Lease Analysis Adjustments

[HangTen]

I'm having discussions with a few co-workers on two elements of lease analysis. The assignment is to conclude a market rental rate for second generation office space. Typical leases in the market are NNN, 5 years, $25 TI allowance on second generation space or renewals, and 2-3% annual escalations. The client wants the conclusion of "market rent " to exclude TI. because the lease they execute will exclude it.

I'm arguing that if the comps in the grid have $25 TI and we model the subject as having $0 TI, we need to very clearly qualify that the resultant conclusion is 'market rent subject to no TI.' I tend to go full-on CYA, and would optimally like to footnote that to make sure the reader understands the market typically includes TI and I'd maybe even go so far as to state what the market rental rate would be under typical market TI terms. My co-workers are maintaining that the conclusion doesn't need to be qualified, that as long as we are modeling the lease terms, we are concluding a market rent (my head wants to explode).. My counter-argument is that, we are not concluding market rent if we are not modeling market terms.


The other issue we are knocking heads on is an adjustment for lease term. I maintain that a comp with a 10 year lease should be adjusted upward compared to the subject's/market's 5-year term. The longer lease is getting a lower rate, so to make it look like the subject/market, the comp has to be adjusted upward. My counterparts are saying no, the longer lease is superior so superior=subtract.

I'm not doing a good job at persuading anyone on either of these problem areas, so I'm at the point where I don't trust my own thinking anymore.

 

[PL1957]

One of the things I've done in the past when comparing lease terms is construct an NPV analysis for each lease. This lets you take into account such factors as lease term, rent steps, TIs and LCs.

 

[HangTen]

One of the things I've done in the past when comparing lease terms is construct an NPV analysis for each lease. This lets you take into account such factors as lease term, rent steps, TIs and LCs.

That's something I hadn't thought of doing. You've given me something to think about.

Do you have any thoughts on modeling $) in a $25 TI market and calling it market rent. Am I wrong to think it needs to be reported as subject to?

In the grid as it is being done, would you say the adjustments for lease term need to be upward or downward?

 

[PL1957]

That's something I hadn't thought of doing. You've given me something to think about.

Do you have any thoughts on modeling $) in a $25 TI market and calling it market rent. Am I wrong to think it needs to be reported as subject to?

In the grid as it is being done, would you say the adjustments for lease term need to be upward or downward?

All "market rent" exists within the framework of the lease terms - how long is the lease, are there rent steps, how much TI, etc. A single point number is meaningless without the other inputs. Now, you can say that lease terms for a typical space are $20/sf for a five year term with a $25 work letter and 2% annual steps, but your $20/sf can be at/above/below market, depending on the other factors ... same with each of the other inputs.

 

[Deleted member 152047]

The client wants the conclusion of "market rent " to exclude TI. because the lease they execute will exclude it.

This sets your scope of work. I do a LOT of market rent appraisals. This is a fairly common issue and this is how we handle it:

1st I explain the problem to the client. The market is offering TI's for this particular market rental rate. I will also explain this within the report. Then I will state the market rent conclusion within the report including the TI's. I will add an additional paragraph explaining that the client wanted to know what the appropriate rent is for the space excluding the market TI's. Obviously, TI moneys have a direct effect on the rent paid for a given piece of property. We see this all day long.

You would then present a table that shows the adjustment to the rental rate over the given lease term based on the TI's and an appropriate return (usually 5-8%). It would look something like this:


Then you take the market rent and adjust out the TI's based on where your TI adjustments take you. This will provide the client with a reasonable rental range. You cover your a** because you provided a market rental rate and a rental rate based upon the client's specific assumptions (one could call it market rent less TI's).

Don't overthink it. You were on the right track at the start. The longer you are in this profession, the better you will get at calling BS on "this is the way we always do it" or advice that tells you to put aside logic (in other words dont listen to your coworkers in this instance).

 

[HangTen]

Thanks for the detailed response NP. I've stopped mumbling to myself. I'm not winning friends but never much cared about that. I'd rather nail a value any day.

 

[Deleted member 126639]

Don't overthink it. You were on the right track at the start. The longer you are in this profession, the better you will get at calling BS on "this is the way we always do it" or advice that tells you to put aside logic (in other words dont listen to your coworkers in this instance).

Outside of the fact this mindset costs you money, it is the #1 reason most people in the real estate industry have no respect for appraisers. We're supposed to report on the behavior of the market and deliver useful knowledge to the client. Most appraisers are in their own world and have no clue about how the market operates.

If everyone did this, not only would we make the same money with less time, but we probably would redeem ourselves in the eyes of other RE professionals and maybe start raising our fees to at least keep up with inflation!

 

[Michael P Jacobs MAI]

Good thread so far.