Above Market Lease Question

[tennvol09]

I am working on an office building where the current tenant is buying the property. The tenant just moved into the building and signed a ten year lease agreement in order to purchase the business.

The lease is above market; however, the tenant has also entered into a sales contract to purchase the property which also appears to be above market value (fee simple). The sales contract appears to be based on the leased fee value with significant weight given to the above market rent. This makes no sense because the tenant is purchasing the property, but there is a long term lease in place at this time.

The buyer told me if the property appraises for the contract price, then the lease will no longer be in place and he will purchase if the property. If the appraisal comes in below the contract price then he will fulfill his lease agreement. The only reason I am discussing the contract price is that it could negate a contractual agreement that appears to have some added value, thus leaving my client in a bad position after the deal closes. Any advice would be appreciated.

 

[glenn walker]

Your client probably knows exactly what he is doing *** I would try to get his comments or the sellers out of my head and look at lease rates and base my opinion off the facts. The lease amount could be totally bogus and just derived to get a higher appraised value. Don't know except in my years selling commercial properties ( I am not a commercial appraiser ) everyone has some angle and you will never really know the facts.

 

[CANative]

Appraise the real property, not the contract. Excess rent has inherent risks and excess rent (contract rent minus market rent) should be calculated separately and capitalized at a higher cap rate. It's intangible personal property.

 

[leasedfee]

It's intangible personal property.

CAN, I disagree. It is not personal property, it's real estate rent and meets the definition thereof. (If a market's rents decline, then does an entire sector now consist of personal property? No. You certainly can't move it or sell it with a bill of sale.)

Poster, assuming the contract rent is valid, no atypical terms or tenant improvement allowances that are loaded into the rent, you have an "as is" leased fee market value versus the "as is" hypothetical fee simple value at market equivalent rents. The owner naturally wants the leased fee value. The tenant-buyer naturally wants to pay the fee simple equivalent. It is their problem, not an appraisal valuation problem, to decide upon the sale price. The party that wants the transaction the most will go towards the other party's favor.

 

[Gobears81]

Sounds like the client would be more interested in the fee simple value, as the property rights adjustment/ negative leasehold adjustment would be less important, due to the lease terminating upon sale. With that said, there might be a lease buyout of sorts reflected as a premium in the purchase price, in which case, the leased fee value is important. I would suggest talking it over with the client-they often have some information that you don't.

You mentioned that the tenant signed a lease agreement to purchase the business. It is possible that the lease and purchase price is above market due to the lease/purchase of the business, in addition to the property. I have also seen cases where the buyer simultaneously purchases the business and makes an allocation for real property that is higher than typical for tax benefits.

 

[NachoPerito]

I am confused. The tenant signed a new lease in order to purchase the business? Who owned the business before, the RE owner? If so then the lease is probably for the Real Estate and Business so you have an issue there.

 

[josephdifranco]

After you discuss the excess rent, you can explain the situation and that the lease is not a typical arm's length transaction.

 

[WestMichiganCG]

I've sat in a class that went over exactly what CANative is describing and it's how I've handled excess rent. If you have an above market lease, the excess rent is going to have a higher capitalization rate because the risk of the property going down in rent is higher than average. I've seen this often done with a blended rate that includes an explanation of why a higher capitalization rate was used and it is always tied to a higher perceived risk by the buyer. I've heard of it being described as intangible personal property and I've broken a value into fee simple, leased fee and excess rent valuations. I've also done a discounted cash flow if the lease was shorter and I suspected that rent was going to reset to market. The owner of the property you are appraising has a tenant with an above market rent they are paying, he could most likely sell the building and lease to someone else who would consider that income stream in the purchase. Good luck and Happy Thanksgiving.

 

[Gobears81]

I've sat in a class that went over exactly what CANative is describing and it's how I've handled excess rent. If you have an above market lease, the excess rent is going to have a higher capitalization rate because the risk of the property going down in rent is higher than average. I've seen this often done with a blended rate that includes an explanation of why a higher capitalization rate was used and it is always tied to a higher perceived risk by the buyer. I've heard of it being described as intangible personal property and I've broken a value into fee simple, leased fee and excess rent valuations. I've also done a discounted cash flow if the lease was shorter and I suspected that rent was going to reset to market. The owner of the property you are appraising has a tenant with an above market rent they are paying, he could most likely sell the building and lease to someone else who would consider that income stream in the purchase. Good luck and Happy Thanksgiving.

While above-market rents typically result in a higher cap rate, I don't do direct cap on the entire NOI regardless of whether there are 2 or 10-years left. If the indicated cap rate would be 8% at market, then it might be, what 9% if the rents are 20% above market and 11% if it is 50% above market? But if there are only a couple years left on the lease, the cap rates might be 9.5% and 11.5%? Same thing for below-market rents. It is too subjective to analyze this without a DCF.

When I think of personal property, I think of furniture, etc. Accounting for additional value related to excess rent is an adjustment to property rights, which is attributable to negative or positive leasehold interests. I stay away from referring to it in the report as negative or positive leasehold as the actual market value of the leasehold is not typically $1 for $1 the same as the property rights adjustment, but nonetheless, the tenant holds positive leasehold with below market rents and negative leasehold at above market rents. For what it is worth, there are some cases where excess rents do not result in additional value. I am actually appraising a property where the rents are roughly 30% above market, but vacancy levels are quite high. The tenants that they are attracting leave often shortly after the lease and there are additional utilities expenses associated with the vacant units.

 

[WestMichiganCG]

I do a DCF and an equivalent direct capitalization. Many lenders are confused about the DCF so I put in the DCF and the equivalent direct capitalization in with an explanation. The direct capitalization is a good spot check and is easier for clients to understand. Investors in our market typically tweak numbers on a direct capitalization instead of running the DCF because it's easier to mess with.