# Using present-value analysis to evaluate lease proposals.

One of the most difficult decisions a property manager has to make is deciding when to accept or reject a lease, particularly in a soft market. This article will attempt to frame this decision in the context of straightforward present value analysis and common sense decision rules.

Basics of present value analysis You do not have to be a financial wizard to understand the basics of present value analysis. We all know that a dollar today is worth more than the promise of a dollar in the future. That assumption is the basis of present value calculations.

Today's calculators can make just about any present value computation imaginable. However, this article will use present value factors (see box at right) which were popular be advent of the calculator.

The two most common computations that a manager will need to make are:

* Converting a stream of periodic (usually monthly) payments into a present value.

* Taking a present value and converting it into a stream of periodic payments. (This is simply the reverse process of the above.)

The first step in present value analysis is choosing a discount rate. Conceptually, the discount rate should be the rate of earnings the property owner would realize from other investments. Therefore, we use this alternative earnings rate to discount cash flows and to provide apples-to-apples comparisons of cash spent or received at different points in time.

For the purpose of this article, a nominal annual rate of 12 percent, or a monthly rate of 1 percent, will be used to discount cash flows.

Computing net effective rent The first step in making any type of decision on a proposed lease is to calculate the net effective rent, after giving consideration to the value of any free rent concessions made or dollars spent in preparing the space for the proposed tenant.

In calculating the values of a rent concession, the first step is to convert the monthly concession into a present value. If the nominal building rent is \$24 per square foot per year, or \$2.00 psf per month, and if the leasing agent has proposed 6 months free rent, the monthly rent figure of \$2.00 psf is multiplied by the present value factor of \$1.00 per period to get the present value of this concession. With an interest rate of 1 percent per month, the factor for 6 months would be 5.795. Multiplying the factor by \$2.00 gives us a present value of 11.59 psf for this rental concession.

It is important to note that in the case of allowances for tenant improvements or actual money spent in improving a suite, there is usually no need to make a calculation of this sort. The money is spent up front and therefore already is in present value.

Converting to an income stream

The reverse of this process expresses the present value as a periodic monthly payment, amortized over the proposed lease term. Two rules of thumb to keep in mind are:

* The longer the lease term, the less significant any upfront concession.

The higher the discount rate, the more significant the value of any upfront concession.

Using the figures from the earlier example, we have a rent concession with a present value of 11.59 psf. If the lease term is three years, we must determine the periodic payment factor necessary to pay off a "loan" of \$1.00. At 1 percent per month interest, the factor for a three-year lease is .0332. Multiply this factor times \$11.95 to get a figure of \$.38 per month.

Giving up 6 months of free rent when the nominal building rent is \$2.00 psf and the proposed lease term is 36 months has a value of \$.38 per month. Deducting this amount from the nominal rent of \$2.00 psf leaves a net effective rent of \$1.62 psf per month, or \$19.38 psf when stated on an annual basis.

Comparing net effective rent to cost

The next step in the analysis is to compare the net effective rent with the total cost of operating the space.

Total cost includes fixed costs, such as mortgage payments and property taxes, as well as variable costs. If a building is almost fully leased, the simplest way to determine these costs would be to look at the prior year's income statement, perhaps apply some sort of inflation factor to variable costs, and divide the total costs by the rentable area of the building.

If the building is not fully leased, you will probably need to spend more time in analyzing what your variable costs psf would be. If you have no operating history, then you can use the expense figures published in either BOMAs Experience Exchange Report or IREM's Income/Expense Analysis.

For the sake of this example, assume that fixed costs amount to \$10 psf and variable costs are \$8.00 psf, for a total cost of \$18.00 psf.

These costs would produce a profit of \$1.38 per square foot, for the net effective rent of \$19.38 psf in our example. Will we take this deal? Chances are we will. If the proposed rent is in line with market rents, then it would be very difficult to pass up a deal which has a net effective rent which exceeds total costs. Space is a perishable asset. Every day it is not rented, the income you could earn is lost. So in this scenario, the decision is relatively easy.

However, if net effective rental is so low that it does not even cover variable costs psf, then we would be foolish to rent the space, as less money would be lost by letting the space sit vacant. The only exception might be a special tenant which would draw in other tenants and therefore have value beyond the dollars and cents of the particular lease. But for purposes of this article, assume that there are no such factors. If net effective rent is less than variable costs, chances are you want to pass up the deal.

Cost of taking a bad deal

The difficult decision comes when proposed net effective rent is greater than variable costs, but less than total costs. If this deal is accepted the costs of operating are covered, and some contribution is made towards fixed expenses.

However, by accepting this deal, the manager is effectively locking in a loss over the lease term. The other side of the equation is that if space sits vacant, it will generate no income but will still incur mortgage payments and taxes.

The key in making this decision is to compare the loss associated with signing such a lease versus the expected loss of letting the space sit vacant. The first question is whether market conditions favor the likelihood of a better deal. To evaluate this, we need to analyze the existing building inventory, scheduled construction, and absorption rates to estimate how long it would take to get a break-even deal.

For the sake of example, assume our best guess is that the market will tighten up in 6 months. Also for the sake of example, assume annual fixed costs are not \$10 psf as previously assumed, but are \$16 psf, so that our total annual costs are \$24 psf. If so, then the proposed deal, which had a net effective rental of \$19.38 psf, per year, will lose us money over the lease term. On an annual basis, the loss will be \$4.62 psf. On a monthly basis, it will be \$.385 psf.

By accepting the proposal, the manager would lose \$.385 psf for a term of 36 months. The 1-percent factor to convert a periodic payment for 36 months into a present value is 30.108. Multiply this times the monthly loss of \$.38 psf, and you get a present value loss of 11.59 psf by accepting this deal.

To make this decision, we must evaluate the fixed costs the property will incur for 6 months without any income. Fixed cost psf amounts to \$16 per year; on a monthly basis this is \$1.33. This amount is calculated by multiplying the uncovered fixed costs per month times the present value factor for \$1 per period for 6 periods of 5.795, giving us a present value of 773.

If the market is such that a break-even deal is likely in 6 months, then the manager is better off taking a chance and passing on the proposed lease deal. In this way the property will only lose 773 in present value terms, whereas by taking the deal, the manager will be locking in a \$11.59 loss. This method of analysis may also be used to determine how many months an owner could wait. for a break-even deal and be no worse off than from taking the below-cost net effective rental rate. For example, the proposed deal above for a 36-month term would translate into a present value loss of 11.59 psf. The equation to use is: loss per month x present value factor = present value of loss.

If the space remains vacant, the loss per month will be the fixed costs psf, which in this case are \$1.33 psf. The present value (PV) of accepting the earlier lease proposal is 11.59 psf. \$1.33 times the PV factor equals 11.59. We divide both sides of the equation by 1.33, and we get a PV factor of 8.71. \$1.33 loss per month times the 8.71 PV factor equals 11.59.

Now look at the present value of \$1.00 per period factors at 1 percent per month and find which factor comes closest to 8.71. The factor for 9 months is 8.566. Thus the manager can afford to wait about 9 months with the space vacant in order to get a break-even deal and be no worse off than accepting the proposed lease deal which locks in a loss of 11.59 psf over 36 months.

Conclusion

Having gone through this hypothetical example, it is clear that there will always be other factors a property manager must consider when deciding whether or not to accept a lease. This application of present value analysis is useful because it gives the property manager an objective way of evaluating what all too frequently is a subjective decision.

Michael Fasano, CPM[R] heads his own consulting practice in the Washington, D.C. area. His client list includes the Senate Public Works Committee, Trans-Union Corporation, and Southwest Realty Advisors. He began his business career at the White House Off ice of Management and Budget, where he was responsible for program review and budget approval of the GSA's 300-million-square-foot federal space inventory. At GenCorp, Inc. (formerly the General Tire and Rubber Company), he served as investment advisor in managing its \$1.7 billion in pension fund assets.

Mr Fasano teaches a graduate-level course in property management at the University of Maryland, College Park, and has spoken at numerous industry seminars. His articles have appeared in Real Estate Review, Pension & Investment Age, and Best's Review He holds a B.A. degree from Northwestern University and an M.A. degree from the University of Wisconsin, Madison.
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