INCOME- PRODUCING PROPERTIES: LEASES AND THE MARKET FOR SPACE Objectives Major property types Economic forces Supply and demand relationships Location analysis Competitive nature of real estate Importance of leases

Classification of Real Estate Uses Single family Multi- family Office Retail Industrial Recreation Institutional Mixed use

Economic Base Analysis- Location Quotients RE- Regional Employment USE- U.S. Employment j- Industry Classification TOT- total LQ= (R.E. j /RE TOT ) / (USE j /USE TOT )

Economic Base Analysis- Location Quotients Continued If LQ is greater than 1.0, then industry is base or driver industry If LQ is less than 1.0, then industry is usually referred to a supporting industry

Housing Demand and Supply Factors Housing factors of demand include: – New household formations, age composition of new households, household income, and mortgage credit conditions. Housing factors of supply include: – Prices of factors of production, productivity factors, number of builders in the market, and credit conditions.

Retail Demand and Supply Factors Retail factors of demand include: – Number of consumers, customer income, consumer tastes and preferences, prices of substitute products, and credit conditions. Retail factors of supply include: – Prices and productivity of factors of production, number of developers, developer expectations, and credit conditions.

Office Demand and Supply Factors Office factors of demand include: – Number of local firms, types of business of local firms, growth in local firms, and office space square feet per employee. Office factors of supply include: – Similar to retail market supply factors.

Location and User- Tenants Firms competing for space will result in the highest rents possible for the most profitable locations Locations will tend to be determined by clusters of users with similar financial structures that relate in similar ways to a given location

Location and User- Tenants Continued Locations with the greatest appeal to users will produce higher rents and also highest densities Firms that are cost- sensitive are competitive for locations

Location and User- Tenants Continued Location decision factors of household: – Users seek to avoid transportation costs, thus having incentives to locate close to economic centers – The price of land decreases with the distance from the economic activity centers within urban areas, and buyers substitute land quantity for location

Location and User- Tenants Continued Location decision factors of firms: – Transportation costs Proximity to customers Proximity to suppliers Proximity to work force – Land requirements – Type of service or product High- density / low- density demand- losing production

The Business of Real Estate Lease v.s. purchase Most tenants find leasing to be more cost- effective than owning Owning requires capital commitment and risks of ownership Owning reduces operating flexibility Maintenance An economic market for real estate services has emerged

The Asset Market Real estate values vary according to their physical characteristics, their locations, and the economic conditions of the market. Real estate values depend on income expectations and its relative riskiness.

Leases- Features and Characteristics Date Term Parties, lessee, and lessor Legal description Allowed uses Restrictions on alterations Responsibility for maintenance and repair

Leases- Features and Characteristics Continued Any restrictions on operations of tenants business Assignment or subletting Use of common areas Adequate insurance Default Base rent and any increases Gross lease v.s. net lease

Leases- Features and Characteristics Continued TI allowance Rent concessions Lease renewal options

Lease Demand and Supply Demand and supply model with vacancy Va= S-D Natural vacancy Rents – Equilibrium rent – Net contract rent – Effective contract rent

Lease Demand and Supply Continued Physical and financial asset markets Functions of space markets: – To allocate existing space – To expand or contract space to meet conditions – To determine new uses for land Demand and supply model with vacancy Va= S-D – Natural vacancy

Financial Content of Leases Base rent Step up provisions (CPI) Percentage rent Maximum rent Overage rent Gross lease Net lease Expense stop

Responsibility for Expenses Gross or full service- owner pays all expenses Net- tenant pays all expenses Expenses stop- owner pays up to the “stop”, expenses in excess of the stop are “passes through” to tenants – The stop is typically the expenses per s.f. during the first year of the lease – There can be a “cap” on the amount passed through

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

Financial Content of Leases Continued Concessions- base rent, TI allowance, etc. Signage Non- compete clause Lender approval of major leases Load factor Load factor for floor= Rental area per floor Usable area per floor Effective rent

Leases Divide the bundle of rights between owners and users. If a lease is over 1 year in length it has to be in writing. Lease must be delivered to the tenant to be valid. Landlords can restrict the use of the property through the lease. Landlords are entitled to enter premises at any reasonable hour with notice Landlords have right to show residence to prospective renters and buyers.

Property needs to be safe and habitable Tenant has right to privacy Lease can be canceled if property is damaged by any peril such as fire, tornado, etc. Tenant can not be forced into taking alternative housing. Tenant has right to withhold rent up to $300 or ½ of monthly rent in order to force landlord to make repairs on code violations. Leases are non-transferable to other tenants Rights of Tenants

Subleasing / Subletting Sublease – someone else takes over the premises but original tenant remains liable for rent and damages Substitute – New tenant is substituted entirely for the old tenant. The new tenant becomes entirely responsible for rent and damages

Lease Termination 95% leases terminate at end of lease Tenant abandonment Formal Eviction Constructive Eviction

Types of Leases Commercial Leases Normally based on Sq. Ft. Net Lease Percentage Lease Triple Net Lease Graduated Lease Index Lease Re-appraisal Lease Ground Lease

Def:It is an opinion of value rendered by an impartial person skilled in the analysis and evaluation of real estate Appraisals

Audience People or parties interested in transferring ownership Taxing Authorities Compensation for property loss and damages for insurance companies Attorneys need appraisals for divorces, estate planning, etc…

Who can be an appraiser ? Prior to 1989 anyone could be an appraiser In 1989 anyone dealing with federal mortgages had to be licensed and certified in all 50 states 2 Types of Appraisers Licensed Appraiser Certified Appraiser

Nature of Fair Market Value Def : Most probable selling price With following conditions Property is exposed to an open market for a reasonable period of time. Buyers and Sellers are well informed and act prudently (in own self interest) Payment is in cash without financing

Appraisal Report Fair Market Value based on current use. What is the fair market value based on its highest and best use.

Steps in Preparing an Appraisal Define the Problem Plan the Appraisal Inspect Subject Property Collect Market Data Study Impact of Economic and Social Factors Estimate Value using 3 Methods Sales Comparison Approach Cost Approach Income Approach Write Formal Report Submit Report to Client

Market Approach (Sales Comparison) An average is never used Rule #1 If the comparable has a more desirable feature we subtract off the market value of that feature Rule #2 If the comparable lacks a desirable feature compared to the subject property then we add the value of this improvement

Cost Method Buyers will pay no more to erect a new building with the same features Three Steps to this Approach 1.Estimate current costs to replace improvements 2.Subtract off the values of improvements that are used up.(e.g. depreciation) 3.Add in value of land

Income Approach Basic philosophy is that buyers will pay no more than the cost of purchasing the same cash flows with equal risk Figure out Net Operating Income and then discount it back EX. Estimated Value = Operating Income Capitalization Rate

Examples An office building is currently producing $38,000 in operating income per year. If an investor requires a return of 14% on their investment, how much should they pay for the property if operating income remains the same in the future? Solution:V = $38,000/.14 = $271,429 Using the facts above, suppose operating income is expected to grow at 3% per year. What would the estimated value be? Solution:V = $38,000/ = $345,454