Chapter 3 Exam Notes

Chapter 3 Exam Notes

Effective Rents Over the Life of a Lease

• Effective Rent:
  • Defined as the average rent payment over the life of a lease.
  • Accounts for rent-free periods, tenant improvement allowances, and other concessions.
  • Useful for comparing individual leasing alternatives to facilitate informed decisions.
  • Method to calculate:
  • Compute the present value of the rent stream.
  • Convert present value to an equivalent level annuity.
  • Evaluate all potential lease alternatives similarly.
  • Understand the return to the lessor and cost to the lessee.

Overage Rent and Percentage Rent

• Percentage Rent:
  • Adjusted based on the tenant’s revenue/sales performance.
  • Includes breakpoints and overage provisions:
  • Base rent is negotiated (flat or step-up), plus a percentage of sales exceeding a specified breakpoint.
  • Overage Rent: Extra rent paid above the base amount triggered by tenant sales performance.
  • If retail revenues decline, rents may revert to base rent.

Types of Leases

• Gross Lease:

  • Tenant pays rent only.
  • Property owner pays all operating expenses.
  • Often referred to as a full-service lease.

• Net Lease:

  • Tenant pays base rent plus some or all operating expenses (e.g., property taxes, insurance, maintenance).
  • Common types include:
  • Single Net Lease (N): Tenant pays some operating expenses.
  • Double Net Lease (NN): Tenant pays property taxes and insurance.
  • Triple Net Lease (NNN): Tenant covers all operating expenses.

Expense Stops

• Expense Stop Provision:
  • Limits the landlord's liability for operating expenses.
  • Landlord pays expenses up to a predetermined limit; tenant pays any overage.

Approaches to Appraisal

1. Cost Approach:
   • Estimate replacement cost of the property.
   • Consider depreciation and add land value.
2. Sales Comparison Approach:
   • Compare similar properties and adjust for differences.
   • Common adjustment variables include financing terms, property rights, and location.
3. Income Capitalization Approach:
   • Direct Capitalization: ext{Value} = rac{ ext{NOI}}{R}
     • Where NOI is Net Operating Income, and R is the capitalization rate.

Capitalization Rates (Cap Rates)

• Defined as the ratio of property value to stabilized NOI:
  R = rac{ ext{NOI}}{ ext{Property Value}}
• Factors affecting cap rates include:
  • Differences in financing, ownership interest, market conditions, and expected future income.
• For built-up cap rate, R = r - g
  • Where r = required return, g = growth rate of NOI.

Net Operating Income (NOI)

• Represents the total income after operating expenses but before debt service and taxes.
• Calculated by:
  ext{NOI} = ext{Effective Gross Income} - ext{Operating Expenses}
• A high cap rate usually correlates with a lower purchase price, while a low cap rate indicates a higher purchase price.

Market Value Definition

• Defined as the most probable price that a property would sell for in an open market:
  • Assumptions include well-informed buyers and sellers, reasonable time for market exposure, and cash consideration.

Debt Coverage Ratio (DCR)

• Defined as:
  ext{DCR} = rac{ ext{NOI}}{ ext{Debt Service}}
• Vital for lenders to assess borrower’s ability to cover debt payments.
• A DCR less than 1 indicates insufficient income to service debt.

Equity and Cash Flows

• Equity Dividend: ext{Equity Dividend} = ext{NOI} - ext{Debt Service}
  • Represents before-tax cash flow from property operations; important for investors.

Depreciation and Tax Rates

• Depreciation can lower the effective tax rate by allowing deductions of taxable income over time despite assets not losing value.

Co-Tenant and Anchor Clauses

• Co-Tenant Clause:
  • Allows tenants to reduce rent or break lease if an essential neighboring tenant leaves.
• Anchor Clause:
  • Protects the status of anchor tenants in a commercial center.

Importance of Appraisals

• Appraisals are conducted to estimate the property’s market value to ensure fair pricing for buyers and sellers and to validate loan amounts for lenders.

Discount Rate in Investments

• The rate used to convert future cash flows to present value; reflects the risk and opportunity cost associated with the investment.
• Higher risks correlate with higher discount rates which result in lower present values.

External and Functional Obsolescence

• Functional Obsolescence:
  • Structural deficiencies, outdated layouts relative to current needs.
• External Obsolescence:
  • Influenced by environmental factors such as traffic congestion, noise pollution, etc.