1. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 1 CHAPTER NINE INTRODUCTION TO INCOME- PRODUCING PROPERTIES: LEASES AND THE MARKET FOR SPACE

2. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 2 Chapter Objectives Major property types Economic forces Supply and demand relationships Location analysis Competitive nature of real estate Importance of leases

3. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 3 Classification of Real Estate Uses Single family Multi- family Office Retail Industrial Recreation Institutional Mixed use

4. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 4 Economic Base Analysis- Location Quotients RE- Regional Employment USE- U.S. Employment j- Industry Classification TOT- total LQ= (R.E. j /RE TOT ) / (USE j /USE TOT )

5. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 5 Economic Base Analysis- Location Quotients Continued If LQ is greater than 1.0, then industry is base or driver industry If LQ is less than 1.0, then industry is usually referred to a supporting industry

6. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 6 Housing Demand and Supply Factors Housing factors of demand include: –New household formations, age composition of new households, household income, and mortgage credit conditions. Housing factors of supply include: –Prices of factors of production, productivity factors, number of builders in the market, and credit conditions.

7. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 7 Retail Demand and Supply Factors Retail factors of demand include: –Number of consumers, customer income, consumer tastes and preferences, prices of substitute products, and credit conditions. Retail factors of supply include: –Prices and productivity of factors of production, number of developers, developer expectations, and credit conditions.

8. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 8 Office Demand and Supply Factors Office factors of demand include: –Number of local firms, types of business of local firms, growth in local firms, and office space square feet per employee. Office factors of supply include: –Similar to retail market supply factors.

9. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 9 Location and User- Tenants Firms competing for space will result in the highest rents possible for the most profitable locations Locations will tend to be determined by clusters of users with similar financial structures that relate in similar ways to a given location

10. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 10 Location and User- Tenants Continued Locations with the greatest appeal to users will produce higher rents and also highest densities Firms that are cost- sensitive are competitive for locations

11. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 11 Location and User- Tenants Continued Location decision factors of household: –Users seek to avoid transportation costs, thus having incentives to locate close to economic centers –The price of land decreases with the distance from the economic activity centers within urban areas, and buyers substitute land quantity for location

12. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 12 Location and User- Tenants Continued Location decision factors of firms: –Transportation costs Proximity to customers Proximity to suppliers Proximity to work force –Land requirements –Type of service or product High- density / low- density demand Weight- gaining / weight- losing production

13. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 13 The Business of Real Estate Lease v.s. purchase Most tenants find leasing to be more cost- effective than owning Owning requires capital commitment and risks of ownership Owning reduces operating flexibility Maintenance An economic market for real estate services has emerged

14. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 14 The Asset Market Real estate values vary according to their physical characteristics, their locations, and the economic conditions of the market. Real estate values depend on income expectations and its relative riskiness.

15. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 15 Leases- Features and Characteristics Date Term Parties, lessee, and lessor Legal description Allowed uses Restrictions on alterations Responsibility for maintenance and repair

16. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 16 Leases- Features and Characteristics Continued Any restrictions on operations of tenants business Assignment or subletting Use of common areas Adequate insurance Default Base rent and any increases Gross lease v.s. net lease

17. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 17 Leases- Features and Characteristics Continued TI allowance Rent concessions Lease renewal options

18. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 18 Lease Demand and Supply Demand and supply model with vacancy Va= S-D Natural vacancy Rents –Equilibrium rent –Net contract rent –Effective contract rent

19. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 19 Lease Demand and Supply Continued Physical and financial asset markets Functions of space markets: –To allocate existing space –To expand or contract space to meet conditions –To determine new uses for land Demand and supply model with vacancy Va= S-D –Natural vacancy

20. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 20 Financial Content of Leases Base rent Step up provisions (CPI) Percentage rent Maximum rent Overage rent Gross lease Net lease Expense stop

21. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 21 Responsibility for Expenses Gross or full service- owner pays all expenses Net- tenant pays all 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. during the first year of the lease –There can be a “cap” on the amount passed through

22. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 22 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? –The owner pays $5 x 15,000= $75,000 –The tenant pays ($7-$5) x 15,000= $30,000

23. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 23 Financial Content of Leases Continued Concessions- base rent, TI allowance, etc. Signage Non- compete clause Lender approval of major leases Load factor Load factor for floor= Rental area per floor Usable area per floor Effective rent