Discounting Excess Percentage Rent

[LeonCLi]

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.

I had varying opinions from supervisors on this, which like it was reiterated by earlier commentators, depends on more data and the background of the situation. The general consensus was "At a rate higher than minimum base rent", but they couldn't say for certain given the context of the problem. Thanks for the input on the higher risk given data for only 1 year. A trend over 2 or 3 years would be better.

 

[Gobears81]

The general consensus was "At a rate higher than minimum base rent", but they couldn't say for certain given the context of the problem.

There's a good reason for that. The base rent is theoretically tied to real property, while the overage rent is a function of business income, which commands higher rates. In reality, the components of a going concern aren't as clearly defined, as if the business does atypically poorly in one year, they might not be able to make minimum rent payments and the success of the business is a partially related to its real estate characteristics. You could argue using a rate related to business income, although in practice, investors wanting passive rental income have different motivations than owner-users of hotels or gas stations, etc. I've dealt with a few bars where they took a lower base rent in exchange for a portion of the video gaming proceeds, and while the total income generated is higher than what market rent would be, it wasn't seriously contended that they have a considerably different value as a result (with one exception).
If you know investors that could be potential purchasers of this type of property, giving them a call might not be such a bad option. That is where asking the right questions can yield better results, as if you ask them what type of rate would you apply to the overage rent only, they might not give you much of an answer. But if you ask an investor what total base rent (with no percentage rent consideration) would they take in exchange for a property with a base rent of $22/ SF and expected overage rents of $5/ SF, you might get a better idea of how investors are treating this portion of the income stream. They might still tell you that it depends based on the business it is in, the strength of the tenant, etc., but also why none of us have given any answer either.

 

[Stephen J. Vertin MAI]

This is an interesting conversation. But the root concept you are kicking around should be addressed. Although the literature on the subject is light at best, it boils down to opinion. This is what some of my betters have expressed.

One year's overage rent is commonly not considered. In fact, honestly, I was raised (as a trainee) to never consider overage under the premise it was business, not real estate driven. The idea was the tenant leaves and so does overage (this idea came from Walter Kuehnle author of much of the 1st through 5th editions of The Appraisal of Real Estate). It is further, supported by James Graaskamp who wrote that separation of the two (RE and Business) is possible and business value enhancements are part of all retail real estate (especially in the retail mall sector). But he also believed this portion was not part of real estate value and should not be considered when estimating real estate taxes.

Many could say, well Dr., Graaskamp was hired throughout the US by mall owners in tax cases, which does throw shade on the author, but not on the concept. Further, Kuehnle had no dog in the fight so why did he expand on this concept?

While I worked with Kuehnle, I never read Graaskamp's opinion on the issue (overage rent directly). But for the sake of consistency, it appears he believed overage would fall within the elements of the business. Someone on the Forum (I will not say who) has a copy of Graaskamp's ideas within this realm. The text now sells north of $150, so it is pricy and I never bought a copy but maybe he could add to this part if he has the proclivity.

I am in total agreement that if the OP is going to pursue the concept, he should consider a higher yield given greater risk (especially if renewals are non-existent). You are betting on the retailer, not the real estate.

Be aware, I have worked with very smart people would say the above is BS. The landlord took lower base rent based on realizing overage, and the overage is real estate locationally based. The best evidence of this is the subject's existing lease. Further, if renewal options exist and the tenant is doing well it may well be a perpetual situation with a lower rate of return (think of it as the Walgreen corner effect).

 

[LeonCLi]

This is an interesting conversation. But the root concept you are kicking around should be addressed. Although the literature on the subject is light at best, it boils down to opinion. This is what some of my betters have expressed.

One year's overage rent is commonly not considered. In fact, honestly, I was raised (as a trainee) to never consider overage under the premise it was business, not real estate driven. The idea was the tenant leaves and so does overage (this idea came from Walter Kuehnle author of much of the 1st through 5th editions of The Appraisal of Real Estate). It is further, supported by James Graaskamp who wrote that separation of the two (RE and Business) is possible and business value enhancements are part of all retail real estate (especially in the retail mall sector). But he also believed this portion was not part of real estate value and should not be considered when estimating real estate taxes.

Many could say, well Dr., Graaskamp was hired throughout the US by mall owners in tax cases, which does throw shade on the author, but not on the concept. Further, Kuehnle had no dog in the fight so why did he expand on this concept?

While I worked with Kuehnle, I never read Graaskamp's opinion on the issue (overage rent directly). But for the sake of consistency, it appears he believed overage would fall within the elements of the business. Someone on the Forum (I will not say who) has a copy of Graaskamp's ideas within this realm. The text now sells north of $150, so it is pricy and I never bought a copy but maybe he could add to this part if he has the proclivity.

I am in total agreement that if the OP is going to pursue the concept, he should consider a higher yield given greater risk (especially if renewals are non-existent). You are betting on the retailer, not the real estate.

Be aware, I have worked with very smart people would say the above is BS. The landlord took lower base rent based on realizing overage, and the overage is real estate locationally based. The best evidence of this is the subject's existing lease. Further, if renewal options exist and the tenant is doing well it may well be a perpetual situation with a lower rate of return (think of it as the Walgreen corner effect).

Thanks for the extra insight, Stephen. I can and have seen a perpetual situation at a lower rate with the tenant doing well happening.