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The profitable influence of lease incentives for new office developments
A research on the phenomenon of office real estate developments (out)competing existing assets on effective rent levels without loss of quality | Graduation presentation - Bram T. Harding – | The profitable influence of incentives on new office developments | 1/71
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Research Introduction
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Intro societal relevance
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Intro problem translation Time Car A Car A T=0 year T=1 year Value:
????? increases? Utility decreases with the passage of time (Baum, 1993) Intro problem translation
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Intro problem statement ?!
With all else being equal, developers are able to sign lease contracts with tenants for yet-to-be developed office space with effective rent levels equal to -or even lower than- effective rent levels of existing office space. Under the assumption of “an arm’s length transaction and rented out to the highest bidder” (Lusht, 2001). The use of lease incentives is suspected to be of influence. yet-to-be developed office space rent levels equal to office space existing incentives ?! yet-to-be developed office space rent levels equal to office space existing Intro problem statement
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?! Intro research aim rent levels equal to office space existing
yet-to-be developed office space developed office space AIM: exploratory How? ? … Incentives? Past? Current? Conditions? empirical Existence? Intro research aim
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Intro research questions
How can lease incentives affect effective rent levels of new to build office projects? How does this enable developers to offer lower effective rent levels than investors of comparable existing office buildings can offer? (THE PHENOMENON) Intro research questions
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Research Methodology
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! Methodology sources literature key-actor interviews
literature key-actor interviews expert interviews theory ! sensitivity analysis 0,001% dataset analysis Methodology sources
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Research Framework
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economic theory explains
Lower production costs! Time Car A Car B Age =0 year Age =1 year Price lagging! Value: economic theory! Utility decreases with the passage of time (Baum, 1993) Framework economic theory explains
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theoretical explanations
rent levels equal to & office space existing developed office space Price lagging! Lower production costs! AIM economic theory! Framework theoretical explanations
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- = margin! Framework additional explanation developed office space $
selling price $ - developed office space = margin! Lower production costs! real estate market! economic theory! The developer can lower the rent level on basis of an expected margin Framework additional explanation
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= Framework additional explanation $ selling price Tenant1 Tenant2
… years to come selling price $ = future net rent income / GIY (risk factor) + (future value change) Framework additional explanation
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Lower production costs
future net rent income selling price $ selling price selling price $ - = margin! Lower production costs WHY?! high developer competition! The developer can lower the rent level on basis of an expected margin Framework additional explanation
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phenomenon explanations
office space existing developed office space Lower production costs Lower production costs OR MARGIN Incentives? Framework phenomenon explanations
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Gift Framework incentives Incentives
“A lease incentive is any factor (financial or nonfinancial) -apart from the contract rent and general asset quality- that enables or motivates a particular housing decision” (altered from Muijsson (2010) Gift Moving costs reimbursement Fitting-out costs reimbursement Rent free period Build-out costs reimbursement Cash incentive reimbursement Higher rent Framework incentives
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Framework incentives explained No incentives 1 2 3 4 5 6 7 8 9 10
Effective rent Contract rent Build-out costs Fitting-out costs Moving costs Framework incentives explained
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Framework incentives explained Moving costs incentive 1 3 4 5 6 7 8 9
1 3 4 5 6 7 8 9 10 Effective rent Contract rent Build-out costs Fitting-out costs Moving costs Framework incentives explained
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Framework incentives explained Moving costs + Fitting-out incentive 1
1 3 4 5 6 7 8 9 10 Effective rent Contract rent Build-out costs Fitting-out costs Moving costs Framework incentives explained
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Framework incentives explained
Moving costs + Fitting-out + Build-out incentive 1 3 4 5 6 7 8 9 10 Effective rent Contract rent Build-out costs Fitting-out costs Moving costs Framework incentives explained
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{ } Framework incentives explained
Moving costs + Fitting-out + Build-out incentive 1 3 4 5 6 7 8 9 10 } { Effective Rent Contract rent Incentives lead to higher contract rents! effective rents remain equal Framework incentives explained
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Framework reflection ???? profit sharing!
How can lease incentives affect effective rent levels of new to build office projects? How does this enable developers to offer lower effective rent levels than investors of comparable existing office buildings can offer? ???? profit sharing! Incentives lead to higher contract rents! effective rents remain equal Framework reflection
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Gift Framework incentives Incentives
“A lease incentive is any factor (financial or nonfinancial) -apart from the contract rent and general asset quality- that enables or motivates a particular housing decision” (altered from Muijsson (2010) Gift Moving costs reimbursement Fitting-out costs reimbursement Rent free period Build-out costs reimbursement Cash incentive reimbursement Profit sharing Higher CONTRACT rent Lower EFFECTIVE rent Framework incentives
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Lower production costs
future net rent income selling price $ selling price selling price $ - = margin! Lower production costs The developer can lower the CONTRACT rent level on basis of an expected margin Framework incentives and effective rent
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Lower production costs
contract rent effective rent selling price $ selling price selling price $ - = margin! Lower production costs Where does this MARGIN come from? The developer can lower the EFFECTIVE rent level on basis of an expected margin Framework profit sharing
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Creators of Lower Production Costs & Margin
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< Margin margin creator segments land additional costs Profit
Financing Overheads value $ < + + labor & material Margin margin creator segments
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Construction costs development
= labor & material (Bureau Documentatie Bouwwezen, 2012) Margin yield compression
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< Margin land value labor & material additional costs Profit
Financing Overheads value $ < + land Margin land value
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- = Margin land value 1/4 Profit Financing Overheads $ land -
labor & material additional costs average value average average AVERAGE Margin land value 1/4
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= Margin land value 1/4 land
average data: Leveraging effect (Wigmans, 2002) Municipal Assumptions Developer realization % difference Developer realization if corrected Contract rent €300 GIY 6,50% 6,00% -7,69% Asset value €4615 €5000 +8,33% Foundation costs €2500 Land costs €1654 €2000 Profit €461,5 €846 +83,33% €500 Margin land value 1/4
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= Margin land value 1/4 land
average data: Leveraging effect (Wigmans, 2002) Municipal Assumptions Developer realization % difference Developer realization if corrected Contract rent €300 €323 +7,69% GIY 6,50% Asset value €4615 €4970 +8,33% Foundation costs €2500 Land costs €1654 €2223 Profit €461,5 €816 +76,7% €497 Margin land value 1/4
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= Margin land value 1/4 land
average data: Leveraging effect (Wigmans, 2002) Municipal Assumptions Developer realization % difference Developer realization if corrected Contract rent €300 GIY 6,50% Asset value €4615 Foundation costs €2500 €2327 -7,69% Land costs €1654 €2173 Profit €461,5 €653 41,5% Margin land value 1/4
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= Margin land value 2/4 land Lagging Once a year fixed Time gap
Current data Change during year? Change during land sale and asset sale? Value increase outlook? Margin land value 2/4
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= Margin land value 3/4 land Land price compression
Competition between municipality Discounts Margin land value 3/4
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= Margin land value 4/4 land Incomparable datasets (UNPROVEN) existing
new asset value x x development costs x land costs lower land value Margin land value 4/4
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Incentives: indirect influence
Stable rent = more investors! Margin market rent analyses distortion
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market rent analyses distortion
equal? land = Incomparable datasets (UNPROVEN) existing new asset value x x development costs x land costs lower land value Margin market rent analyses distortion
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< Margin land value land labor & material additional costs Profit
Financing Overheads value $ < + Margin land value
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market rent analyses distortion
$ = Tenant1 Tenant2 value Margin market rent analyses distortion
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= Margin yield compression yield compression $ value
future net rent income / GIY (risk factor) + (future value change) value Wall of money Overconfidence High competition Margin yield compression
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Lower production costs
contract rent effective rent selling price selling price $ selling price $ - = margin! Lower production costs $ $ = = value value Municipal Assumptions Developer realization 10 year lease 5 year lease Contract rent €300 €350 GIY 10,00% 6,50% Asset value €3000 €3500 €4615 €5385 Foundation costs €2500 Land costs €200 €1654 Profit €800 €462 €1231 Effective rent €318,63 €293,00 €214,90 Margin high-low method
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< Margin land value land + labor & material value $ Profit
Financing Overheads < + additional costs Margin land value
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= Margin yield compression Profit Financing Overheads Wall of money
Lower risk premium due to pre-contracting Lower risk premium due to competition/demand additional costs Margin yield compression
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< Margin land value land + labor & material value $ Profit
Financing Overheads < + additional costs Margin land value
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< Margin land value Profit Financing Overheads $ land + +
labor & material additional costs value leveraging effect (averages) lagging municipal competition incomparable dataset (unproven) incentive influence with datasets (unproven) developer competition pre-contracting wall of money incentive indifference yield compression high-low method Margin land value
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Empirical input
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interview introduction
Interviewee selection Investor: 5 Developer: 3 Municipality: 1 Financier: 2 Market expert: 2 Method In-depth interview Pre-set up directional questions Audio recorded Selective transcripts; not reflected Empirical interview introduction
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Empirical Interview results
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land value dataset analysis
Goal Comparing the expected selling price of the municipality –as determined in their assumptions- with the actual selling price as realized between the developer and investor. In order to check for margin to be created Dataset selection Office assets Single / Multi tenant New development Low risk assets Created between Land value > 4 mln. Developer type: pur sang developer 10’000+ m2 GFA Dataset description 13 cases 6 multi tenant / 7 single 25’955 m2 GFA office space on average 3500 parking places Realized total land value: 325 mln. Advised total land value: 343 mln. Data acquirance Expected selling price: land price advices Realized selling price: deeds of transfer Data processing Expected selling price: inflation correction Empirical land value dataset analysis
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land value dataset analysis
Difference from land advice Year of negotiations Euro/m2 Land Ratio Difference with realized selling price Inflation Corrected Effective rent corrected for incentives Value corrected for Vilsteren data Effective rent level Average +19% € 4029,54 +25% +36% +21% € ,94 20% € ,94 1 +0% 2005 € 5330 +20% +53% +30% € ,86 +51% € ,19 2 -2% 2007 € 4917 +22% +55% +28% € ,11 +26% € ,90 3 2002 € 3111 +35% +1% -10% € ,72 -11% € ,60 4 € 3741 +16% 4% € ,62 3% € ,83 5 2006 € 4883 +31% € ,30 € ,79 6 € 5251 +71% +41% € ,00 +39% € ,45 7 € 4651 € ,40 +23% € ,89 8 2003 € 3893 11% € ,43 +17% € ,44 9 € 3888 +8% € ,74 -9% € ,39 10 -5% 2010 € 3129 +3% 0% € ,40 11 2008 € 3032 +11% 5% € ,41 12 +2% € 3974 +66% +63% € ,64 13 +235% 2012 € 2584 +5% +69% +52% € ,84 Results: On average: +21% to the benefit of the developer Especially in years : +37% Average margin effect on effective rent level: € -82,94 / m2 GFA Average margin effect on effective rent level : € 145,30 / m2 GFA MARGIN! Yield compression However, under the assumptions of: Margin fully shared back to the tenant No increase in production costs compared to the municipal’s assumptions Effective rent corrected for neither inflation nor yield rate Empirical land value dataset analysis
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Empirical sensitivity analysis Goal
To show the effects of both profit sharing and the high-low method, on the basis of residual land value leveraging. Dataset selection Based on real case: Existing asset New asset Data acquiring Existing asset: interview Rent level Service costs 20% rent-free incentive New asset: interview Approximate rent level ‘New asset’s effective rent = Old asset’s effective rent’ (incl. service costs) municipal data Construction costs assumption Program Land value + discount where a=incentive; S = profit; r = inflation/yield; n+1 = lease term Data processing Asset value: capitalization method Base model: discount corrected by higher foundation costs. Effective rent level discounted for inflation: a = S * (1 - r) / (1 - r^n+1); Empirical sensitivity analysis
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Empirical sensitivity analysis Results:
Situation 1 Situation 2 Municipality Existing asset Contract rent Diff % Contract rent increase 27% 138% 0% 83% 55% Yield decrease 1% -16% 20% -26% +6% 14% Yield decrease 1% & Rent increase +30% Rent inc +8,8% 21,2% Yield decrease 1.5% -32% -4% -42% -18% 24% Yield decrease 1.5% & +8% limit -37% -10% -47% -24% 23% GIY needed when +8% limit 0,75% GIY Results: In order to obtain the same effective rent level as the existing asset: Same assumptions as the municipality: -1.5% Lower assumptions than the municipality:: GIY + 8% current market rent increase Yield compression has most impact where a=incentive; S = profit; r = inflation/yield; n+1 = lease term Empirical sensitivity analysis
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Conclusions
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How can lease incentives affect effective rent levels of yet-to-be-developed office buildings?
Sharing of developer profit / High-low method Distorting market analysis How does this enable developers to offer lower effective rent levels for yet-to-be-developed office buildings, than the effective rent levels offered by investors for comparable existing office buildings? (Temporal) yield compression period enables higher selling price Land price leaves margin for the taking Incentive indifference creates possibility for profit sharing High-low method further amplifies Conclusions
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Questions?
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