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Long Term Below-market Lease

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Michael S

Senior Member
Joined
Mar 18, 2009
Professional Status
Certified General Appraiser
State
New Mexico
I'm appraising a proposed day care property that has a 30-year NNN lease at about $5.00/SF that is flat over the entire lease term. Market rent is probably around $15 - $20/SF but this is being built primarily for charitable reasons. I've found plenty of sales and listings of these type of properties on a national basis with new properties trading around a 6.5% - 7.5% cap rate if they've got a 10-15 year lease to a national operator at market rent around $20/SF. This ends up working out to $250-$350/SF as many of them have lease rates in excess of $20/SF. If I cap the existing income at something lower to reflect the reduced risk (while taking into account the lack of escalations) it's maybe $75/SF. This appraisal is for a lender financing the construction and they're primarily interested in the hypothetical fee simple value which I'll determine using cost and local fee simple sales. However I'm trying to figure out how to approach the leased fee interest given that the rent is so far below market. I don't think I'm going to find many sales with similar terms to derive the market's reaction. Obviously I need to apply a pretty substantial property rights adjustment but I'm trying to figure out how best to derive that adjustment.
 

Pittsburgh Pete

Elite Member
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May 6, 2008
Professional Status
Certified General Appraiser
State
Pennsylvania
Compute by capitalized net rent loss attributable to the lease.
 

Gobears81

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Nov 7, 2013
Professional Status
Certified General Appraiser
State
Illinois
I know DCF isn't the shiniest tool in the box here, and I understand that a 30-year lease could, in itself, suggest direct cap. But...the key phrase to me was flat lease. If you are projecting market rent growth at say 2% per year, the discrepancy between market and contract rents will only grow over time.
 

leasedfee

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Joined
Oct 14, 2007
Professional Status
Certified General Appraiser
State
Colorado
I am fond of calculating the positive leasehold interest I_LH = market rent (EGI) minus contract rent. Then an annuity multiplier to convert I_LH into V_LH. This may require one of those J/K factors to reflect that the subject's contract rent is flat. Subtract that off of the hypothetical FS equivalent in all approaches.
 

techbiker

Sophomore Member
Joined
Dec 4, 2015
Professional Status
General Public
State
Texas
I'm appraising a proposed day care property that has a 30-year NNN lease at about $5.00/SF that is flat over the entire lease term. Market rent is probably around $15 - $20/SF but this is being built primarily for charitable reasons. I've found plenty of sales and listings of these type of properties on a national basis with new properties trading around a 6.5% - 7.5% cap rate if they've got a 10-15 year lease to a national operator at market rent around $20/SF. This ends up working out to $250-$350/SF as many of them have lease rates in excess of $20/SF. If I cap the existing income at something lower to reflect the reduced risk (while taking into account the lack of escalations) it's maybe $75/SF. This appraisal is for a lender financing the construction and they're primarily interested in the hypothetical fee simple value which I'll determine using cost and local fee simple sales. However I'm trying to figure out how to approach the leased fee interest given that the rent is so far below market. I don't think I'm going to find many sales with similar terms to derive the market's reaction. Obviously I need to apply a pretty substantial property rights adjustment but I'm trying to figure out how best to derive that adjustment.

I'm not an expert, but normal depreciation for a commercial building occurs over 39 years. If the Daycare sells the property in a lease-buyback scenario, wouldn't the fee simple value be impacted by the length of the fixed ultra-cheap lease? Especially since $5/sf soon probably won't even be enough to maintain the building. When market rents are $15-$20 now, I can't picture many buyers in 20 years @ $5/sf fixed.

Is the lender engaging in charitable lending?
 

Gobears81

Senior Member
Joined
Nov 7, 2013
Professional Status
Certified General Appraiser
State
Illinois
I'm not an expert, but normal depreciation for a commercial building occurs over 39 years. If the Daycare sells the property in a lease-buyback scenario, wouldn't the fee simple value be impacted by the length of the fixed ultra-cheap lease? Especially since $5/sf soon probably won't even be enough to maintain the building. When market rents are $15-$20 now, I can't picture many buyers in 20 years @ $5/sf fixed.

Is the lender engaging in charitable lending?
39-years isn't a bad rule of thumb, but it is just that - a rule of thumb. Some properties have lower anticipated lives, particularly on an economic basis. If memory serves me correct, day care facilities are an example of a property with an economic life of less than 39-years in many cases.

The fee simple value wouldn't be impacted by the length/ lease level, but the leased fee value absolutely will. The OP listed the lease as NNN, so maintenance on the building is paid by the lessee during the lease term. I don't know the whole story, but I would absolutely expect buyers of this property, just nowhere near what the price would be on a fee simple basis.
 

DREA Dean

Sophomore Member
Joined
Apr 16, 2015
Professional Status
Certified General Appraiser
State
Pennsylvania
Is the client asking you to value the leased fee or fee simple interest? It is unclear from the OP, but if you are being asked to value the fee simple, explain that the signed lease is unusual and not reflective of market rents. It seems clear to me that the lease is not arms-length. So, use market rent in the income approach.

If you are valuing the leased fee interest based on the signed lease, then you need to determine the present value of the leasehold interest due to below-market rent over 30 years and deduct that from the fee simple/market rent value. At $5/SF for 30 years, there is simply not enough leased fee value to build the property. But I still think the key point is that the lease is not arms-length, so it can mostly be ignored.

The problem, of course, is if the property is ever sold with the lease in place. Then it is worth very little. I would put plenty of disclaimers and caveats in the report to explain exactly what is going on and how you are handling it. Perhaps an Extraordinary Assumption that you are valuing the property based on market rents, not the lease that incorporates atypical landlord motivations.
 

Michael S

Senior Member
Joined
Mar 18, 2009
Professional Status
Certified General Appraiser
State
New Mexico
Is the client asking you to value the leased fee or fee simple interest? It is unclear from the OP, but if you are being asked to value the fee simple, explain that the signed lease is unusual and not reflective of market rents. It seems clear to me that the lease is not arms-length. So, use market rent in the income approach.

If you are valuing the leased fee interest based on the signed lease, then you need to determine the present value of the leasehold interest due to below-market rent over 30 years and deduct that from the fee simple/market rent value. At $5/SF for 30 years, there is simply not enough leased fee value to build the property. But I still think the key point is that the lease is not arms-length, so it can mostly be ignored.

The problem, of course, is if the property is ever sold with the lease in place. Then it is worth very little. I would put plenty of disclaimers and caveats in the report to explain exactly what is going on and how you are handling it. Perhaps an Extraordinary Assumption that you are valuing the property based on market rents, not the lease that incorporates atypical landlord motivations.

The client originally asked for the as complete leased fee value as they knew it was a build-to-suit property that was going to be leased (with an as is fee simple value of the vacant land). Once I learned the details of the situation I told them that the leased fee interest would likely not amount to much given the substantial negative leasehold value. I suggested providing an as complete fee simple value using the hypothetical condition that no lease was in place. After all, if they ever had to take the property back that's what they would end up with. An investor would not be willing to pay much knowing that, with inflation, they were going to be getting an ever decreasing cash flow and the reversion is so far out as to barely make a difference once discounted back to present value.

My plan is to compare the property to other new construction day care centers which trade pretty regularly and which I can use to determine market rental rates. All of the local day care rent comps are older second generation properties that rent for $7-15/SF while the new construction properties are generally north of $20/SF - more in-line with what a developer would require to make new construction financially feasible. I've pretty much figured out what the property rights adjustment for the negative leasehold value is but I'm trying to decide how to present it and explain it in the report.
 

NachoPerito

Senior Member
Joined
Jul 25, 2012
Professional Status
Certified General Appraiser
State
Washington
What will someone pay for this? Cap the $5/SF at a rate that reflects a very low risk investment while taking into account the lack of escalations.... Walgreens, until recently, had been very low risk with no escalations, you can use that as a guide.
 
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