FIN 3332 Exam 3 Review
The Bottom Line
"Base" rents are typically compared on a $/sf/year or $/sf/mo. basis. However, depending on lease structure, a tenant's rental costs (and a landlord's income) may not be able to be compared just by looking at "base" rent. Gross Leases: - A tenant's rental costs can be compared just by looking at "base" rent - The landlord's "bottom line" will need to account for operating expenses - However, residential is the only type that typically use gross leases Net Leases: - A tenant's rental costs cannot be compared just by looking at "base" rent - If tenant reimbursements are paid to the landlord, the landlord's "top line" would need to account for operating expense reimbursements Landlord is almost always responsible for capital expenditures.
Comparable Sales - Adjustments
"Transactional" adjustments (economic circumstances) to comparables: - Property rights conveyed (did the buyer of the comparable purchase a different combination of rights?) - Financing terms (below rate financing?) - Conditions of sale (arm's length?) - Expenditures made immediately after purchase (did buyer receive a price concession?) - Market conditions (changes in value since sale of comparable?) "Property" adjustments (physical and income attributes) to comparables: - Location - Physical characteristics - Economic characteristics (operating expenses, lease terms, tenant mix) - Use
When is Cost Approach Most Applicable?
1. Properties that do not have an efficient market for occupants (ex. automobile manufacturing facilities) 2. Brand new buildings 3. Insurance appraisals (cost, rather than value, is often the objective) 4. Specialty buildings (ex. religious centers)
Residential Gross Lease Example
80 unit, 2 bedroom complex in Lubbock, Texas. Market rents are $600/mo. per bedroom Market Vacancy: 5% of PGI Landlord OpEx: 40% of EGI CapEx: 10% of EGI Gross lease structure: - Tenant is only responsible for its "interior expenses" - Landlord is responsible for all other operating expenses - No reimbursements show up on the investors' operating statement
Cost Approach
Procedure: Estimated reproduction cost of improvements − Estimated accrued depreciation = Depreciated cost of building improvements + Estimated value of site = Cost approach value Major Assumption: the cost of creating a property is related to its market value
Methods for Setting Rents
- "Base" rents are typically compared on a $/sf/year or $/sf/mo. basis - However, a tenant's rental costs (and a landlord's income) cannot be compared just by looking at "base" rent - Must also determine what other charges will be paid by tenant (or reimbursed to landlord) Three methods: - Gross Lease - Net Lease - Percentage Rent
Sales Comparison Terminology
- "Subject" is the property being appraised - "Comparables" (or "comps") are recently sold, similar properties - The approach estimates the value of subject by adjusting the sales price of the comparables for any differences Calculation: Comparable Sales Price ± Feature Differences = Subject Value Estimate
Agency Creation by a Listing Contract
- An "agency contract" creates a special agency relationship between the principal (property owner) and the agent (broker) - Contract for services, not for real estate - Frequently involves sub-agency through listing services (MLS, etc.) - The contract typically provides that the broker will earn a commission by finding a buyer (or tenant) for the specified price and terms
Property Condition and Repairs
- As a general rule, a tenant under a commercial lease takes the leased property "as is," with all of its problems and benefits - The law may impose minimal duties on a landlord to maintain the property in its initial condition or repair defects to the property - However, the lease should clearly allocate these responsibilities between the landlord and tenant
Office Leases
- Average lease length (5-10 years) - Balance tenant need for flexibility vs. landlord desire for investment returns - Tenants tend to be relatively homogenous The more occupied a building is, the more expenses tend to be passed-through to tenants: - Management efficiency - Desire for passive investments - Most office leases are triple-net
Recent Innovations in Brokerage
- Buyer brokerage - "Unbundling" of brokerage services: ---Advertising ---Document preparation ---Administration of transactions - Discount brokerage - Self-brokerage
Market Distortion: High Transaction Costs
- Buying and selling real estate costs much more than most types of transactions - The costs include search costs, brokerage fees, legal fees, transfer taxes, and due diligence costs - Transaction costs for the seller typically range between 1.5% and 6% of the purchase price - In other countries, transaction costs for both buyer and seller can range between 15% and 20%
Is Cost a Good Estimate of Value?
- Cost, price and value are different monetary concepts - Price may or may not equal "market value" - Not all costs contribute to market value
Commercial Lease Law
- Courts consider commercial tenants to be in a better bargaining position than residential tenants and can negotiate better leases - If burdensome regulation are extended to commercial leases, landlords will raise rents and tenants will pass those costs onto their customers - Minimal regulations are passed on to landlords, but commercial lease law is somewhat uncertain in commercial context - Best method...address directly in lease agreement
What is a lease?
- Legal contract between tenant (lessee) and owner (lessor) for use and possession of real estate (land and improvements) - Leases: the "economic engines" that "drive" values and returns in the real estate industry - When you purchase a multi-tenant property, you are really acquiring a portfolio of leases - Understanding leases is prerequisite to understanding commercial real estate markets and values
Property Management = Another Agency Relationship
- Management contract creates an agency relationship between owner (principal) and manager (agent) - Empowers manager to serve as owner's fiduciary (the words and actions of the manager are binding on the owner) - Agent has a legal obligation to exercise care in managing both money and property for owner Who hires property managers - Developers - REIT's - Banks (foreclosure) - Operating companies - Government agencies - Insurance companies
General License Requirements
- Minimum age, good reputation and character - Pre-licensing education requirement - Pass state licensing exam - Minimum experience (for broker's license) Exemptions from licensure: attorneys, resident managers, government employees, trustees, executors, and those with power of attorney
General Preferences for Approaches to Market Value
1. Income Approach - Property must be income producing - Reliable income and expense data must be available 2. Comparable Sales Approach - Must be an active market for property type - Sufficient amount of sales data must be available - Must be comparable 3. Cost Approach - Cost must indicate value - Sufficient amount of cost data must be available - Appraisers call this "weighting" or "reconciliation" (USPAP Step 7)
Conflicts of Interest
- No standard definition - A conflict arises where the interests of a market intermediary may be inconsistent with, or diverge from, those of its clients, investors, or others Core Issue: separation of ownership and control - Client = owner - Intermediary = control Examples: - Brokers making below (or above) market sales to gain a commission - Banks making risky loans because they are insured (or "too big to fail") - Appraisers over (or under) valuing properties to get more business - Lawyers not acting in the best interest of their client to generate fees This creates a need for some type of control mechanism (usually regulation).
Accrued Depreciation
- Not tax depreciation - Difference between (1) replacement cost and (2) market value of improvements - Types of accrued depreciation that must be considered: 1. Physical deterioration 2. Functional obsolescence (see Working RE article) 3. External (economic) obsolescence
Beginning of Lease Term
- Often, work will have to be done by the tenant or landlord to prepare the premises for the tenant's intended use ("finish out") - As such, the lease may not begin on the date that the lease is signed - The date that the term actually begins is known as the "commencement date" - This is particularly important for financing and sale purposes
A Lemons Example
- One half of the market is "good" sellers (properties valued at $80,000) - One half of the market is "bad" sellers (properties valued at $30,000) - Buyers have no way to tell the difference, so they assume all properties are worth (an average of) $55,000 Only bad sellers will take the buyer's offer: - $55,000 (buyer's offer) < $80,000 (good sellers) - $55,000 (buyer's offer) > $30,000 (bad sellers) - Eventually, buyers will realize that that only bad sellers will take their offer (at a price above what the property is worth) - Leads to a "market failure" - This is a classic example of information asymmetry
Broker = Market Knowledge
- Prices and terms in current market - Marketing approaches that work - Legal obligations of buyers and sellers - Properties in market - Potential customers and their needs - Procedures and requirements of transaction
Why is Property Management Important?
- Property decisions cannot be undone easily or cheaply - Ownership of real estate puts investors in business of providing rental services (management intensive) - Management decisions affect property values and investors' returns - Transaction costs of commercial real estate investments are high... returns are usually maximized by holding assets for long periods - Majority of real estate returns come from periodic rental income (not from sales) - Therefore... commercial real estate returns are significantly affected by property management
Market Distortion: Information Asymmetry
A situation in which one party in a transaction has more or superior information compared to another. Often happens in transactions where the seller knows more than the buyer. Potentially, this could be a harmful situation because one party can take advantage of the other party's lack of knowledge: - Sellers inflate prices - In response, buyers not willing to pay full price
Ground Leases
A lease of (usually vacant) land for a very long term (over 30 years): - Typically, tenant pays for improvements - But, at end of lease term, who owns? When the landlord doesn't want to (or can't) sell (emotion, city restrictions, or tax avoidance). Frequent tool of developers. "Ground use" contemplates infrastructure development: - Tenants needs a long term to build and use - The length of use must justify the economic investment made by the tenant, which will be owned by the landlord at the end of the term
Lease Bargaining
All lease terms are negotiable. In general, the owner of the asset (landlord) has the upper hand. However, this depends on: - Rent paid - Market conditions - Occupancy - Attractiveness of tenant - Credit of tenant Experienced parties will have a feel for what are "market terms".
USPAP Step 6: Three Approaches to Estimating Market Value
Apply Three Approaches to Valuation Sales comparison approach -> Indicated value Cost approach -> Indicated value Income approach -> Indicated value
Damage and Destruction
At common law: - If a building is totally destroyed, the lease terminates and the landlord has no obligation to rebuild - If a building is partially destroyed, the lease doesn't terminate, the landlord has no obligation to rebuild, and the tenant must still pay rent If these "default" rules are not acceptable, then the parties should specify what each must do in the event of damage or destruction. By doing so, the parties allocate these risks. Another solution...insurance.
Sales Comparison Approach
Basic Idea: Value of RE can be determined by analyzing the sale prices of similar properties. - Why? - Based on the 'law of one price' - In a competitive market, close substitutes should sell for similar prices - Major difficulties? - How many truly close substitutes exist? - How many of these have sold recently?
What do real estate brokers do?
Bring together (1) buyers and sellers and (2) landlords and tenants: - With respect to their real estate needs - With respect to communication Collect commission for a successful transaction (typically as a percentage of the price or rent). Major issue: does commission compensation structure create a conflict of interest?
Allocation of Risk
Characterizing a lease as a conveyance creates some interesting dynamics between the landlord and tenant: - Who is responsible to maintain the property? - Who is responsible for ad valorem taxes? - Who pays for basic utilities to serve the property? - Who should insure the property? The buildings? - Who is liable if a third-party gets injured on the property? - What if the improvements are damaged by a natural disaster? The law will provide default rules for each of these, but that may not be how the parties desire to allocate these risks: - As a result, the parties can utilize the lease as a contract to allocate these risks - Also a specific agreement can satisfy the desire for certainty
Asset Management Functions
Comparable to managers of stock portfolios. Before property is acquired: - Finds specific assets in which client can invest - Arranges financing - Negotiates acquisition price - Oversee due diligence and closing process After property is acquired: - Monitor and control operating performance - Report value-enhancing opportunities for rehabilitation, historic preservation, modernization, and conversion - Suggest strategies for lowering owner's cost of capital - Evaluate opportunities to restructure ownership - Continually reassess buy vs. hold decision
Functions of a Property Manager
Day-to-day property operations = property management Functions of a property manager: - Marketing properties ---Leases must constantly be renewed ---Who should be hired to market and lease available space? - Selecting tenants ---Importance of tenant credit ---Tenant mix - Signing leases - Collecting rent - Property expenses paid out of rental income - Repairing and maintaining property - Maintaining tenant relations
Financial Intermediaries in the Real Estate Industry
Depository Institutions - accept deposits to channel funds from savings to surplus (banks, thrifts, S&L's, credit unions, etc.) Investment Companies - pool funds to invest real estate assets (REIT's, private equity funds) Insurance Companies - invest premium payments in real estate assets Pension Funds - pool employee contributions to invest real estate assets (similar to insurance companies) GSE's - government-sponsored enterprises participate in the secondary mortgage market (FNMA, FHLMC)
Duties and Fiduciary Responsibilities of Agents
Disclosure: Being completely open and honest Confidentiality: Never betraying confidential information Accounting: Keeping principal informed about financial aspects of assignment Obedience: Following instructions of the principal fully Loyalty: Never subordinating the best interest of principal Skill and care: Representing principal as agents would represent themselves
Asset Manager Performance and Compensation
During 1970's and 1980's, asset manager compensation was typically based on a % of assets under management (AUM) - 0.50 to 1.50% of AUM (annually) - Produces clear agency problem - Managers have an incentive to acquire and hold assets for principal (even when sales might be advisable) Industry is now moving to performance-based compensation - Fee tied directly to overall portfolio performance - Owner and manager must agree on the performance benchmark - Actual performance typically evaluated over a longer period (typically 3-5 years)
Types of Leasehold Estates
Estate For Years: - Specific starting and ending times - Can be for any length of time, and does not automatically renew - Example: A four (4) year lease term Periodic Estate: - Has an original lease period of fixed length that continually renews itself for like periods - Continues until the tenant or landlord acts to terminate it - Example: A month-to-month lease Estate at Will: - All the normal landlord-tenant rights and duties exist except that the estate can be terminated by either party at any time - No stated term or period Tenancy at Sufferance: - When a tenant stays beyond the legal tenancy without the consent of the landlord - Commonly called a "holdover" tenant and no advance notice is required for eviction - Not a trespasser because original entry onto the property was legal
Steps in Sales Comparison Approach
Estimates the value of a subject property...by selecting comparable sales from the relevant market. - Identify elements of comparison & value adjustment - Select comparable sales - Adjust comparable sale prices to approximate subject - Reconcile adjusted sale prices; obtain indicated value of subject
Lease Termination
Expiration of term - Automatic renewal? - "Holdover" leads to a tenancy at sufferance Mutual agreement Foreclosure of superior lien Breach of the lease contract - Where the landlord is at fault, the tenant can file a court action for termination - Where the tenant is at fault, the landlord can evict and recover possession of the premises
How do intermediaries help solve the lemons problem?
Facilitate the exchange of information. Lower the costs of information. Real estate examples: - Information sources (CoStar) - Analysis (appraisers) - Screening (lenders) - Lower search costs (brokers) - Expertise (title companies) Results: - Buyers confident in ability to distinguish between "good" and "bad" sellers - Assets are priced more accurately
Essential Elements of a Lease?
For a valid lease to exist, it must meet the usual requirements of a contract (offer, acceptance, consideration). In addition, lease must be in writing and contain: - Named lessor and lessee - Adequate description of premises - Conveyance of premises - Starting date, length ("term") - Rental rate Statute of Frauds: - The Texas Statute of Frauds provides that a lease of real estate for a term that cannot be performed within one year must be in writing - A lease of one year or less is not required to be in writing to be enforceable
Eviction
Forcible Entry and Detainer - action against a tenant who takes possession of the premises without the consent of the landlord and then refuses to give up possession after demand is made by the landlord In Texas, the eviction process is governed by statute (Texas Property Code, Chapter 24): - Landlord must give tenant a minimum of 3 days' written notice to vacate - A tenant cannot be guilty of Forcible Entry and Detainer until so adjudged by the Justice of the Peace Court in the precinct where the real estate is situated As you might expect, an eviction proceeding can be a cumbersome litigation process.
Adjustments to Comparable Sale Prices
Goal of Adjustments - convert characteristics of each comparable to an approximation of subject
Retail Leases
Highly variable lease length: - Small retail (2 - 5 years) - Anchor retail (5 - 15 years) Users relatively varied, but all depend on consumers using the site. Percentage rent structure often used. Most retail leases are triple-net.
Residential Landlord - Tenant Law
Historically, a lease was enforceable based solely on the written terms of the lease document. However, with regard to residential property, the trend today is for the legislature to establish special landlord-tenant laws: - Chapter 92, Texas Property Code - Consumer protection - Disparities in bargaining power Residential lease law tries to strike a balance between the responsibilities of landlords and tenants: - Landlord must maintain the premises in a fit condition for living - Tenant is to keep the residence clean and not damage it - Landlord must give advance notice before entering - Right of tenant to make needed repairs and bill the landlord - Procedure for evicting a tenant
Background of Leases
Historically, leases have more "legal leftovers" than other areas: - Began in feudal times - Very little statutory law on leasing (especially commercial leases) - Most law is common (judge-made) law Lease: conveys to the lessee (tenant) the right to possess and use another's (landlord) property for a period of time Leasehold Estate: grants the tenant the right to occupy land of another Reversionary Interest: rights retained by the landlord to retake possession at the end of the lease period
Allowed Use of Premises
How can spaced be used and (perhaps more importantly) how it can not be used by tenant: - Landlord wants? - Tenant wants? May be vital for properties with multiple tenants. Also may address ancillary uses such as parking. The landlord may also have certain rules and regulations that it requires the tenant to observe.
Assignment and Subletting
In Texas, a tenant may not assign a lease or sublet the premises without the landlord's consent (unless provision was made in the lease contract): - An "assignment" is the total transfer of the tenant's rights to another person - These parties are referred to as the assignor and the assignee - The assignee acquires all the right, title, and interest of the assignor, no more and no less - The assignee pays rent to directly to the landlord - However, the assignor remains liable for the performance of the contract unless a release is given by the landlord To "sublet" means to transfer only a portion of the rights held under a lease: - The sublease thereby created may be for a portion of the premises or for part of the lease term - These parties are referred to as the sublessor and the sublessee - The sublessee pays rent to the sublessor who in turn remains liable to the landlord for rent on the entire premises Assignment = Triangular (landlord, tenant (assignor), assignee) Sublease = Linear (landlord, tenant (sublessor), sublessee)
Triple Net (NNN) Leases
In a "triple net" lease, operating expenses are often called "pass- through" expenses, because the landlord passes them through to the tenant in the form of additional rent over and above the base rental rate. If tenant is responsible for some (or all) operating expenses, they may: - Pay them directly (typical in single-tenant properties) - Reimburse landlord (typical in multi-tenant properties) Reimbursements show up in owner's operating statement as (1) expense reimbursement revenue and (2) operating expenses.
The Problem Solved by Intermediaries
In a world where real estate intermediaries did not exist, many problems would be encountered by buyers and sellers: - Search costs - Screening costs - Direct finance - Lack of expertise Information would be very expensive and extremely difficult to obtain. When we do not have full information, bad decisions are made that can lead to market failures. This is known as "information asymmetry"
Tenant's Fixtures
In the context of leasing, the distinction between real and personal property can become very important. Improvements and fixtures (whether or not paid for by the tenant), and by installing these the tenant faces the risk of these items becoming a part of the real estate and revert to the landlord. "Trade fixtures" are items of property that a tenant uses in the conduct of its business and that remain personal property, even though they have the other characteristics of fixtures: - Typically removable items (but removability is only one factor) - Examples: kitchen equipment, shelving, signage - In general, a tenant may remove fixtures if they are trade fixtures - The most important factor in the law of fixtures is intent - The parties' intent can be expressed in the lease The lease agreement should address these risks of tenant and specify (1) its intent in installing, (2) rights of removal, and (3) what happens if abandoned.
Real Estate Intermediaries
Intermediaries: in general, parties that act as a go-between, facilitator or mediator between other parties Real estate intermediaries: facilitate transactions between buyers (tenants) and sellers (landlords) - Do not usually own properties themselves - Paid a fee (often in the form of a commission) for their services - We have already discussed many examples: --Brokers and agents --Appraisers --Data sources --Title companies --Surveyors
Law of Agency and Agents
Law of agency: Governs relationship between an owner (principal) and someone acting on the owner's behalf (agent) - Rights and obligations of agent - Rights and obligations of principal - Potential for abuse - "Fiduciary" relationship - Intended to prevent self-dealing and other conflicts of interest Primary problem: separation of ownership and control
Asset Management
Maximizing value and return = asset management Asset management is a relatively new profession: - Prior to 1970s, institutional investors did not actively invest in commercial real estate - Vast majority of commercial real estate was held by private partnerships (managed by some form of "managing investor") - In the 1970s, institutional investors began investing in commercial real estate These new investment funds transformed commercial real estate markets. A new profession of asset managers (investment advisors) was required to "hold the hands" of institutional investors.
Value of Leases
Like all other real property valuations, lease cash flows are determined by: - Amount - Timing - Risk Is the landlord the only party that realizes value from a lease? Is rent the only consideration? Underwriting tenants: - Financial statements - Credit ratings - Bank relationships - Existing obligations
Industrial Leases
Longest lease length (up to 20 years): - Significant investment from both landlord and tenant - Special modifications for tenant's business (CapEx) - Term reflects need for both parties to recover investments Similar to office leases in structure. Specialized tenants, so leases are more individualized: - Warehouse vs. manufacturing - Space needs - Uses are rapidly changing (ex. Amazon) Most industrial leases are triple-net.
Brokers vs. Agents
Many people unfamiliar with the real estate industry use the terms real estate agent, broker and realtor interchangeably. Agent: - Professional in the industry who has taken and passed a real estate licensing exam - Starting point for most into the real estate field - Agents are sometimes referred to as real estate "associates" - Legally required to work under a licensed broker Broker: - Has (1) continued education past the agent level and (2) obtained a broker's license - Can work independently, or may have other agents working for them Realtor®: - Real estate professional who is a member of the National Association of Realtors (NAR) - Must abide by the association's standards and uphold its code of ethics
Day-to-day operations = Property management
Marketing properties: - Leases must be replenished - Who should market/lease available space? Selecting tenants: - Importance of "willingness and ability to pay" - Tenant mix considerations - Signing leases - Collecting rent - Paying property expenses out of rental income - Repairing and maintaining the property - Maintaining tenant relations
Why leases?
More cost-effective than owning: - Space requirements and cost - Owning is a heavy capital investment - Stay out of the "real estate business" - Maintain operating flexibility...easier to lease new space than to buy - Maintenance and repair - If purchased space is not used, must dispose of excess space This results in specialized real estate functions. The exception is for specialized facilities or headquarter facilities where there are business reasons to own instead of lease.
Commercial Full Service Gross Lease Example
Multi-tenant office building in Lubbock, Texas 4,000 SF Comprised of 10 executive suites of 400 SF each Market rents are $22/SF/year Market Vacancy: 5% of PGI Landlord OpEx: 40% of EGI CapEx: 10% of EGI Full service gross lease structure: - Tenant is only responsible for its interior operating expenses - Landlord is responsible for all other operating expenses - No reimbursements show up on the investors' operating statement
Commercial Net Lease Example: Landlord Reimbursement
Multi-tenant office building in Lubbock, Texas. 4,000 SF Market rents are $17/SF/year Market Vacancy: 5% of PGI OpEx: 40% of EGI*** CapEx: 10% of EGI*** Triple net lease structure: - Tenant is responsible for any operating expenses, and reimburses landlord for them - Landlord initially pays OpEx, but is not ultimately responsible for them - Operating expenses show up on the investors' operating statement as (1) reimbursement revenue and (2) operating expenses When calculating OpEx and CapEx as a percentage of EGI: - Tenant reimbursements are not considered to be part of EGI - Only consider PGI - VCL - Otherwise, would be circular calculations
Licensing of Brokers and Salespersons
Must be licensed to provide any real estate transaction services for others (buying, renting, selling, appraising, leasing, etc.). Two levels of licensure: - Salesperson or Agent: Must work for a broker - Broker: Can operate and own a brokerage agency and employ salespersons Governed by state real estate license law.
Selecting Comparable Sales
Must be properties that prospective buyers would consider substitutes. Should be "arms-length" transactions: - Fairly negotiated prices that occurred under "normal" conditions - Not a distressed sale Select to minimize required physical and locational adjustments. Sources: - Public records (e.g. country tax assessor) - Multiple listing service (MLS) - Private records (title companies, surveyors) - Information companies (CoStar, LoopNet) Importance of personal industry relationships.
Centre Point: Different "Bottom Lines"
NOI: Gross Lease NOI: Net lease with Tenant Direct Payment of OpEx NOI: Net lease with Tenant Reimbursement of OpEx NOI is the same but method of getting there is slightly different depending on whether OpEx are (1) paid directly by tenant or (2) reimbursed to owner.
Managing Corporate Real Estate
Non-real estate companies own more than $2 trillion of commercial real estate assets (corporate offices, etc.). These assets often account for 25 - 40% of total assets on a company's balance sheet. Historically, little effort was spent on managing these assets. Corporations are beginning to pay more attention: - In-house real estate personnel - Asset management consultants
"Modified" or "Full Service" Gross Leases
Not unusual for commercial lease rates to be quoted as "modified" or "full service" gross rates. This is essentially the same as a "gross" lease: - Landlord is responsible for taxes, insurance and maintenance - Tenant is responsible for its own utilities, interior maintenance and janitorial Similar to the residential gross lease arrangement (where tenant is responsible for its own utilities). Typically used for very small commercial spaces (e.g. executive suites).
Commercial Rents
Office, retail and industrial properties typically utilize a triple net lease structure: - Commercial tenants typically responsible for property taxes, insurance and maintenance - If so, a tenant's rental costs cannot be compared just by looking at "base" rent If tenant reimbursements are paid to the landlord, the landlord's "top line" would need to account for operating expense reimbursements. Unless otherwise clearly stated, you can assume that commercial market rents (office, retail, industrial) quotes (e.g. CoStar) are on a triple net basis.
Lease Term
One (1) year leases are common for residential properties. In retail, office, and industrial properties, leases may run from three (3) years to twenty (20) or more years. All else equal, longer lease terms: - Minimize transaction costs - Provide rental rate security for tenant and owner - Decrease tenant and owner flexibility
Real Estate Operating Expenses
Operating expenses (OpEx) of real estate: - Costs associated with the operation and maintenance of an income-producing property - Should include all expenditures required to operate the property and command market rents Most common categories of real estate operating costs: - Property taxes - Insurance - Maintenance (NNN) By default, these costs are the responsibility of the property owner (landlord). However, the responsibility for these expenses is often modified by a contract between the owner (landlord) and occupant (tenant).
Options to Extend
Option clauses give the tenant the right at some future time to lease the property at a pre-determined price - Gives a tenant flexibility - A new business will want a lease that allows an "out'' if the new venture does not succeed but will permit staying if the venture is successful A solution is a lease with options to extend the lease term: - The landlord could offer a one-year lease, plus an option to stay for two more years at a higher rent plus a second option for an additional five years at a still higher rent - If the venture is not successful, the tenant is obligated for only one year - But if successful, he has the option of staying two more years, and if still successful, for five years after that
Nature of a Lease
Originally, a lease was viewed almost as an entire conveyance of the property: - Leases were primarily agricultural - Tenants could find out easily information by inspection (buyer beware) As society became industrialized, courts whittled away at the perceived harshness of the "caveat emptor" doctrine: - Courts began to recognize leases as contracts between landlords and tenants - By doing so, the obligation for certain property conditions shifted from tenants to landlords Now, a lease is viewed as both a conveyance and a contract: - As a conveyance it transfers or conveys rights of possession to the tenant in the form of a leasehold estate - As a contract it establishes legally enforceable provisions for the payment of rent and any other obligations the landlord and tenant have to each other
Gross, Net and Percentage Rent
Our primary focus is on cash flows. The starting point is potential gross income. An investment perspective is that of the landlord (owner) receiving the cash flows. "Gross", "Net" and "Percentage Rent": - Determine the magnitude of the rents - Address ultimate responsibility for expenses (not necessarily who pays or reimburses them)
Types of Accrued Depreciation
Physical deterioration: loss in value due to aging, decay and ordinary use Functional obsolescence: loss in value due to changes in tastes, preferences, technological innovations, or market standards External (economic) obsolescence: loss in value due to changes beyond property boundaries (neighborhood effects) - Increased traffic congestion in area - Decline in desirability of neighborhood Not easy things to estimate.
Income Approach
Rationale: - The value of an asset should be equal to the present value of anticipated income - This reflects "intrinsic" value - Often called "income capitalization" - Capitalize: to convert future income into a present value
Other Industry Designations
Realtor®: Affiliation, through local board, with National Association of Realtors CCIM: Certified Commercial Investment Member SIOR: Society of Industrial and Office Realtors
Texas Licensure
Sales Agent: - Basic license - Anyone who earns a real estate license - Before you can practice as a licensed sales agent you must arrange for a broken to sponsor you as a sales agent Broker: - Four years of active experience as a licensed sales agent - Practical experience - Additional education
Residential Multi-Family Leases
Shortest lease length (usually 1 year): - Tenant desire to maintain flexibility - Market characteristics (number of users, availability of space) drive lease length Consumer protection laws impact risk allocations. Multi-family leases tend to be gross expense structures: - Property taxes, insurance and maintenance paid by landlord - "Interior" expenses (data, electricity) are not operating expenses of the landlord (and are paid by tenants)
Commercial Net Lease Example: Tenant Direct Pay
Single tenant office building in Lubbock, Texas. 4,000 SF Market rents are $17/SF/year Market Vacancy: 5% of PGI OpEx: 40% of EGI*** CapEx: 10% of EGI Triple net lease structure: - Tenant is responsible for all operating expenses, and pays them directly - Landlord is not responsible for any operating expenses - No operating expenses show up on the investors' operating statement Even though the property has operating expenses, they are not reflected on the landlord's operating statement.
Cost Approach
Subject Value Estimate = Cost New - Depreciation + Land Value Depreciation = Accrued Depreciation - Not tax depreciation - Types: ---Physical depreciation ---Functional obsolescence ---External obsolescence - Often estimated by a "straight-line" method Rationale: no informed buyer would pay more for a property than it would cost to build a new one
Statute of Frauds
The "statute of frauds" originated in the Act for Prevention of Frauds and Perjuryes passed by English Parliament in 1677: - Objective was to avoid the misunderstandings and fraudulent activity associated with verbal agreements - Therefore, the act required that written contracts be used for transactions where a large amount of money was at stake All 50 US states have enacted some form of a Statute of Frauds, which generally require that certain types of contracts to be in writing to be legally binding, including: - Any promises made in connection with marriage - Contracts that cannot be completed in less than one year - Contracts for the sale of land - Contracts for the sale of goods above a specific dollar amount (typically $500) The Texas statute of frauds is contained in Tex. Bus. & Com. Code § 26.01.
Why do real estate intermediaries exist?
The characteristics of real estate markets cause market distortions: - Private information - Heterogeneity - Immobility - Information asymmetry - High transaction costs Intermediaries lower transaction costs: - Facilitate the exchange of information (which would otherwise be more difficult and/or costly to obtain ) - Lower search costs by knowledge of private markets - Offer economies of scale as experts in specialized functions (which results in lower average costs)
When is the Income Approach Most Applicable?
The income approach is the favored approach for all commercial real estate valuations. Reflects the "intrinsic" value of the real estate asset. However, not all properties are income producing: - Owner-occupied properties (no rent is paid) - Vacant properties Reliable income and expense data must be available: - Real estate markets are informationally inefficient - Income and expense data is not always accessible and affordable (e.g. CoStar) - Even if it is accessible, it is not always reliable (e.g. LCAD)
Types of Agents
Universal agent: Power to act for principal in ALL matters - Medical documents - Personal agreements - Taxes and other business with govt. - Living arrangements - Insurance General agent: Power to act within limits of a business or employment relationship (can act for principal within a specific business) - Corporate officers - Property managers Special agent: Power to act in a specific event or transaction - Brokers
When is the Sales Comparison Approach Most Applicable?
Think about the characteristics of the market - Properties that are not income producing - Properties in a market with high transaction volume Single-family residential
Market Distortion: Long Time Delays
Time delays due to the length of time it takes to finance, design and construct new supplies of real estate assets: - Relatively slow rate of change of demand - Potential for disequilibrium in the short run Adjustment mechanisms tend to be slow relative to more fluid markets.
Property Management Fees
Typical property management fee? - Usually based on effective gross income (in other words, rent collected) - Range from 5% to 10% of EGI (depends on property type) What about incentive compatibility? How are expenses controlled?
Residential Rents
Typically utilize a gross lease structure. Residential tenants are not typically responsible for property taxes, insurance or maintenance. Residential tenants are typically responsible for its "interior expenses" allocable to their specific unit (electricity, internet, etc.) - Not true "operating expenses" because they do not apply to the property as a whole - Usually noted by a "+" in the rent price A tenant's rental costs can be compared just by looking at "base" rent. The landlord's "bottom line" would need to account for operating expenses. Unless otherwise clearly stated, you can assume that residential market rents quotes (e.g. CoStar) are on a gross basis.
Insurance
Typically, at least two types of insurance are addressed in a lease: - Liability: Insurance for liabilities created in common areas (i.e. mugging) and premises (i.e. slip and fall) - Casualty: Insurance for physical destruction of property The parties should specify what types of insurance each must carry. By doing so, the parties will further allocate these risks (or the costs to insure around them).
OpEx and CapEx Responsibility
Understand the difference between the amount of expenses and the responsibility for them. Responsibility for expenses is ultimately addressed by the lease. However, certain market standards exist: - Tenant is rarely (if ever) responsible for Capital Expenditures - Operating Expenses - Industrial Properties: Typically a "triple-net" lease with tenants responsible for all OpEx - Retail Properties: Typically a "triple-net" lease with tenants responsible for all OpEx - Office Properties: Typically a "triple-net" lease with tenants responsible for all OpEx - Multi-Family Residential: Typically a "gross" lease with landlord responsible for all OpEx
Unique Characteristics of Real Estate Markets
Unique characteristics of real estate: - Durability - Heterogeneity - High transaction costs - Long time delays - Immobility These characteristics cause market distortions. Market distortion: a situation in which prices are determined by forces other than supply and demand In other words, market distortion cause price imperfections.
Example: Sales Comparison Approach
You are valuing a residential property located adjacent to a high speed freeway. Improvements consist of a one-story frame house: - 8 rooms - 2 baths - Total area of 2,000 sq. ft Average quality construction, home is in good condition. Floor plan and finished are standard for the market.
