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  #1  
Old 02-21-2008, 09:22 PM
Shannon Holsinger Shannon Holsinger is offline
 
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Default Risk and Sandwich Leasehold Position

Hello all -- thanks for taking the time to read and in advance for any imput you may provide.

Here is the problem in a nustshell. A sandwich leasehold exists in which the leasehold has sublet a portion of the site with a big-box for the entirety of the ground lease payments, and then retained a portion of the site with adjunct retail improvements and gains all of the sublease income from them.

Here's the rub. At first glance, it would appear as though the sandwich has a zero net payment responsibility for the use of the ground (as it is being absorbed by the big box sublease), thereby getting the entiry of the adjunct sublease income "for free."

But there is risk there; if the big box sublease defaults, the sandwich is stuck with the entiry of the land lease payments, offset only by the much smaller adjunct retail income.

Since when everything is operating as it should, the net "rent" for the sandwich is zero, the application of any risk is difficult (10% risk times $0 is $0). So here is the best soluation I have come up with:

1) discount the big box sublease income at a rate commensurate with the tenant's corporate bond ratings (say 7%).
2) discount the lease payments as though using a sinking fund account with a safe rate of say 4.5% compounded daily.

Thus, although the sublease income and lease payments are equal in dollars, they are disparate in risk. Over 30 years, the overall risk associated with continuing to receive sublease income for the land is 7%, while the overall "risk" associated with paying the lease payments is 4.5%. The offsetting income then, is essentially subject to a 2.5% lower discount rate than the offsetting income.

Since the dollars per period are equal, I see no way to associate the income risk with the much more certain need to pay the lease.

Overall, then, the investment would be:

Income from the big box land lease discounted at 7%
Income from the adjunct retail center discounted at "typical" retail -- say 9%
Expense from the master land lease payments discounted at a safe sinking fund rate of 4.5%

Using this, the net present value of the sandwic leasehold position should include the risk of all income sources and the discount applicable to the time value of money related to future payment obligations to maintain the sandwich leasehold.

Just saying that the income from the big box lease offsets the output for the land lease is not correct, as the investor runs the risk of losing the big box income but still being responsible for paying the land lease. The adjusnct retail income seems pretty much out of the loop and not subject to any atypical discount.

Does any of this make any sense out there? If not, then how to best account for the difference in risk for the bog box income offsetting the master land lease payments -- they sure son't equate to zero. Who would incur the obligation to pay $1,000,000 a year in land leases for the benefit of obtaining $200,000 in adjunct retail income just because some company (B rated) agreed to pay the $1,000,000 for the life of the lease and call it a wash?

THANKS!!!!!

Braindead.
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  #2  
Old 02-21-2008, 09:35 PM
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PropertyEconomics PropertyEconomics is offline
 
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Quote:
Originally Posted by Shannon Holsinger View Post
Hello all -- thanks for taking the time to read and in advance for any imput you may provide.

Here is the problem in a nustshell. A sandwich leasehold exists in which the leasehold has sublet a portion of the site with a big-box for the entirety of the ground lease payments, and then retained a portion of the site with adjunct retail improvements and gains all of the sublease income from them.

Here's the rub. At first glance, it would appear as though the sandwich has a zero net payment responsibility for the use of the ground (as it is being absorbed by the big box sublease), thereby getting the entiry of the adjunct sublease income "for free."

But there is risk there; if the big box sublease defaults, the sandwich is stuck with the entiry of the land lease payments, offset only by the much smaller adjunct retail income.

Since when everything is operating as it should, the net "rent" for the sandwich is zero, the application of any risk is difficult (10% risk times $0 is $0). So here is the best soluation I have come up with:

1) discount the big box sublease income at a rate commensurate with the tenant's corporate bond ratings (say 7%).
2) discount the lease payments as though using a sinking fund account with a safe rate of say 4.5% compounded daily.

Thus, although the sublease income and lease payments are equal in dollars, they are disparate in risk. Over 30 years, the overall risk associated with continuing to receive sublease income for the land is 7%, while the overall "risk" associated with paying the lease payments is 4.5%. The offsetting income then, is essentially subject to a 2.5% lower discount rate than the offsetting income.

Since the dollars per period are equal, I see no way to associate the income risk with the much more certain need to pay the lease.

Overall, then, the investment would be:

Income from the big box land lease discounted at 7%
Income from the adjunct retail center discounted at "typical" retail -- say 9%
Expense from the master land lease payments discounted at a safe sinking fund rate of 4.5%

Using this, the net present value of the sandwic leasehold position should include the risk of all income sources and the discount applicable to the time value of money related to future payment obligations to maintain the sandwich leasehold.

Just saying that the income from the big box lease offsets the output for the land lease is not correct, as the investor runs the risk of losing the big box income but still being responsible for paying the land lease. The adjusnct retail income seems pretty much out of the loop and not subject to any atypical discount.

Does any of this make any sense out there? If not, then how to best account for the difference in risk for the bog box income offsetting the master land lease payments -- they sure son't equate to zero. Who would incur the obligation to pay $1,000,000 a year in land leases for the benefit of obtaining $200,000 in adjunct retail income just because some company (B rated) agreed to pay the $1,000,000 for the life of the lease and call it a wash?

THANKS!!!!!

Braindead.

Which position are you appraising?
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  #3  
Old 02-22-2008, 06:42 AM
Shannon Holsinger Shannon Holsinger is offline
 
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Sorry --

Master Land Lease
My position (Tenant to master, collects from subs, pays for master land lease)
Big Box (Subtenant, pays rent equal to master land lease)
Adjunct Retail (Subtenant, pays rents my position keeps)
  #4  
Old 02-22-2008, 07:01 AM
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I'm confused as well. What is the question and what is it you are appraising or want to know the value/risk/other considerations?
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  #5  
Old 02-22-2008, 07:24 AM
Shannon Holsinger Shannon Holsinger is offline
 
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Yes -- this one is tough to explain. Let me try again. There are four players:

The fee owners: they have leased the ground (say 10 acres for say $10,000 a month).
The Sandwich: they are tenant in the ground lease. They are responsible for the $10,000 a month

The Big Box: They came along and are using say six acres and paying the rent for the entire 10 acres to the sandwich as a sublessee -- paying $10,000 a month

The adjunct retail: multi-tenant retail on the remainder four acres - sublessee paying retail rents to the sandwich. Say $4,000 a month total.

In this set-up, it looks like the Sandwich is essentially getting the use of the 4 acres with the adjunct retail for "free" since the entirety of the land lease rent is being paid by the Big Box. The $10,000 a month in land lease payments are cancelled by the $10,000 a month in Big Box rents, leaving the Sandwich with $4,000 in income.

Trouble is, if Big Box ever goes belly up, then Sandwich is stuck with the full 10 acres of ground lease payments (minus $10,000 a month), while only getting the income from the much smaller four acre Adjunct Retail rent.

Since the income from the Bog Box and the payment to the Ground Lease always zero out, it is difficult to apply a risk consideration. So my idea has been to apply risk separately to income (rent) and expense (lease payment) for the Sandwich.

Income from the Big Box is logically as risky as the tenant's corporate rating, so that is what I am thinking about using as a risk factor ties to the Big Box income. Lease payment is a given, so I am using a safe rate on that. If you assign risk of say 7% to the income, but only 4.5% to the lease, then you finally get an indication of the risk the Sandwich is incurring.

So instead of the Sandwich looking like this:
Income from Big Box Cancels Rent for Ground Lease (+10,000-10,000=0)(
Income from Adjunct Retail assigned normal risk ($4,000 @9-10%)
We get this:
Income from Big Box ($10,000 risk:7%)
Income from Adjunct Retail ($4,000 @ 9-10%)
Ground Lease Obligation ($10,000 @ 4.5% sinking fund)
This way, the big box rent does not simply "cancel out" the ground lease rent requirement, and the risk the Sandwich is incurring is reflected. Trouble is, it requires dicounting income and expense separately, before any "net" income is calculated. If you applied risk traditionally, to net income, the result would be zero risk because at present, income from the Big Box does indeed "cancel out" the ground lease expense. As long as they pay.

We are stuck with the Sandich position on this one.

Thanks!!

Last edited by Shannon Holsinger : 02-22-2008 at 07:28 AM.
  #6  
Old 02-22-2008, 10:56 AM
Denis DeSaix Denis DeSaix is offline
 
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Shannon-

This is what I understand:
  • The interest you are appraising is the first leasehold, which is sandwiched by two subleases and to which is responsible for paying the ground lease ($10k/month).
  • You are trying to figure out the value of the leasehold and it is complicated by the fact that one sublease tenantís terms call for the payment of the entire land lease ($10k) while the other sublease tenantís terms are based on a different set of terms.
Your question is how should these incomes be evaluated in terms of a discount rate?

My answer is this- and please understand Iím posting so as to learn too- so I guess what Iím saying is donít listen to my answer unless it is confirmed by others:

The problem seems straightforward to me. Although the terms of the subleases may have been written indicating rent is allocated for X ($10k for the ground lease), and Y is for something else, the bottom-line is income to your leasehold interest is income. That big boxís rent is being allocated to pay the master ground lease does not change the quality or durability of that income or the fact that your client is on-the-hook for it should big box fail.
Similarly, in my opinion, the fact that big box pays an amount that is supposed to offset the ground lease doesnít mean that the other tenantís rent is doesnít include a portion that should go to the ďlandĒ it occupies- unless they have some unusual other-than-market rent, no?

I agree that the quality of the income streams may warrant different discount rates to reflect the different risks associated with the quality of the tenants. But that is no different from any other multi-lease scenario, no?
Rather than allocate rent from one sublease to apply to the ground lease and rent from another sublease to apply to operating income, Iíd analyze it as just ďincomeĒ adjusted accordingly for its quality, and take it from there.

Please let me know if I totally misunderstood your question so I can learn.

Thanks!
  #7  
Old 02-22-2008, 11:55 AM
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PropertyEconomics PropertyEconomics is offline
 
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Quote:
Originally Posted by Denis DeSaix View Post
Shannon-

This is what I understand:
  • The interest you are appraising is the first leasehold, which is sandwiched by two subleases and to which is responsible for paying the ground lease ($10k/month).
  • You are trying to figure out the value of the leasehold and it is complicated by the fact that one sublease tenantís terms call for the payment of the entire land lease ($10k) while the other sublease tenantís terms are based on a different set of terms.
Your question is how should these incomes be evaluated in terms of a discount rate?

My answer is this- and please understand Iím posting so as to learn too- so I guess what Iím saying is donít listen to my answer unless it is confirmed by others:

The problem seems straightforward to me. Although the terms of the subleases may have been written indicating rent is allocated for X ($10k for the ground lease), and Y is for something else, the bottom-line is income to your leasehold interest is income. That big boxís rent is being allocated to pay the master ground lease does not change the quality or durability of that income or the fact that your client is on-the-hook for it should big box fail.
Similarly, in my opinion, the fact that big box pays an amount that is supposed to offset the ground lease doesnít mean that the other tenantís rent is doesnít include a portion that should go to the ďlandĒ it occupies- unless they have some unusual other-than-market rent, no?

I agree that the quality of the income streams may warrant different discount rates to reflect the different risks associated with the quality of the tenants. But that is no different from any other multi-lease scenario, no?
Rather than allocate rent from one sublease to apply to the ground lease and rent from another sublease to apply to operating income, Iíd analyze it as just ďincomeĒ adjusted accordingly for its quality, and take it from there.

Please let me know if I totally misunderstood your question so I can learn.

Thanks!

Denis I think I agree with you. If you are appraising the postion of the Master Land Lease Holder ... the only risk associated with that is the original lessee as they are required to perform on their original contract. The subleases and sand witch positions are those created by the original lessee and dont overly impact the master lessor unless the original lessee defaults. The original lessee has assumed the risk of the sandwich and sublease positions. While this may be considered overall as risk, the real question is what is the risk between the Lessor and the Lesee in the master rental agreement. The original lessor is only entitled to payment from the original lessee for the land payments. How the original lessee collects these incomes may show their strength or weakness which would be reflected in the appropriate overall rate or discount rate.
Disclosure of the sub-positions is required but im not overly sure they are relative to the position being appraised.
What would happen if the orginal lessee failed .. would an investor be attracted to the ground lease?

I hope I have understood this situation correctly. Its complicated with all the players and Im trying to see through the smoke created by all the positions.
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Last edited by PropertyEconomics : 02-22-2008 at 11:58 AM.
  #8  
Old 02-22-2008, 01:26 PM
Shannon Holsinger Shannon Holsinger is offline
 
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Thanks to both of you -- you make excelent points.

The trouble with considering the Big Box income as standard income and the land lease payment as an expense is in the very assignment of risk itself.

If treated as typical income and expenses, they effectively cancel each other out by the time the net operating income is arrived at. Any discount applied to the NOI would not, then, reflect the fact that the income stream is dependent upon collecting an amount 2.5x net operating income (expense rate of 250%) from a source with risk against the commitment to pay the amount.

I'll simplifiy by going to a direct cap situation:

Gross income from Big Box: $120,000
Gross income from Retail: $ 48,000

Less Expenses (simplified)
Lease Payment: ($120,000)

NOI: $ 48,000

In this case, it APPEARS that the NOI to the leashold interest would be $48,000 per year. But you sure wouldn't want to stick a 6% cap rate on it, because the $120,000 in income is not guaranteed, whereas the $120,000 in payments are guaranteed.

Normally, just a higher risk (cap) rate would work to allow for the fact that the $120,000 in offsetting income is not guaranteed, but in this case, any risk would be applied to the $48,000, which is only some 30% of the total amount involved.

So, how best to reflect the relatively large risk of the $120,000 offsetting income/expense to the sandwich position by application to the $48,000 in NOI? I don't think it is reasonable. That is why I am thinking that the $120,000 in income and expense have to be treated separately from the retail cash flow and assigned individual risks.

PS sorry for bad typing -- keyboard suffered its last spill of diet coke this morning. New one on order
  #9  
Old 02-22-2008, 01:33 PM
Shannon Holsinger Shannon Holsinger is offline
 
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So my idea at present:

Big Box Value: Present value of $120,000 per year for 20 years discounted at 7.5% (the rate of Big Box's Corporate bonds)

Retail Value: Present value of $48,000 per year for 20 years discounted at 9.5% (the market IRR in the area)

Present value of lease payment: $120,000 per year for 20 years based on a sinking fund annuity at 4.5% (safe) growth

Value of sandwich leasehold = present value of big box income + present value of retail income - present value of lease payments

or
  #10  
Old 02-22-2008, 03:15 PM
Denis DeSaix Denis DeSaix is offline
 
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Quote:
Originally Posted by Shannon Holsinger View Post
So my idea at present:

Big Box Value: Present value of $120,000 per year for 20 years discounted at 7.5% (the rate of Big Box's Corporate bonds)

Retail Value: Present value of $48,000 per year for 20 years discounted at 9.5% (the market IRR in the area)

Present value of lease payment: $120,000 per year for 20 years based on a sinking fund annuity at 4.5% (safe) growth

Value of sandwich leasehold = present value of big box income + present value of retail income - present value of lease payments

or
If I were an investor, I'd analyze the incomes that way.
I guess what threw me in your original post is that I was reading big box rent takes care of the ground rent and getting hung-up on that allocation.
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