Chapter 9 Introduction to Income-Producing Properties: Leases, Rents, and the Market for Space

Overview Property Types Supply & Demand Short-Run Supply Long-Run Supply Determinants of Supply and Demand for Major Property Types Location & User-Tenants

Property Types

Supply & Demand Equilibrium Market Rent Equilibrium Vacancy Rate Determined by the supply and demand for space In the short-term supply of space is fixed Equilibrium Vacancy Rate Vacant space because tenants moving and the time it takes for newly constructed space to be offered for lease

Short-Run Supply

Long-Run Supply

Determinants of Supply and Demand for Major Property Types

Location & User-Tenants Motivating Factors Increase sales Business type where success requires a higher revenue stream and heavy pedestrian traffic Reduce operating costs Business type where success is based on a lower cost structure and large amount of land Clustering and submarkets Similar businesses and operating cost structures locate in similar locations

The Business of Real Estate Most real estate used by firms is leased rather than owned Leasing is more cost-effective than owning Space requirement can be met without significant capital commitment Stay out of the “real estate business” Maintenance and repair Maintain operating flexibility This results in specialized real estate firms

Real Estate Income Market Rent Vacancy Supply & demand for specific property type Population demographics & income level Economic base of the area Economic forecasts Vacancy Allowance for unused space. It should always be included in cash flow projections It is more predictable for space already in use It is difficult to estimate for newly constructed properties

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 Use of and maintenance responsibility for common areas Responsibilities for specific expenses

Lease Income Base Rent Flat Rent Leases Step Up Leases Indexed Leases Initial rent or minimum 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 – dollar amount of rent that exceeds the base rent

Leases & Expenses Recoveries Gross Leases Modified Full Service Leases Operating expenses are usually shared with tenants These operating expenses are prorated among tenants Typical operating expenses: Cleaning, repairs, maintenance, landscaping, water/sewer, security, management, real estate taxes, insurance Gross Leases Tenant pays rent only Property owner pays all operating expenses Modified Full Service Leases Tenant pays rent & specified expenses

Leases & Expenses – Continued Leases with Expense Recoveries in Excess of Expense Stops Tenant pays rent plus some pro-rated “recoverable” operating expenses after an “expense stop” is reached Pass-Through Leases Expense pass-through leases that require tenant payments on expenses Net leases – all operating expenses are passed to tenant with usually no expense stops Net, net leases – all operating expenses plus property taxes and insurance costs are passed to tenant Net, net, net leases (triple net) – in additions to all above expenses, tenant pays for maintenance, repairs, and building alterations (tenant improvements) Combinations Leases can be designed to serve for the best interest of parties involved and therefore they may have features that are not distinct

Effective Rent Used to compare different leases Compute present value of rent stream Convert present value to an equivalent annual annuity Consider the following rent schedule Year 1 = $12/square foot Year 2 = $14/square foot Year 3 = $15/square foot If the interest rate is 12%, what is the effective rent?

Effective Rent – Continued

Effective Rent – Continued

Effective Rent – Continued

Effective Rent – Continued

Pro-Forma Cash Flow Statement

Office Leases Normally 3-7 year terms Renewal option of tenant Premium rents for highly desirable space Rent discounts for space Right of first refusal Right to rent contiguous space as it becomes available Right to put back space Purchase option

Industrial Property Leases Similar to office leases Individualized and longer Tend to be pass-through or Net Net, net Net, net, net leases Premiums & discounts

Retail Leases Sales per square foot Provisions on operations Limits on other tenants Anchor and in-line tenants Rent differences Common Area Maintenance (CAM)

Apartment Leases Shorter term Consumer protection laws Gross potential rental income Based on full occupancy Loss to lease - lease difference between new and old leases times number of old leases/units