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Retail
> Shoping Centers
> Determination of Market Rents
> Influence and Importance of Sales, Including Sale of the Subject
> Fee Simple Income Analysis Fundamentals
Shopping Centers
The statistics contained in an analysis
of a retail center should include a collection of factual data and opinions
of market conditions with respect
to the measures of value as illustrated herein and as commonly applied
in real property appraisal. One should seek to compare actual performance
(demonstrated
by the rent roll and accrual operating statement) with market conditions
to
arrive at an opinion of market value as
defined by text in the Texas Property Tax Code and by case law derived
from trials applying these laws. The fee
simple appraisal method is the correct method.
We have created fee simple income
models based on:
- Tenants in place and leases made
- Evaluating the performance
of tenants by a percentage rent analysis.
- Evaluating leases made in the last
year according to market standards and by
analyzing potential non-real estate influences
on rent.
- Measuring occupancy of the subject against published
occupancy reports.
- Configuration of the real property improvements and
an assessment of the relationship of the subject property
to contemporary market standards.
- Size and shape of buildings.
- Adequacy / superadequacy of improvements.
We have applied the following theories to all of our models:
Rents
Fee Simple Rent is
the amount that is paid to lease the real estate and building improvements
with standard market allowances for leasehold improvements,
standard market incentives, and standard market leasing commissions. Any
influences exceeding that of the real estate and related market standards
may be considered intangible, such as:
- Attraction of credit tenants and
anchor stores (the allure of the business influence of these tenants
is not related to the real estate – it is
a business value).
- Attraction of management expertise and ownership
intentions and capabilities.
- Excess TI’s or incentives – in
effect, an amortizing loan to enter the lease.
Occupancy
As rents are rising in a market (timely and/or geographically), occupancy will
decrease and should be constructively realized; for falling rents the inverse
is true.
Operating Expenses
A property that is leased at market standard occupancy operates at market.
A property that is over or under occupied for market standards will realize
expense changes with occupancy changes.
Reserves
Any and every prudent investor/buyer will consider the cost of repairs to maintain
the property as well as the ongoing cost to sustain
and replace the income stream, and will accrue these funds as an operating expense. (In addition
to repairs, it is reasonable to assume a future remodeling expense between
the 15th and 20th year and it is appropriate to accrue those funds.)
Income replacement costs include: tenant improvements, real estate commissions,
legal fees, and such other incentives as free rent, relocation allowances,
and design services.
Capitalization Rate
The effective cap rate should consider the influences of age, condition, location,
and relative market status of the subject but not the influence of creditworthiness
of tenants. Moreover, there must be a balance among rents, occupancy, and
cap rate factors. Highest market rents and occupancy cannot match with lowest
cap rate (there is no upside potential). By deducting the cost of taxes in
operating expenses and adding the tax rate to the cap rate (loading the cap
rate), a fair and accurate analysis is made.
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Determination of Market Rents
In pursuing an equitable assessment by an income and expense evaluation, one
must look at rents more than anything else. We believe that each and every
lease is made for profit. Some leases are more profitable than others. Leases
that earn a profit above a reasonable standard could be considered non-market
for any number of influences.
Shopping Centers provide opportunity for the individual entrepreneur more
than any other type of real estate. By controlling land on which a grocer may
wish to operate, a developer achieves leveraged opportunity. A signed grocery
store lease (at relative minimum profitability) allows the developer to create
a mix of businesses to complement the neighborhood with the grocer as an anchor.
Businesses occupying space in a grocery-anchored center will always pay more
than for space in a strip center.
One can first start to seek the market rent by determining
the net depreciated cost of the improvements and the value of the land as
encumbered by the existing
improvements. The next step is to estimate a reasonable rate of return for
a real estate owner/developer who takes the effort to run a shopping center
business. A sale of a property to an investor who takes the benefit of the
developer/seller’s expertise is an investment sale and is the measure
for capitalization rate in our economy. The difference between the relative
risk level of the developer/seller and the assumed risk level of the investor
buyer is the seller’s profit and reward.
We believe that there is a market standard for the spread between development
risk and investment risk just as there is a standard for cap rate of a specific
class of shopping center developer. For the year 2004 we believe that the spread
is approximately 2-3% and that the market risk level for the net depreciated
value of real estate (cost) is approximately 12%. Thereby, if the net depreciated
value (cost) of a property is $100 per square foot (land and buildings) the
maximum market rent is $12.00.
Another measure of market rent is found with a percentage
rent analysis of the sales of tenants in the center. If a history of tenant
sales can be reviewed
for trends (up or down) and if an appropriate market percentage rent factor
is applied to each (as 1-1.5% for grocers, 6% for a small restaurant) one can
determine the success of the center and the relative success of the developer
and the relative risk interest of an investor. If a grocer is paying $9 rents
and three year’s sales indicate a $6 rent, the rent is not market and
a buyer will not give equal weight to the grocer’s lease. Any percentage
rent which effects a rental rate in excess of fair market rent (reasonable
return on cost) is intangible.
It is unfair and unreasonable to apply the average rent of the center to a
market model for many theoretical reasons, and most importantly because it
is not statistically relevant or accurate.
Example: A 100,000 square foot center has 10 tenants
including a 50,000 square foot grocery store. The grocer pays $6.00 rent,
the 8,000 square foot drug
store $9.00, and the balance of side shops an average of $12.00, for a total
of $876,000 – an average of $8.76. If the grocer goes dark (closes for
whatever reason) not only are the small tenants devastated, but also the average
rent of the center now calculates to $11.52. Applying this average rent in
an analysis implies that the center could lease for that amount when in reality
the grocer’s $6.00 was too high.
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Influence and Importance of Sales, Including Sale of the
Subject
Any commercial property sale which includes rent paying tenants (or
the prospect of leasing to a tenant in hand) is, by the very nature of the
business, a leased
fee sale. In order to define the sale in terms prescribed by the Texas Property
Tax Code (fee simple analysis), it is necessary to take numerous measurements
in order to break down the sale into its fee simple components and intangible
elements. Most of those measurement criteria are virtually impossible to access
and, thereby, reliance on leased fee sales for property tax analysis is inaccurate,
inappropriate, and unnecessary.
Who’s on First: The most important consideration
in any investment sale is the credit of the leases in place. The investor
considers the tenancy
the primary collateral in the transaction, not the real estate.
How’s on Second: The second most important consideration is how the
tenants are doing – are sales meeting industry and individual tenant
standards for success? If sales are too low, clearly there is risk of loss
of tenancy and reason either to not buy or to pay less.
Where’s on Third: Are the boxes which the credit tenants occupy the
contemporary standard which they would seek as of January 1 of the tax year?
Is the store appropriately sized, shaped, and configured; i.e., will they
stay at the end of the lease?
What’s up Last: Finally, the prudent investor looks at the real estate
and the boxes as the partial collateral in the transaction. If some or all
businesses fail, who will occupy the spaces – are the improvements useful
to contemporary credit businesses and what additional investment will be required
to sustain and replace the income stream? To what degree is the current income
stream sustainable by the boxes in place?
A shopping center leased to a credit grocery store
and other similar national credit tenants will exchange at a much lower yield
than the same or a similar
property without the credit. Credit lowers the cap rate by at least one percentage
point and often more than 2%. Credit tenant influence on value is intangible and should be separated from the sale (along with the credit’s influence
on non-credit tenancies and rental rates) to derive the fee simple value.
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Fee Simple Income Analysis Fundamentals
Review of Base Rents, Percentage Rents, Expenses, Reserves (as Expenses)
Identification and Extraction of Intangibles
Base Rent - Market Rent - Fee Simple Basis
The base rent is the rent the tenant pays before any additional rent is paid
(including expense recapture and percentage rents). The base rent should
be a function of the cost of the land and building with a standard market
allowance for tenant improvements. Amounts in excess of a fair return on
cost may be intangible based on the source and influence of the additional
rent (The Appraisal of Real Estate, pp 641-649).
Direct Sources of intangibles
for excess base rent over market standards
- Landlord provides excess tenant
improvement allowance and repayment is a loan repayment. For example,
if the standard allowance is, say, $15
for first
generation space and, say, $5.00 for later terms, and the tenant gets,
say, $25 for 1st or $15 for 2nd generation in a 5 year lease, $2.00 of
the rent
is intangible - $10 excess divided by the term. The rent may also include
use of personal property left in the space or provided by Landlord.
- Rental
Abatements - Term of lease is, say, five years but tenant pays for only
4 1/2 years - 6 mo. free rent Face value of lease rate is, say,
$12 -
effective value of the lease is $10.80.
- Other allowances and fees not
standard such as relocation expenses, construction management.
Indirect
Sources of intangibles for excess base rent over market standards
- Landlord
reputation and wherewithal - Tenant recognizes superiority of landlord
management and experience and is, thereby, willing
to pay more for
stability
of center. Tenant has ongoing relationship with same
owner. This is generally referred to as branding and is widely recognized
(The Appraisal of Real
Estate, 12th Edition).
- Landlord has created a mix of anchors
and complementary businesses to attract shoppers. A property with contracts,
alone, is not
fee simple -
the entrepreneurial
effort that goes into developing a project creates
Business Enterprise Value that must be extracted to get to the real
estate value
(The Appraisal of
Real Estate, Twelfth Edition, page 641).
- Major tenants
spend substantial sums to draw traffic - business of other tenants draws
traffic to location and
therefore
the
business is
the attraction
and not the real estate. Example: Cost of space is
approx. $100 psf - Anchors are paying $8.00 and less for more
expensive space
- subject
space leases
for $18.00 - $6.00 higher than fair return on cost
and $10 more than expensive space.
- Percentage Rents - total
rent tenant pays as a result of business success exceeds market standards.
The base
rent may be lower
than market but the
total rent is in excess of market - one must look
to the demised tenant space, determine
relative cost, and estimate rent based on cost
of space and in comparison with similar spaces.
Expenses
Expenses are not a function of rent - it would be an almost-perfect much more
risk-free business environment if that were true. Expenses are static while
rent is dynamic. Expenses change slightly with occupancy and type of tenant
- as with parking lot maintenance/wear and tear, but most things like security,
utilities, most CAM, and repairs are constant and predictable. The level
of expense should be proportionate to the level of commitment of the owner
to maintain at high quality and to fulfill its obligations to tenants as
promised and expected. To assign expenses as a function of rent or to say
that there is a standard ratio is inaccurate.
Reserves as Expenses
Reserves are unspent expenses which are recurring but not on the same schedule
as other expenses as noted above. This includes the typical reserve for future
repairs such as for the roof, but also considers the 15th- 20th year remodeling
and the annual expenditure of funds to attract and replace tenants - tenant
improvement allowances, real estate leasing commissions, and legal fees.
Tenant Improvements are the most significant portion of this
item and must necessarily be in balance with the rent as scheduled. A higher
rent generally
requires higher TI's and a review of leases in place must necessarily consider
as well the TI paid to gain the rent (notwithstanding the other possible
influences on that face rent).
Commissions and legal fees are recurring with each
transaction. A commission is paid virtually with every lease albeit at varying
rates - between 2% and
8% of the gross consideration of the lease (if paid over the term). From time
to time the tenant has no representation and the lease renews in place - a
possible 2% fee (paid to a passive property manager) but more often than not,
there is a fee paid to the tenant's broker and one to the landlord/property
manager. We believe that the average commission is 4% of the gross consideration.
(Because most commissions in Texas are cashed-out at a 20% discount and financial
analysis is review of annual expenses, a 4% term commission equates to a 3
1/3% cash-out commission – a 4% cash-out commission would be a 5% term
rate.)
Backup Support for Intangibles
The Internal Revenue Service (IRS) has declared that intangibles as a function
of real estate are depreciable at a 15 year life and that REITs can book
up to 22% of their assets as intangible. The Financial Accounting Standards
Board (FASB) in statement 141 has declared that real estate owners must declare
intangibles in order to comply with GAAP. In the Twelfth Edition of the Appraisal
of Real Estate, the text describes the necessity to extract intangibles and
business enterprise value when making appraisals particularly with respect
to tax value analysis (pages 641-649). Dr. Charles Gilliland, Texas A&M
University, in his speech to the Legal Conference in San Antonio in September,
2002, noted "If there is an unusually high return on cost, there is
evidence of intangibles."
The simplest method to identify and extract intangibles is to estimate the
net depreciated cost of the improvements, add the value of the land, and apply
a reasonable rate of return. Any lease exceeding that rate may be intangible
for various influences as noted.
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