Actual Income vs. Economic Income

[post450]

I am appraising a retail property with three units, the largest of which is a convenience store (with fuel) midway through a 10 year lease at a rate substancially below market (around 40% less). The other 2 units are month to month. Client's scope of work calls for development of market rental rates and direct cap based on economic rent.

Since the primary lease is well below market and I know that the next year of income will be at that rate, would it not be better to base the income approach on actual income as market rent could not be achieved for at least another five years and therefore is not truly applicable?

Of course I can base the other units on market rates, but if I must use the actual income for the one unit, what basis is the overall approach on or what type of value basis am I reporting, As-is or As Stable?

To further complicate things, most of these types of properties in my area are purchased by owner/operators and I feel like the lease could be a marketing problem.

Any thoughts or suggestions from those who have faced similar scenarios are sincerely appreciated.

 

[Fred]

would it not be better to base the income approach on actual income as market rent could not be achieved for at least another five years and therefore is not truly applicable?

Of course I can base the other units on market rates, but if I must use the actual income for the one unit, what basis is the overall approach on or what type of value basis am I reporting, As-is or As Stable?

I am having trouble following this, but it seems to me you have to first figure out if the intended use requires value as is, or value based on some other premise. That ought to tell whether you need to base value on actual income or assumed income, or do it both ways.

 

[post450]

Steven, sorry for not being more precise. The indended use is for financing. The premise of the report will be as is.

I believe the problem may be that it's a common practice for some other appraiser's in the area to develop the income approach based on market rent, even when the actual rent is available. I understand how this would be required for an owner occupied property with no income history but not for an active income producing property. My client may simply be requesting what he is accustomed to receiving. If this methodology is flawed, I would certainly like to be able to point that out.

The vast majority of properties in this rural market are rented month to month or on short term leases, so I see very few leases of this length. Basically my question is how relevant is the economic rent to an "as is" value with this lease in place?

 

[Fred]

I believe the problem may be that it's a common practice for some other appraiser's in the area to develop the income approach based on market rent, even when the actual rent is available. I understand how this would be required for an owner occupied property with no income history but not for an active income producing property. My client may simply be requesting what he is accustomed to receiving. If this methodology is flawed, I would certainly like to be able to point that out.

If you are asking me, I'd sure say it's flawed. If I am buying the property, I am not pricing by capitalizing hypothetical rent I am not going to receive. Hypothetical rent can't pay the mortgage either. That said, we had a poll here once, and the results indicate a pretty fair percentage of responses seemed to indicate capitalizing market when the two are different.

 

[PL1957]

IMO, you have two ways to come up with an "as is" value. You can either use the contract rent for the long-term leased space and market rents for the month-to-month spaces, or you can use market rents for the whole property, deducting the rent loss from the below market space after capitalization. The method I would use depends on the length of the below market lease and most importantly, how an actual purchaser would look at the property.

 

[Bill_FL]

Are you being asked to appraise the leased fee estate or the fee simple estate?

 

[Y-TOWN]

I would say you should be trying to mirror the marketplace for your value indication - what would a typical buyer do with this property.

When I was taught the business I was instructed as follows:

Contract rent = what the C-Store is paying in your case (could be lower, even or higher than market). If lower and for any length of term (say over a few months remaining on lease) typically would impair the property, if even then leased fee = fee simple). If higher would enhance the property but not at the same rate utilized for a market priced lease.

Market rent = what is typical rent associated with like space in the subject's marketplace or what a typical tenant would pay.

Economic rent = rent in excess of market rent which we segregated and valued by a DCF at a rate higher than the market rent (based on risk of receipt).

 

[Wayne Tomlinson]

I wwould say that in your analysis that you at least consider that the owner would like you to arrive at a value for his loan which will be higher than might be available if the actual rent is considered.

Who is your client? The owner or the lender. If the owner was told by the banker to "order an appraisal" and he has engaged you, ask him to give you written instructions, then include those instructions in your report.

As said above, doing both should not be too much of a job given that you will already have market rent gathered when you do the other two properties.

CYA is always a good choice.

Wayne Tomlinson

 

[post450]

Are you being asked to appraise the leased fee estate or the fee simple estate?

I am appraising the fee simple interest.

When I was taught the business I was instructed as follows:

Contract rent = what the C-Store is paying in your case (could be lower, even or higher than market). If lower and for any length of term (say over a few months remaining on lease) typically would impair the property, if even then leased fee = fee simple). If higher would enhance the property but not at the same rate utilized for a market priced lease.

Market rent = what is typical rent associated with like space in the subject's marketplace or what a typical tenant would pay.

Economic rent = rent in excess of market rent which we segregated and valued by a DCF at a rate higher than the market rent (based on risk of receipt).

I was taught that market rent rent and economic rent are the same and that a rate higher than market rent is considered excess rent.

The bank engaged me directly and has provided a detailed scope of work which includes includes the analyzation and reporting of market rents. After sleeping on it last night and reading your responses this morning, I think I will cap it both ways.

Thanks for your responses and thoughts.

 

[Fred]

After sleeping on it last night and reading your responses this morning, I think I will cap it both ways.

Hopefully keeping in mind that both cannot be "as is."