Session Plan Chapter Five: – Importance of Market Research – The Anatomy of a Lease – Mini-case on reading a lease

Location & Tenants Individual Households – Seek to avoid transportation costs, want to locate close to economic centers Firms – Seek proximity to customers, suppliers, and work force Land Prices – Price of land decreases with further distance from economic activity centers.

Local Market Studies Real Estate Brokers typically have regional or sub- market related information available for their customers (for a fee). Local appraisers can also be hired to conduct market studies for an investor – Study vacancy, rental, and expense rates in area – Determine level of new construction approved or underway – Provide analysis of demographic information This is similar to your WFU Off-Campus Student Housing Occupancy Studies

Kick the Tires Yourself Nothing beats visiting the property yourself, obtaining pictures of the property, and assessing the neighborhood and overall location of the property being considered as an investment. Pictures in broker packages often represent the “best case” view of a property, so as an investor, seeing is believing!

Importance of Leases Lease represents the “duration” of the income stream for an investment property Lease is an agreement between the lessor (owner) and lessee (tenant) Lease Terms can vary depending on property type: – Apartment: monthly to annually – Office/retail: monthly up to five years – Hotel/motel: daily – Warehouse/industrial: much longer terms (20 years)

How Price of Rent is Determined Market Rates for Comparable Space – Ask brokers, appraisers, other market participants View additional rent relative to IRR and NPV Negotiation between lessor and lessee

The Anatomy of a Lease Date Parties to lease Length of Lease Approved use & legal description of property Responsibility for maintenance and repair – Determined by negotiating power of landlord and tenants Any Limitations on expenses Common area maintenance (CAM) Base rent plus any escalations Renewal options

Anatomy of a Lease Continued Rent – Could be set over entire term of lease – Could rise with a certain index (CPI for example) Index should not be something controlled by the landlord – Percentage/Overage Rent For retail properties. Have a base rent and then additional rent once tenant’s sales surpass a certain benchmark For example: Tenant pays $20 per square foot annually, but could also pay 1% annually for sales over $400,000 at the Panera Bread located on Miller Street. If rent is fixed over entire term of lease, who bears the risk if rental rates rise over the period?

Types of Leases Type of lease: Gross, Modified Gross, or Net – Gross/Full Service: owner pays all expenses – Modified Gross: tenant pays for some expenses (possibly utilities for an office building) – Absolute Net: tenant pays all expenses – Triple Net: tenant pays for taxes, insurance, and maintenance of property – Expense Stops: owner pays for expenses up to a certain (stop) point. Above this level, the tenant pays Expenses are passed through to the tenant.

Types of Leases Index Lease – Rent and operating expenses tied to index (CPI) Graduated Rental Lease – Rent can move up or down during term of lease Escalator Lease – Lessor pays first year operating expenses – Lessee pays overage for remaining years Revaluation Lease – Periodic rent adjustments based on revaluation of property Good for properties in flux (redevelopment)

CAM and NNN Leases Some leases provide for tenants reimbursing owners for various expenses – Typically for the maintenance of the common areas of a property – Also could be for repairs, taxes, insurance, and utilities as negotiated by the owner and tenants – Common Area Maintenance (CAM) must be paid by the owner for any space in property that is vacant.

Common Area Maintenance (CAM) CAM is typically for repairs, maintenance, and utilities but can be for any expense depending on how the lease is structured Each tenant would typically reimburse the owner for their proportionate share of the expense being shared Consider the following rent roll and expenses Sq. Ft.Tenant 2,500 Uncle Bobby's Toy & Hobby 5,000Marvelous Marvin's 1,000Stop and Rob 1,500The Eatery Taxes25,000 Insurance12,500 Repair/Maint24,000 Utilities18,500

Common Area Maintenance (CAM) Sq. Ft.TenantTaxesInsurRepair/MainUtilities 2,500 Uncle Bobby's Toy & Hobby 6,250 3,125 6,000 4,625 5,000Marvelous Marvin's 12,500 6,250 12,000 9,250 1,000Stop and Rob 2,500 1,250 2,400 1,850 1,500The Eatery 3,750 1,875 3,600 2,775 10,000Totals 25,000 12,500 24,000 18,500 Who pays if there is a vacancy?

Another CAM Example You own a 20,000 sq. ft. retail strip center. There are currently four tenants. The leases allow for the taxes, insurance, utilities, repairs and maintenance to be paid by the tenants. How much in $ per square foot would each tenant reimburse the landlord for the current year if… – Taxes are $20,000 – Insurance is $4,500 – Utilities are $7,500 – Repairs & maintenance is $20,000 How much would each tenant pay annually if each tenant occupied 5,000 square feet of space? What if a tenant vacates? Who pays the expenses then?

Example of an expense stop A tenant has an expense stop of $5 per square foot based on expenses during the first year of the lease Expenses are currently $7 per square foot and the tenant has 15,000 sq. ft. of rentable area. How much does the owner and tenant pay in expenses for this tenant’s space? – Owner pays: $5 x 15,000= $75,000 – Tenant pays: $2 x 15,000= $30,000

Other Lease Contents Concessions – Lease will disclose amount of free rent, if tenant improvements will be paid by the owner, and other discounts When would these be more likely: Low or High Vacancy markets? Non-compete clause – Lease will specify if cannot lease adjacent space to a competitor Non-dilution/radius clause – Or if tenant cannot lease another location within a certain radius – Common for retail leases. Domino (or “Go Dark”) Clause – If anchor tenant vacates, in-line (or supporting) tenants may have the ability to break their leases for a specified fee

Lease Contents Continued Lender approval of major leases – For both changes to existing tenant mix and for any new tenants Load Factor – Used to pro-rate space – Rentable area per floor divided by useable area per floor

Lease Addendums: SNDA Subordination: lease is subordinate to all provisions of loan including renewals, modifications and extensions. Non-Disturbance: in event of foreclosure, tenant can stay in property as long as they are paying rent as agreed. Attornment: tenant agrees to be tenant for any subsequent landlord (bank or otherwise).

Lease Rollover Risk Evaluation of % of leases maturing in same period – Stated maturity vs. business risk issue This is a concern for both investors and lenders – Specific property may be performing well but others in portfolio could cause repayment issues

Effective Rent Present value of the expected income stream from the lease minus any expenses. Used to compare leasing alternatives – Subtract out any expenses landlord must pay Example: Panera Bread leases 2,000 sq. ft. in a retail strip center in Winston-Salem. They are paying $20 per square foot for the next five years, absolute net. Each year, the rent will increase by 5%. Determine the effective rent for this lease assuming a 10% discount rate.

Panera Bread Effective Rent Year 1Year 2Year 3Year 4Year 5 Annual Rent $ 40,000 $ 42,000 $ 44,100 $ 46,305 $ 48,620 Discount Factor PV of Rent $ 36, $34, $33, $31, $30, Total PV $166, To then calculate effective rent: N=5, I=10, PV= (166,025.65), FV=0 Solve for PMT= $43, Remember: Set your calculator to 1 P/Yr!!!

Ground Lease Decision  How many different owners could there be in a ground lease?  Which portion of the property would you want to own and why?

Ground Leases: Bank’s Perspective Sale and Lease Back of Land creates a ground lease between the purchaser of the land, and the owner of the building Most banks will not want to loan against a property that has a ground lease, unless that ground lease has a substantial period of time left on the lease – One Rule of Thumb is that lease should exceed the amortization of the loan by at least 25 years. Once the ground lease expires, the building improvements may revert back to the owner of the land…

End of Session Next Session – Chapter 6 – Market Research Mini-Case