Huge Excess Rent

[allansappraisal]

I am appraising an office condo and have run into a bit of a problem. There is definite excess rent being paid. Here is the scenario:

• 7,091sf
  
• leased to a local, no-name tenant
• lease commenced in 2009
• renewed in 2017 (five year term)
  
• expires in 2022 (4 years, 4 months remain)
  
• $29.05/sf contract rent (gross basis)
• 4.5% annual escalations
• Contract rent includes $100,000 in TIs to be paid over the five-year term (no interest)
  
• $15.00/sf market rent (gross basis) - no future increases anticipated

I spoke to a local broker who not only knows the market very well, but also knows the owner/landlord as well as the tenant. Him and I are certain of the market rent stated above. The fee simple value is between $350,000 ($50.00/sf) and $400,000 ($55.00/sf). Market participants that I have spoke to have been uncertain as to handling the excess rent situation. So my question is this: since the excess over the remaining term is so significant, is it appropriate to apply a discount rate to it and add the value of such to the fee simple value, or would it be more appropriate to utilize the contract rent and increase the cap rate. Either way, I have no market data with regard to a discount rate or cap rate, so a ??% discount rate or a ??? basis point increase would be arbitrary at this point. How would some of you handle $500,000 in excess rent over the remaining term? Any thoughts out there?

-Much appreciated!

 

[hastalavista]

I am appraising an office condo and have run into a bit of a problem. There is definite excess rent being paid. Here is the scenario:

• 7,091sf
  
• leased to a local, no-name tenant
• lease commenced in 2009
• renewed in 2017 (five year term)
  
• expires in 2022 (4 years, 4 months remain)
  
• $29.05/sf contract rent (gross basis)
• 4.5% annual escalations
• Contract rent includes $100,000 in TIs to be paid over the five-year term (no interest)
  
• $15.00/sf market rent (gross basis) - no future increases anticipated

I spoke to a local broker who not only knows the market very well, but also knows the owner/landlord as well as the tenant. Him and I are certain of the market rent stated above. The fee simple value is between $350,000 ($50.00/sf) and $400,000 ($55.00/sf). Market participants that I have spoke to have been uncertain as to handling the excess rent situation. So my question is this: since the excess over the remaining term is so significant, is it appropriate to apply a discount rate to it and add the value of such to the fee simple value, or would it be more appropriate to utilize the contract rent and increase the cap rate. Either way, I have no market data with regard to a discount rate or cap rate, so a ??% discount rate or a ??? basis point increase would be arbitrary at this point. How would some of you handle $500,000 in excess rent over the remaining term? Any thoughts out there?

-Much appreciated!

Are you sure the $29.05/sf rent continues after the first year?

While you can adjust the cap rate, that is capitalizing the current contract rent into perpetuity. I think the presumption would be that the tenant would at a minimum reset the rate at the time of renewal to market.
Discounting the excess rent over the remainder of the lease and adding that to the fee simple rate would be the expected technique.

Was the original term over-market as well? Something doesn't sound right here... I'm not saying anyone is pulling a fast one, but I am questioning the accuracy of the terms/conditions you've been given?

What did the owner say regarding how the lease/lease renewal was negotiated?

 

[George Hatch]

They've already been onsite for 9 years, so there's that.

I'd do a separate Fee Simple Interest and then do a PV/excess rents and use that as an adjustment for the Leased Fee Interest. Let the Client decide what the contract rent for the next 4.25 years means to their decision.

 

[Gobears81]

I'd be diligent in making sure that it is an arms length lease. Some are quick to announce their $30/ sf rents, but more digging yields that as effectively an arbitrary number between the operating and holding company

 

[allansappraisal]

Are you sure the $29.05/sf rent continues after the first year?

While you can adjust the cap rate, that is capitalizing the current contract rent into perpetuity. I think the presumption would be that the tenant would at a minimum reset the rate at the time of renewal to market.
Discounting the excess rent over the remainder of the lease and adding that to the fee simple rate would be the expected technique.

Was the original term over-market as well? Something doesn't sound right here... I'm not saying anyone is pulling a fast one, but I am questioning the accuracy of the terms/conditions you've been given?

What did the owner say regarding how the lease/lease renewal was negotiated?

Yes I’m sure the $29.05sf continues throughout the term, but also escalates 4.5% per annum. The original lease was negotiated in 2009. I dont have time to analyze rents from that time. Also, the tenant started leasing only a portion of what they occupy now and have expanded into the 7,091sf over the last few years.

As far as I know (from what I was told) the owner and tenant did not know each other prior to the initial 2009 lease agreement. For what its worth, the owner is affiliated with a real eatate firm.

 

[allansappraisal]

So in our office, we typically value the subject with market rents, then add/subtract the value of any excess/deficit rents to get the market value of the leased fee interest. So I’m looking for what to do with such a huge amount of excess. I think an investor would be extremely hesitant when valuing the excess, but how can I prove/support that? Market participants that I interviewed don’t really have an andwer for me. One guy in my office suggest that I discount it 100%, some others said 20%...

 

[Vernon Martin]

I don't think a buyer would pay extra for the excess rent unless it was a credit tenant, like McDonald's. The OP did not mention what the tenant used the space for.

I had a similar situation a few weeks ago, with two tenants paying several times market rent. They were pot growers. Of course, that's legal in California now, right? Wrong. We only legalized recreational cultivation. Commercial cultivation is banned in the city where this industrial property was located, and these were unlicensed growers.

I once reviewed an appraisal of a commercial building used as a spa in Houston with a tenant paying well above market rent. A check of the tenant's Yellow Pages listing had it classified under "adult services". The photos of the massage tables made me suspect that the excess rent was the price paid for "happy endings".

Another possible situation is a "pocket-to-pocket" lease in which an LLC is used to disguise the owner as a tenant.

Or it could be a con with another partner in crime. Canadian swindler Ed Okun wrote a fake high-rent lease to a phony tenant who never actually paid anything, and then syndicated the deal to TIC investors. He's serving a 100-year prison term now.

 

[leasedfee]

increase the cap rate

Too short of a term to apply a loaded cap reliably. DCF is better.

I dont have time to analyze rents from that time.

It sorta behooves you to take a quick gander at this. During my career, my office market has been very volatile often resulting in sizable leaseholds, positive or negative. I'm under the impression that Illinois market has suffered from the State budget woes in the last few years. . . . . The TI allowance contributes about $3.63/sf of the rent. If it isn't normally given or only nominally, then this explains a little of the gap. As Vernon noted, there are plenty of shenanigans that happen with leases. Sometimes just ask the landlord and the tenant about the extreme rent, do their comments jive and do they pass the smell test?

 

[George Hatch]

Yes I’m sure the $29.05sf continues throughout the term, but also escalates 4.5% per annum. The original lease was negotiated in 2009. I dont have time to analyze rents from that time. Also, the tenant started leasing only a portion of what they occupy now and have expanded into the 7,091sf over the last few years.

As far as I know (from what I was told) the owner and tenant did not know each other prior to the initial 2009 lease agreement. For what its worth, the owner is affiliated with a real eatate firm.

This type of situation is *exactly* the time to stop worrying about how profitable the assignment is for you and to slow down to do whatever it takes to put the puzzle together. You can't have an informed opinion of a situation without understanding it.

I don't know if this is the case in this situation or not, but another big red flag would be if this assignment just popped up at the last second and everyone is trying to rush it through to finish within the next day or two. Those "emergency" conditions are sometimes contrived for the specific purpose of pressuring the appraiser to cut corners in order to meet their due date so as to save the universe from imploding.

 

[DREA Dean]

Are you sure the rent doesn't include payoff of TIs, and will go down at some point? I see rents that seem high, but include payoff of TIs over 5 or 10 years.

"Too short of a term to apply a loaded cap reliably. DCF is better."

This is the way I would handle it. Not the cap rate. Discount the annual above-market rent (cash flow) at a risk-adjusted discount rate for the remainder of the lease term. Even if it is payoff of TIs, it is still excess rent looking at it from the date of appraisal.

"One guy in my office suggest that I discount it 100%, some others said 20%..."

Huh? I don't even know what this means. Just apply an arbitrary percentage as a discount?