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Below Market Rent In Commercial Building

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undergroundPOP

Sophomore Member
Joined
May 29, 2013
Professional Status
Certified Residential Appraiser
State
California
Hi everyone,

I'm working on an appraisal for a commercial building in West Hollywood, CA. It appears that the rents for the subject are significantly below market due to the fact that they've been long time tenants (10+ years) and escalations have not been keeping up with the market. The SCA is coming in at around $430 per sf, which I feel is a well-supported number, but the IA is coming in at around $330 per sf... In the past I've dealt with below-market rents by first developing a stabilized value then applying a rent loss calculation to the stabilized value.

Are there other ways of reconciling these two models?
 

hastalavista

Elite Member
Joined
May 16, 2005
Professional Status
Certified General Appraiser
State
California
Are you saying that the $430/sf in the SCA is after the property rights adjustments (Leased Fee @ below market rates)? The difference between the two $/sf indications is 23%.

Your methodology sounds correct; so I'm thinking some of your inputs are incorrect.
 

undergroundPOP

Sophomore Member
Joined
May 29, 2013
Professional Status
Certified Residential Appraiser
State
California
Are you saying that the $430/sf in the SCA is after the property rights adjustments (Leased Fee @ below market rates)? The difference between the two $/sf indications is 23%.

Your methodology sounds correct; so I'm thinking some of your inputs are incorrect.

Denis, I'm not familiar with the property rights adjustment that you mentioned. What is the reasoning and methodology behind it?
 

hastalavista

Elite Member
Joined
May 16, 2005
Professional Status
Certified General Appraiser
State
California
I should have started out by asking you what was the intended use and what property rights are you appraising; my bad for not doing that.

I'm assuming you are valuing the property based on the leased fee rights of the owner. I'll assume that this is for a commercial loan of some kind (the loan part isn't that important; the property rights being appraised is critical).

You have long term tenants with below market rents. I'm presuming that they have some time to run on their leases (ergo, the rent loss calculation).

You indicated you completed the IA of the subject as-stabilized. "As-stablized" means market rents and market vacancy. You came up with a value. This would reflect the fee simple value in nearly all cases.
However, your subject, under its current lease terms and assuming you are valuing the owner's interest, is leased fee. The rents are below market; therefore, some rent loss analysis has to be performed to account for the difference between what the stabilized value indicated and what actually exists. When you complete that analysis, you deduct it from the stabilized value (the fee simple value) and what you arrive at is the subject's leased fee value based on the specific terms/conditions of the leases that are in place. That adjustment is a property rights adjustment; it accounts for the differences in the rights being appraised: stabilized (fee simple) vs. as-is (leased fee). Since your rents are below market, it is a deduction. If your rents are above market, it would be an addition. The process of analyzing the rent differential is very similar but a positive (excess rent) situation would be handled differently in the discounting than a negative (deficit rent) situation.

In the sales comparison approach, unless you found similar properties with a similar scenario (they had the same level of deficit rent and that deficit would be in-place for the same duration as the subject), you are likely going to need to make a property rights adjustment to those sales to account for the lower contract rents. Good luck finding sales comps with the same leases/contract rent conditions as the subject.

What many do in such a case is the same thing you did in the IA. You value the subject in the sales comparison approach as-if it were stabilized (market rents and vacancy) and then apply the same adjustment that was applied in the IA to the SCA. In fact, many will conclude the as-stabilized value (reconcile the approaches) and then apply the adjustment to that value-point to arrive at the final value opinion of the leased fee rights being appraised.

Unless you've accounted appropriately for the subject's below market rents in the sales comparison approach vs. the comparables, you are going to have an unreliable value indication.

Does that make sense?
 

Gobears81

Senior Member
Joined
Nov 7, 2013
Professional Status
Certified General Appraiser
State
Illinois
OP-How did you determine the rent-loss calculation? Did you apply that rent loss calculation to the SCA? How long is the lease?
 

undergroundPOP

Sophomore Member
Joined
May 29, 2013
Professional Status
Certified Residential Appraiser
State
California
The appraisal is actually a restricted use report for a client who is just wanting an opinion of value for his buildings. The property rights appraised is fee simple, so I guess I can just discuss that the subject's rents are below market and apply market rents in the direct cap model?

Thanks for taking the time to answer my questions Denis.
 

hastalavista

Elite Member
Joined
May 16, 2005
Professional Status
Certified General Appraiser
State
California
The appraisal is actually a restricted use report for a client who is just wanting an opinion of value for his buildings. The property rights appraised is fee simple, so I guess I can just discuss that the subject's rents are below market and apply market rents in the direct cap model?

Thanks for taking the time to answer my questions Denis.

If the property rights being appraised are fee simple, that implies stabilized (market rents and market vacancy); both in the SCA & IA.

You should caution your client that the fee simple valuation may not reflect the market-value as-is (leased fee with below market rents). Make sure you and the client fully understand what the appraisal is going to be used for.

Good luck!
 
Joined
Jun 2, 2007
Professional Status
Certified General Appraiser
State
Florida
Assuming its a leased asset profile peoperty and leases have significant time with options left, you are pretty much there with a couple of textbook tweaks. The tenants have a positive leasehold. In this case V=FS-LH. Calc FS at market terms and deduct PV of rent loss, incentive/profit (Sorry Howard) and if significant PV of difference between PV and FV. Use safe rates and include option periods.

Sounds like a candidate for a quick DCF.
 

Gobears81

Senior Member
Joined
Nov 7, 2013
Professional Status
Certified General Appraiser
State
Illinois
Assuming its a leased asset profile peoperty and leases have significant time with options left, you are pretty much there with a couple of textbook tweaks. The tenants have a positive leasehold. In this case V=FS-LH. Calc FS at market terms and deduct PV of rent loss, incentive/profit (Sorry Howard) and if significant PV of difference between PV and FV. Use safe rates and include option periods.

Sounds like a candidate for a quick DCF.
Doesn't sound like it is an issue for the OP, but what do you mean by accounting for the PV of incentive/profit in this type of case?
 
Joined
Jun 2, 2007
Professional Status
Certified General Appraiser
State
Florida
Sorry, didn't mean PV of profit, but in trying to fix it all I've somehow triple posted. I've made a mess and don't see a DELETE button. No more posting from a smartphone for me!
 
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