In-Depth Capitalization Rate Review

In-Depth Capitalization Rate Review Leonard J. Patcella, Jr., CMI, MAI President Equity Appraisal Co., Inc. Springhouse, PA jack.equityappraisal@comcast.net David A. Schneider, Esq. Partner Archer & Greiner, P.C. Princeton, NJ dschneider@archerlaw.com

Fee Simple vs. Leased Fee, Impact on Capitalization 2016 IPT s 40 th Annual Property Tax Symposium 2

Fee Simple vs. Leased Fee, Impact on Capitalization RENT ROLL 100 OFFICE DRIVE 10/1/2011 --- Rent Dates --- Annual Annual Annual --- Future Rent Changes --- Base Base Cost Annual Suite ID Tenant Name Start End GLA SF Rent PSF Recovery Date Rent PSF 101 COST OF LIVING 10/1/201110/1/2016 10,000 200,000 20.00 10/1/2012 210,000 21.00 10/1/2013 220,000 22.00 10/1/2014 230,000 23.00 10/1/2015 240,000 24.00 AVERAGE: 220,000 22.00 2016 IPT s 40 th Annual Property Tax Symposium 3

Fee Simple vs. Leased Fee, Impact on Capitalization 40,000 35,000 30,000 25,000 20,000 15,000 INCOME EXPENSES NOI 10,000 5,000 0 1 2 3 4 5 6 7 8 9 10 11 2016 IPT s 40 th Annual Property Tax Symposium 4

Fee Simple vs. Leased Fee, Impact on Capitalization RENT ROLL 100 OFFICE DRIVE 10/1/2011 --- Rent Dates --- Annual Annual Annual --- Future Rent Changes --- Base Base Cost Annual Suite ID Tenant Name Start End GLA SF Rent PSF Recovery Date Rent PSF 101 COST OF LIVING 10/1/201110/1/2016 10,000 200,000 20.00 10/1/2012 210,000 21.00 10/1/2013 220,000 22.00 10/1/2014 230,000 23.00 10/1/2015 240,000 24.00 AVERAGE: 220,000 22.00 Note: PV at 3% annual rate for cost of living = $20.07 PSF 2016 IPT s 40 th Annual Property Tax Symposium 5

Fee Simple vs. Leased Fee, Impact on Capitalization 2016 IPT s 40 th Annual Property Tax Symposium 6

Fee Simple vs. Leased Fee, Impact on Capitalization RENT ROLL 100 OFFICE DRIVE 10/1/2011 --- Rent Dates --- Annual Annual Annual --- Future Rent Changes --- Base Base Cost Annual Suite ID Tenant Name Start End GLA SF Rent PSF Recovery Date Rent PSF 102 1 YEAR FREE (2010) 10/1/2010 10/1/2015 10,000 260,000 26.00 10/1/2012 270,000 27.00 10/1/2013 280,000 28.00 10/1/2014 290,000 29.00 AVERAGE: 275,000 27.50 AVG w/ FREE: 220,000 22.00 2016 IPT s 40 th Annual Property Tax Symposium 7

Fee Simple vs. Leased Fee, Impact on Capitalization RENT ROLL 100 OFFICE DRIVE 10/1/2011 --- Rent Dates --- Annual Annual Annual --- Future Rent Changes --- Suite ID Tenant Name Start End GLA SF Base Rent Base PSF Cost Recovery Date Annual Rent PSF 103 $25 ABOVE MKT. T.I. 10/1/201110/1/2016 10,000 250,000 25.00 10/1/2012 260,000 26.00 10/1/2013 270,000 27.00 10/1/2014 280,000 28.00 10/1/2015 290,000 29.00 AVERAGE: 270,000 27.00 AVG - T.I.: 220,000 22.00 2016 IPT s 40 th Annual Property Tax Symposium 8

Fee Simple vs. Leased Fee, Impact on Capitalization RENT ROLL 100 OFFICE DRIVE 10/1/2011 Suite ID Tenant Name Start End GLA SF --- Rent Dates --- Annual Annual Incr./Base Yr. --- Future Rent Changes --- Base Base Cost Rent PSF Recovery Date Annual Rent PSF Total PSF - 10/1/2007 200,000 20.00 20.00 0.50 10/1/2008 205,000 20.50 21.00 1.00 10/1/2009 210,000 21.00 22.00 1.50 10/1/2010 215,000 21.50 23.00 105 OLD LEASE w/ EXP. 10/1/2007 10/1/2012 10,000 220,000 22.00 2.00 24.00 INCR. OVER BASE 2.50 10/1/2012 225,000 22.50 25.00 2016 IPT s 40 th Annual Property Tax Symposium 9

Fee Simple vs. Leased Fee, Impact on Capitalization 40,000 35,000 30,000 25,000 20,000 15,000 INCOME EXPENSES NOI 10,000 5,000 0 1 2 3 4 5 6 7 8 9 10 11 2016 IPT s 40 th Annual Property Tax Symposium 10

Query: Should the following be taken as expenses to derive the NOI to be capitalized? leasing commissions tenant improvements reserves for replacements Issues: - Capital improvements? - Below the line expenses? 2016 IPT s 40 th Annual Property Tax Symposium 11

2016 IPT s 40 th Annual Property Tax Symposium 12

Pine Plaza Associates, L.L.C. v. Hanover Tp., 16 N.J. Tax 194, 209-210 (Tax 1996) ( Tenant improvement costs incurred by the landlord may be either capital expenditures or operating expenses. If the proofs establish that, in the relevant market, landlords customarily and regularly incur such costs, then deduction of such costs as an operating expense is appropriate. ) 2016 IPT s 40 th Annual Property Tax Symposium 13

Assumptions Market rent 15 Net Tenant improvements Term 5 Years New $25 PSF Renewal $5 PSF Taxpayer Taxing District Rent SF Rent SF Potential Gross Income 15.00 100,000 1,500,000 15.00 100,000 1,500,000 Vacancy & Collection Loss 10.0% 150,000 10.0% 150,000 Effective Gross Income 1,350,000 1,350,000 Expenses Management 3.0% 40,500 3.0% 40,500 Leasing 5.0% 67,500 0.0% - Tenant improvements $3.00 300,000 $0.00 - Building reserves $0.30 30,000 $0.30 30,000 Total Expenses 438,000 70,500 Net Operating Income 912,000 1,279,500 Capitalization Rate 8.00% 8.00% Indicated Value 11,400,000 16,000,000 2016 IPT s 40 th Annual Property Tax Symposium 14

Taxing District Rent SF Potential Gross Income 15.00 100,000 1,500,000 Vacancy & Collection Loss 10.0% 150,000 Effective Gross Income 1,350,000 Expenses Management 3.0% 40,500 Leasing 0.0% - Tenant improvements $0.00 - Building reserves $0.30 30,000 Total expenses 70,500 Net Operating Income 1,279,500 Capitalization Rate 8.00% Indicated Value 16,000,000 2016 IPT s 40 th Annual Property Tax Symposium 15

Taxing District Taxing District Return w/ Lsg., TI Rent SF Rent SF Potential Gross Income 15.00 100,000 1,500,000 15.00 100,000 1,500,000 Vacancy & Collection Loss 10.0% 150,000 10.0% 150,000 Effective Gross Income 1,350,000 1,350,000 Expenses Management 3.0% 40,500 3.0% 40,500 Leasing 0.0% - 5.0% 67,500 Tenant improvements $0.00 - $3.00 300,000 Building reserves $0.30 30,000 $0.30 30,000 Total Expenses 70,500 438,000 Net Operating Income 1,279,500 912,000 Capitalization Rate 8.00% Indicated Value 16,000,000 2016 IPT s 40 th Annual Property Tax Symposium 16

Taxing District Taxing District Return w/ Lsg., TI Rent SF Rent SF Potential Gross Income 15.00 100,000 1,500,000 15.00 100,000 1,500,000 Vacancy & Collection Loss 10.0% 150,000 10.0% 150,000 Effective Gross Income 1,350,000 1,350,000 Expenses Management 3.0% 40,500 3.0% 40,500 Leasing 0.0% - 5.0% 67,500 Tenant improvements $0.00 - $3.00 300,000 Building reserves $0.30 30,000 $0.30 30,000 Total Expenses 70,500 438,000 Net Operating Income 1,279,500 912,000 Capitalization Rate (solve for 2 nd ) 8.00% Indicated Value 16,000,000 16,000,000 2016 IPT s 40 th Annual Property Tax Symposium 17

Taxing District Taxing District Return w/ Lsg., TI Rent SF Rent SF Potential Gross Income 15.00 100,000 1,500,000 15.00 100,000 1,500,000 Vacancy & Collection Loss 10.0% 150,000 10.0% 150,000 Effective Gross Income 1,350,000 1,350,000 Expenses Management 3.0% 40,500 3.0% 40,500 Leasing 0.0% - 5.0% 67,500 Tenant improvements $0.00 - $3.00 300,000 Building reserves $0.30 30,000 $0.30 30,000 Total Expenses 70,500 438,000 Net Operating Income 1,279,500 912,000 Capitalization Rate (solve for 2 nd ) 8.00% 5.70% Indicated Value 16,000,000 16,000,000 2016 IPT s 40 th Annual Property Tax Symposium 18

Parameters Mortgage Information Equity Dividend Rate -1.06% Amortization Period 20 Loan to Value Ratio 70.00% Amortization Method Monthly Holding Period (Years) 20 Number of Periods 240 Interest Rate 6.00% Mortgage Constant 8.60% Mortgage/Equity Band of Investment Mortgage Portion Mortgage Constant Product 70.00% x 8.60% = 0.0602 Equity Portion Equity Dividend Rate 30.00% x -1.06% = -0.0032 Weighted Rate = 0.0570 2016 IPT s 40 th Annual Property Tax Symposium 19

Assumptions Market rent 15 Net Tenant improvements Term 5 Years New $25 PSF Renewal $5 PSF Taxpayer Taxing District Rent SF Rent SF Potential Gross Income 15.00 100,000 1,500,000 15.00 100,000 1,500,000 Vacancy & Collection Loss 10.0% 150,000 10.0% 150,000 Effective Gross Income 1,350,000 1,350,000 Expenses Management 3.0% 40,500 3.0% 40,500 Leasing 5.0% 67,500 0.0% - Tenant improvements $3.00 300,000 $0.00 - Building reserves $0.30 30,000 $0.30 30,000 Total Expenses 438,000 70,500 Net Operating Income 912,000 1,279,500 Capitalization Rate 8.00% 8.00% Indicated Value 11,400,000 16,000,000 2016 IPT s 40 th Annual Property Tax Symposium 20

DISCOUNTED CASH FLOW ANALYSIS Indicated Value 11,503,731 100,000 SF Estimated Yield (IRR) 10.00% CASH FLOWS: Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Gross Income: $1,500,000 $1,545,000 $1,591,350 $1,639,091 $1,688,263 $1,738,911 $1,791,078 $1,844,811 $1,900,155 $1,957,160 $2,015,875 Occupancy Ratio 90.00% 90.00% 90.00% 90.00% 90.00% 90.00% 90.00% 90.00% 90.00% 90.00% 90.00% = Effective Gross Inc.: $1,350,000 $1,390,500 $1,432,215 $1,475,181 $1,519,437 $1,565,020 $1,611,971 $1,660,330 $1,710,140 $1,761,444 $1,814,287 * Management: 3.00% 40,500 41,715 42,966 44,255 45,583 46,951 48,359 49,810 51,304 52,843 54,429 * Leasing: 5.00% 67,500 69,525 71,611 73,759 75,972 78,251 80,599 83,016 85,507 88,072 90,714 * TI: $ 3.00 300,000 309,000 318,270 327,818 337,653 347,782 358,216 368,962 380,031 391,432 403,175 * Reserve: $ 0.30 30,000 30,900 31,827 32,782 33,765 34,778 35,822 36,896 38,003 39,143 40,317 Less Expenses: 438,000 451,140 464,674 478,614 492,973 507,762 522,995 538,685 554,845 571,491 588,635 = Net Operating Inc.: $912,000 $939,360 $967,541 $996,567 $1,026,464 $1,057,258 $1,088,976 $1,121,645 $1,155,294 $1,189,953 $1,225,652 INCOME & MARKET DATA: MORTGAGE TERMS: RESALE DATA: Req. Yield Rate (IRR) 10.00% Term (Years) 25 Net Income In Year 11 $1,225,652 (all cash) Interest Rate 6.50% Terminal Cap Rate 8.50% Ave. Ann. Incr. in P.G.I. 3.05% Debt Coverage Ratio (after 1st year) 1.44 Resale Price $14,419,432 Ave. Ann. Incr. in Exp. 3.05% Annual Debt Service ($652,462) (11th Year NOI/Terminal Cap Rate) Ave. Ann. Incr. - N.O.I. 3.05% Max. Mortgage Amount $8,052,611 Less Sales Costs @ 6.00% $865,166 Terminal Cap Rate 8.50% Loan to Value Ratio 70.00% = Net Sale Proceeds $13,554,266 Going in Cap Rate (calc.) 7.93% Mortgage Balance After 10 Years $6,241,689 Less Mortgage Balance $6,241,689 Equity Divided Rate Year 1 7.52% = Before Tax Reversion $7,312,578 2016 IPT s 40 th Annual Property Tax Symposium 21

Assumptions Market rent 15 Net Tenant improvements Term 5 Years New $25 PSF Renewal $5 PSF Taxpayer Taxing District Rent SF Rent SF Potential Gross Income 15.00 100,000 1,500,000 15.00 100,000 1,500,000 Vacancy & Collection Loss 10.0% 150,000 10.0% 150,000 Effective Gross Income 1,350,000 1,350,000 Expenses Management 3.0% 40,500 3.0% 40,500 Leasing 5.0% 67,500 0.0% - Tenant improvements $3.00 300,000 $0.00 - Building reserves $0.30 30,000 $0.30 30,000 Total Expenses 438,000 70,500 Net Operating Income 912,000 1,279,500 Capitalization Rate 8.00% 8.00% Indicated Value 11,400,000 16,000,000 LESS: - Leasing comm. ($75,000/yr. x 10 yrs.) 750,000 - TI Cost ($30/SF x 10 yrs.) 3,000,000 Indicated value reflecting stabilized lease-up costs (ignoring PV) 12,250,000 2016 IPT s 40 th Annual Property Tax Symposium 22

2016 IPT s 40 th Annual Property Tax Symposium 23

PWC Survey 3 Definitions of NOI Effective Gross Income - Operating Expenses (2) NOI before reserves, leasing commissions & TI - Reserves (1) NOI after reserves, before leasing commissions & TI - Leasing commissions & TI (3) NOI after reserves, leasing commissions & TI The Elusive Definitions of NOI and OAR, Francis, J., THE APPRAISAL JOURNAL, January 1998 at 56. 2016 IPT s 40 th Annual Property Tax Symposium 24

OVERALL CAP RATE, 3 RD QUARTER 2011 Low Average High Phila., PA 7.50% 8.62% 10.00% (3) (2) 2016 IPT s 40 th Annual Property Tax Symposium 25

American Cyanamid Co. v. Wayne Tp., 17 N.J.Tax 542, 576 (Tax 1998): Defendant's appraiser testified that such [tenant improvement] costs... are built into the capitalization rate. Even if he were correct in theory, the appraiser failed to demonstrate that the data upon which he (or plaintiff's appraiser) relied in selecting a capitalization rate included a factor related to tenant improvement costs. 2016 IPT s 40 th Annual Property Tax Symposium 26

Conclusion Capitalization rate considerations? Rent levels, expenses and leasing costs Risk of obtaining projected income Techniques to refute erroneous cap rates 2016 IPT s 40 th Annual Property Tax Symposium 27