Leasing Term Impacts to Valuation

Leasing Term Impacts to

Valuation

RealLeasing Conference October 2nd. 2013

Lachlan MacQuarrie, Vice President

Oxford Properties Group

Vice President, Real Estate Management – National Programs.

S. Michael Brooks, Partner

Aird & Berlis LLP

Static Model: Real Estate Finance

Real Estate

Investor

Tenants

Owner

Contractors and suppliers NER, Discount Rate,

yield, budgeting, lease vs buy Cap Rates, DCF, IRR, NPV, FFO, Financial Modelling Lender Amortization, Yield

Budgeting and financial modelling

•Net Effective Rent “NER”

NER is the “effective” net rent to the landlord over the term of a lease after present valuing leasing commissions,

leasehold improvement allowances, old lease takeovers, and free rent periods, then amortizing that PV over the fixed initial term of the lease like an annuity

•Gross Effective Rent “GER”

GER is the “effective” gross (ie inclusive of tax and operating costs) rent to the landlord over the term of a lease – same mechanics as above

•NER key metric: owners run NER screens

•Face Rents – that shown on reading the lease rent clause -illusory: but buyers buy Face Rent (rent roll)

•Face Rent may be significantly higher than market NER’s

Leasing: NER’s answer the question: which deal best?

Deal 1

Deal 2

Deal 3

10 year term

10 year term

10 year term

$14 net psf/yr

$16

$18

$10 LIA

$20

$30

$1 Commission $1

$1

Right to

terminate yr 5

Option to

expand yr 3

First right of

refusal

adjoining space

3 Step NER: PV calc then net annuity

Should we do an NER if they don’t terminate yr 5?

Deal 1 a b c d e

Year 1 2 3 4 5

face rent $ 7.00 $ 14.00 $ 14.00 $ 14.00 $ 14.00 PV to Yr 1@10% $ 7.00 $ 12.60 $ 11.34 $ 10.21 $ 9.18 f total PV rent a-e $ 50.33

g less LIA $ 10.00 h less Commission $ 1.00 i Net PV (f-g-h) $ 39.33

j re-amortize @10% $ 9.43 $ 9.43 $ 9.43 $ 9.43 $ 9.43 therefore NER $ 9.43

Deal 2: The 3 step approach

But what about the option to expand Year 3?

Do we have to hold space off the market?

Should we compute that “opportunity cost”?

a b c d e f g h i j

Deal 2 Year 1 2 3 4 5 6 7 8 9 10 face rent $ 4.00 $ 16.00 $ 16.00 $ 16.00 $ 16.00 $ 16.00 $ 16.00 $ 16.00 $ 16.00 $ 16.00 PV to Yr 1@10% $ 4.00 $ 14.40 $ 12.96 $ 11.66 $ 10.50 $ 9.44 $ 8.48 $ 7.65 $ 6.88 $ 6.19 k total PV rent a-j $ 92.16

l less LIA $ 20.00 m less Commission $ 1.00 n Net PV (k-l-m) $ 71.16

o re-amortize @10% $ 10.53 $ 10.53 $ 10.53 $ 10.53 $ 10.53 $ 10.53 $ 10.53 $ 10.53 $ 10.53 $ 10.53 Therefore NER $ 10.53

Deal 3: The 3 Step Approach

What about the First Right of Refusal to Lease

adjoining space? Does that cost us anything?

a b c d e f g h i j

Deal 3 Year 1 2 3 4 5 6 7 8 9 10

face rent $ - $ 18.00 $ 18.00 $ 18.00 $ 18.00 $ 18.00 $ 18.00 $ 18.00 $ 18.00 $ 18.00 PV to year 1@10% $ - $ 16.20 $ 14.58 $ 13.14 $ 11.81 $ 10.62 $ 9.54 $ 8.64 $ 7.74 $ 6.97 k Total PV rent a-j $ 99.23

l less LIA $ 30.00

m less Commission $ 1.00 n Net PV (k-l-m) $ 68.23

n re-amortize@10% $ 10.09 $ 10.09 $ 10.09 $ 10.09 $ 10.09 $ 10.09 $ 10.09 $ 10.09 $ 10.09 $ 10.09 Therefore NER $ 10.09

Leasing: NER’s answer the question: which deal best?

Deal 1

Deal 2

Deal 3

10 year term

10 year term

10 year term

$14 net psf/yr

$16

$18

$10 LIA

$20

$30

$1 Commission $1

$1

Right to

terminate yr 5

Option to

expand yr 3

First right of

refusal

adjoining space

6 mos rent free 9 mos

12 mos

Approaches to Direct Real Estate

Valuation

•

Discounted Cash Flow (Income Capitalization)

•

Relative Valuation (Sales or “Direct”

Comparison)

Cost

•

Assumes value = cost

•

= Land value + (building replacement cost –

accumulated depreciation)

•

Land value estimated separately – direct comparison

•

Depreciation estimated from observation, age of

building, building condition.

Direct Comparison

•Useful if sufficient comparable sales available

•Sale prices of comparable sale prices indicate a range within subject property should sell

•But must equalize for differences – subjectivity

•Result is an “equalized” value for each comparable

•typical in residential markets

•but value to unique user may be higher than for investor

Income Approach

•PV of future benefits - current income and resale value upon reversion capitalized into current lump sum value

•2 Methods: Direct capitalization and yield capitalization

•Direct Capitalization: take current income stream and use market capitalization rate, or market based gross income multiplier

•Yield Capitalization: uses Discounted Cash Flow: PV of income stream and PV of terminal value

•Current cash flow a reflection of Face Rent NOT NER, and does not reflect the “investment” the Landlord has made to secure those tenants

Discounted Cash Flow: Example 1

D.C.F Summary Sale at a 6 cap

( a ) ( b ) ( c ) ( d ) ( e ) = (b) + (d)

Year NOI PVNOI @ 8% REV PVREV @ 8% Total PV

1 $481,875.86 $ 446,181.35 $ 446,181.35 2 $ 491,513.38 $ 421,393.50 $ 421,393.50 3 $ 501,343.64 $ 397,982.75 $ 397,982.75 4 $ 511,370.52 $ 375,872.60 $ 375,872.60 5 $ 521,597.93 $ 354,990.79 $ 354,990.79 6 $ 532,029.89 $ 335,269.08 $ 335,269.08 7 $ 542,670.48 $ 316,643.02 $ 316,643.02 8 $ 553,523.89 $ 299,051.74 $ 299,051.74 9 $ 564,594.37 $ 282,437.75 $ 282,437.75 10 $ 575,886.26 $ 266,746.77 $ 9,790,066.41 $ 4,534,695.01 $ 4,801,441.77 Total = $ 8,031,264.33

Direct Capitalization Method @ 6% cap rate = $8,031,250

Yield Capitalization Method @ 2% rent increases:

DCF Example 2.

14

D.C.F Summary Sale at a 5 cap

( a ) ( b ) ( c ) ( d ) ( e ) = (b) + (d)

Year NOI PVNOI @ 7% REV PVREV @ 7% Total PV

1 $481,875.86 $ 450,351.27 $ 450,351.27 2 $ 491,513.38 $ 429,306.82 $ 429,306.82 3 $ 501,343.64 $ 409,245.75 $ 409,245.75 4 $ 511,370.52 $ 390,122.12 $ 390,122.12 5 $ 521,597.93 $ 371,892.11 $ 371,892.11 6 $ 532,029.89 $ 354,513.98 $ 354,513.98 7 $ 542,670.48 $ 337,947.90 $ 337,947.90 8 $ 553,523.89 $ 322,155.95 $ 322,155.95 9 $ 564,594.37 $ 307,101.93 $ 307,101.93 10 $ 575,886.26 $ 292,751.37 $ 11,748,079.69 $ 5,972,127.99 $ 6,264,879.37 Total = $ 9,637,517.20

Yield Capitalization Method @ 2% rent increases

Deal structure impacts the value of leases and the valuation of the asset

•Rate

•Term

•Options / ROFR / Right to Expand

•Tenant Allowances •Restoration Clauses •Exclusivity / Restrictions •Operating Costs •Termination Options •Parking •Commitments to…

•Subletting and Assignments

Rate –obviously!

• Over market (or under market)

• Last rent paid?

• Same NER can have different valuation impacts

• Favored nations clauses – in particular new builds, or large tenant deals, can impact valuation

Clear IMPACT to valuation! Sometimes even if over market.

Term

•

• 10 years is better than 5 in a falling market

• ST is better than LT in a volatile market – it depends

– Ideally consider the market – the more stabilized the longer the term, the more volatile the shorter (assuming things are going up!)

• Use rent steps to protect

• Standard fit out / uses vs customized

• Staggered terms can help an asset (requiring leasing and AM to talk)

• ½ of the value of an asset occurs outside of the lease term of the committed cash flow…the residual value

Options / ROFR / Right to Expand etc

•ROFR gives control to a tenant, credit worthiness is a concern in extreme cases

•Right to Expand is like a “melting ice cube” for an asset

•Right to Terminate (LL) can limit securing the best tenants and introduces risk / cost to valuation models

Control will impact how PV cash flow + residual value is forecasted

Tenant Allowances

•Give tenants a market TI, maintain the face rate.

•Analysts capitalize the face rent for residual, and the last rent paid has an impact on negotiations

•Over market TI’s – analysts will see past the face rent, assume termination, and then renewal at market – an impact to valuation! Psychology has an impact, even in valuation!

Restoration Clauses

•Can be an unseen cost of a lease deal if waived

•Significant exposure to high tech, excessive partitions, specialty uses such as libraries can detract value on assets

•The main issue is the impact on valuation if the use / equipment is unique, non-standard.

Should be a cost in NER if waived, will be considered in valuation

Exclusivity / Restrictions / Use Clauses

•

• Restrictions limit the pool of possible tenants.

• Use clauses that impact wear / tear on a building can impact asset value.

Largely these are a qualitative impact on valuation unless the impact is significant which can be the case in thin markets

Operating Costs

•Any restriction on recoverability will impact the valuation

• CAM stops

• Exclusions

• Semi-gross

• Inflationary controls

• Only costs which must be recovered by everyone…

Will get picked up in valuation as an impact to value.

Termination Options

• Why not just give a ST deal as opposed to giving a tenant control.

• T. Options give the benefit of a buyout in an over market situation to the Tenant.

• Analysts look at forecasted rent curves to see market vs. termination rate.

• Better to give ST deals and a market renewal – avoid the valuation impact

Avoid analysts assuming a termination will occur, which impacts valuation.

Parking

•

• Impacted deals mean capital (if parking can be added), or loss in face rent – both impact valuation.

Lack of parking, or overcommitted can’t always be cured!

Commitments to…

•Lobbies

•Certifications (such as LEED)

•Control on others

All have an impact on valuation – analyst will assume the commitment to be met which will require capital!

Subletting and Assignment

•

• LL should control the right to “take back” space if necessary, and consider buy outs

• In a rising market LL should capture any upside Tenant’s secure…. If terms and controls are not strong enough generally then major

impacts on “quality” can impact cap rates.

Questions and Discussion?

RealLeasing Conference October 2nd. 2013

Lachlan MacQuarrie, Vice President

Oxford Properties Group

Vice President, Real Estate Management – National Programs.

S. Michael Brooks, Partner

Aird & Berlis LLP