McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved CHAPTER9CHAPTER9 CHAPTER9CHAPTER9 Introduction to Income- Producing Properties: Leases, Rents, and the Market for Space

9-2 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Property Types Residential  Single Family  Multifamily Nonresidential  Commercial Office Buildings Retail  Industrial Warehouse Space Manufacturing

9-3 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Property Types  Hotel/Motel One-night stays Destination resorts  Recreational  Institutional Government Hospital University

9-4 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Popular Business Choice: Leasing More cost-effective than owning  Space requirements  Owning is a heavy capital investment  Stay out of the “real estate business” Maintenance and repair  Maintain operating flexibility This results in specialized real estate firms.

9-5 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Leases Lessor-Owner, Lessee-Tenant Qualify the tenant – underwriting  Financial capacity Some Lease Content Items  Parties, Dates, Length  Base rent & any adjustments, deposits  Allowable uses & restrictions

9-6 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Lease Income Base Rent  Initial rent Flat Rent Leases  No rent change over lease term Step-up Leases  Specified rent increases at specified times Indexed Leases  Periodic rent adjustment-CPI Index Percentage Lease  Rent partially based on sales  Overage Rent

9-7 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Responsibility for Expenses Gross / full service lease  Owner/landlord pays all expenses Net lease  tenant pays all operating expenses Expenses stop  Owner pays up to the “stop”  Expenses in excess of the stop are “passes through” to tenants  The stop is typically the expenses per s.f. in the first year of the lease  There can be a “cap” on the amount passed through

9-8 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Example of Expense Stop A tenant has an expenses stop of $5 per s.f. based on expenses the first year of the lease Expenses per s.f. are currently $7 per s.f. and the tenant has 15,000 s.f. of leaseable area How much does the owner and tenant pay in expenses for this tenant’s space? A: The owner pays $5 x 15,000= $75,000 The tenant pays ($7-$5) x 15,000= $30,000

9-9 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Pro-Forma Cash Flow Statement Rental Income + Other Income + Recovery of Expenses -Vacancy & Collections - Concessions ______________________ Effective Gross Income (EGI)

9-10 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Pro-Forma Cash Flow Statement EGI - Operating Expenses ______________________ Cash Flow from Operations (NOI) -Lease Commissions - Recurring Capital Outlays - Nonrecurring Capital Outlays ______________________ Net Cash Flow

9-11 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Effective rent We need a single measure to compare leasing alternatives To calculate effective rent, we need to:  Calculate the PV of expected net rental stream to the owner of the building Net of any operating expenses paid by owner  Calculate an equivalent level annuity over the term of lease which has the same PV This measures the return to the lessor and cost to the lessee.

9-12 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Effective rent - Examples What are the effective rents for the following 6 5-year leases at 10% discount rate? 1. net lease with steps  $10 / sf for 1 st year and increases by $1 each of the following 4 years  Tenants pay all operating expenses

9-13 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Effective rent - Examples 2. net lease with one year free rent  Free rent in the 1 st year  $14.50 / sf for 2 st year and increases by $1 per year thereafter  Tenants pay all operating expenses

9-14 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Effective rent - Examples 3. net lease with CPI adjustments  $11 / sf for 1 st year and increases by CPI in each following 4 years  Tenants pay all operating expenses  CPI is expected to grow at 2% during year 2, 3% year 3, 4% year 4 and 5% year 5

9-15 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Effective rent - Examples 4. gross lease  $17.50 / sf for 1 st year and stays flat  Lessor responsible for all operating expenses  Expenses estimated to be $4 in year1, and increase by $0.50 each year

9-16 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Effective rent - Examples 5. gross lease with expense stop  Base rent $15.5 / sf for 1 st year and stays flat  Lessor responsible for operating expenses up to an expense stop of $4/sf  Expenses expected to be $4 for year 1, and increase by 50 cents each year

9-17 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Effective rent - Examples 6. gross lease with expense stop and CPI adjustment  $14.5 / sf for 1 st year and increases by CPI changes in each of the following 5 years  Expense stop at $4/sf  CPI is expected to be 2% during year 2, 3% year 3, 4% year 4 and 5% year 5  Expenses expected to be $4 for year 1, and increase by 50 cents each year

9-18 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Office Leases: Load factors Load factor for floor = Rental area per floor Usable area per floor  Example: a floor has 20K rental area and 2K common area, or 18K usable area.  Q: What is the square footage that a tenant with 4,500 sf usable area need to pay for?  Load factor = 20K/18K = 1.11  4,500 * 1.11 = 5,000

9-19 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Office Leases: Load factors Load factor for building can be calculated similarly Example: 200K rentable sf over 10 floors and a first floor lobby/common area of 20K. If $20 per sf base rents, what is total rents for 4,500 sf? 20K/200K = 10% (building load factor of 1.1) Revised load factor = 1.11*(1+10%) = Rentable sf = 4,500*1.222 = 5,500 $20/sf, the rent is 5,500*20 = $ 110,000

9-20 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Retail Leases Overage Rents  Assume 1,000 sf of rentable space with a base rent of $35/sf and 8% overage rents at breakpoint of $900K. If the expected sale is $1 million, what is the expected rents?

9-21 Copyright ©2008 by The McGraw-Hill Companies, Inc. All Rights Reserved Retail Leases Common area maintenance (CAM)  Anchor vs in-line tenants  CAM /sf for in-line space = total CAM expenses – contribution by anchor Total rentable space by in-line tenants Example: A a million sf mall, of which 1.2 million is rentable, costs $5 million per year for CAM expenses. Of the 1.2 million rentable anchors occupy 700K sf, and pay $2/sf CAM charge. Q: what is CAM charge per sf for in-line tenants?