1. Chapter 9: Leased Fee and Leasehold Valuation

2. Introduction  Leases affect typical investment returns by impacting:  Net operating income  Reversionary value estimate  Financing options  Investment risk

3. Ownership interests subject to leases  Leased fee interest (leased fee estate)  Could be greater than, less than, or equal to the market value of the fee simple interest  Typical purchaser is a real estate investor  Value = PV of NOI considering existing leases + PV of reversion from resale of property at end of holding period  Discount rate used is that desired by the purchasers of leased fee interests

4. Ownership interests subject to leases  Leasehold interest (leasehold estate)  Typical purchaser is a tenant  Value = PV of rent differentials between the contract rent and market rent  Discount rate is the rate desired by purchasers of leasehold interests

5. Ownership interests subject to leases  Value of leased fee interest plus the value of the leasehold interest may or may not equal the value of the fee simple interest  Investors of leased fee interests operate in different markets than investors in leasehold interests.  Investment criteria may differ  Investment horizons may differ

6. Cash-flow forecasting with existing leases: the lease agreement  Important considerations affecting cash flow in the lease agreement:  Date of agreement  Date of execution of the lease  Date the rental payments begin  Date the lease expires  Date of any renewal options  Date of notice  Parties to the lease (check for arm’s length agreement)  Description of the leased premises  Uses allowed for the property

7. Cash-flow forecasting with existing leases: the lease agreement  Payment amount and method of calculation of rent:  Contract rent  Fixed  Based on price index  Percentage rent  Overage rent  Excess rent  Expenses:  Gross lease  Absolute net lease  Net lease  Net net net lease (triple net lease)  Expense pass-through  Remaining lease provisions

8. Net operating income forecast  Contract rents  Absorption of unleased space  Vacancy and collection loss allowances  Income from other sources  Operating expenses  Expense pass-through  Fixed expenses  Variable expenses

9. Resale proceeds forecast  Methods  Actual dollar forecast  Change in value over the holding period  Terminal capitalization rate  Leased fee NOI may change at a different rate than market NOI

10. Resale proceeds forecast  A significant change in NOI because of lease renewals may not induce an equal change in the value of the lease-fee estate over the same time period  Value of the lease-fee estate depends on both the NOI from the existing leases and the proceeds from resale of the property at the end of the holding period  The resale price of the property at the end of the holding period depends on the expected NOI in the years after the property is sold

11. Resale proceeds forecast  Terminal capitalization rate may have to be adjusted if leases have not expired at end of holding period.

12. Leased-fee discount (yield) rate  May be higher, lower or equal to fee simple discount rate  Depends on credit rating of tenants and whether leases are above or below market

13. Example: Market Assumptions  Gross building area: 24,000 sqft  Net building area: 20,000 sqft  Market rent: $15/sqft  Income: Increasing at 4% per year for 5 years  Vacancy: Level at 6% per year  Management: 5% of EGI  Property tax: $11,900 level for 3 years, increasing to $15,000 in years 4-6  Insurance: $0.20 per sqft of net rentable area, increasing by 3% per year  Utilities: $1.25 per sqft of gross area, increasing by 5% per year  Janitorial: $0.90 per sqft of net rentable area, increasing by 4% per year  Maintenance: $4,000 per year increasing by 3% per year

14. Example: Fee simple value estimate  Assuming a 5 year holding period, if I=12%, solving for NPV gives a value estimate of $2,142,209 123456 PGI300,000312,000324,480337,459350,958364,996 Less vacancy and credit loss18,00018,72019,46920,24821,05721,900 EGI282,000293,280305,011317,211329,901343,096 Less operating expense82,00085,02488,13894,58098,021101,616 NOI200,000208,256216,873222,631231,880241,480 Net resale proceeds2,414,800

15. Example: Market Assumptions  Gross building area: 24,000 sqft  Net building area: 20,000 sqft  Market rent: Increasing by 4% per year  Vacancy: 6% of released space; 0% during term of existing leases  Management: 5% of EGI  Property tax: $11,900 level for 3 years, increasing to $15,000 in years 4-6  Insurance: $0.20 per sqft of net rentable area, increasing by 3% per year  Utilities: $1.25 per sqft of gross area, increasing by 5% per year  Janitorial: $0.90 per sqft of net rentable area, increasing by 4% per year  Maintenance: $4,000 per year increasing by 3% per year

16. Example: Existing Leases Present Tenant Leased area(sqft) Current annual rent Contract rent/sqft Remaining term Market rent/sqf tComments C&B Bank10,000$100,000$10.004 year$15.00 Tax stop above $0.20 per sqft Valley Mortgage6,000$69,000$11.501 year$15.00 2-year option @$13 per sqft Apex Insurance4,000$48,000$12.003 years$15.00 2% annual increase

17. Example: Leased fee value estimate  Assuming a 5 year holding period, if I=12%, solving for NPV gives a value estimate of $1,962,344 Year12345 Income C&B Bank$100,000 $175,479 Valley Mortgage$69,000$78,000 $101,238$105,287 Apex Insurance$48,000$48,960$49,939$67,492$70,192 Total$217,000$226,960$227,939$268,730$350,958 Vacancy @ 6%$0 $10,124$21,057 EGI $217,000$226,960$227,939$258,606$329,901 Expenses Management$10,850$11,348$11,397$12,930$16,495 Property tax$11,900 $15,000 Insurance$4,000$4,120$4,244$4,371$4,502 Utilities$30,000$31,500$33,075$34,729$36,465 Janitorial$18,000$18,720$19,469$20,248$21,057 Maintenance$4,000$4,120$4,244$4,371$4,502 Total expenses$78,750$81,708$84,328$91,649$98,022 Pass-throughs$3,950 $5,5000 NOI $142,200$149,202$147,561$172,457$231,879