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Excess Rent

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CVal

Sophomore Member
Joined
Jan 17, 2017
Professional Status
Certified General Appraiser
State
Illinois
Hello,

I'm appraising a strip center. Market rent is $16.00/SF, but half of the tenants are paying $24/SF or so. Two of these tenants have been at the center since it was built in 2004. Two others since 2010. Another leased in 2014 at $19/SF.

In the past, my firm has used market rent to calculate PGI in the operating income statement, then adding back the discounted value of the excess rent. However, I'm not sure most market participants in my area necessarily use this method.

In a few cases, where there wasn't substantial excess rent, we used contract rent and applied a higher than normal cap rate.

In my case, the purchaser appears to have simply used the contract rents, and has applied a market-oriented cap rate.

Using market rents and adding back the discount excess rent leaves the value well below contract price. I have no problem giving bad news, but it seems like my value would be too far below contract using this method. If I just apply an above-market cap rate to the contract rent, I could not support that very well, as I have no cap rate sales which had above market rents.

I would like to hear any methods others use to handle excess rent, and/or any suggestions. Thanks in advance.
 

Howard Klahr

Senior Member
Joined
Oct 4, 2004
Professional Status
Certified General Appraiser
State
Florida
Market rent is $16.00/SF, but half of the tenants are paying $24/SF or so
Sounds very unusual. If the market is really so depressed compared to contract rent levels why have the tenants not attempted re-negotiation of the leases?

What is occurring at the sale comparable properties? What percent of those tenants are paying above market rents?
 

hastalavista

Elite Member
Joined
May 16, 2005
Professional Status
Certified General Appraiser
State
California
Are you sure you have the right market rents for the subject?
 

Gobears81

Senior Member
Joined
Nov 7, 2013
Professional Status
Certified General Appraiser
State
Illinois
Sounds very unusual.
I've seen it happen. Not sure where in Illinois you are at OP, but I've appraised strips that have contract rents at double the market rent opinion. Rents seem to diverge from market more frequently with national tenants.

In the past, my firm has used market rent to calculate PGI in the operating income statement, then adding back the discounted value of the excess rent. However, I'm not sure most market participants in my area necessarily use this method.

In a few cases, where there wasn't substantial excess rent, we used contract rent and applied a higher than normal cap rate.

In my case, the purchaser appears to have simply used the contract rents, and has applied a market-oriented cap rate.

Using market rents and adding back the discount excess rent leaves the value well below contract price. I have no problem giving bad news, but it seems like my value would be too far below contract using this method. If I just apply an above-market cap rate to the contract rent, I could not support that very well, as I have no cap rate sales which had above market rents.

I would like to hear any methods others use to handle excess rent, and/or any suggestions. Thanks in advance.
Are these national tenants and what is the remainder of the leases? Personally, I still agree with your firm's original approach. However, the inputs in your parameters may cause the cap rate implied from the DCF analysis to diverge from a "market rent cap rate" more than it should. Depending on the characteristics, take another look at the discount rate and if it is a fully occupied property leased to national tenants, will the market recognize a vacancy loss during the initial lease term? I find that properties leased to local tenants (or the State of Illinois :cautious:) will experience a more fundamental divergence in cap rates for above-market rents than properties leased to national tenants.
 

Michael S

Senior Member
Joined
Mar 18, 2009
Professional Status
Certified General Appraiser
State
New Mexico
Do those tenants with higher rent have better locations such as endcaps with greater visibility? Are they national credit tenants vs. local businesses? Did they receive a substantial TI allowance or have flat rent vs. a lower rent with annual escalations? A lot of first generation leases in retail strip centers can be above-market because they include amortized TIs or other incentives. However, most tenants will try to renegotiate if they are well above-market, especially if they have a lease renewal coming up. I don’t see investors discounting excess rent typically. It seems that for the most part they will reflect that risk in a higher cap rate – or they may just plain ignore it in the case of national credit tenants. Just because someone has a million dollars to invest in a commercial property doesn’t make them a savvy investor. We’ve all seen cases where people make their money in some other industry (doctors, lawyers, etc.) and then buy real estate thinking they’re so smart only to lose a bunch of money.
 

Gobears81

Senior Member
Joined
Nov 7, 2013
Professional Status
Certified General Appraiser
State
Illinois
Do those tenants with higher rent have better locations such as endcaps with greater visibility? Are they national credit tenants vs. local businesses? Did they receive a substantial TI allowance or have flat rent vs. a lower rent with annual escalations? A lot of first generation leases in retail strip centers can be above-market because they include amortized TIs or other incentives. However, most tenants will try to renegotiate if they are well above-market, especially if they have a lease renewal coming up. I don’t see investors discounting excess rent typically. It seems that for the most part they will reflect that risk in a higher cap rate – or they may just plain ignore it in the case of national credit tenants. Just because someone has a million dollars to invest in a commercial property doesn’t make them a savvy investor. We’ve all seen cases where people make their money in some other industry (doctors, lawyers, etc.) and then buy real estate thinking they’re so smart only to lose a bunch of money.
If you don't discount, how do you quantify a property rights adjustment for the sales comparison approach? I suppose that you could just deduct the difference between the ICA value and that indicated by the capitalized market rent, but if the cap rate isn't altered to a higher level, it would imply excess rent to perpetuity, which suggests an aberration for the market
 
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Michael S

Senior Member
Joined
Mar 18, 2009
Professional Status
Certified General Appraiser
State
New Mexico
If you don't discount, how do you quantify a property rights adjustment for the sales comparison approach? I suppose that you could just deduct the difference between the ICA value and that indicated by the capitalized market rent, but if the cap rate isn't altered to a higher level, it would imply excess rent to perpetuity, which suggests an aberration for the market

I have utilized discounting excess rent before. However, I don't find that many investors look at it that way. Usually this is in the context of retail buildings that are leased to national credit tenants and trade almost solely based on cap rates with the SCA given secondary consideration.
 

CVal

Sophomore Member
Joined
Jan 17, 2017
Professional Status
Certified General Appraiser
State
Illinois
To reply to others, I have only local tenants. There is a Papa John's but its just a franchisee. I'm right on for market rent. The two most recent leases went for $16.00 nnn.

The subject was placed on the market in November 2016 and went under contract on December 10, 2016. The listing broker reported that there were six written offers, with one over list price, and two at the same price of the accepted offer.

I'm thinking, what the hell?
 

Michael S

Senior Member
Joined
Mar 18, 2009
Professional Status
Certified General Appraiser
State
New Mexico
To reply to others, I have only local tenants. There is a Papa John's but its just a franchisee. I'm right on for market rent. The two most recent leases went for $16.00 nnn.

The subject was placed on the market in November 2016 and went under contract on December 10, 2016. The listing broker reported that there were six written offers, with one over list price, and two at the same price of the accepted offer.

I'm thinking, what the hell?

1031 Exchange money probably. There's still a lot of cash out there chasing deals like this. A multi-tenant retail strip center with almost all national tenants is a very saleable property on the national market. I'm guessing it's somewhere around a 7% cap rate, maybe less. These type of investors don't seem to care much if the rents are above-market. They figure national tenants will just keep renewing and exercising above-market renewal options.
 

CANative

Elite Member
Joined
Jun 18, 2003
Professional Status
Retired Appraiser
State
California
Seems like the tenants are happy where they are and don't want to move away from the area where their business is coming from even if they pay more on the rent. Maybe rent isn't that big a deal to them.

FWIW.
 
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