party. This all must be agreed on, including the
cost and timing.
Management Company.
The RFP should request as much information as
possible about the property management company.
Moving Expenses.
This section will determine if the landlord is willing to help
defray the costs of the tenant moving to the new location.
Right to Terminate. Some users wish to negotiate the right to terminate the
lease early for various reasons. If this is a must-have requirement for the user, it
should be clearly stated in the RFP. Since this clause is detrimental to the
landlord, this section would determine the cost (sometimes called the early
termination penalty) as well as the notice period and any other terms. Lenders
and potential buyers for a building will view a right-to-terminate clause as a
potential decreased income stream. For example, if a tenant signs a five-year
lease with a right to terminate after three years, lenders likely will view the lease
as a three-year income stream.
Holding Over. This section determines the cost of rent if the tenant continues
to occupy the premises after the term of the lease expires.
Relocation of Premises. The landlord will want the right to relocate the tenant
should the landlord secure another tenant who needs a contiguous amount of
space that infringes on the original tenant‘s space. This section defines the
items the tenant wishes to retain if relocated, such as a view, lobby exposure, or
a certain floor level. Relocation clauses might contain provisions for the
landlord to reimburse the tenant for relocation costs, such as reprinting
stationary and business cards.
Parking. The parking requirements of the tenant, and the parking capacity of
the proposed premises are defined in this section. Parking is an area that could
eliminate a building if the tenant needs can‘t be met. This section should solicit
information on the parking ratio and how it is applied to all tenants, and in
certain markets, the ratio or number of covered parking spaces and the cost.
User Decision Analysis for Commercial Investment Real Estate • 3.19
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non-binding letter. If used, the LOI articulates the business points agreed to by
both parties.
Lease Document Negotiation and Execution
In this phase, the tenant and landlord negotiate clauses in the lease document,and the point and extent of legal counsel involvement is determined by each
individual party. When negotiating a lease, it is typical to expect several
iterations before arriving at the final document. It is standard procedure for a
tenant or tenant rep to note desired revisions and return the lease to the
landlord. The parties should engage an attorney to review the lease, since it is a
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Lease Clauses
Most commercial leases contain the following sections.
Parties to the LeaseThis section must clearly identify the legal entities that are taking on landlord
and tenant accountabilities. When the tenant is leasing on behalf of a
corporation, the lease document will contain assurance that the tenant is
authorized to enter in to the lease on behalf of their corporation. The same
authority language is required of the landlord.
Premises and Building Description
This section references and/or describes the premises and property including,for instance, the suite number and the square footage being leased. An exhibit
in the lease most likely depicts the area. This section also sets forth the total
size of the building and the physical address. The lease should contain a legal
description of the site on which the building is situated, typically contained in an
exhibit to the lease.
Lease Term
The lease term states the timeframe in which the tenant has exclusive rights tooccupy the leased space and provides the specific or conditional start date
(commencement and/or occupancy) and end date (termination). This section
sets forth when the landlord will start charging the tenant rent. A definition of
substantial completion of improvements also is one of the items included in this
section.
Rent
This section details the amount to be paid, when it will be paid, and what makes
up rent. It also documents any penalties and/or interest incurred in the event oflate payments. In many leases, the rent has provisions to be escalated, or
increased over some set period. Contract rent is determined by a number of
provisions within a lease. The section that follows, Rent Terminology in
3.22 •User Decision Analysis for Commercial Investment Real Estate
Occupancy and Use
This provision dictates the agreed-to use of the space, as well as all laws and
regulations pertaining to its use. This section protects the landlord and other
tenants in the property from any actions the tenant might take that would be
detrimental to the property, damage the building or increase insurance rates.
Utilities and Service
This section specifies which utilities the landlord will provide and which the
tenant is responsible for. To protect against service interruptions, the lease
might include language requiring the landlord to make all reasonable attempts
to prevent interruptions and to compensate the tenant if they occur. This
section also details the landlord‘s position regarding acceptable and excessive
utility use. The lease should be very clear on the normal, or base, utility useincluded in the utilities payments and how ―excessive‖ is defined.
Parking Clause
This clause ensures that the tenant will have ample, agreed-upon parking for
employees and customers. Reserved or assigned parking and the costs (if any)
are included in this section of the lease.
SignageThis section discloses the Landlord‘s policy, restrictions, terms and conditions
on the type and size of signs they allow tenants to erect.
Tenant Improvements
The TIs laid out in the landlord‘s final proposal are stated in more detail in the
lease. The ―base building‖ or shell is typically defined, and all terms and
conditions relating to TIs detailed, along with any applicable plans or space
planner drawings. This section also should include payments terms for TIs. Insome instances, a separate addendum to the lease, many times referred to as a
work letter further defines the process and procedure of tenant improvement
3.24 •User Decision Analysis for Commercial Investment Real Estate
Right to Relocate the Premises
This clause defines under what conditions (if any) that allows the landlord to
relocate the tenant‘s premises. Large tenants sometimes can strike the clause,
but small tenants generally don‘t have this leverage. Consequently, this section
defines the conditions and consideration for relocations, such as
reimbursement of any expenses incurred, such as printing new signs or new
stationary, or other requirements such as lobby exposure, the same view and
amenities.
Options to Renew
Many commercial leases grant a tenant the right, but not the obligation, to
renew their lease for pre-specified periods after the initial lease term expires.
Sometimes the renewal rental rate is specified in the initial lease contract, butmore frequently the right to renew is at a rent equal to market rates at the time
the renewal option is exercised. Renewal options are valuable to tenants
because they ensure that the tenant can stay and operate their business in the
same space.
Right to Assignment or Sublease, Novation
Unless prohibited or limited by the lease, the tenant has the right to sublet or
assign all or a portion of its leasehold interest to another tenant (sub-tenant). If
the tenant subleases its space, a further division of interests in the property
results. In a sublease, the tenant conveys part of its leasehold interest to a
subtenant, while retaining an interest in the property. The sublease could
involve a partitioning of space, with the subtenant occupying part of the original
tenant‘s space, or it could involve a sublease of the entire property for a portion
of the original tenant‘s term.
In a sublease, the original tenant remains obligated to pay rent to the landlord
and must collect rent from the subtenant, who has no obligation to the landlord.
If the original tenant transfers all interest in the lease to the subtenant, it is
generally referred to as a lease assignment. It is important to note that the
original tenant still remains liable for the obligations of the lease unless the
tenant is specifically released from obligations by the owner through a novation.
A novation is a mutual agreement between all of the parties to substitute a new
agreement in place of the existing agreement, terminating the old agreement.
User Decision Analysis for Commercial Investment Real Estate • 3.25
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S p a c e A c q u i s i t i o n
Expansion and Contraction Options
Most businesses seek growth. This section, if included in the lease, allows the
tenant the right to occupy additional space in the property, after a specified
notice period, at then market rental rates. In some cases, the owner will agree
to give a tenant the right of first refusal when space becomes available in thebuilding. If additional contiguous space cannot be provided in a reasonable
timeframe, the owner may agree to relocate the tenant within the property as
soon as possible.
For a user expecting to expand, (and if the expansion is critical for the user), the
lease should provide for cancellation, after reasonable notice, if suitable
expansion or relocation opportunities are not made available by the owner. .
Holdover Clause
This section delineates the terms, conditions and rent if the tenant needs to stay
in the space after the lease terminates.
Subordination
This lease clause explains the conditions under which the tenant agrees that the
lease document will be subordinate to any deed of trust, mortgage, ground
lease, or master lease.
Estoppel Certificates
This provision defines how the landlord will request and how the tenant will
comply with a request for execution of an estoppel certificate. An estoppels
certificate is a written, signed statement setting forth for another parties benefit
(such as a lender or purchaser) that certain facts are correct, such as that a lease
exists, there are no defaults, and that rent is paid to a certain date. The
landlord generally needs this documentation for refinancing or selling the
building.
Default and Remedies
This clause lays out the landlord‘s rights in the event of any default on the part
of the tenant , and further, defines the tenant‘s rights in the event of any default
User Decision Analysis for Commercial Investment Real Estate • 3.27
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S p a c e A c q u i s i t i o n
Rent Terminology in Leases
A commercial lease may call for the following:
A fixed amount of contract rent over the entire lease term
Rental payments that change, or step up, by set amounts or percentages atgiven dates (step leases)
Variable levels of contract rent based on changes in an index (indexed
leases)
Variable amounts of monthly rent based on a percentage of the tenant‘s
gross sales receipts (percentage leases)
Periodic changes in contract rent based on pre-negotiation
Fixed Rent
Contract rents are fixed (don‘t increase) for the duration of the lease.
Step Leases
Contract rents change by preset amounts or percentages on predetermined
dates, such as every year or every five years. Although the lease payments vary
over the lease term, all payments are determined at the beginning of the lease
agreement. Thus, unless the tenant defaults, all lease payments are known with
certainty when the lease is signed.
Indexed Leases
Contract rent is indexed (tied) to movements in a pre-specified index, usually
the consumer price index. For example, if general inflation in the U.S.
economy was 3 percent in 2010, monthly lease payments for the year 2011 will
be increased 3 percent over their 2010 level. Indexation prevents inflation
from eroding the real value of the tenant‘s lease payments and more likely is
included in long-term leases. If all else is the same, owners would prefer toinclude this protection against inflation in their commercial leases because, in
effect, indexation passes any inflation risk from the owner to the tenant.
User Decision Analysis for Commercial Investment Real Estate • 3.31
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S p a c e A c q u i s i t i o n
Operating Expenses
The lease document specifies who is responsible for the payment of operating
expenses.
Under a gross lease, the tenant pays the owner a gross amount for rent. From
this amount, the owner then pays the operating expenses (property taxes,
insurance, maintenance, utilities, janitorial, and security costs). Gross (or full-
service) leases are used primarily in multitenant office buildings.
In a net lease, the tenant pays all or some of the operating expenses. The first
net usually obligates the tenant to pay annual property taxes. In a net-net lease,
the tenant pays both property taxes and hazard/fire insurance. In a triple-net
lease, the tenant is also responsible for its proportionate share of operating
expenses. The lease terms should be examined carefully, as the definition of a
net lease varies from market to market. Generally, however, a net lease
includes property taxes, insurance, and operating expenses.
For a given level of rent, owners clearly prefer to pass as much risk and
responsibility for operating expenses to tenants as possible. However, the
extent to which owners and tenants share the payment of operating expenses
depends on the current standard in the market and the relative bargaining
power of the two parties.
Many commercial leases contain alternative treatments (compromises) of
operating expenses. These alternatives may require owners to pay operating
expenses up to a given maximum amount (expense stops); or, may allow
owners to pass certain operating expenses through to the tenant (expense pass-throughs); or, may allow the owner to charge the tenant for some or all of
operating cost increases after lease commencement (base year expense stop).
When applying lease terminology such as gross, full service, or net to leases, it is
important to understand that most leases are hybrids of these lease types.
Note:
Although operating expenses may be referenced in the rent section, in
the majority of leases operating expenses are treated as a separate provision
given their complexity and importance.
Expense Stops
With some commercial leases, the owner may add an expense stop clause. In
this situation, the owner pays operating expenses up to a specified amount,
usually stated as an amount per square foot of rentable space in the building.
Expenses in excess of the expense stop are passed through to tenants based on
3.32 •User Decision Analysis for Commercial Investment Real Estate
For example, an office lease may state that a tenant will pay $18 per rentable
square foot (rsf) per year and that the owner will pay all operating expenses
associated with the property —so long as expenses do not exceed $4 per rsf of
building area. If the building has 50,000 sf of rentable area, then this clause
obligates the owner to pay the first $200,000 in annual operating expenses ($4 ×
50,000). Any amount over $200,000 will be paid by the tenants based on thepercentage of the building‘s rentable area or the sf that the tenant occupies.
This clause effectively limits—or stops—the owner‘s operating expense exposure
at $200,000.
Although expense stops appear to benefit owners by limiting their exposure to
greater-than-expected operating expenses, this owner benefit comes at the
tenants‘ direct expense. Thus, in a competitive rental market, ow ners must give
knowledgeable tenants something of value in exchange for the expense stop
clause, which can be a lower contract rental rate if competitive leases in the
market do not contain expense stops.
Expense Caps
With some commercial leases, the tenant may add an expense cap clause. In
this situation, the tenant pays certain operating expenses up to a specified
amount, usually stated as an amount psf. Expenses in excess of the expense cap
are paid by the owner.
In some cases, the tenant‘s expense cap is combined with the landlord‘s
expense stop. In this application, the tenant‘s expense cap may be expressed as
a limit to the amount a landlord‘s expense stop category (such as property taxes,
for example) may increase in any given year.
Expense Pass-Throughs
The landlord may pay some, if not all, operating expenses and then pass them
through to the tenants. This is especially true in multitenant office buildings
and retail shopping centers. In retail properties, a tenant‘s share of these
expense pass-throughs is based on the gross leasable area (GLA) of the tenant‘s
store as a proportion of the GLA of the entire shopping center. In officeproperties, the pass-through is based on the tenant‘s rentable area as a
percentage of the building‘s total rentable area.
As with expense stops, owners must give knowledgeable tenants something of
value in exchange for expense pass-through, which can be a lower contract
rental rate if competitive leases in the market do not contain pass-throughs.
User Decision Analysis for Commercial Investment Real Estate • 3.33
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S p a c e A c q u i s i t i o n
Common Area Maintenance
A common expense pass-through in commercial leases is common area
maintenance (CAM) expenditures, or the costs associated with maintaining the
common areas of a property, such as hallways, lobbies, outside areas, and
parking lots. These costs may be included in a gross lease or excluded in a netlease, but in either case they usually are calculated on the percentage of rentable
space the tenant occupies. If maintenance costs or taxes increase, CAM clauses
benefit owners because the increase is passed on to the tenants. Tenants also
benefit, at least in theory, to the extent that monies collected for CAM cannot
be used for other expenses, helping ensure that the property is properly
maintained. As with any expense pass-through, the contract rent is lower than it
would be in the absence of a CAM clause.
Gross-up Clause Another consideration is whether current market conditions allow the landlord
to insert a gross-up clause, in which the landlord increases the expenses as if the
building was 95–100 percent occupied, even if the building is not. That is, if
the building is not fully occupied, this provision allows the landlord to gross up
or overstate the expenses as if the building is fully occupied (or 95 percent
occupied or the agreed-upon occupancy). The result is that since the actual
expense of operating the property is grossed up to an amount that the landlord
believes the operating expense would be if the building were 95 percent or fully
occupied, the amount that the tenant must pay increases.
Due Diligence: A Chance to Investigate the Causes of
Risk
All risks can be categorized as avoidable, unavoidable, or acceptable. If a risk is
neither avoidable nor acceptable, then logically the property also is not
acceptable. Risks that are accepted must be priced, but the astute real estate
user first will shift or avoid risks that are manageable. Understanding what types
of risk are present and potentially manageable requires a careful analysis of the
entire space acquisition process, from needs assessment to move in to move
out.
Much of this analysis occurs during due diligence. Once a tentative purchase
contract has been written, the buyer must assess all possible modifications and
adjustments based on the detailed discovery learned during due diligence. This
must be accomplished quickly, as few sellers will a long period of time—even on
a large property —for the completion of due diligence.
3.36 •User Decision Analysis for Commercial Investment Real Estate
Tenant mix and the impact of that mix, if any, on the property‘s success
Operations, Management, and Third-Party Contracts. In this phase, the
purchaser should survey the quality and price of existing service contracts
compared to the market, as well as the efficiency of building operations (energy,
HVAC, ability to retrofit, etc.).
People Due Diligence
This category of review is unusual as part of the due diligence process, but the
point is to determine whether or not contracts are binding and whether or not
all critical elements are as represented. It overlaps with the due diligence items
previously listed, but it helps further delve into the information already
obtained. Questions to answer during this process include:
Who really is signing all contracts and transfers?
Is their authority to sign clear and unambiguous? What is the track record of the brokers, owners, and parties involved
regarding their follow through on verbal or written agreements?
Are known risks, such as pending repairs, enforceable or backed in any
way?
Are escrow accounts and trustworthy people involved in monitoring the
process of eliminating contingencies?
Will deferred payments be used in any way?
Will personal guarantees be used?
Who is in charge of fixing problems? How much time do they have?
What if they don‘t resolve the problem?
Contractual Due Diligence
Several important contracts may arise during the real estate purchasing process,
including a letter of intent, a more detailed purchase contract, a revised
purchase contract, a preparation of deeds, numerous leases and service
contracts, mortgage liens, and more. The buyer must take into account how
time delays will impact costs and clearly detail how disputes will be resolved.Good contracts include mathematical examples showing what will happen in
the event of problems.
Key questions during this phase include:
What are the deadlines for each step prior to closing? (This includes
document and lease reviews, inspections, and certifications.)
User Decision Analysis for Commercial Investment Real Estate • 3.37
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S p a c e A c q u i s i t i o n
Who will take charge of resolving disputes?
How will time delays affect the price and terms of the agreement?
How will closing costs be allocated (i.e., to brokers, leasing commissions,
lawyers, title costs, surveys, appraisals, or inspections)?
The purpose of due diligence is to discover in detail any problems that exist onthe property that may affect returns and liabilities in the future. Once problems
are discovered, the buyer and seller may work out an agreement detailing who
shares the cost or risk of the concern or problem. It is not uncommon for
price adjustments and escrow accounts to be used to mitigate such concerns.
For example, a repair is not yet complete, but the seller assures the buyer that it
will be finished by closing. The logical agreement would allow for a generous
escrow account to be set up if the purchase occurs and title is transferred before
the repairs are complete. Once the repairs are paid, the seller would receive
the balance of the escrow account.
Needless to say, the process of deducting actual costs and the timing of repair
completion, penalties, and responsibilities for notifications and oversight should
3.44 •User Decision Analysis for Commercial Investment Real Estate
11. If the annual base rent for a retail tenant occupying 10,000 square feet is
$100,000 and the overage rate is 5 percent of gross sales, what is the tenant‘s
natural breakpoint on gross sales before paying percentage rent?
b. 2,000,000
Natural breakpoint =
Annual base rent
Overage rate
Natural Breakpoint =100,000
5%
100,000
= 2,000,000 5%
12.
If the tenant in question 10 is paying percentage rent on gross sales of$2,500,000, what is the effective triple-net rental rate to the owner, including
percentage rent and base rent?
c. 12.50
Total sales – natural breakpoint = amount of sales subject to percentage rent
$2,500,000 – $2,000,000 = $500,000
Amount of sales subject to percentage rent × percent amount = percentage rent
$500,000 × 5% = $25,000
Base rent + percent rent = total rent$100,000 + 25,000 = $125,000
Total rent ÷ premises square footage = rental rate
$125,000 ÷ 10,000 sf = $12.50/sf
13. In reference to questions 10 and 11, if the tenant enjoyed gross sales of
$2,375,420, what is the tenant‘s percentage rent (excluding its base rent)?
d. 18,771
Total sales – natural breakpoint = amount of sales subject to percentage rent
$2,375,420 – $2,000,000 = $375,420
Amount of sales subject to percentage rent × percent amount = percentage rent
Ownership of the Premises Transfers to theUser at the End of the Lease Term .................. 4.28
The Lease Includes a Bargain PurchaseOption ................................................................ 4.28
The Lease Term Exceeds 75 Percent of the
Remaining Useful Life of the Premises ............ 4.29 The Present Value of the Minimum Lease
Payments Is 90 Percent or More of the Fair Value of the Premises at the Inception of theLease ................................................................... 4.29
Sample Problem 4-3: FAS-13 Lease Analysis—Capital Lease Tests ............................................ 4.31
Practical Applications and Facts about FAS-13 ........................................................................ 4.33
User Decision Analysis for Commercial Investment Real Estate • 4.3
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L e a s e A n a l y s i s ,
L e a s e h o l d I n t e r e s t s
Average Annual Effective Rent
This is the total effective rent over the entire term of the lease divided by the
number of years in the lease term.
Total effective rent ÷ lease term (years) = average annual effective rent
Average Annual Effective Rate
This is the average annual effective rent divided by the square footage of the
leased premises.
Average annual effective rent ÷ premises square footage = average annual effective rate
Discounted Effective Rent
This is the sum of all discounted cash flows over the entire term of the lease, with the cash flows discounted to the present value (PV) at the user‟s discount
rate.
Total Cost of Occupancy
This is the total of all actual out-of-pocket costs to the user necessary to take
occupancy of a space. In other words, it is the total effective rent plus or minus
additional costs or allowances that are not attributable to the lease, such as
telephone hook-up or stationery. When such adjustments are addressed in the
lease or in the transaction between the owner and the user, they may be
included in the calculations of total effective rent or rate.
expansion capabilities—essentially all interests and factors not driven by costs.
Those interests then must be combined with the financial analyses to make the
final determination. The financial pieces must take into account the user‟s
available cash, borrowing capacity, and financial situation, as well as alternative
uses for the cash. These factors drive the type of occupancy the user might
consider entering.
For example, Property A might have an overall lower cost of occupancy than
Property B, but it requires a higher upfront cash outlay. The user‟s financial
situation may not be able to accommodate that upfront cost, or it may be moreprudent for the user to preserve or otherwise use the capital. Thus, the user
may determine that the best decision is to enter the more expensive lease with
less upfront costs. If the user‟s business is young and projected to have
increased cash flow, the user might decide to defray some of the lease costs
until later in the business‟s lifecycle. The user also might decide to enter the
more expensive alternative if that choice better meets the user‟s subjective
interests. The bottom line is that the choice with the lowest cost of occupancy
may not always be the best decision for the user.
The various types of leases, with one exception, are defined primarily by whichoperating expenses are included in the base rent —in other words, which
operating expenses the landlord pays and which operating expenses the user
pays. Given that lease terminology and included expenses vary from market to
market, landlord to landlord, and even building to building, it is extremely
important for the user to understand exactly which operating expenses will be
included as part of the base rent and which operating expenses will be paid in
addition to the base rent.
Leases can be viewed on a continuum. At one end is the full service lease
(sometimes referred to as a gross lease), in which all operating expenses are
included in the base rent (the landlord pays the operating expenses). Moving in
the continuum next is a modified gross lease, in which the user is responsible
for paying some of the operating expenses, and the landlord is responsible for
paying the balance. On the other end of the continuum is net leases (or triple-
net or absolute-net leases), in which the user pays all operating expenses in
utilities, and janitorial service. An expense stop often is utilized to set a ceilingon expenses paid by the landlord.
Modified Gross Lease
Sometimes called flex or industrial gross, these leases typically are seen in small
office, service, or warehouse buildings (sometimes called showroom buildings)
or R&D (research and development). While similar to full service, a modified
gross lease includes fewer operating costs in the base rent. For example,
depending on the lease structure, a modified gross lease may include propertytaxes but not insurance, or vice versa. It‟s especially important for the user to
understand exactly which operating expenses are included in the base rent and
which expenses must be paid in addition to base rent. As a rule of thumb, if
the property is not a multitenant office or industrial building, the user will pay
electricity directly to the utility provider and coordinate their own janitorial
service. Modified gross leases generally are applicable for single-story buildings
with separate electrical meters, enabling the utilities provider to separately meter
and directly charge each tenant.
Net Lease
These typically are used for large warehouse or industrial properties, retail
buildings, and office properties in some markets. With a net lease, the user
pays all operating expenses in addition to the base rent, on a pro rata basis.
The cost, sometimes referred to as the triple nets, includes property taxes,
property insurance, and common area maintenance (CAM). As in the
modified gross lease described above, the user typically pays their own utilities
(with the possible exception of water) and janitorial directly to the provider.
User Decision Analysis for Commercial Investment Real Estate • 4.7
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L e a s e A n a l y s i s ,
L e a s e h o l d I n t e r e s t s
Objective Leasing Decisions
In many instances, subjective factors enable a user to narrow occupancy
choices. A comparative financial analysis then provides objective measures to
determine the best occupancy alternative for the user‟s needs. On one hand,
the comparative financial analysis can determine the least cost of occupancy.
On the other hand, the financial analysis can be utilized to place a comparative
value on the amenities and subjective factors.
Sample Problem 4-1: Lease Comparison
Your client is considering proposals from two similar buildings for a five-year
lease, both are 3,500 rentable square feet (rsf) in size. Potential Lease A is
being offered at $17.50 per rsf for the first year of the term, with annualincreases of 3.0 percent. Lease B is being offered at $17 per rsf for year one,
with $0.50 per rsf annual bumps in the rent for each year thereafter. Lease B
also is offering four months free at the beginning of the term. (Assume, for
simplicity, that the lease payments are made annually at the end of each year.)
Your client has asked for your help in evaluating the two lease proposals and in
making a selection. What should you do to help your client reach a decision?
1. Determine the cash inflows and outflows on both lease alternatives:
4.12 •User Decision Analysis for Commercial Investment Real Estate
Analyzing Lease Cost
In the previous example, no consideration was given to additional leasing costs
or allowances—base rent equaled effective rent. However, most commercial
leases are not so simple. In completing a more in-depth analysis, all cash flows
(costs to the user) must be included to determine the total effective rent.
The basic formula for calculating the effective rent cost of occupancy is
Base (contract) rent
+ Additional costs
– Concessions and/or allowances
Total Effective Rent (or Rate if divided by sf)
Cost of occupancy may include items that are not strictly leasing costs or that
are not a result of the negotiated lease agreement between the owner and user.
In this course, some of these costs are included in calculating effective rent or
rate, and some are excluded. Examples of costs that are excluded are expense
items that are the same for the user no matter which space is chosen, such as
the cost of new stationery. Also keep in mind that effective rent to the owner is
not the same as effective rent to the user because some of the expenses
incurred by the user are not paid to the owner (i.e., phone hook up, moving
expenses), and some of the occupancy costs incurred by the owner are not
incurred by the user.
In calculating effective rent or rate, it is necessary to include cost, concession,and allowance items separately because they may occur or be incurred at
User Decision Analysis for Commercial Investment Real Estate • 4.13
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L e a s e A n a l y s i s ,
L e a s e h o l d I n t e r e s t s
The analysis must be adapted for the circumstances of each lease, as follows:
Basic (contract) rent
+ Amortized percentage rent (retail only)
+ Amortized TIs (as additional rent)
+ Parking
+ Real estate taxes
+ Operating expenses
+ Total TIs
+ Moving expenses
+ Existing lease buyout
+ Moving costs
– Rent concession
– Parking stop
– Real estate tax stop– Operating expense stop
– TI allowance
– Amortized TIs
– Moving expense allowance
– Existing lease buyout allowance
Effective rent paid by the user
Where cost and concession items completely or partly cancel out each other,they can be entered separately into the tally or netted and shown as a net cost or
net allowance. Because rental rates, expenses, and allowances normally are
quoted on a psf basis, all expense and allowances items must be converted to
the same unit basis (rentable or useable area) to complete the lease analysis.
User Decision Analysis for Commercial Investment Real Estate • 4.25
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L e a s e A n a l y s i s ,
L e a s e h o l d I n t e r e s t s
Principles of Financial Accounting and
Reporting for Leases As introduced in Module 2, there are financial accounting, reporting rules, and
standards specific to leases. These rules and standards must be taken intoaccount by a user when making occupancy decisions. Specific rules and
standards are
FAS-13: The standards of financial accounting and reporting for leases
FAS-146: The standards of financial accounting and reporting for subleases
If an organization uses generally accepted accounting principles (GAAP), the
company‟s balance sheet must account for the lease liability and asset attributes,
depending on whether certain tests are met. If those tests are met, the lease is
classified as a capital lease, and the company is obligated to meet certain
accounting standards, including reporting the lease asset and liability
characteristics on the company‟s balance statement. If all of those tests are not
met, the lease is classified as an operating lease, and the company is not
obligated to formally report the lease asset or liability on their balance
statement. They only are required to include a footnote to their financial
statements providing certain details of the lease obligation.
For many companies, the ramifications of accounting for the lease transaction
on the balance statement (capital lease) versus not (operating lease) can be
significant. Generally speaking, companies prefer lease transactions to be
structured as operating leases to avoid accounting for the lease on the balancestatement. However, if circumstances dictate, many organizations will accept a
capital lease transaction and the requisite balance statement entries depending
on which lease transaction structure is in the company‟s best interests.
The determination of whether a lease is a capital lease versus an operating lease
lies in the proposed lease‟s specific attributes, and the user should clearly
understand those attributes.
For organizations utilizing GAAP, the standards contained in FAS-13 affect
lease accounting. Under GAAP accounting and FAS-13, there are two types of
leases: operating leases and capital leases. Operating leases, which comprisethe vast majority of leases, do not pass any of the GAAP FAS-13 tests for a
4.26 •User Decision Analysis for Commercial Investment Real Estate
Operating Lease Reporting
Under GAAP, operating leases require the following accounting and reporting:
Rent is entered as an expense on the user‟s income statement.
Rent expense is straight lined over the full term of the lease, including freerent, build-out periods, or rent vacations— virtually the same as total effective
rent as defined earlier, however, the rent reported is net of any expense if
the lease is a full service, gross or modified gross lease.
No lease liability or asset is included on the balance statement.
TIs paid by the tenant are entered on the tenant‟s balance statement as an
asset, less accumulated depreciation.
Tenant improvement depreciation is included as an expense on the user‟s
income statement.
The terms of the lease obligation are reported as a footnote to the financial
statements.
Under GAAP, capital leases have accounting and reporting characteristics
similar to those of a real estate purchase with 100 percent financing, requiring
the following accounting and reporting:
The discounted present value (PV) of the lease is entered as both an asset
and as a liability on the user‟s balance statement. The net rent cash flows,
including free rent periods, are discounted at the user‟s incremental
borrowing rate, which is the market interest rate the user might incur if they
had purchased the premises with the loan term being equivalent to the lease
term. A good surrogate rate is the user‟s revolving credit facility interest
rate.
The capital lease asset and liability are amortized similar to a mortgage with
an imputed interest rate. The amortized portions of the lease payments are
classified on the financial statements as interest, and the “principal” portion
is accounted for as cost recovery amortization. The interest rate generally
used is the user‟s incremental borrowing rate. The “principal” amort izationportion reduces the outstanding balance of the capital lease liability on the
user‟s balance statement.
The interest and cost recovery expense appear on the user‟s income
4.30 •User Decision Analysis for Commercial Investment Real Estate
Include rent only to the earliest termination option date.
Include any early termination fees.
Discount the cash flows at the user‟s incremental borrowing rate. This is
the rate that the user would incur if they purchased the property with a loan
term similar to the lease term. The interest rate on the user‟s revolving
bank line is a possible surrogate for the incremental borrowing rate if an
incremental borrowing rate is not readily available or feasible.
Once the PV of the user‟s lease cash flows is determined, that PV then is tested
against (or compared to) 90 percent of the fair market value of the premises.
FAS-13 provides the following guidance for determining the premise‟s fair
market value:
The value is as of the inception of the lease. Inception generally is defined
as when the user takes occupancy of the premises, assuming TIs need to be
completed. Otherwise, such as in the case of an extension, it is uponmutual execution of the lease document.
The fair market value is based on the premises being occupied and
stabilized with the subject lease in place. As such, vacancy, free rent, or
other concessions should not be factored into the value.
Comparable sales are appropriate determinates of fair market value.
The FAS-13 capital lease test compares the PV of the user‟s lease cash flows
against 90 percent of the fair market value of the premises at inception of the
lease. If the PV of the user‟s lease cash flows is equal to or greater than 90
percent of the fair market value of the premises, the lease is accounted for as acapital lease. If the PV of lease cash flows is less than 90 percent of the fair
market value of the premises, the lease is accounted for as an operating lease.
To illustrate, an empty building may be worth $100 psf; however, once a credit
tenant signs a long-term net lease, the value of the building increases since
future cash flow uncertainties have been reduced. Value can be determined by
the property‟s ability to generate cash flow.
If a building is empty and the market assumes continued vacancy for the next
two years, the value is affected substantially by the two-year vacancy and related
costs of putting a tenant in the building. However, if the proposed lease werein place, the value would be much higher. FAS-13 stipulates that the market
value determination should be calculated as if the subject lease was already in
place, and the property stabilized.
A user can estimate market value based on comparable sales of similar
buildings with similar credit tenants or by deriving an appropriate cap rate range
from comparable sales to apply to the subject lease.
User Decision Analysis for Commercial Investment Real Estate • 4.33
4 •
L e a s e A n a l y s i s ,
L e a s e h o l d I n t e r e s t s
Practical Applications and Facts about FAS-13
Because of their off-balance-sheet accounting, operating leases are generally the
preferred transaction for a user. Longer leases have more years of net rent to
discount, which increases their chance of passing the capital lease classification
test. Thus, the FAS-13 calculations should be done early in the transaction toresolves questions such as
Are the comps reasonable or too conservative? For example, is the user
applying an 8 percent cap rate when the user should be using a market rate
of 6 percent, which results in a higher building value?
Can the term be shortened?
Can a termination clause be added?
Prior to signing, many leases still can be structured (or restructured) to achieve
the desired accounting impact. However, it is difficult to change the structureand accounting after the lease document is signed. Some users are fine with
capital leases because the longer lease term (typically more prone to capital
lease classification) reflects the user‟s best interests and business needs.
It should be noted that all land or ground leases are classified as operating
leases unless the lease terms allow for a transfer of ownership at the end of the
lease term.
Straight-Lining Operating Lease Rent
FAS-13 GAAP guidance requires a user to straight line the rent expense evenly
over the period (lease term) benefited in an Operating Lease. The complicated
accounting rules applying to the treatment of various landlord concessions,
allowances, and tenant-paid expenses are beyond the scope of this review, but
in practice a user can preliminarily calculate the impact of rent expense on the
income statement in the same manner as total effective net rent. In other
words, the calculation for straight lining the rent expense per GAAP is very
similar to the calculation for total effective rent and average annual effective
rent. However, in GAAP, the rent component of the expense is essentially only
the net rent, wherein operating expenses are deducted from the total effectiverent and average annual effective rent. Thus, it becomes the average annual
effective net rent. The operating expenses are recognized (expensed) on the
income statement in the month that they are incurred, per GAAP.
Straight-line rent =Total effective net rent
= Average annual effective net rentLease term (years)
4.38 •User Decision Analysis for Commercial Investment Real Estate
Activity 4-5: Comparing Dissimilar Leases
Renaissance Computer Systems (RCS) is a 20-year-old company that repairs
and upgrades mainframe and midsize computer systems. RCS owns a
headquarters facility in Maryland, where they conduct administrative functions
as well as complete computer repair and system upgrades.
RCS leases their regional facility in Dallas, and the lease terminates in 10
months. The company also occupies 12,000 sf in a flex/R&D building, of
which regional administrative services and sales operations occupy 7,000 sf, and
the remaining 5,000 sf is used as a work area for the company‟s technicians who
perform computer repair and upgrade work.
The market for space in the area is soft, and you, as broker for RCS, inform
your client that it‟s a good time to find other suitable locations and negotiate an
aggressive deal. RCS has directed you to conduct a search for facilities within a
five-mile radius of their current facility and no more than one-half mile from anentrance/exit of a major freeway. They also inform you that renewing the lease
in their current location is a strong possibility, provided that the space is
refurbished with new carpet, paint, and some minor electrical and lighting
modifications.
After extensively searching the market, reviewing the results with the RCS
leadership, and touring the finalists, RCS authorizes you to submit requests for
proposals (RFPs) to the three buildings that appear to most closely satisfy their
needs and interests.
1.
The current RCS location in Building A of InfoTech Park (12,000 sf): Inthe current modified gross lease, most operating expenses are included in
the base rent, with a base year expense stop. The tenant is directly
responsible for electric and janitorial costs.
2.
The Chambers Building (11,500 rsf): This is a multistory office building.
The space RCS is considering is on the first floor and has a separate
delivery entrance that would be suitable for incoming delivery and outgoing
shipping of computer systems. The building owner uses a full service lease
with all operating expenses included in the base rent. Operating expense
increases are paid by the user via a base year expense stop.3.
Building G of InfoTech Park (14,000 sf): This is an office/warehouse
building that has an office area and an air-conditioned work area that are
sufficient to accommodate RCS‟s needs with only minor modification. The
space has an additional 2,000 sf of non-air-conditioned space that RCS
doesn‟t immediately need, but can make use of in the future. Building G
utilizes a net lease with the tenant paying a base rent plus their
proportionate share of property taxes, insurance, and common area
4.44 •User Decision Analysis for Commercial Investment Real Estate
Refinements in Comparative Lease Analysis
Unequal Terms
Useful comparisons are difficult if the terms of the alternative leases vary. For
example, if one proposed lease term is five years and the other is eight years,
the analyst must make an adjustment for the shorter-term lease. Following are
several ways to make this adjustment:
Ask the landlord offering the shorter-term lease to suggest informal terms
for an additional three years, and estimate the cash flows on the five-year
lease as if it were for eight years.
Estimate the market rates at the end of the five-year lease term, and
calculate the additional three years using estimated rates, expenses, and
growth factors.
Carry the terms of the five-year lease through eight years using the same
growth factors as in the first five years.
Divide the eight-year lease into two leases, one of five years and one of three
years. Use the terms of the three-year lease as the terms of the estimated
three years of the original five-year lease.
Adjustments to Cash Flows
The preceding examples have considered only a few of the items that might
affect the cost of occupancy. In actual practice, many other factors also must be
considered, such as
Security deposits (cash outflow at the beginning of the term and inflow at
the end)
Key fees (cash outflow at the beginning of the term and inflow at the end)
Early termination cost (early termination fee paid to the landlord from theuser) or gain (early termination fee paid from the landlord to the user) from
terminating the previous lease (sandwich lease)
Value of sublease or option rights
Percentage rent (retail property)
Timing of concession payments
Cost recovery and depreciation on TIs (income tax consequences)
4.52 •User Decision Analysis for Commercial Investment Real Estate
Activity 4-1: Economic Lease Comparison
1. The term “effective rent ” includes downward adjustments for concessionsand allowances and upward adjustments for tenant-paid costs and expenses.
a.
True
2. The term “total effective rent ” refers to the total rent paid by a user overonly the first year of a multiyear lease.b. False
3. The term “total effective rate” refers to the total effective rent divided by thetotal rentable square feet occupied by a user.a. True
4. The term “average annual effective rent ” is equal to the total effective rentdivided by the number of years in the term of the lease.a. True
5. The term “average annual effective rate” is equal to the average annualeffective rent divided by the number of years in the term of the lease.b. False
6.
The term “discounted effective rent ” takes into account the time value ofmoney by discounting future lease payments to a present value at aprescribed discount rate.a. True
User Decision Analysis for Commercial Investment Real Estate • 5.3
5 •
L e a s e v e r s u s O w n
Leasing
Leasing is a means of obtaining the physical and partial economic use of a
property for a specified period without obtaining an ownership interest. The
lease contract is a legal document in which the owner (lessor) agrees to allow the
tenant (lessee) to use the property for the specified time and under specified
conditions. In return, the lessee agrees to make periodic payments to the
lessor.
As with other business decisions, leasing affords a user certain advantages and
disadvantages.
Advantages of Leasing
Availability of Cash Most lease arrangements have fewer restrictions than loan
agreements, providing flexible financing. Leasing is well suited to piecemeal
financing. A firm that is acquiring assets over time may find it more convenient
to lease than to negotiate loan terms or to sell securities each time the firm
makes a new capital outlay.
Financial Flexibility Leasing can provide more flexibility for owners who may
need cash to invest in their business (inventories, salaries, or equipment). It
may be more prudent and profitable to use their financing capabilities to run
the business than to invest in real estate to house the business. Avoiding a
down payment frees that money for other uses. Opportunity costs and capital
costs are important investor (and user) considerations.
Additional Tax Deductions
Since lease payments are fully tax deductible and
reflect rent paid for both the land and improvements, the lessee can deduct the
cost of rent paid for the land. In an ownership position, cost recovery is not
allowed on the land portion of the investment. If the lease is a net lease and the
lessee pays operating expenses in addition to rent, the operating expenses are
deductible as well.
Source of Financing Leasing is often the only available source of financing for
a small or marginally profitable firm since the title to leased property remains
with the lessor, reducing the lessor’s risk in the event of the firm’s failure. If thelessee does fail, the lessor can recover the leased property. Also, leasing is said
to provide 100 percent financing, while most borrowing requires a down
payment. Because lease payments typically are made in advance of each
period, this 100 percent financing is diminished by the amount of the first
5.4 • User Decision Analysis for Commercial Investment Real Estate
Low Risk of Obsolescence It may be possible for the lessee to avoid some of
the risks of obsolescence associated with ownership. The lessor charges a lease
rate based on its required rate of return on the investment property, provided it
is less than or equal to market lease rates. The net investment is equal to the
cost of the asset minus the present value (PV) of the expected salvage value at
the end of the lease. If the actual salvage value is less than originally expected,the lessor bears the loss.
Stability of Costs Leasing tends to stabilize the lessee’s expenses. Because
lease payments are a continual periodic outlay, earnings tend to appear more
stable when assets are leased rather than owned. This can be very important to
businesses that strictly monitor cash flows or have seasonal cash flows. The
ability to anticipate costs accurately is very important to many businesses.
Spatial Flexibility/Mobility
Leasing can provide more flexibility if a business
expands or contracts. It also provides more mobility if a business needs or
wants to relocate.
Technology Leasing allows a commercial user to respond to technological
changes more quickly. Some businesses must be on the cutting edge of
technology, and moving may be the most efficient way to accomplish that goal.
Location Leasing allows the user to be at a premier location that otherwise
would be unaffordable.
Focus Leasing allows the user to concentrate on his primary business without
the distraction of managing real estate.
Disadvantages of Leasing
Cost For a firm with a strong earnings record, good access to financing, and
the ability to take advantage of the tax benefits of ownership, leasing is often a
more expensive alternative. Individuals and small firms may find that leasing
and borrowing terms are approximately equal.
Loss of the Asset’s Salvage Value In real estate, this loss can be substantial. A
lessee may have difficulty obtaining approval for property improvements on
leased real estate if the improvements substantially alter the property or reduce
its potential range of uses. Although the lessee considers the improvementsimportant —such as technological changes necessary to the business, physical
changes to accommodate staff, or cosmetic changes to impress customers—the
lessor may be reluctant to allow them.
Contractual Penalties If a leased property becomes obsolete or if the capital
project financed by the lease becomes uneconomical, the lessee is legally
5.6 • User Decision Analysis for Commercial Investment Real Estate
Owning
Owning is a means of obtaining the full economic use of a property for an
unspecified period in the form of an ownership interest. If an owner is also a
user, physical use of the property is obtained as well. Owners generally are free
to use the property as they wish, even though they may be obligated to a
mortgagee.
Just as leasing can have distinct advantages and disadvantages, so can owning.
Consider the following elements when making the decision to own.
Advantages of Owning
Tax Savings The owner of a property is entitled to the tax savings resulting
from cost recovery rules and mortgage interest expense deduction during the
holding period and when the property is sold.
Appreciation The owner of an asset, a building in particular, is entitled to all
of the appreciation in value.
Income If a portion of the property is rented, income from the lessees can be
used to pay the mortgage on the property, f und the owner’s principal business,
or be used for other investments.
Control The user or investor who owns a building has, within the limits of the
law, freedom to operate the building as the user sees fit. Controlling the
appearance of a site and taking advantage of the prestige of its location may beimportant to certain businesses. Other owners, perhaps nearing the end of
their holding period, may wish to keep expenses low. Ownership also allows
some control of costs.
Disadvantages of Owning
Initial Capital Outlay Down payments to acquire the property may divert cash
that could be used to finance the company’s operations or other investments.
Financing Often a company’s ability to obtain a loan not only depends on itsfinancial condition, but also on the financial marketplace.
Financial Liability
A mortgage loan or a deed of trust can affect the balance
sheet (by increasing long-term debt) and the related debt restrictions sometimes
required by a lender.
Legal Compliance Compliance with changes in laws or zoning may be
5.8 • User Decision Analysis for Commercial Investment Real Estate
Value Line Chart
(Negative NPV/PV)
Positive NPV/PV
Lesser
NPV/PV
Greater
NPV/PV
( $ 5 0 , 0
0 0 )
( $ 4 0 , 0
0 0 )
( $ 3 0 , 0
0 0 )
( $ 2 0 , 0
0 0 )
( $ 1 0 , 0
0 0 )
$ 0
$ 1 0 , 0
0 0
$ 2 0 , 0
0 0
$ 3 0 , 0
0 0
$ 4 0 , 0
0 0
$ 5 0 , 0
0 0
Comparison Techniques
The two methods of comparing leasing and owning costs are the NPV method
and the internal rate of return (IRR) method. The NPV method compares the
NPVs of the cash flows for each of the alternatives. The IRR method calculates
the IRR on the difference between the owning and leasing cash flows. Since the
tax situations of owning and leasing are dissimilar, use cash flow after tax
(CFAT) in both methods. CFAT refers to the amount of money left after
accounting for all operating expenses, including property taxes, financing costs,
and income tax obligations. Regardless of which method is used, the holding
period for the leasing and owning alternatives must be the same.
Net Present Value Method
This method reduces each alternative to its periodic cash flows after tax. Applying the user’s appropriate after-tax discount rate, an NPV is calculated for
each alternative. Corporate users typically use their after-tax weighted average
cost of capital as the discount rate, while non-corporate users typically use their
after-tax opportunity cost. Once the PVs or NPVs are calculated for each
alternative, compare the values. The greater value is always the better
economic choice.
The following value line chart shows that values increase as you move from left
to right.
Figure 5.1 Value Line Chart
For example, if an NPV analysis indicates that one alternative result in an NPV
of ($40,000) and another alternative results in an NPV of ($30,000), the correct
choice would be the alternative that results in an NPV of ($30,000). As shown
in the previous chart, ($30,000) is farther to the right than ($40,000) and
User Decision Analysis for Commercial Investment Real Estate • 5.9
5 •
L e a s e v e r s u s O w n
therefore is the greater value. The value of ($30,000) is greater than ($40,000),
even though in raw numbers, 40,000 would be greater. As a practical matter, in
this example the fact that both NPVs are negative means that the user is giving
up something for either choice. The lesser amount given up is the better
choice. In other words, giving up $30,000 is better than giving up $40,000.
Also look at the comparison in terms of the cost associated with eachalternative. A cost of $30,000 is a better choice than a cost of $40,000.
Consider another example of an NPV analysis in which one alternative result in
an NPV of $10,000 and another alternative result in an NPV of $20,000. The
NPV of $20,000 is the better choice. The chart shows that $20,000 is farther to
the right than $10,000 and therefore is the greater value. The fact that both
alternatives result in a positive NPV indicates that a positive economic benefit is
associated with either choice. The greater economic benefit of $20,000 is the
better choice.
Consider a last example of an NPV analysis in which one alternative result in anNPV of ($20,000) and another alternative result in an NPV of $10,000. The
NPV of $10,000 is the better choice. As shown in the chart, $10,000 is farther
to the right than ($20,000) and therefore is the greater value. Even though in
terms of raw numbers, 20,000 would be greater than 10,000, $10,000 is a
greater value than ($20,000). This example indicates that one alternative results
in the user giving up $20,000, but in the other alternative, the user receives a
positive economic benefit of $10,000. Receiving a positive economic benefit of
$10,000 is a better choice than giving up $20,000.
If applied correctly, NPV/PV can be a useful tool for users when making
economic decisions. The correct application is to choose the greater value, or
the one that is farther to the right on the value line. In the case of negative
values, the greater value is also the lesser cost. In other words, choose the value
on the right, and you will always be right.
Internal Rate of Return of the Differential Cash Flows
Method
The IRR method subtracts the lease alternative’s periodic cash flows after tax
from the own alternative’s periodic cash flows after tax and calculates an IRR ofthis differential. This IRR is after tax and is compared to the user’s appropriate
after-tax discount rate. This method allows the user to identify the discount
rate/opportunity cost at which the costs to own or lease are equal. When the
decision maker’s opportunity cost is higher than this equilibrium rate, it will be
User Decision Analysis for Commercial Investment Real Estate • 5.13
5 •
L e a s e v e r s u s O w n
Sample Problem 5-1: SAV-A-LOT Stores
SAV-A-LOT Stores is one of the largest small-box discount retailers in the
country, with more than 8,000 stores in 40 states. Your real estate department
has identified a recently completed 8,000 square foot (sf) freestanding building
that is very similar to their prototype store and would take very little retrofittingto adequately serve as one of their outlets. The identified property is owned by
a developer who built it on speculation and will sell or lease the building with a
long-term lease. The SAV-A-LOT Chief Executive Officer (CEO) has asked
your department to recommend the optimum method to acquire the space.
The Chief Financial Officer (CFO) wants to know the impact each of the
acquisition alternatives would have on the corporate financial statements. The
CFO thinks that if the building is purchased, it should not be encumbered with
any debt financing. The CFO also thinks that if they choose to lease, the lease
should be an operating lease for at least 15 years. The CFO is amenable toincluding an early termination clause in the lease to avoid it being categorized as
a capital lease. A termination clause at the tenant’s option allows the tenant to
terminate the lease at the end of 10 years by paying a penalty in the amount
equal to the eleventh year’s rent.
User Information
Ordinary income tax rate: 34 percent
Capital gains tax rate: 34 percent
Cost recovery recapture tax rate: 34 percent
After-tax weighted average cost of capital: 7 percent
After-tax discount rate applied to leasing cash flows after tax: 5 percent
After-tax discount rate applied to ownership annual cash flows after tax:
6.75 percent
After-tax discount rate applied to ownership sale proceeds after tax (SPAT):
5.24 • User Decision Analysis for Commercial Investment Real Estate
3. Then, calculate the NPV of the annual cash flows after tax from ownership
and the after-tax cash flow from disposition using the after-tax weighted
average cost of capital as the discount rate (7 percent).
n
Annual Cash
Flows
Sale Proceeds
After Tax
0 ($1,450,000)
1 $9,085
2 $9,480
3 $9,480
4 $9,480
5 $9,480
6 $9,480
7 $9,480
8 $9,480
9 $9,480
10 $9,480
11 $9,480
12 $9,480
13 $9,480
14 $9,480
15 $9,085 + $1,557,722
NPV @ 7.00% ( 799,576)
Summary of the Net Present Value Method Using a Single Discount
Rate
Compare the two NPVs of the own and lease alternatives using a single discount
rate. Assuming the appropriate after tax discount rate was used, the alternative
that produces the greater NPV (lower cost) is the better economic alternative.
NPV of owning: ($799,576)
NPV of leasing: ($721,347)
In this case, both NPVs are negative, so the lesser negative is the greater NPV, which is ($721,347), the leasing alternative. In other words, expending
$721,347 in occupancy costs is more desirable than expending $799,576.
User Decision Analysis for Commercial Investment Real Estate • 5.25
5 •
L e a s e v e r s u s O w n
Future Sales Price Sensitivity
The NPV comparisons previously described are only as good as the
assumptions that are used. The assumption used to forecast the projected sale
price for the ownership alternative arguably is the least predictable number in
the entire analysis. Historic rates of inflation may not support the assumptionsnecessary to achieve the sale price at the end of the holding period. Therefore,
it is necessary to calculate the future reversionary value (sale price) essential to
make the leasing and owning decision economically equivalent. With that
information, the analyst then can evaluate the average rate of inflation necessary
to achieve the sale price at which the lease versus-own decision is economically
equal.
When calculating the indifferent sale price, whereby the owning alternative and
leasing alternatives are mathematically equal, it is important to recognize
whether the adjustment to the forecast sale price needs to be adjusted up ordown to balance the two alternatives. Recognizing whether the forecast sale
price is higher or lower than necessary to balance the two alternatives will
dictate the sign convention when inputting the information into a financial
calculator, which effects whether the resulting FV is positive or negative.
A positive FV to the differential cash flows will increase the sale price, and a
negative FV of the differential cash flows will decrease the sale price.
As a rule of thumb, if the cost of the own alternative is less than the cost of the
lease alternative (making the own alternative the more desirable alternative), the
sale price is higher than is necessary to balance the two alternatives. Conversely,if the cost of the own alternative is more than the cost of the lease alternative
(making the lease alternative the more desirable alternative), then the
reversionary SPAT is too low.
Therefore, the proper methodology to use when calculating the indifferent sale
price is to subtract the PV of the lease alternative from the PV of the own
alternative to derive the PV of the differential T-bar.
A simple method for remembering the proper methodology is the acronym
“OLD,” or Own – Lease = Differential.
The following process illustrates how to determine the sale price at the end of
the occupancy period for the ownership alternative to make the two NPVs
equal (sale price point of indifference).
Ultimately, if the user believes the property will appreciate over the holding
period to a value greater than the sales price point of indifference, then the user
should own. On the other hand, if the user anticipates that the property value
5.26 • User Decision Analysis for Commercial Investment Real Estate
at the end of holding period will be less than the sales price point of
indifference, then the user should lease.
The sale price sensitivity analysis assumes a given discount rate. In order to
arrive at a sale price where the user is indifferent about the decision to lease or
own, the analyst must balance the PVs of the respective leasing and owning cash
flows. This is done by leaving the respective cash flows unchanged andadjusting the sales price. In order to accomplish this task, the first step is to
identify the differential cash flows from the leasing and owning alternatives, then
compound the PV of the differential at that given discount rate over the holding
period. The steps to calculate the sale price at the end of the holding period to
make the two NPVs equal are as follows:
1.
Calculate the difference between the NPV of owning and the NPV of
leasing by subtracting the NPV of the lease alternative from the NPV of the
own alternative.
2.
Calculate the future SPAT adjustment (the increase or decrease) needed at
the end of the holding period to equalize the two NPVs. This results in the
calculation of an incremental amount of sale proceeds after tax (SPAT)
necessary to balance the two alternatives, (not the entire SPAT necessary to
calculate the PV of the ownership cash flows). The incremental change in
SPAT then needs to be ―grossed up‖ (in the following steps) to reflect the
amount of tax paid on gain and costs of sale. To make this incremental
SPAT adjustment calculation, calculate the FV of the difference in NPVs
calculated in Step 1 using the appropriate single discount rate as the annual
compounding rate.
Note: if the cost of the owning alternative is less than the cost of the leasing
alternative, the reason the cost of owning is less than the cost of leasing is
because the forecast sale price is higher than an indifferent sale price.
Therefore, a downward adjustment to the forecast sale price is needed in
order to mathematically balance the two alternatives. Input a positive value
into PV and compound forward over the holding period using the given
discount rate. The resulting negative FV represents the incremental
downward adjustment needed to SPAT.
3. The incremental adjustment needs to be grossed up to account for the
incremental capital gains tax obligation.
Calculate the capital gains tax on the sale proceeds after-tax incremental
adjustment calculated in Step 2, and then add the resulting tax amount to
the sale proceeds after-tax incremental adjustment calculated in Step 2 to
determine the sale proceeds before tax (SPBT) incremental adjustment
needed to equalize the two NPVs. Following is the model for making this
User Decision Analysis for Commercial Investment Real Estate • 5.27
5 •
L e a s e v e r s u s O w n
SPAT adjustment (Step 2) – SPAT adjustment = Tax
(1 – tax rate)
SPAT adjustment (Step 2)
+ Tax (Step 3)
SPBT adjustment
4. The SPBT incremental adjustment needs to be grossed up again to account
for the incremental costs of sale.
Calculate the cost of sale on the SPBT incremental adjustment calculated in
Step 3, and then add the resulting costs of sale amount to the SPBT
incremental adjustment to determine the sale price adjustment needed to
equalize the two NPVs. Following is the model for making this calculation:
SPBT adjustment (Step 3) – SPBT adjustment = Cost of sale
(1 – Cost of sale percentage)
SPBT adjustment (Step 3)
+ Cost of sale (Step 4)
Sale price adjustment
5.
Add the sale price adjustment calculated in Step 4 to the originally forecastsale price to arrive at the indifferent sale price. Calculate the sale price
needed to equalize the two NPVs using the following model.
Original forecast sale price
+ Sale price adjustment (Step 4)
SPAT adjustment needed to equalize the NPVs
The following illustrates the sales price point of indifference using the outcome
of Sample Problem 5-1:NPV of the own alternative ($799,576)
+ Cost of sale on SPBT adjustment [$327,027 ÷ (1 – 3%) –
$327,027]$10,114
Sale price adjustment needed to equalize the NPVs $337,141
+ Original projected sale price $1,884,000
Sale price needed to equalize the NPVs (rounded to the
nearest $1,000)$2,221,000
Calculate the growth rate necessary to achieve the sale price point of
indifference.
The ultimate decision whether to lease or buy depends on the client’s
assessment of future market trends and the rates of inflation over the projected
holding period. By calculating the growth rate necessary to achieve the point ofindifference, the client can make an informed choice of whether to lease or
buy.
If the client feels the rate of inflation over the holding period will exceed the
calculated growth rate, the decision to buy is simple. Equally, if the client feels
the rate of inflation over the holding period will not meet or exceed the
calculated growth rate, the decision to lease is equally simple.
Purchase price 15 years End of year 15 sale price
$1,400,000 $2,221,000
Annual growth rate in value needed to equalize the NPVs: 3.12 percent
User Decision Analysis for Commercial Investment Real Estate • 5.29
5 •
L e a s e v e r s u s O w n
Method 3: Internal Rate of Return of the Differential
Cash Flows Method
The IRR of the differential cash flows method is another way to compare the
own and lease alternatives. The NPV methods previously illustrated compare
the NPV of each alternative using a given discount rate or rates. The alternative
that creates the highest NPV (the lowest net present cost of occupancy) is the
better alternative.
The IRR of the differential method utilizes the periodic CFAT for each (lease
or own) alternative to determine the differential cash flows. These differential
cash flows are simply the difference between the own alternative after tax cash
flows and the lease alternative after tax cash flows.
Own - Lease = Differential
n n n
Period 0 Initial Investment Period 0 Period 0 Costs Period 0 Difference
Year 1 CFAT of Own Year 1 CFAT of Lease Year 1 Difference
Year 2 CFAT of Own Year 2 CFAT of Lease Year 2 Difference
Year 3 CFAT of Own Year 3 CFAT of Lease Year 3 Difference
Year 4 CFAT of Own Year 4 CFAT of Lease Year 4 Difference
Year 5 CFAT of Own + SPAT Year 5 CFAT of Lease Year 5 Difference
Once the differential cash flows are calculated, the IRR of the differential cash
flows is calculated. This IRR identifies the after-tax yield on the capital if it isinvested in the ownership alternative. This rate of return is then compared to
the user's opportunity cost:
If IRR > Opportunity cost, then buyIf IRR < Opportunity cost, then lease
If IRR = Opportunity cost, then revert to subjective factors
If the user chooses to purchase, they are relinquishing the opportunity to invest
the funds required for the purchase in an alternative investment such as their
core business.
The future cash flows after tax attributable to this investment in the ownershipalternative are the difference between the future cash flows after tax of the
ownership alternative and the future cash flows after tax of the lease alternative.
The IRR of the differential cash flows calculates the after-tax yield on this
investment when choosing to own instead of lease. This differential cash flow
yield then can be compared to after-tax yields available in alternative
investments, particularly the user's core business. If alternative investments can
The 6.42 percent IRR of the differential (after-tax yield of the funds invested in
the purchasing alternative) is less than the corporation’s 7 percent after-tax weighted average cost of capital (generally the yield the corporation earns in
their core business), so the lease alternative is the better alternative.
The 6.42 percent IRR of the differential indicates the after-tax yield on the
$1,450,000 invested in the owning alternative. The corporation’s after-tax cost
of capital of 7 percent indicates that its threshold after-tax target yield for
investments is 7 percent. If the corporation does in fact have earning
5.42 • User Decision Analysis for Commercial Investment Real Estate
Activity 5-1: Methods of Comparing Costs
1.
The two methods of comparing leasing and owning costs are the net present
value method and the future value method.
b.
False
2.
The net present value method compares the net present values of the after-
tax cash flows for each of the alternatives.
a. True
3.
When using the net present value method, the user provides the discount
rate to be applied to the cash flows, not the broker or any other individual.
a. True
4.
When evaluating the net present values of leasing and owning, thealternative with the lowest cost represents the best alternative.
a. True
5. The internal rate of return method calculates the internal rate of return for
the differential cash flows between owning and leasing and then compares
the internal rate of return of the differential to the user’s appropriate
discount rate.
a. True
6. If the internal rate of return of the differential cash flows is greater than the
user’s appropriate discount rate, then the user should buy (own) instead of
lease.
a. True
7. If the internal rate of return of the differential cash flows is less than the
user’s opportunity cost, then the user should lease instead of buy (own).
a. True
8.
If the internal rate of return of the differential cash flows is equal to theuser’s opportunity cost, then the user should evaluate the subjective aspects
5.44 • User Decision Analysis for Commercial Investment Real Estate
9. What is the indifferent sale price?
4,535,954 + 11,400,000 = 15,935,954
Module 5: Self-Assessment Review
1.
When is it appropriate to consider owning rather than leasing?
c. When a user is considering a long-term lease
2. A user is evaluating whether to own or lease and is using a 10 percent
opportunity cost to evaluate the alternatives. Based only on the after taxcash flows for each alternative described below, which alternative is best forthe user?
n Own Lease = Difference
0 ($100,000) ($10,000) ($90,000)
1 (37,864) (35,000) (2,864)
2 (39,766) (36,750) (3,016)
3 (41,569) (38,588) (2,981)
4 (43,871) (40,517) (3,354)
5 $147,653 ($42,543) $190,196
PV =( 136,801)
PV =( 155,271)
IRR =13.99%
d. Own, since the internal rate of return of the differential is greater than
the user’s
opportunity cost
The internal rate of return of the differential cash flows is 13.99 percent,
greater than the user’s opportunity cost of 1 percent.
3.
Referring to Question 2, another reason is
b. The present cost of owning is less than that of leasing
4.
To determine the annual tax reduction for leasing:
a. Multiply the annual rent paid to the owner by the user’s tax bracket
User Decision Analysis for Commercial Investment Real Estate • 6.1
Lease Exit Strategies
Module Snapshot
Module Goal
In the previous modules, leases were examined from the standpoint of the
user’s occupancy cost. The analyses focused on decision-making between
several similar and dissimilar lease options. However, just as understanding
occupancy cost economics is a critical part of deciding between various leases,
understanding them once a user is occupying the space is equally important.
In this module, the decision to lease has been made, and the focus is on the value of the lease, which may change as market conditions change. Similarly,
the user’s need for space may change as business needs change. The module
contains information and activities designed to help the user value the property
and maximize that value by subleasing all or part of the space. Within the
activities, the value of a lease (or sublease) is evaluated under conditions where
market rents are both higher and lower than contract rent. Decisions about
when and whether to sublease, as well as whether to negotiate a lease buyout
also are discussed.
Objectives
Calculate the value of leasehold and sub-leasehold interests.
Explain the implications when market rent is higher or lower than the
contract rent.
Recognize the optimal time to sublease.
Identify and explain the components of sublease analysis.
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However, it should be noted that the lease obligates the tenant to pay the full
$200,000 per year, and the owner may not be willing to accept only $205,010.
Thus, the tenant may have to pay as much as the PV of the $200,000, which
would be calculated as follows:
EOY Contract
1 $200,000
2 $200,000
3 $200,000
4 $200,000
5 $200,000
Present value @ 7.00% $820,039
If the tenant can sublease the space for $150,000 per year, they would be losing
$50,000 per year. Therefore, they should be willing to pay $205,010. Of
course, it could take time to find someone to sublease the space plus additionalcosts to put the tenant in place, such as leasing commissions and tenant
improvements.
The amount the tenant might have to pay likely depends on whether they can
sublease and what they can negotiate with the owner. Another factor in the
sublease is any owner motivation for allowing the tenant to terminate the lease
early such as accommodating another existing tenant’s expansion needs or the
desire to convert the building to a higher and better use. Many other economic
and subjective factors can enter into this type of analysis.
User Decision Analysis for Commercial Investment Real Estate • 6.15
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Activity 6-2: Do Nothing versus Sublease and Relocate
Just a few months after Consolidated Mortgage (CM) signed a new five-year
lease for 10,000 sf of class A office space at the top of the market, the market
dramatically changed, resulting in a dramatic slowdown in CM’s business as well
as an overall slump in office space demand. CM has asked you, as their broker,to market their current space (all or part) for sublease.
As a result of your superior marketing efforts, you have identified a potential
subtenant who would like to take all of CM’s space for the remaining term at a
rental rate that is less than CM’s contract rent. If CM accepts this offer, they
will need to relocate to smaller space elsewhere. However, they expect to take
advantage of the lower market rates themselves and move to class B space to
save additional facilities expense.
Your assignment is to determine whether CM is better off economically by
entering into the sublease at a loss and relocating to smaller, less expensivespace, or if they should stay in place and pay out their current contract rent for
the remaining four years of lease term.
CM’s Current Lease Sublease Terms CM’s New Location
Term 4 years remaining 4 years remaining 4 years for comparison
Size 10,000 sf 10,000 sf 7,000 sf
Base rent $22 psf $18 psf $15 psf
Base rent increase None None None
Operating expenses $9.70 $9.70 $7.50
Operating expense stop $9.00 $9.70 $7.50
Sublease commission 4% of base rent Paid by Landlord
Relocation costs $30,000
Tenant improvements$2 psf paid bySublessor
None needed
Additional assumptions are as follows:
Operating expense growth rate: 3 percent
CM’s discount rate: 8.5 percent
Current Lease Period 0 Year 1 Year 2 Year 3 Year 4
6.18 • User Decision Analysis for Commercial Investment Real Estate
Module 6: Self-Assessment ReviewTo test your understanding of the key concepts in this module, answer thefollowing questions.
1.
When the contract rent of a sublease is higher than the contract rent of theprimary user, the sublease has a positive value to the owner.
a. True
b.
False
2.
When the market rent for a sublease is higher than the contract rent, the
sublease has a positive value to the user.
a.
True
b. False
3. When the market rent is lower than the contract rent, the user may bemotivated to accept a below-market sublease and pay the loss for thefollowing reason:
a. The user needs more or less square footage
b. The user prefers a buyout to relocate to higher quality space
c.
The user’s alternative lease rate is substantially below its existing rate
d. All of the above
4.
An owner may elect to buy out a user’s lease when:
a.
The terms of the lease are comparable to market terms
User Decision Analysis for Commercial Investment Real Estate • 6.19
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5. If a user indicates a desire to relocate when market rents are higher thantheir contract rent, the owner may elect to negotiate a ____________ to re-
lease at a profit.
a.
Renewal option
b.
Buyout
c. Expansion option
d. Contraction provision
6. A user has three years remaining on a 5,000 square foot lease, payable at$10 per square foot gross that escalates at 5 percent annually. The marketrate for comparable space is $12 per square foot gross but is expected toremain flat for the next three years. If the user elected to sublease, what is
the value of the lease to the primary user when the present value of thedifferential cash flows is discounted at 9 percent?
a.
$18,231
b. $16,598
c. $19,251
d.
$27,228
7. An industrial user has four years remaining on a 10,000 square foot lease with a current rate of $6 per square foot triple-net, which escalates at 4
percent annually over the remaining term. The user wants to relocate sinceit needs an additional 10,000 square foot that cannot be accommodated at
its present location. A sub-user offers to pay $6 per square foot triple-net without escalation through the term. Without regard to the operatingexpenses, what is the present value of the differential cash flows whendiscounted at 10 percent?
User Decision Analysis for Commercial Investment Real Estate • 6.21
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12. From the information in Question 11 and using the owner’s 15 percent
opportunity cost, what is the present value of the new lease?
a. $43,652
b. $69,233
c.
$77,459
d. $64,266
13.
From the information in questions 10 through 12, assume the total cost to
the owner to attract the new user, including tenant finish and movingallowance, is $7,500. What is the internal rate of return of the cash flowdifferential between the revenue from the existing lease and the proposedlease?
a.
34.23 percent
b. 26.54 percent
c. 15.00 percent
d.
8.67 percent
14. When comparing the internal rate of return of the differential cash flows to
the owner’s desired rate of return, should the owner elect to release theexisting user and enter into a new lease under the terms proposed?
a. Yes, because the owner may be able to negotiate a buyout with the
existing user
b.
Yes, because the present value of the differential exceeds the costs to
obtain the new lease
c.
Yes, because the internal rate of return of the differential exceeds the
User Decision Analysis for Commercial Investment Real Estate • 6.29
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Module 6: Self-Assessment Review
1. When the contract rent of a sublease is higher than the contract rent of theprimary user, the sublease has a positive value to the owner.
b.
False
2.
When the market rent for a sublease is higher than the contract rent, the
sublease has a positive value to the user.
a. True
3. When the market rent is lower than the contract rent, the user may bemotivated to accept a below-market sublease and pay the loss for the
following reason:
d. All of the above
4.
An owner may elect to buy out a user’s lease when:
c. The o wner wants a better-quality user
5. If a user indicates a desire to relocate when market rents are higher thantheir contract rent, the owner may elect to negotiate a ____________ to re-
lease at a profit.
b. Buyout
6. A user has three years remaining on a 5,000 square foot lease, payable at$10 per square foot gross, which escalates at 5 percent annually. The
market rate for comparable space is $12 per square foot gross but isexpected to remain flat for the next three years. If the user elected tosublease, what is the value of the lease to the primary user when the present value of the differential cash flows is discounted at 9 percent?
6.30 • User Decision Analysis for Commercial Investment Real Estate
7. An industrial user has four years remaining on a 10,000 square foot lease
with a current rate of $6 per square foot triple-net, which escalates at 4percent annually over the remaining term. The user wants to relocate since
it needs an additional 10,000 square foot that cannot be accommodated atits present location. A sub-user offers to pay $6 per square foot triple-net without escalation through the term. Without regard to the operating
expenses, what is the present value of the differential cash flows whendiscounted at 10 percent?
a. ( 10,779)
8.
When the contract rent to a user is in excess of current market rents, the
differential between what the user actually pays and the market rentsrepresents the excess amount above market rents that the user is paying to
stay in the space as opposed to relocating to new space.
a. True
9. When a user is paying rents in excess of market rents, it may elect to
d. All of the above
10. A 3,000 square foot user with two years remaining on its lease has expresseda desire to relocate in order to expand. The lease provides for rentalpayments of $36,000 in year one and $37,800 in year two. Using theowner’s 15 percent cost of capital what is the discounted value of the user’s
6.32 • User Decision Analysis for Commercial Investment Real Estate
13. From the information in questions 10 through 12, assume the total cost to
the owner to attract the new user, including tenant finish and movingallowance, is $7,500. What is the internal rate of return of the cash flow
differential between the revenue from the existing lease and the proposedlease?
a.
34.23 percent
14. When comparing the internal rate of return of the differential cash flows tothe owner’s desired rate of return, should the owner elect to release the
existing user and enter into a new lease under the terms proposed?
User Decision Analysis for Commercial Investment Real Estate • 7.1
Sale-Leaseback Transactions
Module Snapshot
Module Goal
In a sale-leaseback transaction, an investor purchases a property currently
owned and occupied by a user. Simultaneous with the sale, the parties execute
a lease whereby the user leases the property back from the investor. If
structured properly, these sale-leaseback transactions can provide excellent
benefits to both the investor and the user.
Owners/users have used sale-leaseback transactions for decades to free upcapital invested in real estate and convert it to alternative uses, primarily for
their businesses. Property types that lend themselves to sale leasebacks are
7.6 • User Decision Analysis for Commercial Investment Real Estate
User GAAP Accounting and Reporting For
Sale LeasebacksOne financial reporting rule in particular relates to sale leasebacks:
FAS-98: The financial accounting and reporting standards for sale
leasebacks
Income Statement Impact
Sale transactions can create a gain or loss depending on the book value
(adjusted basis). When selling a property as a user in any situation, certainly in
a sale leaseback, it is important to know the book value. For example, a user
can sell a building for $5,000,000. If the book value is $3,000,000, the user will
record a gain of $2,000,000. However, if the book value is $6,000,000, the user will record a loss of $1,000,000. With the same selling price, the difference lies
in the property’s book value (adjusted basis).
Basis at acquisition
+ Capital additions
- Cost recovery (depreciation taken)
- Basis in partial sale
= Adjusted basis at sale
Balance Sheet ImpactReal estate assets are often the largest individual category of operating assets for
a company. When planning the disposition of any assets, a practitioner first
should learn the book value of the property to determine whether the sale will
result in a gain or a loss. The real estate practitioner needs to set or confirm
expectations on the correct impact of that disposition on the company’s
financials.
High market values with low book values (adjusted basis) create an opportunity
to engineer a sale resulting in a gain, including through a sale-leaseback
scenario. A typical user real estate disposition ordinarily occurs because theclient doesn’t need the property anymore. In a sale leaseback disposition,
however, a low book value/high market value situation enables the company to
sell at a higher value than the book value, thus actually realizing the market
increase, albeit over the life of the lease. This allows the user to capture the real
estate’s v alue over time, ultimately appearing as a gain on financials.
User Decision Analysis for Commercial Investment Real Estate • 7.9
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Why is the gain taken over the life (term) of the lease? Financial accounting
standards require the deferred gain to be done in order to prevent the sale price
from being manipulated by increasing the lease rate artificially, which would
increase the current year’s earnings from the sale proceeds while creating a
burden on future years’ earnings with a higher lease expense.
Sale leasebacks generally fall into two categories for corporate users: strategic ortactical.
Strategic sale leasebacks are used to raise cash. The company still has a long-
term need for the facility, but the user wants to use the property to raise capital
from outside the usual sources. Sale leasebacks also are done when large,
unrealized gains can be harvested along with the cash. This is why most
corporations execute a sale leaseback. Although operating expenses increase,
the company still receives significant revenue through the gain recognized over
the lease term.
Tactical sale leasebacks are done when a company plans to exit all or a portionof a facility in the foreseeable future. The sale leaseback gives the user the
ability to walk away at the end of its need for the facility, while still capturing
some of the value of its tenancy in the sale. The investor is more oriented
toward the repositioning or redevelopment opportunity than a traditional
―coupon-clipping ‖ net lease buyer. The investor gets to control the property
and have substantial time during the lease term to pre-market space that will
become available or time to design and develop the future use for the property.
7.10 • User Decision Analysis for Commercial Investment Real Estate
User Economic Analysis
In making the sale-leaseback decision, a user has two primary alternatives to
analyze:
1.
Continue to own for a projected occupancy period
2. Sell and leaseback for the same projected occupancy period
The two approaches to compare the two alternatives are the NPV method and
the IRR of the differential cash flows method.
Net Present Value Method
The NPV method reduces each alternative to its periodic cash flows after tax.
Applying the user’s appropriate after-tax discount rate, an NPV is calculated for
each alternative. Corporate users typically use their after-tax weighted averagecost of capital as the discount rate, while non-corporate users typically use their
after-tax opportunity cost. Once the present values (PVs) or NPVs are
calculated for each alternative, the resulting values are compared. The greater
value is always the better choice.
The value line chart that follows shows that as you move from left to right, the
values increase.
Figure 7.1 Value Line Chart
For example, if an NPV analysis indicates that one alternative results in an NPV
of ($40,000) and another alternative results in an NPV of ($30,000), the correctchoice is the latter alternative. As shown in the previous chart, ($30,000) is
farther to the right than ($40,000) and therefore is the greater value. The value
of ($30,000) is greater than ($40,000), even though 40,000 is greater in raw
numbers. As a practical matter in this example, the fact that both NPVs are
negative means that the user would be giving up something for either choice.
Thus, the lesser amount given up is the better choice. In other words, giving up
$30,000 is better than giving up $40,000. Also look at the comparison in terms
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of the cost associated with each alternative. A cost of $30,000 is a better choice
than a cost of $40,000.
Consider another example in which one alternative results in an NPV of
$10,000 and another alternative results in an NPV of $20,000. The NPV of
$20,000 is the better choice. The chart shows that $20,000 is farther to the
right than $10,000 and therefore is the greater value. The fact that bothalternatives result in a positive NPV indicates a positive economic benefit
associated with both. The greater economic benefit of $20,000 is the better
choice.
Consider a last example in which one alternative results in an NPV of ($20,000)
and another alternative results in an NPV of $10,000. The NPV of $10,000 is
the better choice. As shown in the chart, $10,000 is farther to the right than
($20,000) and therefore is the greater value. Even though 20,000 is greater than
10,000 in terms of raw numbers, $10,000 is a greater value than ($20,000).
One alternative results in the user giving up $20,000, but in the other alternativethe user receives a positive economic benefit of $10,000, which is a better
choice than giving up $20,000.
If applied correctly, NPV/PV can be a useful tool for users when making
economic decisions. The correct application is to choose the greater value—or
the one that is farther to the right on the value line. In the case of negative
values, the greater value is also the lesser cost. In other words, choose the value
on the right, and you will always be right.
Internal Rate of Return of the Differential Cash FlowsMethod
This method subtracts the periodic cash flows after tax of the sale-leaseback
alternative from the periodic cash flows after tax of the continue-to-own
alternative and calculates an IRR of this differential. This IRR is after tax and is
compared to the user’s appropriate after-tax discount rate.
In a sense, this IRR quantifies the after-tax cost of the funds generated from the
sale leaseback, which can be compared to the after-tax cost of funds that may be
available from other sources.
Even if the cost of funds that could be raised from the sale leaseback is more
expensive than funds that could be raised from other sources, the sale-leaseback
alternative still could be the better choice depending on the impact to the
balance sheet or other business variables, such as the availability of other capital
sources, or the intended use of the funds to be raised.
The IRR of the differential cash flows also indicates the after-tax yield on the
capital left invested in the ownership alternative if the user continues to own and
+ Cost of sale on SPBT adjustment [$2,961,572 ÷ (1 – 4%) – $2,961,572] $123,399
Sale price adjustment needed to equalize the NPVs $3,084,971
+ Original projected sale price $5,376,000
Sale price needed to equalize the NPVs (rounded to the nearest $1,000) $8,461,000
Lastly, calculate the growth rate (i) of the value today (PV) to the sales price
point of indifference (FV) over the anticipated holding period (n).
If the value today is $4,000,000 and the EOY 10 sale price is $8,461,000, the
annual growth rate in value needed to equalize the NPVs is 7.78 percent.
Method 2: Internal Rate of Return of the Differential
Cash Flows
The IRR of the differential cash flows method is another way to compare thecontinue-to-own alternative with the sale-leaseback alternative. The NPV
method previously illustrated compares the NPV of each alternative using a
given discount rate. The alternative that creates the highest NPV is the better
alternative. Essentially, the NPV determines the capital raised through the sale
leaseback decision.
The IRR of the differential method also uses the periodic cash flows after tax
for each alternative as calculated in the NPV method, but it doesn’t use a given
discount rate for the analysis. Rather, it determines the discount rate that would
make the NPVs of the two alternatives equal. Once this discount rate (the IRRof the differential cash flows) is determined, the user compares this rate to the
after-tax weighted average cost of capital. Essentially, the IRR of the differential
method determines the cost of the capital raised through the sale leaseback
decision.
In essence, the IRR of the differential is the after-tax cost of the funds generated
from the sale in a sale-leaseback transaction. If this rate is lower than the after-
tax weighted average cost of capital (or the marginal cost of capital from
User Decision Analysis for Commercial Investment Real Estate • 7.25
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3.
Calculate the IRR of the differential cash flows.
EOY Ownership Leaseback = Differential
0 $0 $3,610,505 ($3,610,505)
1 24,459 (250,800) 275,349
2 24,459 (250,800) 275,349
3 24,459 (250,800) 275,349
4 24,459 (250,800) 275,349
5 24,459 (250,800) 275,349
6 24,459 (280,896) 305,445
7 24,459 (280,896) 305,445
8 24,459 (280,896) 305,445
9 24,459 (280,896) 305,445
10 $23,524 + $4,236,852 ($280,896) $4,541,273
IRR of the differential = 9.09%
The 9.09 percent IRR of the differential (the after-tax cost of the funds that can
be raised from the sale leaseback) is less than the corporation’s 12 percent aft er-
tax weighted average cost of capital (the after-tax cost of funds that could be
raised by going to the capital markets and maintaining their current debt-to-
equity ratio). Thus, the sale-leaseback alternative is the less expensive source of
funds.
The 9.09 percent IRR of the differential also indicates the after-tax yield on the
$3,610,505 invested in the real estate from today forward if the company
continues to own the real estate. The corporation’s after-tax cost of capital of12 percent indicates that its threshold after-tax target yield for investments is 12
percent. If the corporation has earning opportunities at a yield higher than 9.09
percent, it is better off taking the $3,610,505 that would be available from the
sale of the real estate and placing that money in a higher yielding investment.
7.40 • User Decision Analysis for Commercial Investment Real Estate
Module 7: Self-Assessment Review
1. A user who bought an office building five years ago for $1,000,000 now is
considering a sale-leaseback. A recent appraisal pegs the value today at
$1,250,000. The user owes $600,000, has taken $102,000 in cost recovery,
and is a C-corporation taxed at 34 percent. Costs of sale are estimated at 8percent. If the user sells the property today, how much after-tax cash would
be generated?
b.
464,320
6 Sale Price $1,250,000 Recent appraised value
7 Basis at Acquisition $1,000,000
9
- Cost Recovery
Taken ($102,000)
11 = Adjusted Basis $898,000
12 Sale Price $ 1,250,000
13 - Costs of Sale ($100,000) 8 percent
14 - Adjusted Basis ($898,000) From line 11 above
16 = Gain $252,000
As a corporation, gain from appreciation and gain f
Recapture are taxed at the same rate
23 Sale Price $1,250,000
24 - Costs of Sale ($100,000)
26 - Mortgage Balance ($600,000)
28 = SPBT $550,000
31 - Tax on Capital Gain ($85,680) at 34%
32 = SPAT $464,320
2. The user in the previous problem can refinance the office building under
the following terms:
70% loan-to-value ratio 20-year amortization11% interest Monthly payments
Costs to refinance: $35,500
How much will the user receive in net loan proceeds if the user goes ahead with the refinance?
User Decision Analysis for Commercial Investment Real Estate • 8.1
CCIM Interest-Based
Negotiations Review Model Module Snapshot
Module Goal
In today’s commercial real estate environment, a purely transactional approach
to negotiation that favors short-term hardball tactics over long-term relationships
does not make sound business sense. A more sophisticated and successfulapproach to the practice of commercial real estate emphasizes negotiation skills
that enable practitioners to leverage relationships for sustainable results. This
module reviews the CCIM Interest-based Negotiations Model.
Objectives
Discuss the philosophy and reasoning behind the interest-based approach
to negotiations.
Discuss the role creativity plays in negotiation.
List the three steps of the CCIM Interest-based Negotiations Model.
Identify the basic methodology for each step of the CCIM Interest-based
8.4 • User Decision Analysis for Commercial Investment Real Estate
Discussion Questions
What types of negotiations do you typically do?
How do you prepare for those negotiations?
What makes a negotiation successful?
The CCIM Approach and Negotiation Theory
Collaboration versus Competition
A tension often experienced in professional relationships is the perceived trade-
off between satisfying our own needs and satisfying the needs of others. Asdepicted below, we often compromise our needs to satisfy the needs of others
or ask other people to sacrifice their needs so we can meet ours. In addition to
resulting in suboptimal outcomes for both sides, this approach actually can
harm relationships, as compromises may lead to dissatisfaction,
misunderstandings, and even conflict.
Figure 8.1 Approach to Negotiation
A more effective approach to negotiation follows a different path. As suggested
by the diagram, instead of seeking compromise— where each party makes
sacrifices to achieve limited gains— we can use creativity to find imaginative ways
to simultaneously satisfy our own needs and the needs of others, leaving
8.6 • User Decision Analysis for Commercial Investment Real Estate
What Is Interest-Based Negotiation?
Sometimes referred to as principled negotiation, collaborative negotiation, or
win-win negotiation, in the context of commercial real estate, interest-based
negotiation includes the following aspects:
People make decisions based on their own interests (or needs).
The key to successful negotiating is finding creative and effective ways to
satisfy those interests (yours and theirs).
Before accepting or rejecting a deal, both parties understand how the
proposed deal (and alternatives to the deal) will satisfy (or harm) their
critical interests.
The CCIM approach focuses on interest-based analysis and decision-making
and shares a proven step-by-step approach that has been utilized by world
leaders in negotiation. Those steps are
1. Stakeholder interests analysis: Who is involved and what do they need?
2. Brainstorming actions: What can we do to get them what they need so we
can get what we want?
3. Risk analysis and evaluating fighting alternatives: What happens if we can’t
come to an agreement?
It may be helpful to contrast interest-based negotiation with the approach to
which people frequently resort: negotiating only about price, which often is
referred to as the high-low game. Unlike the high-low game, interest-basednegotiation places no importance on starting high or responding low. It is not
about taking unreasonable positions and sticking to them. It does not focus on
beating the other person or winning a battle of wills.
The interest-based approach to negotiation finds the best way to satisfy your
own interests, which often means finding ways to satisfy others’ interests and
leverage that satisfaction in exchange for what you want. In that sense, it may
feel like win-win, though the interest-based approach to negotiation does not
guarantee a win-win outcome (particularly when the parties may be in very
different places, such as when one side has many options—or leverage—and theother side does not).
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other people attach to specific interests. Finally, consider nonmonetary as well
as monetary interests.
Active Listening Skills and Techniques
When trying to determine a stakeholder’s interests, it is important to rememberactive listening skills and techniques. Effective negotiators listen as well as they
talk, but it’s not enough to just listen— you must prove that you are listening by
paraphrasing what the other person is saying, asking questions, and
acknowledging their interests when you hear them.
The Importance of Nonmonetary Interests
Money isn’t the only important issue in commercial real estate deals. While
nonmonetary issues can be harder to quantify than financial issues, in the real
world, concerns such as reputation, timing, flexibility, and relationships often
drive decision-making. To effectively represent their clients in commercial real
estate deals, practitioners must understand and track qualitative issues just as
they must compute a deal’s financial implications.
Finding additional ways to bring value to a deal is even more important when
you consider the ongoing relationship between the parties. Back-and-forth
squabbles focused entirely on money usually harm relationships. No matter the
outcome, it is difficult to feel good about the other side after battling about
money. On the other hand, if you seek ways to build value in a deal, you can
both build the relationship and generally improve your substantive outcomes.
The Interest Chart
The interest chart is the key deliverable from Step 1. The interest chart:
Captures all of the information needed for an interest analysis (the players,
issues, player interests on each issue, and the importance of each interest)
Shows where parties are aligned and where they are opposed
Creates a roadmap to solutions and shows the root causes of problems
8.14 • User Decision Analysis for Commercial Investment Real Estate
Objectives
In this example, the tenant’s objectives are:
Flexible: Sublease approval
Good: Relationship with landlord
Low: Rent
Automatic: Holdover
ASAP: Tenant possession
Specific Actions
The package of actions for the tenant includes:
An automatic holdover provision
Maintaining the same rent each year, which satisfies his low objective
Scheduling quarterly phone calls to the landlord, which satisfies his good
relationship objective
Obtaining sublease approval, which satisfies his flexible objective
Tenant moving in upon signing, which satisfies his ASAP objective
Tenant making changes if approved by landlord
Step 2 Conclusion
The conclusion also should reiterate how critical and important interests will besatisfied. You should invite feedback and suggestions from the tenant on how
to improve the proposal and better satisfy common interests. Tell him that you
look forward to discussing further specifics about how to move the business
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Step 3: Risk Analysis and Evaluating Fighting
AlternativesNow that you have completed Steps 1 and 2 of the three-step process, you are
ready to move to Step 3, in which you will predict what each stakeholder maydo if no agreement can be negotiated. Step 3 is the final piece of your analysis.
Although most practitioners don’t want to think about the possibility of not
closing a deal, it is important to consider each stakeholder’s “fighting
alternatives.” As shown in the next section on implementation, sometimes it’s
better to not close a proposed deal, but the only way to be sure is to perform
the Step 3 analysis.
In addition, the Step 3 analysis can be used to educate stakeholders about the
consequences of not coming to an agreement. This can be a powerful tool for
generating agreement, particularly if the fighting alternatives are communicatedin a professional, nonthreatening manner. It’s akin to educating the
stakeholders about risks.
Finally, in the Step 3 risk analysis you may think of other stakeholders or issues
that were missed in Step 1 and update your Step 1 analysis. Similarly, you may
discover that you should return to Step 2 and brainstorm additional actions to
satisfy particular stakeholder interests.
Risk Analysis
During the risk analysis, you should:
Identify fighting alternatives.
Evaluate the consequences of each fighting alternative (for your client and
the other stakeholders).
Respectfully communicate the effects of fighting alternatives on critical
interests when necessary.
Understanding and Measuring the Consequences of NoDeal
In this step, you should define your bottom line and help all stakeholders fully
appreciate the costs of the fighting alternatives.
8.16 • User Decision Analysis for Commercial Investment Real Estate
Implementation of the Three-Step Process:
Formulating and Presenting an OfferOnce you understand what may happen if you and the other stakeholders do
not come to an agreement, the next step is to return to your list of possibleactions (Step 2) and redefine it further into a best-case proposal based on a
realistic assessment of how to best satisfy your own interests as well as those of
other essential stakeholders. Be creative and flexible as you both design and
communicate your best-case proposal.
A format that is particularly effective and persuasive is to:
Identify how your proposal will satisfy each stakeholder’s interests.
Link specific actions in your proposal to the interests of specific
stakeholders.
Express flexibility if the other stakeholders propose ways to satisfy those
interests more effectively by modifying your proposal without harming your
interests.
To handle counters and objections, remain focused on your bottom line, which
should be based on a realistic assessment of how you can satisfy your interests
unilaterally and how others can satisfy theirs (perhaps harming the interests of
others) in the event you cannot reach agreement.
When you actually communicate your proposal, use your analysis to generate
talking points linking the actions to the other stakeholders’ interests. Do notdepend on the other stakeholders to figure it out. Be explicit.
Defining Your Bottom Line for Negotiations
Select actions to include in your bottom line for negotiations. Consider the
following as you do this
Evaluate how your interests will be affected if you do not come to an
agreement (Step 3: fighting alternatives).
Recognize that you are better off not agreeing to a negotiated deal that
harms your interests than if you pursued your fighting alternatives.
Calibrate your bottom line for negotiations based on that point at which you
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Case Study 2: Lease versus Purchase
Case Setup
You have been contacted by a doctor from a local medical practice, Best
Practices LLC (―Best Practices‖). The practice originally was founded by Dr.
Bob Scotting, a dynamic medical doctor and entrepreneur, who built the
organization from a small single-practitioner family medical practice into a
highly respected medical center with five physician partners (including Dr.
Bob).
The medical center has grown in reputation and services slowly and surely
under Dr. Bob’s leadership. Now the center is the go-to clinic for obstetrics
and gynecology; baby, youth, and adult general-family practice needs; sports
medicine and physical therapy; and geriatric care with a focus on arthritis and joint medicine.
Over the past 15 years, Dr. Bob has added medical specialists to build the
practice. His vision of building a business/medical practice that is "Your Clinic
for Life" has been realized. Five very compatible physician partners are now in
the practice, including Dr. Bob, and all, as Bob demanded, have an equal
ownership share.
The next step in the Best Practices ‖Your Clinic for Life‖ vision is moving into
the ―ideal‖ medical facility. The doctors have been designing that ideal facility
for years. During medical conferences, they toured the best facilities andinterviewed dozens of their peers around the country. They have informally
polled patients to solicit their input on their likes and dislikes. Key employees
and nursing staff have invested in the process as well. Several medical design
specialists have been engaged for various consulting activities and design tasks,
resulting in the final design that the doctor partners affectionately have named
‖Clinic 2.0.‖
A long-time friend of Dr. Bob who is a much-respected developer also has
been very involved in the design and creation of Clinic 2.0. He and the
principals in his firm have provided value engineering suggestions and haveearned the respect and confidence of all the doctor partners. After completing
several rounds of competitive construction bids, the development firm offered a
very interesting proposal: an alternative to either lease or purchase the facility.
This is where you enter the picture. You’ve been asked by the doctor partners
of Best Practices to recommend whether the clinic should lease or purchase the
building. You will report your recommendation to the Management
Committee, which consists of the five doctor partners, Dr. Bob (the chair) with
10.4 • User Decision Analysis for Commercial Investment Real Estate
whom you have met in the past, and the practice’s controller and office
manager.
After a brief meeting with the partners, you feel confident that they are unified
in their desire to make the best business decision for the clinic. However, they
seem genuinely ambivalent as to whether they should lease or purchase Clinic
2.0. They are looking to you for a thoughtful recommendation.
During an extensive conversation with Best Practices’ Controller, Minnie Liu,
she says that cash flow is strong and that the partnership has been accruing
capital to invest in the new facility for some time. Minnie explains that the
partnership has adopted GAAP as their accounting standard, since their various
banking, insurance, and medical equipment lease relationships require annual
audited financial statements for the practice to maintain their borrowing
capacity (debt/equity ratios), liquidity ratios, and the like.
Minnie recently attended an excellent Certified Public Accountant continuing
education course where she learned about recent financial accounting standards
(FAS) rulings. She clearly understands the accounting rules of a capital lease
and is very concerned about the potential impact of a capital lease on the firm’s
borrowing capacity. The partners have agreed that they will not enter into a
lease that would classify as a capital lease under GAAP accounting guidelines.
Minnie confides that she is leaning toward a purchase. However, she believes
that the projected sale price for any building the clinic might purchase could be
wildly inflated, so any NPV calculations for a purchase would be too optimistic.
―Plus, be sure you add up all the hidden costs of a lease,‖ she warns. ―We may
be much better off purchasing.‖
Minnie also provides some input regarding the partners. She confirms that
each partner earns the same amount from the partnership via their LLC
dividends. She also confirms that each of the partners is in the top federal
income tax bracket and that each owns their share of the limited liability
company, not as a corporation but as individuals. Minnie closes the
conversation by saying, ―These docs pay a lot of taxes.‖
In addition to chatting with Minnie, you also speak with Will Washington, the
office manager, and you sense a bias toward leasing. Will thinks that any good
business should not buy a building because it will be compelled to stay, even ifthe real estate market tanks and it makes operational sense to get out. ―I know
how these things work,‖ Will warns you. ―Easy in, but you never get out.‖
Will confirms that both he and Minnie had contacted their bank relationship
manager, Bryce Donaldson, and that Bryce is expecting your call to obtain
potential financing details. Will and Minnie gave Bryce all of the information
he requested regarding the building, and Bryce already submitted their current
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financial information to the bank’s loan committee. You make a note to call
Bryce upon your return to your office.
Ask Will if he has any input for you on lease terms, since leasing seems to be
his preference. He tells you that he thinks the lease should be long term, such
as 15 or 20 years. One of the reasons for a long-term lease is that it will be a
custom-built facility. ―It is the dream medical office for all the partners,especially Dr. Bob,‖ he says. ―We can’t allow a landlord to hold us hostage five
or 10 years in the future when the lease is up for renewal. We need to lock in
our rent for the long term, so we don’t end up paying too much down the road
when it is time for our lease rene wal.‖
You thank Will for his candid perspectives and advice and go to a meeting with
the developer. The developer provides additional details regarding their cost-
plus construction/sale price proposal, as well as the simple methodology they
used to determine the starting lease rate. Jim Bridges, the developer’s lead
representative, indicates that they are totally ambivalent about whether thedoctors purchase or lease the facility. ―Either way,‖ Jim says, ―we’d love to
work with the doctors. We’d be happy to sell them the facility, or we’d be just
as pleased to have them as tenants. We would be honored to work with them,
and we know how important this facility is to them. This will be a showpiece
for them—and us.‖
Before leaving, Jim asks you to compliment the doctors on their comprehensive
and detailed building plans. Based on those detailed plans and the multiple
bids they had solicited, Jim is very confident in the accuracy of the project’s
cost. He provides the basic formulas that they would apply to determine the
purchase price and the lease rate depending on various lease terms, whether 10,
15, or 20 years.
Your phone call with Bryce, the lender, goes well. Per Will and Minnie’s input,
as well as his knowledge of the loan covenants of the partnership’s existing
credit facilities, Bryce gives you an overview of the loan terms that the loan
committee approved. He promises to e-mail you a copy of the loan
commitment that was based on Will and Minnie’s direction. Based on prior
conversations with the partners, he believes that several of them may prefer a
nonrecourse loan, so Bryce agrees to work on terms for a nonrecourse loan
alternative, which he will present to the loan committee at their meeting next week.
10.6 • User Decision Analysis for Commercial Investment Real Estate
Task 2-1: Initial Interests and Economic Analyses
The decision analysis is, should Best Practices lease or buy the medical center?
In your analysis, keep in mind that the doctor partners want to know how each
acquisition alternative will impact their partnership’s financial statement s. Although they are ambivalent toward leasing or purchasing, it is important to
them to not negatively affect their banking, insurance, and equipment leasing
relationships on both the partnership’s income statement and its balance sheet.
In addition, they are very curious how each alternative will impact the practice’s
cash flow.
Based on the information you have compiled to date, you complete the
following Interests Chart. After reviewing the Interests Chart, apply the
following information using the Lease Versus Purchase workbook to complete
your initial economic analysis. Remember the partners have identical tax rates.
After completing your initial economic analysis, answer the questions on the
following page.
User Information
Ordinary income tax rate: 35 percent
Capital gains tax rate: 15 percent
Cost recovery recapture tax rate: 25 percent
After-tax weighted average cost of capital: 8 percent
After-tax discount rate applied to leasing cash flows after tax: 8 percent
After-tax discount rate applied to ownership annual cash flows after tax: 8
percent
After-tax discount rate applied to ownership sale proceeds after tax: 8
10.10 • User Decision Analysis for Commercial Investment Real Estate
Task 2-2: Update Your Interests and Financial Analyses
You report your preliminary findings to Dr. Bob, the rest of the Best Practices
partners, Minnie and Will.
After a healthy discussion, they all confirm that it would not be in the bestinterests of the business to enter into a capital lease. The potential impact on
the practice’s borrowing capacity could be devastating due to an ongoing
reliance on the bank’s credit facilities for cash flow as payments from myriad
insurance companies are processed. Based on your recommendation, they
direct you to modify the lease term to 15 years to eliminate the capital lease
classification. They also tell you to ask Jim, the developer’s representative, for a
proposal on rental rate and rent escalations for the shorter-term lease.
The financing terms are discussed as well, and the partners direct you to
proceed with the alternative that Bryce prepared for a nonrecourse loan, whichincludes the following terms:
65 percent loan-to-value ratio instead of 75 percent
15-year term instead of a 20-year term (but still a 20-year amortization)
7 percent interest rate instead of 6.5 percent
Although they are looking for an unbiased recommendation from you, the
partners relay their concern about purchasing the building and the amount of
capital it might require.
After the meeting, you contact Jim, who provides the developer’s terms for the15-year lease. Given the shorter term, the starting rent would be based on an 8
percent cap rate, and the increases at years 6 and 11 would be 10 percent
instead of 8 percent. Jim also confirms that the purchase price of $9,000,000
would not change if the partners elected to proceed with the purchase
alternative.
You convey the terms of Jim’s proposal to the partners, Minnie, and Will, and
they agree to the lease terms if their decision is to lease the building.
Based on the new lease and financing information, update both your interest
analysis and your financial analysis. Use the Interests Chart on the followingpage to record changes, and then use the Lease Versus Purchase Workbook to
update your financial analysis. When you have completed both analyses,
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Case Study 3: Lease Buyout
Case Setup
You are the trusted asset manager for an astute investor, George Lu, whose realestate investment portfolio includes a 24,000 square foot (sf)
warehouse/showroom through his LLC, Lu‟s Investments. A credit corporate
tenant, Accent Manufacturing Inc. (AMI) leases the building. Although eight
years remain on the 20-year lease, the Chief Executive Officer (CEO) of AMI,
Bob Roberts Jr., called his long-time friend George Lu and requested to be
released from the lease. Bob confides that AMI may be acquired by a larger
company and that AMI‟s operations in George‟s building would be
consolidated into one of the acquiring company‟s locations.
As subleasing is not allowed under the lease terms, AMI‟s only exit option is tobuy out of the lease. “I don‟t want to soak a friend, but in this economy, every
dollar counts,” George tells you. “Get me as much as you can, but do it fast. If
we‟re going to get a comparable tenant, I don‟t want to wait. I don‟t think I
should bear this kind of risk just to help a friend. If the economy slips further,
I could be in for a long wait to land a top-notch tenant, and I might have to
really drop the rent. Plus, I don‟t want to come out of pocket to make
improvements for a new tenant. AMI has got to get all of their custom
equipment out of there and leave the building as it was before they moved in.”
As you lea ve George‟s office, he says, “One more thing. I can‟t stand some of
Bob‟s people at AMI. I wouldn‟t mind having a tenant whose senior peopledon‟t whine about everything.”
Based on your previous interactions with AMI, you understand George‟s
concern. AMI constantly asks for “just a little favor,” and those little favors add
up, especially when you factor in the headache of dealing with a whiny tenant.
You recall that the original lease negotiation 12 years ago was contentious. It
seemed that they negotiated every paragraph of the lease document. You
remember that George said they kept “nibbling” on him.
You call Will Cruz, AMI‟s chief operating officer (COO), to learn more about
AMI‟s motivations to get out of the lease. Will tells you that his compa ny is
exploring acquisition and that it‟s still “hush-hush.” Toward the end of your
conversation, Will offers whatever help AMI can provide to locate a new
tenant. “I know we haven‟t always been the most cooperative in the past,” Will
admits. “I will personally make sure we do whatever we can to help.
Terminating this lease is important to the company.”
11.4 • User Decision Analysis for Commercial Investment Real Estate
Task 3-1: Review Interests Analysis
Who is involved in this scenario, and what do they need? Using the
information provided in the case study setup, stakeholders, interests, and issues
are summarized in the following Interests Chart.
Remember, to develop any interest chart:
1. Identify the stakeholders and place the primary stakeholder first on the
interest chart.
2. Note primary stakeholders, and identify them by placing an asterisk next
to each.
3. Identify all issues, and place them on the chart. To ensure that none are
missed, it is helpful to list each stakeholder and their issues separately.
4. For each issue, work horizontally across the chart, and list each
stakeholder‟s interests as they relate to that issue.
5. Determine each issue‟s level of importance. Underline critical issues.
George Lu AMI
George’s relationship with Bob Jr. SUPERFICIAL GOOD
Timing of buyoutASAP ASAP
Whether to do the buyoutDEPENDS YES
Relationship with tenantNO HEADACHES N A
Prospective tenant STRONG CREDIT N/A
RiskAVOID ??
Constant nibblingEND EXPLOIT
New tenant improvementsAMI PAYS
LU P YS
Buyout priceMAXIMIZE
MINIMIZE
Only two stakeholders are listed. Do you think Will Cruz should be included
in this chart? Why/why not? Are any other stakeholders involved at this point?
As you move forward in the case study, you may come across other influentialstakeholders, but at the onset of our analysis, we will focus on the two main
12.2 • User Decision Analysis for Commercial Investment Real Estate
Case Study 4: Sale Leaseback
Case Setup
Under the leadership of Chief Executive Officer (CEO) Alan B. Allen, Acme
Enterprises Inc. (“AEI”), an agri-business company with annual sales in excess
of $250,000,000, owns a 40,000 square foot (sf) office building that is being
used as its corporate home office. They have been in business for more than
40 years, and their Moody’s credit rating is A1.
Alan was brought in from a competing firm eight years ago to grow the business,
and he has increased revenues by 20 percent per year for the last five years.
Now the board of directors is encouraging him to expand into organic farming
support. Research and development (R&D) for their new products is
producing several promising concepts, but so far these products are just in theconceptual stage.
Tim Newman, head of R&D, is a well-known researcher and consultant, and
also teaches at the Agribusiness School at the University of California, Davis.
His decision to join private industry was driven primarily by his belief in the
potential of AEI. He feels strongly that the company can become an industry
leader in innovation in an area that generally has been slow to change. Tim was
given a position on the executive team and has the respect of the board.
AEI’s corporate structure is closely held, with 80 percent of the shares
concentrated in the hands of five stockholders. These shareholders serve as theboard of directors and have been with the company since shortly after its
inception. They are excited about moving into organic farming due to its profit
potential and the prestige the company would receive for being known as an
innovator. John Miller, one of the original founders, articulated the board’s
feelings when he told Tim Newman, “You know, as farmers, we traditionally
have been pretty conservative in our farming practices. While this new
direction is risky, we’re nervous, but excited about the potential to be on the
leading edge of 21st century farming. In addition to being extremely profitable,
we would like to be seen as creating a legacy.”
Alan, Tim, and the stockholders generally agree that they will need funding to
expand their business. Additionally, the original shareholders would like to
enjoy the fruit of their labors.
AEI purchased this building seven years ago for $5,000,000 cash, as well as
$100,000 in acquisition costs. The building has never been encumbered with
debt financing. The original allocation for improvements was 75 percent. The
useful life for cost recovery was 39 years. AEI acquired the property on the first
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day of the tax year and used midmonth convention for the cost recovery
deduction for the first year of ownership.
The company still has a long-term need for the facility, but the chief financial
officer (CFO) is considering using the property to raise capital to expand their
core business. The company needs an analysis performed to help it determine
the impact of a sale leaseback on their cost of occupancy for the next 15 years,as well as the impact on their financial statements under GAAP accounting
rules.
Based on the following assumptions, perform this analysis for the user and the
investor. Generate the solutions for this case using the Sale-Leaseback
Spreadsheet.
User Analysis Assumptions
Corporate tax rate for all sources of income, including capital gains and cost
recovery recapture: 34 percent
AEI’s after-tax weighted average cost of capital: 8 percent
AEI’s incremental borrowing rate: 6.5 percent
Sale price if sold today: $7,000,000
Cost of sale if sold today: 3 percent
Annual growth rate forecast in value for the next 15 years: 2 percent
(Round the forecast sale price to the nearest thousand.)
End of year (EOY) 15 cost of sale: 3 percent Leaseback terms: 15-year absolute net lease with annual lease payments
payable at the end of the year
Years one through five lease payments: based on a 8 percent cap rate of the
sale price
Years six through 10 lease payments: escalated with a one-time increase of
10 percent
Years 11 through 15 lease payments: escalated with a one-time increase of