Chapter 09 - Income-Producing Properties: Leases, Rents, and the Market for Space 9-1 Solutions to Questions - Chapter 9 Income-Producing Properties: Leases, Rents, and the Market for Space Question 9-1 How does the use of leases shift the risk from lessor to the lessee? Leases determine how much risk will be borne by the lessor versus the lessee. Future increases in market rent are compensated for by including an inflationary adjustment, such as a CPI adjustment. In the case of a CPI adjustment, the risk is shifted to the lessee, because the change in rents is not known in advance. As the lessee is responsible for any unexpected increases in the level of inflation, the lessor is insured that the real value of the lease will be preserved. The lessor can shift additional risk to the lessee by including net lease or expense stop provisions in the lease. It is important to note, however, that we would expect the lessor to accept a lower base rent as the burden of risk is shifted to the lessee. Question 9-2 What is the difference between base rents and effective rents? Base rents reflect rent that will be paid per rentable square foot of leased space. It does not include additional items such as finish out costs, expense pass throughs and other costs that are included when calculating effective rents. Question 9-3 What is meant by usable vs. rentable space? Usable space is the area actually occupied by the tenant. Rentable space is usable space plus a share of common area in a property which is included in the load factor. Question 9-4 What are CAM charges? These are expenses related to common area maintenance of hallways, lobbies, etc. that are usually prorated and passed on to tenants. Question 9-5 What are (a) pass through expenses, (b) recoverable expenses, (c) common area expenses? Give examples of each. Pass throughs are expenses such as electricity, insurance, and property taxes that are billed directly to tenants on the basis of rentable area that they occupy. Recoverables are expenses incurred by owners for specific expenses identified in a lease such as security, maintenance, utilities, etc. and are pro-rated and billed to tenants. Common areas include mallways, parking areas, lobbies, and hallways. Expenses related to these areas are referred to as common area expenses. Question 9-6 What is an estoppel? Why is it used? It is a legal document used in many circumstances. In real estate, it is used by prospective investors to determine factual information with tenants, such as amount of any rent owed, improvements promised by the current owners, etc. Question 9-7 What is meant by "loss to lease"? Many leases reflect market conditions and rents that existed when the lease was executed. Many financial statements estimate gross rental revenue based on (1) all rental space re-leased today at prevailing rents and compare that amount to (2) actual rental revenue based on leases that have been executed at various times in the past. The difference between (1) and (2) is "loss to lease", or the difference between current market rents and rents actually collected based on lease terms with each tenant.Chapter 09 - Income-Producing Properties: Leases, Rents, and the Market for Space 9-2 Solutions to Problems - Chapter 9 Income-Producing Properties: Leases, Rents, and the Market for Space Problem 9-1 a) Discount rate 10.00% I. Net Lease with Steps: Year 1 2 3 4 5 Net Rent $15.00 16.50 18.00 19.50 21.00 Average rent $18.00 Present value $67.15 Effective rent $17.72 II. Net Lease with 100% CPI Adjustment: Year 1 2 3 4 5 Exp. CPI 3.00% 3.00% 3.00% 3.00% Net Rent $16.00 16.48 16.97 17.48 18.01 Average rent $16.99 Present value $64.04 Effective rent $16.89 III. Gross Lease Year 1 2 3 4 5 Gross rent $30.00 $30.00 $30.00 $30.00 $30.00 Less: expenses $9.00 10.00 11.00 12.00 13.00 Net rent 21.00 20.00 19.00 18.00 17.00 Average rent $19.00 Present value $72.74 Effective rent $19.19 IV. Gross Lease with Expense Stop at $9.00 and CPI Adjustment: Year 1 2 3 4 5 Exp. CPI 3.00% 3.00% 3.00% 3.00% Gross rent $22.00 $22.66 $23.34 $24.04 $24.76 Less: expenses $9.00 10.00 11.00 12.00 13.00 Plus: reimbursement 0.00 1.00 2.00 3.00 4.00 Net rent 13.00 13.66 14.34 15.04 15.76 Average rent $14.36 Present value $53.94 Effective rent $14.23 Note: Effective Rent = Present Value / PVIFA, 10%, 5yrsChapter 09 - Income-Producing Properties: Leases, Rents, and the Market for Space 9-3 b) With the first type of lease, the tenant bears the risk of any unexpected change in operation expense. For the lessor, although the lease includes a step-up, higher than anticipated inflation could erode the real value of the rental income. The second alternative includes a CPI adjustment rather than fixed step-ups. The risk of unexpected inflation is shifted to the lessee. The third alternative is a gross lease. This is much riskier for the lessor than any of the net leases. The lessor bears the risk if operating expenses differ from what is expected. The fourth one is a gross lease that combines a CPI adjustment with an expense stop. This shifts the risk of any increases in expenses to the tenant, while retaining any decrease in expenses. Overall, if we rank the alternatives in terms of risk to the lessor, from the least risky to the most risky, the order should be: Gross Lease with Expense Stop and CPI Adjustments, Net Lease with CPI Adjustments, Net Lease with Steps and Gross Lease. That is: 4<2<1<3. c) Based on the analysis in (b), we might expect the effective rents for the four alternatives should exhibit the same order, from the least to the most risky to the lessor: 4<2<1<3. As the results showed in (a), the effective rents for four alternatives do rank the same way. The one with the most risk is also the one that offers the greatest effective rent. Problem 9-2 (a) Total Rentable Area = Gross Area – Interior Area – Common Area 225,000 sq. ft. = 300,000 - 45,000 - 30,000 (b) Load Factor on 7th Floor = Rentable Area / Usable Area 1.12 = 28,000 / 25,000 Common Area on 7th Floor = Rentable Area – Usable Area 3,000 = 28,000 - 25,000 (c) Rentable Area for the Tenant = Usable Area x Load Factor 5,600 sq. ft. = 5,000 x