REAL ESTATE INVESTMENTS PROBLEM SET 2 1. PROBLEM The leases for space in an office building provide for limitations or stops on the lessor s liability for real estate taxes and operating expenses. Each lease requires the lessee to reimburse the lessor on a pro rata basis for any increases in taxes after the first or base year of the lease and for any increases in annual operating expenses in excess of a stipulated amount per square foot. A tenant occupies 20% of the space in the building, which has a total rentable area of 100,000 square feet. Total real estate taxes are expected to be $225,000 during the first year of the tenant s occupancy. The tenant s lease calls for an annual base rental rate of $15 per square foot and a term of five years. Operating expenses during the first year of occupancy are expected to amount to $3 per square foot, and the lease stipulates that any annual operating expenses in excess of $3.50 per square foot will be charged to the tenant as additional rent. Assume that taxes and expenses will escalate at 6% per year. A. Project the total gross revenue, including reimbursements, from the tenant for the term of the lease. B. Show a year-by-year breakdown of base rent and reimbursements, or escalation income. Given lease data as follows: Total rentable area 100,000 sq. ft. Total real estate taxes for Year 1 $225,000 Projected operating expenses for Year 1 $3 per sq. ft. Tenant s leased space 20,000 sq. ft. Lease terms for the tenant $15 per sq. ft. for 5 years plus 1. Any increases in taxes after the first year, and 2. Any increases in annual operating expenses in excess of $3.50 per square foot. 1. SUGGESTED SOLUTION This problem requires the projection of rental income in accordance with the terms of a lease based on assumptions concerning inflation. The most direct way to solve this problem is by developing a spreadsheet or simple table for the tenant as shown below. Note that taxes and expenses are shown to increase at the specified rate. Data Year 1($) Year 2($) Year 3($) Year 4($) Year 5($) a. Base year taxes (20%) b. Current year taxes (20%) c. Expenses per sq. ft. d. Expenses for 20,000 sq. ft. e. Landlord s share @$3.50/sq. ft. Cash Flows 3.00 60,000 47,700 3.18 63,600 50,562 3.37 67,416 53,596 3.57 71,461 56,811 3.79 75,749 f. Excess of (d) over (e), if any none none none 1,461 5,749 g. Base rent of tenant 300,000 300,000 300,000 300,000 300,000 h. Reimb. of taxes (b - a) 2,700 5,562 8,596 11,811 i. Reimb. of expenses (f) 1,461 5,749 j. Total rent of tenant (g+h+i) 300,000 302,700 305,562 310,057 317,560 1. COMMENT Often leases provide clauses or stipulations that limit the liability of the lessor to pay taxes or expenses above a stated amount. The addition of this type of clause spreads the risk of unforeseen increases in taxes and expenses between the tenant and the lessor. The building owner or manager is now able to place a cap on out of pocket expenses and is able to forecast cash flows within a range, thus, he or she is better able to match cash inflows with cash outflows.
2. PROBLEM This problem illustrates the calculation of leased fee value when the rent is based on both a minimum and overage calculations. Pat leased a store unit to Chris for 10 years at $1,600 per month net with payments to be made monthly in advance. The minimum rental is against 7% of gross sales, whichever is greater. Sales have been between $32,000 and $38,000 per month, averaging $35,000 per month. The fee simple overall rate is 10% and the rate to the leased fee, considering monthly compounding, is estimated at 9%. Percentage rentals are discounted at a 15% annual rate. Market rent for this store is $2,100 net per month against 6% of gross sales. The fee simple value of the property is not expected to change over the lease term. A. What is the indicated fee simple value of the property (free and clear of the lease)? B. What is the range in expected rent? C. What is the average expected rent? D. What is the overage rental? E. What is the excess rent due to the lease term? F. What is the value of the leased fee interest? 2. SUGGESTED SOLUTIONS A. What is the market value of the property free and clear of the lease? $2,100 x 12; Value = 25,200/.10 = $252,000 B. What is the range in expected rent? $32,000 x.07 = $2,240 per month $38,000 x.07 = $2,660 per month C. What is the average expected rent? $35,000 x.07 = $2,450 per month D. What is the overage rental? Actual rent based on 7% of average sales Minimum base rent Overage rental E. What is the excess rent due to the lease terms? Expected average rent Less: Market rent Excess Rent $2,450/month 1,600/month $ 850/month $2,450/month 2,100/month $ 350/month F. What is the value of the leased fee estate? The present value of the right to receive $1,600 per month (minimum rent) for 120 months at an effective yield rate of.75 (annual rate, 9%) with payments at the beginning of the month PV = $127,254 plus The present value of the right to receive $10,200 ($850 x 12) per year at a yield rate of 15% for ten years PV = $ 51,191 plus The present value of the reversion of $250,000, 10 years hence at a yield rate of 9% PV = $105,603 Value of leased fee estate = $284,048 say $285,000 Note: Although the timing of the minimum rent is monthly, overage rental is considered to be received at the end of the year. 2
3. PROBLEM This problem illustrates market extraction of leasehold discount rate and application to finding leasehold value. Jones owned a business in a 2,000 square foot store in a shopping center. His 10-year lease was signed four years ago. His rental rate was $9 per square foot net, payable monthly in advance. In addition, as was common in the area, he paid his pro-rata share of taxes, operating expenses, and common area maintenance as additional rent. Because he was retiring and did not want to keep the business, he contacted the center s leasing agent to see if he could get out of his lease. The agent told him that the current rental rate was $13.50 per square foot, and that he could easily sublease the space. The agent also told Jones that last month he had sold the leasehold on a 3,000 square foot store across the highway for $32,000. That store had 4 years to go on the lease, with a rental of $10 per square foot, and the terms were the same as Jones lease. A. What annual yield rate should be applied to Jones leasehold interest, compounded monthly? B. What is the indicated value of Jones leasehold interest? 3. SUGGESTED SOLUTIONS A. What annual yield rate should be applied to Jones leasehold interest? Store across the street: Market rental, 3,000 sq. ft. at $13.50 $40,500 Lease contract rental, 3,000 sq. ft. at $10.00 30,000 Lessee s rental advantage $10,500 $10,500/12 = $875 per month for 48 months Sale Price = $32,000 Solution: 32,000 47 875 =Σ=0 + t (1 i) i = 1.225% Annual rate = 1.225 * 12 = 14.7% (say, 15%) B. What is the indicated value of Jones leasehold interest? t Market rental, 2,000 sq. ft. at $13.50 $27,000 Contract rental, 2,000 sq. ft. at $9.00 18,000 Lessee s rental advantage $ 9,000 $9,000/12 = $750 for 72 months at 15% Present Value with payments in advance is $35,913. 3
4. PROBLEM You are analyzing a four-unit apartment property located on the east side of town. Each unit contains 925 square feet. The building contains 16 rooms and is in average condition. You have concluded that sale price per unit is the appropriate unit of comparison. Your market research indicates comparable sale properties in Table 1. A. Calculate the sale price per unit for each comparable. B. What is the effect of location (east versus west) on sale price? C. What is the trend in prices over time? D. What is the indicated overall capitalization rate, gross income multiplier, and equity dividend rate? E. Using the rent comparable data, what is your estimate of the PGI, EGI, and NOI for the subject property? 4. SUGGESTED SOLUTIONS A. Comp S1 S2 S3 S4 S5 S6 S7 S8 S9 S10 Price/Unit $32,500 $35,000 $25,000 $27,500 $30,000 $31,667 $25,125 $29,167 $24,500 $32,950 B. Location Effect Sale 1 $32,500 Sale 5-30,000 $ 2,500 Sale 4 $27,500 Sale 3-25,000 $ 2,500 Answer: the location effect is about $2,500 per unit with properties on the east side selling for more than the west. C. Time Trend Sale 9 $24,500 675/24,500 = 2.5% Sale 7 25,125 in 6 months $ 675 up in 6 mos. Sale 10 $32,950 450/32,500 = 1.4% Sale 1 32,500 in 3 months $ 450 up in 3 mos. 4
Conclusion: Property prices seem to be increasing about 5% per year. D. Comparable GIM NOI Overall Cap Rate Monthly Loan Payment Equity Div. Rate S1 4.19 $16,000 0.1231 $827 0.1558 S2 4.12 $9,000 0.1286 $437 0.1791 S3 3.85 $12,000 0.1200 $612 0.1862 S4 4.07 $12,000 0.1091 $750 0.1092 S5 4.00 $7,000 0.1167 $374 0.1394 S6 4.42 $22,000 0.1158 $1,162 0.1413 S7 3.72 $13,000 0.1294 $615 0.1865 S8 4.07 $21,000 0.1200 $1,272 0.1638 S9 3.63 $13,000 0.1327 $600 0.1976 S10 4.25 $16,000 0.1214 $822 0.1552 Gross Income Multiplier = Sale Price/EGI Equity Dividend Rate = BTCF/Equity Investment Overall Capitalization Rate = NOI/Sale Price Comparable sales 1 and 10 seem to be the most similar. The indicated overall capitalization rate is about 12% to 12.5%. The indicated GIM is about 4.2 to 4.25. The indicated EDR is about 15%. PGI EGI NOI OER R1 $36,000 $33,840 $15,840 0.5319 R2 $34,800 $33,408 $15,908 0.5238 R3 $52,200 $50,112 $16,112 0.6785 R4 $54,000 $50,760 $16,060 0.6836 R5 $32,640 $30,682 $15,682 0.4889 R6 $36,000 $33,840 $15,840 0.5319 E. The rent per month is somewhere between $725 and $750 At $737, PGI = 737 * 12 * 4 = $35,376 F. If the rent is $750 per month, vacancy should be about 6%, if between $725 and $750 it should be 5%, if $725, then vacancy should be around 4%. Say 5%, EGI = PGI * (1-vac) = $35,376 * (1-.05) = $33,607 Notice that R1, R2, and R6 are the most similar to the subject indicating around 53% operating expense ratio. NOI = EGI * (1-OER) = $33,607 * (1-.53) = $15,795 5
Sale Comp Date of Sale (mos ago) Sale Price # of Units # of Rooms Table 1 Avg. s.f. per unit Location Condition Effective Gross Income Operating Expenses Financing (all monthly payments) S1 4 $130,000 4 16 925 east side average $31,000 $15,000 70%L/V; 25 yr; 10% S2 3 $ 2 8 925 west side good $17,000 $8,000 70%L/V; 25 yr; 9.75% S3 4 $100,000 4 16 925 west side poor $26,000 $14,000 75%L/V; 25 yr; S4 3 $110,000 4 16 925 east side poor $27,000 $15,000 75%L/V; 25 yr; 10% S5 4 $60,000 2 8 925 west side average $15,000 $8,000 70%LV; 25 yr; S6 6 $190,000 6 20 800 east side good $43,000 $21,000 70%L/V; 25 yr; S7 1 $100,500 4 16 925 west side poor $27,000 $14,000 70%L/V; 25 yr; S8 6 $175,000 6 20 800 west side good $43,000 $22,000 80%L/V; 25 yr; 10% S9 7 $98,000 4 16 925 west side poor $27,000 $14,000 70%L/V; 25 yr; S10 1 $131,750 4 16 925 east side average $31,000 $15,000 70%L/V; 25 yr; 9.75% You have also gathered information from the comparable rentals in Table 2. Table 2 Rental Rent/Unit # of Vacancy Avg s.f. Operating Comp /Month Units Rate Location Condition per Unit Expenses R1 $750 4 6% east side average 925 $18,000 R2 $725 4 4% east side average 925 $17,500 R3 $725 6 4% east side average 925 $34,000 R4 $750 6 6% east side average 925 $34,700 R5 $680 4 6% east side poor 925 $15,000 R6 $750 4 6% east side average 925 $18,000 6