Discounting Excess Percentage Rent

[LeonCLi]

If contract rent is below market, and there is a percentage rent clause in place requiring 5% of gross sales over a natural breakeven point, which the subject exceeded, how should excess rent be discounted given a 5 year holding period? Higher or equal to minimum base rent rate? Equal to or lower than market rent?

 

[Michigan CG]

If contract rent is below market, and there is a percentage rent clause in place requiring 5% of gross sales over a natural breakeven point, which the subject exceeded, how should excess rent be discounted given a 5 year holding period? Higher or equal to minimum base rent rate? Equal to or lower than market rent?

You most likely should explain your question a little more clearly with more specifics. I am moving this to the commercial section of the forum as you will get a lot more answers there.

 

[LeonCLi]

Thanks for directing me to the right place. Lets say that market rent for a retail profit center is $24, per SF per year, contract rent is $22 per SF per year. A percentage rent agreement allows for 5% of gross sales over $1,000,000 and sales volume has exceeded that, say $1,500,000 last year. The hold period is 5 years. How should we discount excess rent? At a higher rate than minimum base rent?

 

[Stephen J. Vertin MAI]

I am not trying to complicate your assignment but think your problem out step by step and understand what your client seeks. This, in turn, should drive your Scope of Work. Does your client need market or leased fee value? With 5-years remaining on the lease, I suspect value is subject to the lease (unless there are hypotheticals). Michigan is correct. You need to tell us what the end goal is. If it is market rent, then base and overage rent combined, may exceed market, not fall short.

If it is leased fee, percentage rents are tricky. Did overage occur one year or is there a stable history of overage? If a history exist there are two tools; a) adding the numbers and dividing them by overage square footage, for a one year snap shot, or b) discounting amounts over the term (just as you no doubt suspected). The correct selection should be market data driven based on which method is more credible. We do not know which because we do not have all of the data you possess. If you have cap rates or can support cap rates better than yields, I would add the data and capitalize it. If you have similar caps, from similar situations, the rate takes into consideration, rents going up or down at the end of the term. It is that simple. If you do not you have to gaguage the risk related to overage. We can not do this because we are not familiar with your market situation.

Of course, I am not sure how flexible cash flow stands and my answer is based on some sort of stability (meaning overage is fairly consistent). Either way (discounting or direct cap) is correct, again, it is a decision as to credibility rather than an exact process or the tools used within the process. While this is true of all appraisal problems having multiple tools, sometime returning to the goal (Scope) and the methods credibility can answer a lot of questions. Good luck

 

[Deleted member 152047]

Thanks for directing me to the right place. Lets say that market rent for a retail profit center is $24, per SF per year, contract rent is $22 per SF per year. A percentage rent agreement allows for 5% of gross sales over $1,000,000 and sales volume has exceeded that, say $1,500,000 last year. The hold period is 5 years. How should we discount excess rent? At a higher rate than minimum base rent?

You are mixing $ PSF with total $ numbers and we cannot decipher the problem.

Why do you think that there is excess rent if the market rent is greater than the contract rent? Percentage rent above a certain break point may or may not be excess rent depending on where the market rent falls.

 

[LeonCLi]

I am not trying to complicate your assignment but think your problem out step by step and understand what your client seeks. This, in turn, should drive your Scope of Work. Does your client need market or leased fee value? With 5-years remaining on the lease, I suspect value is subject to the lease (unless there are hypotheticals). Michigan is correct. You need to tell us what the end goal is. If it is market rent, then base and overage rent combined, may exceed market, not fall short.

If it is leased fee, percentage rents are tricky. Did overage occur one year or is there a stable history of overage? If a history exist there are two tools; a) adding the numbers and dividing them by overage square footage, for a one year snap shot, or b) discounting amounts over the term (just as you no doubt suspected). The correct selection should be market data driven based on which method is more credible. We do not know which because we do not have all of the data you possess. If you have cap rates or can support cap rates better than yields, I would add the data and capitalize it. If you have similar caps, from similar situations, the rate takes into consideration, rents going up or down at the end of the term. It is that simple. If you do not you have to gaguage the risk related to overage. We can not do this because we are not familiar with your market situation.

Of course, I am not sure how flexible cash flow stands and my answer is based on some sort of stability (meaning overage is fairly consistent). Either way (discounting or direct cap) is correct, again, it is a decision as to credibility rather than an exact process or the tools used within the process. While this is true of all appraisal problems having multiple tools, sometime returning to the goal (Scope) and the methods credibility can answer a lot of questions. Good luck

Thanks, Stephen. The background would be more relevant for real life situations. I'm asking this in the context of a certain type of example problem. Here's another one:

"A retail space has a net rentable area of 10,000 sf. Market rent is $24 per sf per
year. Contract rent is $22 per sf per year. The lease has a percentage rent clause
that requires 5% of gross sales volume over $4,400,000 on a natural breakeven
point. Sales volume last year was $5,500,000.
Considering a five-year holding period, how should the excess rent be discounted in
the appraisal of this property?"

A) At a rate higher than minimum base rent
B) At a rate equal to the market rent
C) At a rate lower than market rent
D) At a rate equal to minimum base rent

In this case, is there enough info given for us to make a choice on what rate relative to market or base rent to discount by? I was going to go with higher than minimum base rent.

 

[Deleted member 152047]

Yes, at a rate higher than the minimum base rent. I am not a fan of the structure of the problem.

 

[cpalub01]

+1 Bad Question but A) At a rate higher than minimum base rent

 

[LeonCLi]

Thanks, guys. It is a terribly phrased question, but I needed the confirmation on that answer choice.

 

[Gobears81]

Put yourself in the shoes of a potential purchaser (something that we should try to do for any property ). If the breakeven point was reached last year only, a potential purchaser might not give significant value to the overage rent potential. If it is a stable business that has surpassed that breakeven for several years and is expected to continue to surpass that level, additional value may be assigned to the overage portion. Either way, it is a riskier portion of the cash flow than the base rent, which directly impacts the discount rate.
Also, hope this doesn't sound rude because that's not the intention, but this is the type of problem that is ideal for working closely with a supervisor on. They know more about the background and the market than us, since we are speaking purely on generalities.