Session Plan

Chapter Five: – Importance of Market Research– The Anatomy of a Lease– Mini-case on reading a lease

Location & Tenants

Individual Households– Seek to avoid transportation costs, want to locate

close to economic centers Firms

– Seek proximity to customers, suppliers, and work force

Land Prices– Price of land decreases with further distance from

economic activity centers.

Local Market Studies

Real Estate Brokers typically have regional or sub-market related information available for their customers (for a fee).

Local appraisers can also be hired to conduct market studies for an investor

– Study vacancy, rental, and expense rates in area– Determine level of new construction approved or underway– Provide analysis of demographic information

This is similar to your WFU Off-Campus Student Housing Occupancy Studies

Kick the Tires Yourself

Nothing beats visiting the property yourself, obtaining pictures of the property, and assessing the neighborhood and overall location of the property being considered as an investment.

Pictures in broker packages often represent the “best case” view of a property, so as an investor, seeing is believing!

Importance of Leases

Lease represents the “duration” of the income stream for an investment property

Lease is an agreement between the lessor (owner) and lessee (tenant)

Lease Terms can vary depending on property type:– Apartment: monthly to annually– Office/retail: monthly up to five years– Hotel/motel: daily– Warehouse/industrial: much longer terms (20 years)

How Price of Rent is Determined

Market Rates for Comparable Space– Ask brokers, appraisers, other market participants

View additional rent relative to IRR and NPV Negotiation between lessor and lessee

The Anatomy of a Lease

Date Parties to lease Length of Lease Approved use & legal description of property Responsibility for maintenance and repair

– Determined by negotiating power of landlord and tenants Any Limitations on expenses Common area maintenance (CAM) Base rent plus any escalations Renewal options

Anatomy of a Lease Continued

Rent– Could be set over entire term of lease– Could rise with a certain index (CPI for example)

Index should not be something controlled by the landlord– Percentage/Overage Rent

For retail properties. Have a base rent and then additional rent once tenant’s sales surpass a certain benchmark

For example: Tenant pays $20 per square foot annually, but could also pay 1% annually for sales over $400,000 at the Panera Bread located on Miller Street.

If rent is fixed over entire term of lease, who bears the risk if rental rates rise over the period?

Types of Leases

Type of lease: Gross, Modified Gross, or Net– Gross/Full Service: owner pays all expenses– Modified Gross: tenant pays for some expenses (possibly

utilities for an office building)– Absolute Net: tenant pays all expenses– Triple Net: tenant pays for taxes, insurance, and

maintenance of property– Expense Stops: owner pays for expenses up to a certain

(stop) point. Above this level, the tenant pays Expenses are passed through to the tenant.

Types of Leases

Index Lease– Rent and operating expenses tied to index (CPI)

Graduated Rental Lease– Rent can move up or down during term of lease

Escalator Lease– Lessor pays first year operating expenses– Lessee pays overage for remaining years

Revaluation Lease– Periodic rent adjustments based on revaluation of property

Good for properties in flux (redevelopment)

CAM and NNN Leases

Some leases provide for tenants reimbursing owners for various expenses– Typically for the maintenance of the common

areas of a property– Also could be for repairs, taxes, insurance, and

utilities as negotiated by the owner and tenants– Common Area Maintenance (CAM) must be paid

by the owner for any space in property that is vacant.

Common Area Maintenance (CAM)

CAM is typically for repairs, maintenance, and utilities but can be for any expense depending on how the lease is structured

Each tenant would typically reimburse the owner for their proportionate share of the expense being shared

Consider the following rent roll and expenses

Sq. Ft. Tenant

2,500 Uncle Bobby's Toy &

Hobby

5,000 Marvelous Marvin's

1,000 Stop and Rob

1,500 The Eatery

Taxes 25,000

Insurance 12,500

Repair/Maint 24,000

Utilities 18,500

Common Area Maintenance (CAM)

Sq. Ft. Tenant Taxes Insur Repair/Main Utilities

2,500 Uncle Bobby's Toy & Hobby 6,250 3,125 6,000 4,625

5,000 Marvelous Marvin's 12,500 6,250 12,000 9,250

1,000 Stop and Rob 2,500 1,250 2,400 1,850

1,500 The Eatery 3,750 1,875 3,600 2,775

10,000 Totals 25,000 12,500 24,000 18,500

Who pays if there is a vacancy?

Another CAM Example

You own a 20,000 sq. ft. retail strip center. There are currently four tenants. The leases allow for the taxes, insurance, utilities, repairs and maintenance to be paid by the tenants.

How much in $ per square foot would each tenant reimburse the landlord for the current year if…

– Taxes are $20,000– Insurance is $4,500– Utilities are $7,500– Repairs & maintenance is $20,000

How much would each tenant pay annually if each tenant occupied 5,000 square feet of space?

What if a tenant vacates? Who pays the expenses then?

Example of an expense stop

A tenant has an expense stop of $5 per square foot based on expenses during the first year of the lease

Expenses are currently $7 per square foot and the tenant has 15,000 sq. ft. of rentable area.

How much does the owner and tenant pay in expenses for this tenant’s space?

– Owner pays: $5 x 15,000= $75,000– Tenant pays: $2 x 15,000= $30,000

Other Lease Contents

Concessions– Lease will disclose amount of free rent, if tenant improvements will

be paid by the owner, and other discounts When would these be more likely: Low or High Vacancy markets?

Non-compete clause– Lease will specify if cannot lease adjacent space to a competitor

Non-dilution/radius clause– Or if tenant cannot lease another location within a certain radius– Common for retail leases.

Domino (or “Go Dark”) Clause– If anchor tenant vacates, in-line (or supporting) tenants may have

the ability to break their leases for a specified fee

Lease Contents Continued

Lender approval of major leases– For both changes to existing tenant mix and for

any new tenants

Load Factor– Used to pro-rate space– Rentable area per floor divided by useable area

per floor

Lease Addendums: SNDA

Subordination: lease is subordinate to all provisions of loan including renewals, modifications and extensions.

Non-Disturbance: in event of foreclosure, tenant can stay in property as long as they are paying rent as agreed.

Attornment: tenant agrees to be tenant for any subsequent landlord (bank or otherwise).

Lease Rollover Risk

Evaluation of % of leases maturing in same period– Stated maturity vs. business risk issue

This is a concern for both investors and lenders– Specific property may be performing well but

others in portfolio could cause repayment issues

Effective Rent

Present value of the expected income stream from the lease minus any expenses.

Used to compare leasing alternatives– Subtract out any expenses landlord must pay

Example: Panera Bread leases 2,000 sq. ft. in a retail strip center in Winston-Salem. They are paying $20 per square foot for the next five years, absolute net. Each year, the rent will increase by 5%.

Determine the effective rent for this lease assuming a 10% discount rate.

Panera Bread Effective Rent

  Year 1 Year 2 Year 3 Year 4 Year 5

Annual Rent $ 40,000 $ 42,000 $ 44,100 $ 46,305 $ 48,620

DiscountFactor 1.10 1.21 1.331 1.464 1.61051

PV of Rent $ 36,363.64 $34,710.74 $33,132.98 $31,629.10 $30,189.19

Total PV $166,025.65        

To then calculate effective rent:N=5, I=10, PV= (166,025.65), FV=0Solve for PMT= $43,797.15

Remember: Set your calculator to 1 P/Yr!!!

Ground Lease Decision

How many different owners could there be in a ground lease?Which portion of the property would you want to own and why?

Ground Leases: Bank’s Perspective

Sale and Lease Back of Land creates a ground lease between the purchaser of the land, and the owner of the building

Most banks will not want to loan against a property that has a ground lease, unless that ground lease has a substantial period of time left on the lease

– One Rule of Thumb is that lease should exceed the amortization of the loan by at least 25 years.

Once the ground lease expires, the building improvements may revert back to the owner of the land…

End of Session

Next Session– Chapter 6– Market Research

Mini-Case