leases - contract vs market

[justinschroeder]

I have conflicting info from several sources on this.

If a property has a short term lease Month to Month or even Year to Year and it is rented below market should its current rent be used as the owner would have to raise rent with the risk of the tenant moving and then being left vacant or should market rent be used.

On the flip side if a property is rented at above market should this rent be used or market.

 

[Calvin the Airedale]

I have conflicting info from several sources on this.

If a property has a short term lease Month to Month or even Year to Year and it is rented below market should its current rent be used as the owner would have to raise rent with the risk of the tenant moving and then being left vacant or should market rent be used.

On the flip side if a property is rented at above market should this rent be used or market.

The answer to this question one must determine what definition of value is being opined, to what purpose will the appraisal be put, and what interest in the real estate is being appraised?

The owner/borrower's interest (leased fee) in a leased property that is rented well below the market on a long term lease will not have the same value as the unencumbered fee simple interest at market rents using the same definition of market value.

The same property with above market rents on a long term lease may or may not be different than the value at market rents depending upon the the credit quality of the tenant.

 

[Vernon Martin]

Appraising below-market rents, above-market rents

If the below-market tenancy is just month-to-month, I would assume that the space was re-leased at market rent, making appropriate deductions for turnover costs (cleaning, renovation, leasing commissions and time to lease).

An above-market rent may be due to different factors:

1. The space required special buildout and the costs were amortized and added to market rent. This is why Walgreen's, for instance, always seems to be paying above market rent. NNN-leased properties occupied by nationally known credit tenants are typically bought and sold on this above-market rent unless the lease is expiring soon or the tenant has already vacated but is still paying rent. On the other hand, an above-market lease to Rite-Aid, which is perennially on the verge of bankruptcy, might be more likely to be ignored in favor of market rents.

2. If the tenant is an unknown, you may have a pocket-to-pocket lease, in which the tenant is the landlord (which may be disguised as an LLC or a corporation under a different name). When in doubt, I use market rent instead of contract rent.

3. Perhaps the tenant signed the lease at an earlier date when market rent was higher. If it is a credit tenant or a tenant in good standing (no late payments). I might do a DCF model assuming the higher rents until the end of the lease, then assuming market rent thereafter, making appropriate deductions for turnover costs.

 

[justinschroeder]

Two follow up questions.

1. If you put the property at market rent and deduct for cleaning, nenovation, leasing, and time to lease. Are these items deducted after the value is derived via the income approach because it would not happen every year.

2. How about apartments. Example if a 60 unit apartment building has most units rented under market but on short term leases would you still use market rent and try and estimate all the cost to raise it to market.

Thanks

 

[Vernon Martin]

Two follow up questions.

1. If you put the property at market rent and deduct for cleaning, nenovation, leasing, and time to lease. Are these items deducted after the value is derived via the income approach because it would not happen every year.

2. How about apartments. Example if a 60 unit apartment building has most units rented under market but on short term leases would you still use market rent and try and estimate all the cost to raise it to market.

Thanks

1. Yes, if you are using direct capitalization. If you are using DCF analysis, those deductions should already be in the DCF model.

2. Yes, but make sure you have correctly estimated market rent. Many landlords tell me that their rents are below market but are making comparisons to superior buildings.

 

[PL1957]

1. Yes, if you are using direct capitalization. If you are using DCF analysis, those deductions should already be in the DCF model.

2. Yes, but make sure you have correctly estimated market rent. Many landlords tell me that their rents are below market but are making comparisons to superior buildings.

Just to add a little to Vernon's note - with apartments, you cannot assume all units will go to market immediately, since lease obligations do exist. You have to model a return to market rent over a period of time, most likely one year, since most apartment leases are annual. We often show this as a "loss to lease" item in the direct cap.