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Risk and reasonableness for nonmarket occupancy. (Features).

abstract

Properties may have income that is different from otherwise comparable properties due to above- or below-market leases or below-market occupancy. A common approach to valuing such properties is to begin with the value as if the property were stabilized at market rents. This value must then be adjusted for the present value of the rent differential actually realized by the property. Should this rent differential be discounted at a higher or lower rate than a property at stabilized market rents? As this article will illustrate, the answer is that it depends.

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Anytime the full right of occupancy cannot be transferred with a property due to the presence of tenants, a leased fee estate exists. The impact on value of a leased fee estate becomes meaningful if the contract rent is substantially above or below market rent, or if occupancy is significantly different than stabilized market rents but greater than zero. (1) Such conditions are collectively referred to as nonmarket occupancy. Unlike most appraisal problems, which can ultimately be solved by isolating market behavior, nonmarket occupancy valuation problems usually lack the benefit of empirical evidence. Each condition is inherently unique and, therefore, appraisers--and the market--must rely upon other means for measuring their impact on value.

A common approach to determine the value of a property suffering from nonmarket occupancy is to start with the value as if the property were at stabilized market rents and then adjust for the rent differential due to the nonmarket leases or due to the time until vacant space has been absorbed and leased at market rents. The advantage of this approach is that the "as if stabilized market value" is often much easier to estimate and all three valuation approaches can often be applied, resulting in a reliable value indication for the theoretical fee simple estate. For the reason stated above, it is virtually impossible to independently value a leased fee estate in the sales comparison and cost approaches. Any valuation that relies on only one approach is de facto less reliable than a value derived with two or more approaches. It follows then that if a reliable determination can be made of the "as if stabilized market value" (occupied fee simple), isolating the value attributable to the rent differential will redu ce the opportunity for error in total property value.

Thus, the "as if stabilized market value" often provides a good starting point for estimating the value of a property that has nonmarket income. This value must be adjusted for the present value of the projected rent differential due to whatever is causing the income to be more or less than its stabilized level. This involves two steps. First, there should be an estimate of the rent differential until the property reaches stabilized occupancy or market rents. Second, the rent differential should be discounted at an appropriate rate to find the present value of the rent differential.

But what discount rate should be used for discounting the rent differential? Should the discount rate be higher or lower than the rate that might be used in a discounted cash flow analysis to find the occupied fee simple value? For above-marker rent, also known as "excess rent," (2) we know that greater risk is involved in collecting the rent than would normally be present and, therefore, a discount rate higher than normal is appropriate. (3) For below-market occupancy and below-market rent (collectively referred to as "rent loss"), the answer is not so clear. Should a "safe rate" be used to discount the rent loss? It depends. Not all sources of rent loss should be treated the same way. In some cases the rent loss is less risky and in other cases it is more risky.

The goal of this article is to provide insight into the selection of the discount rate to be applied to the rent differential by looking more carefully at the causes of the difference and theoretical issues that apply in each case.

Case I--Below-Market Rent

Suppose that a property has some existing leases that are significantly below market rates. These leases are expected to roll over to market rents within the next couple of years. There are plenty of comparable properties at market rents so you are comfortable estimating the fee simple value as a starting point. The existing use is considered the highest and best use of the site and the cost approach confirms the fee simple value. Assume that the discount rate for valuing the property with rents at market levels is 12% based on conversations with investors who have purchased similar properties.

What discount rate should be applied to the rent loss? It would be expected that the proper property discount rate ([Y.sub.o]) for this property would be less than 12%. For the isolated rent loss, however, the rate would be higher than 12%. The rent loss is measured as the difference between market rents and the rent from the existing below-market lease. This rent differential is highly dependent on fluctuations in market rents. A decrease (increase) in market rents can result in a significant decrease (increase) in the amount of rent loss. For example, assume market rents are at $20 per square foot and the rent from the existing lease is at $16 per square foot. A $2 decrease in market rents is only a 10% change in market rents, but the rent loss decreases from $4 to $2 or a 50% change. The greater uncertainty associated with the rent loss means a higher discount rate must be applied to it.

Another way to approach this case is to consider the discount rate that would be applied to value the property using its actual rents, which includes the below-market lease. The bad news is that a below-marker lease results in less income. The good news is that there is less uncertainty about getting this income. It is more constant than market rents due to the lease, and if the tenant defaults the space presumably can be leased at the higher market rent. This is completely consistent with the conclusion that the rent loss must be discounted at a higher rate because the discount rate applicable to the property as if it were at stabilized market rents is conceptually a weighted average of the lower rate that would be applicable to the below-market lease and the higher rate applicable to the rent loss.

Exhibit I summarizes the relationship between the discount rates for this market rent scenario. The income loss would be discounted at a higher rate and the actual income from existing leases would be discounted at a lower rate so that the weighted average of these two rates would be the rate applied to the income as if stabilized at market rents. The value of the income as if stabilized at market rent is equal to the value of the actual-below market income from existing leases plus the value of the rent loss. Note that Exhibit I assumes multi-tenancy with the rollover of leases gradually decreasing the income loss.

By way of example, assume a 10,000-square-foot property with projected market net operating income over the next five years of $10.00 per square foot, increasing 2% per year. At the end of the five-year period, the property will be sold based on a 10% capitalization rate. If the appropriate market (occupied fee simple) discount rate is 12%, an indication of value can be obtained as shown in Table 1.

Now assume that the same property is under lease for five years, which generates a net income of $7.25 per square foot, increasing 2% per year. In addition, assume that about 20% of the space rolls over each year and that space is re-leased at market rent. If the risk were the same, then the same discount rate would apply and the property would be valued as in Table 2.

But if all other factors are equal, an investor should view this property as less risky and apply a discount rate to the leased fee position that is less than the fee simple rate. How much less is the question. The danger is in reducing the discount rate to the point that the property is worth more than the fee simple value. This can be avoided by focusing on the rent differential. The uncertainty associated with the rent differential demands a risk premium. This leads to the conclusion that the discount rate associated with the rent differential must be greater than that applied to the market income stream. If in this case a rate of 18% is appropriate, then the value of the rent differential is calculated as shown in Table 3.

The value of the property indicated by this approach is the fee simple value ($1,000,000) less the value of the rent differential ($57,840), or $942,160. Is this a reasonable conclusion? Only if the resultant discount rate for the leased fee estate (internal rate of return) is less than the fee simple rate. This is determined as shown in Table 4.

This indicates that the leased fee estate value produces an 11.811% internal rate of return (IRR), which is less than the 12% fee simple yield rate.

Another way of looking at the risk associated with below-market rent is to approach the problem as if the rates represent the components of a weighted average cost of capital. In this case the leased fee estate represents about 94% of the fee simple value and has a discount rate of 11.811%; the rent differential makes up the remaining 6% of value and has a discount rate of 18%. The weighted average cost of capital can be derived as follows:
Leased Fee Component 94% x 11.811% = 0.111
Rent Differential Component 6% x 18.00% = 0.011

Weighted Average Cost of Capital 0.122


The fact that the weighted average (12.2%) does not precisely equate to the fee simple yield rate (12%) is due to the changing nature of the ratios. But the approximation confirms the relationship and can itself be used as a test of reasonableness.

Case II--Below-Market Occupancy

In this case assume that the property was just renovated, and there is space in the building that is not currently occupied because the space could not be leased during the renovation. (4) Market analysis reveals that the vacant space will be leased at market rents within the next several years. Thus there is currently a rent loss due to above-market vacancy. If all other factors are equal, an investor should view this property as more risky than one fully occupied at market terms. Therefore the discount rate applied to the leased fee should be greater than the fee simple rate. How much greater is the question.

As Case I illustrates an appraiser may feel comfortable estimating the value as if the building were leased at typical market rents and occupancy levels. This allows the leased fee valuation to focus on the rent differential only, thus avoiding the decision about how much to load the fee simple discount rate. Thus the problem is reduced to what rate to use to discount the rent loss due to the above-market vacancy The answer in this case is that the rent loss must be discounted at a lower rate than the fee simple rate, e.g., if as in Case I the discount rate applicable if the property were 12% at stabilized market rents, then the rate applicable to the rent differential (in this case a loss) would be lower than 12%. Why would the rate be lower in this case?

Note that in this case the lower rent is not due to existing leases that provide stability to the rent that is being received from the below-market leases. Rather the rent loss is due to lower than normal occupancy. In Case I it was known when the existing below-market leases would terminate and the uncertainty was the impact of market rent on the leases and lease renewal. In this case how long it will be until the property reaches stabilized occupancy is not known, and there is still uncertainty as to what market rents will be when the property is leased.

Furthermore, consider what might happen if there is an unexpected softening in the market. Not only will this likely result in a longer time to lease the vacant space, but it also means that the likely market rent received when the space is leased will be lower.

Thus, whereas the leased fee income from a below-market lease was less risky and discounted at a lower rate (with a higher rate applied to the rent loss), the leased fee income from existing leases and lease renewals in this case is more risky and must be discounted at a higher rate (with a lower rate applied to the rent loss). The leased fee income is more risky because it includes the future lease income as well as existing income over the absorption period. (5) Since the income from projected lease of vacant space is so uncertain, the total income from existing leases and projected leases is more risky than income as if all the space were already leased at market rents.

What is more difficult to envision in this case is the intuition behind a lower rate applied to the rent loss. It is important to realize that in this case the rent loss does not accrue to any legal or economic interest in the property, as was true in the first case where the rent loss accrued to the tenants or leasehold estate. (6) In this second case no one benefits from the loss in income due to lower occupancy. It is conceivable, however, that a third party would be paid to cover this rent loss. (7) For example, a third-party guarantor would agree to cover any loss in income due to occupancy being less than market occupancy. This is analogous to buying insurance rather than making an investment. You are paying to lower the overall risk of the investment and, therefore, must expect to lower your overall rate of return. The guarantor you pay to incur the rent loss would expect an up-front payment that was equal to the present value of the expected rent loss. The payment amount would be based on discounting of the expected rent loss at a relatively low discount rate to ensure the funds are available to cover the loss when needed. They would be covering the expected rent loss by investing the amount received up front at a conservative or safe rate of return. These funds would have to be in a relatively safe investment in order to be sure the money was available to cover the rent loss. Thus, the interest rate earned on these funds would be relatively low.

Exhibit II summarizes the discount rates for the below-market occupancy case. The point of the discussion above is that in this case the rent loss is discounted at a lower rate and the income based on projected income from occupancy due to existing leases and projected rent-up of space would have to be discounted at a higher rate. The weighted average of these two rates is the one that would apply to the income as if stabilized at market occupancy. The value of the income as if stabilized at market level is equal to the value of the actual income from below market occupancy plus the value of the rent loss. Note that Exhibit II assumes multi-tenancy with the gradual absorption of vacant space and the gradual reduction in the income loss.

Considering the same example in Case I, assume the rent loss was due to below-market occupancy and not due to below-market rents. In addition, assume this time that about 20% of the vacant space will be absorbed each year. The fee simple value would be the same and the rent differential would be the same. However, in this case the rent loss should be discounted at a safe rate of 6%. The valuation of the rent differential would be as shown in Table 5.

In this case the value of the rent loss is $73,084 and thus the indicated value of the leased fee estate is $926,916 ($1,000,000 - 73,084 = $926,916). What does this value say about the leased fee's internal rate of return? This is indicated in Table 6.

The weighted average cost of capital supports the valuation:
Leased Fee Component 93% x 12.234% = 0.114
Rent Differential Component 7% X 6.00% = 0.004

Weighted Average Cost of Capital 0.118


Note that the leased fee income in the above example includes both the income from existing leased space plus the projected income from lease of vacant space (as shown by the rising curve in the middle portion of Exhibit II). The exact rate at which this income will increase as space is leased is relatively uncertain as discussed above.

It may be useful to think of the income from existing leases (prior to new leasing) as about the same risk as if the space was fully leased (fee simple). Because the income from new leasing of space is riskier and must be discounted at a higher rate, the rent differential in Exhibit II must be discounted at a lower rate so that the average of these two rates is about the same as the rate that would be applied to the fee simple estate. Again the conclusion is that the rate must be lower for the rent loss.

Case III--Above-Market Rent

Intuitively we know that a property with above-market rent should be worth more than the same property if it were leased at market terms. Yet greater risk is involved in collecting the rent and, therefore, a higher discount rate is appropriate. How much greater is the question. The danger is in inflating the discount rate to the point that the property is worth less than the fee simple value. As in the other two cases, this can be avoided by focusing on the rent differential.

Exhibit III summarizes the relationship between the discount rates for the above- market rent case. In this case, there is no balance between a high-risk and low-risk condition. The rent differential (income bonus) would be discounted at a higher rate and the actual income itself from existing leases would also be discounted at a higher rate than the fee simple rate. In this case, the weighted average recognizes that the excess rent value must be deducted from the leased fee value to arrive at the fee simple value. The value of the income as if stabilized at market level is equal to the value of the actual above-market income from existing leases, less the value of the bonus rent. The rent differential created by above-market rent is more risky for exactly the same reasons as that created by below-market rents.

Continuing the same example from Case I, assume that the same property is under a five-year lease that generates a net income of $11.90 per square foot, increasing by 2% per year. In this case, rollover of space is ignored. Recognizing that the uncertainty associated with the rent differential demands a risk premium leads to the conclusion that the discount rare associated with the rent differential must be greater than that applied to the market income stream. If in this case a rate 18% is appropriate, then the value of the rent differential is calculated as indicated in Table 7.

The value of the property indicated by this approach is the fee simple value ($1,000,000) plus the value of the rent differential ($61,441), or $1,061,441. Is this a reasonable conclusion? Only if the resultant discount rate for the leased fee estate is greater than the fee simple rate. This is determined as indicated in Table 8.

This indicates that the leased fee estate value produces a 12.245% internal rate of return, which is greater than the 12% fee simple yield rate. The weighted average cost of capital supports the valuation:
Leased For Component 106.1% x 12.245% = 0.1299
Rent Differential Component -6.1% x 18.000% = -0.0110

Weighted Average Cost of Capital 0.1189


Again, the weighted average (11.89%) does not precisely equate to the fee simple yield rate (12%), but the approximation confirms the relationship and can itself be used as a test of reasonableness.

Conclusion

The common problem of valuing a leased fee estate with occupancy characteristics significantly different from the market is often further complicated by the lack of true comparables. Since cash flow discounting is the preferred valuation technique, the lack of empirical evidence on a discount rate is troublesome.

This article shows that the dangers of over- or undervaluing a leased fee estate can be minimized by first focusing on the fee simple (stabilized) value and then adjusting that value to account for the impact of the rent differential. In each of the three cases presented, knowledge of the relationship between the rent differential and the fee simple discount rates assures the proper treatment of the cash flows. This can lead to more reliable and defensible value conclusions. It also provides tests of reasonableness for the discount rate if projected income for the leased fee estate is discounted. The key is to have discount rates for the various income streams that are internally consistent as discussed in this article.
Table 1

Fee Simple Value

Year 1 2 3 4

Market Income $100,000 $102,000 $104,040 $106,121
Reversion
Total Fee Simple Cash Flow $100,000 $102,000 $104,040 $106,121
PV Factor @ 12.00% 1.00000 1.00000 1.00000 1.00000
PV of Cash Flow $100,000 $102,000 $104,040 $106,121
Fee Simple Value $1,624,484

Year 5 6

Market Income $108,243 $110,408
Reversion $1,104,080
Total Fee Simple Cash Flow $1,212,323
PV Factor @ 12.00% 1.00000
PV of Cash Flow $1,212,323
Fee Simple Value

Table 2

Contract Rent Value--Below-Market Rent

Year 1 2 3 4 5

Realized Income $72,500 $79,785 $87,216 $94,795 $102,526
Reversion $1,104,080
Total Leased Cash Flow $72,500 $79,785 $87,216 $94,795 $1,206,606
RV Factor @ 12.00% 0.89286 0.79719 0.71178 0.63552 0.56743
PV of Cash Flow $64,732 $63,604 $62,079 $60,244 $684,661
Indicated Value $935,319

Year 6

Realized Jncome $110,408
Reversion
Total Leased Cash Flow
RV Factor @ 12.00%
PV of Cash Flow
Indicated Value

Table 3

Rent Differential Valuation--Below-Market Rent

Year 1 2 3 4

Market Income $100,000 $102,000 $104,040 $106,121
Realized Income ($72,500) ($79,785) ($87,216) ($94,795)
Difference $27,500 $22,215 $16,824 $11,326
PV Factor @ 18.00% 0.84746 0.71818 0.60863 0.51579
PV of Cash Flow $23,305 $15,954 $10,240 $5,842
Total Present Value $57,840

Year 5 6

Market Income $108,243 $110,408
Realized Income ($102,526)
Difference $5,717
PV Factor @ 18.00% 0.43711
PV of Cash Flow $2,499
Total Present Value

Table 4

Leased Fee Analysis--Below-Market Rent

Target Value: $942,160

Year 1 2 3 4

Realized income $72,500 $79,785 $87,216 $94,795
Reversion
Total Leased Fee Cash Flow $72,500 $79,785 $87,216 $94,795
PV of Cash Flow @ IRR 11.811% $64,841 $63,819 $62,393 $60,651
Concluded Value $942,160

Year 5

Realized income $102,526
Reversion $1,104,080
Total Leased Fee Cash Flow $1,206,606
PV of Cash Flow @ IRR 11.811% $690,455
Concluded Value

Table 5

Real Differential Valuation--Due to Vacancy

Year 1 2 3 4

Market Income $100,000 $102,000 $104,040 $106,121
Realized Income ($72,500) ($79,785) ($87,216) ($94,795)
Difference $27,500 $22,215 $16,824 $11,326
PV Factor @ 6.00% 0.94340 0.89000 0.83962 0.79209
PV of Cash Flow $25,944 %19,771 $14,126 $8,971
Total Present Value $73,084

Year 5 6

Market Income $108,243 $110,408
Realized Income ($102,526)
Difference $5,717
PV Factor @ 6.00% 0.74726
PV of Cash Flow $4,272
Total Present Value

Table 6

Leased Fee Analysis--Below-Market Occupancy

Target Value: $926,916

Year 1 2 3 4

Realized Income $72,500 $79,785 $87,216 $94,795
Reversion
Total Leased Fee Cash Flow $72,500 $79,785 $87,216 $94,795
PV of Cash Flow @ IRR 12.234% $64,597 $63,339 $61,691 $59,743
Concluded Value $926,916

Year 5

Realized Income $102,526
Reversion $1,104,080
Total Leased Fee Cash Flow $1,206,606
PV of Cash Flow @ IRR 12.234% $677,547
Concluded Value

Table 7

Rent Differential Valuation--Above-Market Rent

Year 1 2 3 4 5

Contract Income $119,000 $121,380 $123,808 $126,284 $128,809
Market Rent $100,000 $102,000 $104,040 $106,121 $108,243
Rent Differential $19,000 $19,380 $19,768 $20,163 $20,566
PV Factor @ 18.00% 1.00000 1.00000 1.00000 1.00000 1.00000
PV of Cash Flow $19,000 $19,380 $19,768 $20,163 $20,566
Total Present Value $98,877

Table 8

Leased Fee Analysis--Below-Market Occupancy

Target Value: $1,061,441

Year 1 2 3 4

Realized Income $119,000 $121,380 $123,808 $126,284
Reversion
Total Leased Fee Cash Flow $119,000 $121,380 $123,808 $126,284
PV of Cash Flow @ IRR 12.245% $106,018 $96,342 $87,548 $79,558
Concluded Value $1,061,441

Year 5

Realized Income $128,809
Reversion $1,104,080
Total Leased Fee Cash Flow $1,232,889
PV of Cash Flow @ IRR 12.245% $691,975
Concluded Value


(1.) In this discussion, the vacancy issue for fee simple estate valuation is ignored. The term to describe this might best be "occupied fee simple" since fee simple implies no lease obligations. For further clarification on this issue, see David C. Lennhoff, "Fee Simple? Hardly," The Appraisal Journal (October 1997): 400-402.

(2.) Appraisal Institute, The Appraisal of Real Estate, Appraisal Institute, 12th ed. (Chicago: Appraisal Institute, 2001), 482.

(3.) In theory above-market occupancy can exist and likewise produce a rent differential, e.g., 100% occupancy. Treatment of this situation may be appropriate through an adjustment to the vacancy and credit loss factor after consideration of tenant quality.

(4.) Below-market occupancy also could be attributed to a project being newly developed or due to poor management.

(5.) What is important to realize is that the income from projected leasing of occupied space is what makes this more risky than the case of a below-market lease. The income from existing tenants is relatively certain as discussed in the first case. We thank an anonymous reviewer for pointing out the importance of distinguishing between the risk of existing tenants versus the risk of space absorption in this case.

(6.) The value attributed to a leasehold estate may or may not be the same as the present value of the rent loss so we are not calling this difference a leasehold value in the discussion above. A developer who is selling a project sometimes guarantees that a certain level of occupancy will be achieved or the developer will cover the losses.

(7.) A developer who is selling a project sometimes guarantees that a certain level of occupancy will be achieved or the developer will cover the losses.

Richard L. Parli, MAI, is president of Parli Appraisal, Inc., a full-service real estate appraisal firm in Fairfax, Virginia. He has an MBA in finance from Pennsylvania State University and is the current chief reviewer for Appraisal Institute Course 520, Highest & Best Use and Market Analysis. He is vice chair of the Appraisal Institute's Curriculum Subcommittee and is a member of the review panel for The Appraisal Journal. Contact: (703) 273-6677; email: parliapp@erols.com

Jeffrey D. Fisher, PhD, CRE, is Director of the Center for Real Estate Studies and the Charles H. and Barbara F. Dunn Professor of Real Estate at the Indiana University Kelley School of Business. He is also the Consulting Director of Research and Technology with the National Council of Real Estate Investment Fiduciaries (NCREIF). Fisher has a doctorate in real estate from Ohio State University.

He has published numerous articles in journals such as the Journal of the American Real Estate and Urban Economics Association, The Journal of Real Estate Finance and Economics, Journal of Urban Economics, Journal of Real Estate Research, Journal of Portfolio Management, National Tax Journal, Public Finance Quarterly, The Appraisal Journal, Real Estate Review, The Real Estate Appraiser and Analyst, Real Estate Issues, and Journal of Property Tax Management. Fisher has developed and taught several courses and seminars for the Appraisal Institute, including Course 510, Advanced Income Capitalization and the Internet Search Strategies for Real Estate

Appraisers seminar. Contact: fisher@indiana.edu
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Author:Parli, Richard L.; Fisher, Jeffrey D.
Publication:Appraisal Journal
Geographic Code:1USA
Date:Apr 1, 2003
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