"leases In Place" As An Intangible Asset

[leasedfee]

The appraiser argues that unencumbered fee simple market value assumes a vacant building

There is no such assumption implied in fee simple -- though it may often be the situation.

 

[Gobears81]

But which would you shell out for first, a building with leases at market or a vacant building? There is a significant cost associated with getting a building from empty to full, even if those leases are all at market.

I would recommend the Advanced Concepts and Case Studies offered by AI.

I remember the related examples in that class somewhat vaguely. If I recall correctly, they were reflecting leaseup costs, etc in the cost approach. That does not imply that reaching stabilized occupancy in itself on a multi-tenant building would be an intangible asset or that fee simple property rights would be based on a vacant property. But, maybe I am remembering a different example. It seems a bit odd to adjust downward to adjust back up (ie discount for leaseup but then include a stabilized value when the property is stabilized). With that said, the value enhancement concept that I referred to in my first post (which I think was also mentioned in that class) is of relevance in some cases (perhaps in the OP's case?) that would certainly not be accounted for in the fee simple interest. It is a balancing act and something that I haven't gone so far as to argue it as being an intangible, but am open-minded on it being a possibility.

 

[CANative]

There is no such assumption implied in fee simple -- though it may often be the situation.

It almost sounds like the OP is dealing with a California property tax issue based on phrase he used (unencumbered fee simple.)

Isn't the solution to use market/economic rent versus contract rent (on the date of value) and then to get to the stabilized, as is, value (a separate issue) discount for lease up of vacant space (versus the concept that the building is vacant) and/or the time and expense of getting to stabilized market rent and/or occupancy?

 

[leasedfee]

. . . Isn't the solution to use market/economic rent versus contract rent (on the date of value) and then to get to the stabilized, as is, value (a separate issue) discount for lease up of vacant space (versus the concept that the building is vacant) and/or the time and expense of getting to stabilized market rent and/or occupancy?

CAN, I have no problem with that. There might (note italics) even be no need to discount for lease-up of vacant space if getting to hypothetical at-market fee simple. My dispute is simply that fee simple does not equal or imply vacancy. Fee simple is property rights (The bundle of sticks.). Vacancy/occupancy is a stock or physical occurrence in time and space -- even "vacancy" has variations in definitions.

Do you think leases in place are an intangible asset or part of the real estate?

No. Real property leases are not an intangible asset. The whole of appraisal theory collapses if we go down that road, and we'd need to re-write and re-invent the entire lexicon as well as the concepts of common law. (There might be some synthetic Wall Street hypothecated leases that are so bizarre that they escape conventional definition, but they are an extreme rarity.)

 

[CANative]

My dispute is simply that fee simple does not equal or imply vacancy.

That was also my point. The OP's post was saying that some other party was under the impression that when valuing the UNENCUMBERED fee simple the premise had to be that the property is hypothetically vacant. That's simply not the case. If it was I'd win tax appeals all of the time.

Edit: Even then a high vacancy property doesn't always sell for less. There is often an "upside" factor.

 

[Gobears81]

No. Real property leases are not an intangible asset. The whole of appraisal theory collapses if we go down that road, and we'd need to re-write and re-invent the entire lexicon as well as the concepts of common law. (There might be some synthetic Wall Street hypothecated leases that are so bizarre that they escape conventional definition, but they are an extreme rarity.)

Tim-I don't necessarily disagree with you on this. But I'd be interested in your take on long-term leases to national tenants. It seems that 10-years for an initial lease term is somewhat of a benchmark that developers are willing to construct. Assuming said leases are at market, I find that cap rates for an initial lease term decrease by at least 1% for an initial term of 20-years or 25-years, rather than a 10-year initial lease term. (which could reflect a value increase of at least 15%). If developers are willing to construct a building at market rents for an initial lease term of 10-years, what do you attribute that additional value from the increase of 10 to 20 or 25-years? Perhaps you could argue negative leasehold, but if it the lease is at market, that would be a challenging position, as you could also argue that the tenant negotiates a longer-term lease for their own security, due to the potential for rent increases after the initial term-depending on how the lease is written.

 

[leasedfee]

If developers are willing to construct a building at market rents for an initial lease term of 10-years, what do you attribute that additional value from the increase of 10 to 20 or 25-years?

These types of absolute or bonded triple-net leases are sale-leasebacks. They are signed by or guaranteed by the parent corporation. In contrast, many at-market leases to say a Subway or Rent-a-Center for 5 to 10 year leases are signed by a local or semi-regional franchisee. Not the national parent. That explains 50 to 150 BPs in the cap rate.

Secondly, unlike at-market buildings, investors see these bonded NNN investments as having no vacancy, no lease-up costs, no turn-over, no ongoing leasing brokerage costs, no capital repairs during the leasehold, no interruption in rent if the building is damaged (e.g., sewer backup or roof collapse), and no landlord operating expenses that leak through in the so-called at-market NNN lease. Rent is just pure NOI.

They are an ingenious way for a national/international credit mega-corporation to leverage the strength of their corporate balance sheet. (Investors assumes of course that their model is sustainable in the very long term and will not implode like Blockbuster. I am always amazed at the enthusiasm of investors to price things to the hilt.) The corporation oversees via a private developer the construction of a building that costs say $4.5 million, including land, and they sell it for $5.5 to $6 million. This cash in-flow can then fund future expansion. Because the leases are so favorable to a landlord and because of the perceived strength of the corporate balance sheet, a 5% cap on say a Walgreens takes on the characteristics of a long-term corporate bond, but is directly secured by real estate unlike a general obligation bond. Even better, it avails of the 1031 tax deferred exchange laws.

Nevertheless, absolute triple-net leases are still a leased fee valuation with a large negative leasehold. They are not an intangible asset or a going concern. It is just a highly valuable LF distorted from market norms. At the opposite end of the spectrum, a $1 per year lease for 99 years made to a cherished charity or religious organization has the affect of giving away the property. There is no intangible asset value, just a large positive leasehold equaling, more or less, the hypothetical equivalent fee simple estate.

 

[Gobears81]

These types of absolute or bonded triple-net leases are sale-leasebacks. They are signed by or guaranteed by the parent corporation. In contrast, many at-market leases to say a Subway or Rent-a-Center for 5 to 10 year leases are signed by a local or semi-regional franchisee. Not the national parent. That explains 50 to 150 BPs in the cap rate.

Secondly, unlike at-market buildings, investors see these bonded NNN investments as having no vacancy, no lease-up costs, no turn-over, no ongoing leasing brokerage costs, no capital repairs during the leasehold, no interruption in rent if the building is damaged (e.g., sewer backup or roof collapse), and no landlord operating expenses that leak through in the so-called at-market NNN lease. Rent is just pure NOI.

They are an ingenious way for a national/international credit mega-corporation to leverage the strength of their corporate balance sheet. (Investors assumes of course that their model is sustainable in the very long term and will not implode like Blockbuster. I am always amazed at the enthusiasm of investors to price things to the hilt.) The corporation oversees via a private developer the construction of a building that costs say $4.5 million, including land, and they sell it for $5.5 to $6 million. This cash in-flow can then fund future expansion. Because the leases are so favorable to a landlord and because of the perceived strength of the corporate balance sheet, a 5% cap on say a Walgreens takes on the characteristics of a long-term corporate bond, but is directly secured by real estate unlike a general obligation bond. Even better, it avails of the 1031 tax deferred exchange laws.

Nevertheless, absolute triple-net leases are still a leased fee valuation with a large negative leasehold. They are not an intangible asset or a going concern. It is just a highly valuable LF distorted from market norms. At the opposite end of the spectrum, a $1 per year lease for 99 years made to a cherished charity or religious organization has the affect of giving away the property. There is no intangible asset value, just a large positive leasehold equaling, more or less, the hypothetical equivalent fee simple estate.

I appreciate the response and agree that these leases are distorted (as well as the NNN market not showing much opportunity for upside anymore). Based on the data that I have, I don't agree regarding a comparison of Subway franchisee cap rates vs say Walgreens cap rates or those which are guaranteed by the parent company. I have seen leases similar to a 5-year term to a Subway franchisee result in cap rates that are more than .5 - 1.5% higher than a Walgreens cap rate on a 25-year lease as an example. I have also seen a 10-year vs 20 or 25-year lease term resulting in a notable decline in cap rates, all else equal. If you interview NNN brokers, I believe that they would also attest to at least a 1% decline in cap rates for a 20 or 25-year lease vs a 10-year lease, all else equal.

I also agree regarding the leaseback being beneficial to the parent company, due to them utilizing their own strength. But, assuming the lease is at market, I would venture that Walgreens could sign a 25-year lease and the resulting leased fee value would still be well in excess of building costs, land purchase, and typical entrepreneurial incentive. Could you argue that as being negative leasehold? Perhaps, as Walgreens could probably negotiate below market rents given their tenant strength and length of the lease. But as appraisers, determining negative leasehold based on leases at market is an uphill climb.

I understand that the majority of these leases are above market, so the above discussion is slightly hypothetical. But I feel it is still important as most appraisers would limit negative leasehold/ property rights adjustments to the above market rents, and there is an added wrinkle to these long-term leases.

 

[leasedfee]

If you interview NNN brokers, I believe that they would also attest to at least a 1% decline in cap rates for a 20 or 25-year lease vs a 10-year lease, all else equal.

GoBears, for each $1 of NOI, a local at-market rent investor would have to anticipate re-tenanting it at years 11, 21, and 31 with brokerage costs, TI allowance, rent loss, and fixed expense loss while vacant, etc. (CAM recoveries also don't always equal CAM expenses. Plus there's capital repairs. Also rent escalations are even more at the mercy of the market.) In contrast, for each $1 of NOI the absolute triple-net NOI in a 20+ year lease has no interruption of NOI. Plug these differences into the DCF it results in a lower cap rate.

I also agree regarding the leaseback being beneficial to the parent company, due to them utilizing their own strength. But, assuming the lease is at market, I would venture that Walgreens could sign a 25-year lease and the resulting leased fee value would still be well in excess of building costs,

Walgreens, et al., could price themselves to market for a normal recovery of building and land returns. Though, as noted by the absolute NNN parameters above, it would require some tweaking to get the numbers aligned right to the market. Hyper rents and terms is the CFO's strategy.

 

[Gobears81]

GoBears, for each $1 of NOI, a local at-market rent investor would have to anticipate re-tenanting it at years 11, 21, and 31 with brokerage costs, TI allowance, rent loss, and fixed expense loss while vacant, etc. (CAM recoveries also don't always equal CAM expenses. Plus there's capital repairs. Also rent escalations are even more at the mercy of the market.) In contrast, for each $1 of NOI the absolute triple-net NOI in a 20+ year lease has no interruption of NOI. Plug these differences into the DCF it results in a lower cap rate.

I looked at cap rates for new Walgreens and they were at 6% and below (25-year leases calculated based on PGI=NOI/ Sale price). There are also Walgreens sales with cap rates in the upper 7% and lease terms of 5-10-years (same calculations), though they are at that point not new properties, whereas the 25-year leases are based on new properties. To compare, other NNN properties with similar 10-year lease terms sell in the low 7%'s when new. This would imply that some of the discrepancy in cap rates is attributable to age, but a large portion is based on lease terms. Personally, it makes sense to me-I have no interest in purchasing these types of properties, but what would I rather have-a new property with a 10-year lease at 7% or a new property with a 20-year lease at 6%? These types of properties decline in value so much and the returns are so razor thin that I'd take 6% for 20-years of guaranteed payments and anything that I make after that would be gravy. But, there is always difference in markets, and I wouldn't be surprised if less of a risk premium wouldn't be incorporated into local franchisee leases in your primary market, since there is not a massive appetite for that around here.