CCIM CI 103

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CCIM NEW DESIGN TION CURRICULUM

Enhance your career, deepen your knowledge, and be better equipped for today’smarket with CCIM’s new, evolved courses.

CI 101 – Financial Analysis

for Commercial Investment Real Estate Make better investment decisions by using the CCIM Cash Flow Model as a framework for real estate

analysis.

Apply state-of-the-art real estate analysis tools to quantify investment return.

Measure the impact of federal taxation and financial leverage on the cash flow from acquisition,

ownership, and disposition phases of real estate investment.

CI 102 – Market Analysis

for Commercial Investment Real Estate Apply the CCIM Strategic Analysis Model to make a “go” or “no -go” investment decision.

Use state-of-the-art geospatial technology for strategic analyses.

Examine real-world case studies of comprehensive strategic analyses for each of the four

major property types: office, industrial, multifamily, and retail.

Preparing to Negotiate (online, self-paced course) Apply the CCIM Interest-Based Communications/Negotiations Model to your negotiations

and presentations.

Interpret CCIM Interest Analysis Chart elements, and consider creative solutions for identified

interests and issues.

Assess risks and action plans for potential conflicts.

CI 103 – User Decision Analysisfor Commercial Investment Real Estate

Apply key occupancy decision-making skills such as comparative lease analysis, lease vs. purchase

analysis, lease buyout analysis, and sale-leaseback analysis to optimize user space decisions.

Determine how financial reporting requirements for real estate influences user decisions.

Integrate negotiation skills with financial analysis skills to maximize user outcomes.

CI 104 – Investment Analysis

for Commercial Investment Real Estate

Apply key investor decision-making analyses to optimize investment returns.

More effectively forecast investment performance by quantifying real estate risk.

Leverage CCIM analytical tools to improve decision-making.

For the most up to date course schedule and to register for a course,visit www.ccim.com/course/catalog or call (800) 621-7027, ext. 3100.

7/23/2019 CCIM CI 103


CCIM DESIGN TION ND INSTITUTE MEMBERSHIP

Joining the CCIM Institute and earning the coveted CCIM Designation equips you toface the challenges of the commercial real estate market.

CCIM Institute Member Benefits

Commercial Investment Real Estate (CIRE) Magazine CCIM’s award-winning magazine is your bi-monthly source for the latest articles,

analysis, and insight into all facets of commercial investment real estate.

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For a complete list of CCIM Institute member benefits and to join, visit www.ccim.com/membership.

Earning the CCIM Designation To earn the coveted CCIM Designation you must:

Become a Candidate of the Institute

Successfully complete the designation courses

Successfully complete the CCIM Online Ethics Course

Earn elective credits

Submit the Portfolio of Qualifying Experience

Successfully pass the Comprehensive Exam

For complete details and updated information on earning the CCIM designation,visit www.ccim.com/membership or call (800) 621-7027, ext. 3100.

7/23/2019 CCIM CI 103


User Decision Analysis for Commercial Investment Real Estate

In This Section Welcome Letter ....................................................... i

Course Material ...................................................... ii

Table of Icons ......................................................... ii

Table of Contents………………………………. TOC iIntroduction

CI 103

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© Copyright 2011 by the CCIM Institute

All rights reserved•

Revision date 05/11

7/23/2019 CCIM CI 103


User Decision for Commercial Investment Real Estate• i

C o n t e n t s

Welcome

Dear Student:

The CCIM Institute welcomes you to the CI 103 course, User Decision

Analysis for Commercial Investment Real Estate .

This course is designed to give you a thorough understanding of financialanalysis tools, concepts, and calculations. It provides you with the foundation

you will need to take subsequent CCIM courses. The course material consists

of three components—a reference manual, CD-ROM, and an in-class exam.

Each component is described later in this section.

To receive the maximum benefit from this course, students are advised to

complete all practice problems and actively participate in classroom activities.

This course is designed to be interactive, so student discussion and questions

are welcomed.

Students seeking the Certified Commercial Investment Member (CCIM)designation are required to successfully complete the final exam under the

supervision of the instructor(s).

Students seeking only continuing education credit are required to complete the

State Continuing Education Request Form (available from the instructor) and

may be required to successfully complete the exam, depending on their state’s

regulations.

Please remember that the classroom is a nonsmoking environment. Also,

inappropriate behavior will not be tolerated. Offenders will be asked to leave

the course immediately and will forfeit their tuition.

If you have any questions during the course regarding the CCIM program or

courses, do not hesitate to ask either an instructor or the Institute’s on-site

administrator. Enjoy the course.

CCIM Institute

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ii• User Decision Analysis for Commercial Investment Real Estate

Course Material

All Institute courses are designed to ensure a highly effective learning

experience. This course consists of the following components:

Reference Manual

The reference manual is designed to be used as an in-class textbook and an

after-class reference tool. This manual includes conceptual material,

calculations, examples, and activities. The activities are real-life real estate

scenarios that require application of the skills, calculations, and theories

presented in each course module.

CD-ROM

The CD-ROM contains Excel spreadsheets and other tools that students can

use to solve course activities and tasks.

In-Class Exam

The course ends with an in-class exam to test particular skills taught throughout

the course. It is multiple-choice and open-book. The exam is formatted in the

same manner as the self-assessment questions at the end of each module.

Information from the reference manual will be on the exam. (Students taking

the course for continuing education credit in Illinois also must take a closed-

book exam.)

Table of Icons

Included throughout the reference manual are the following icons to help you

identify particular sections or concepts in the course material:

Activity Instructor

Demonstration /

Sample Problem

Material found on

the CD ROM

Summary Case Study

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User Decision Analysis for Commercial Investment Real Estate • TOC i

Table of Contents

Module 1: Introduction to User Decision Analysis

Module Snapshot ............................................................................... 1.1

Module Goal ......................................................................................................... 1.1

Objectives .............................................................................................................. 1.1

Overview ............................................................................................ 1.2

User Decisions ................................................................................... 1.3

Space (User/Tenant) Markets versus Capital (Investment) Markets ..... 1.5

Space Market ........................................................................................................ 1.5

Capital Market ...................................................................................................... 1.6

Activity 1-1: Rent Setting Using Cap Rate .......................................................... 1.10

Sources of Debt and Equity Capital .................................................... 1.12

The Equity Component of Commercial Real Estate ........................................ 1.12

The Debt Component of Commercial Real Estate ........................................... 1.14

Summary ......................................................................................... 1.17

Module 1: Self-Assessment Review ................................................... 1.18

Answer Section ................................................................................ 1.21

Activity 1-1: Rent Setting Using Cap Rate .......................................................... 1.22

Module 1: Self-Assessment Review .................................................................... 1.23

Module 2: Special Considerations for Cost of

Occupancy

Module Snapshot ............................................................................... 2.1

Module Goal ......................................................................................................... 2.1

Objectives .............................................................................................................. 2.1

Concepts of Financial Reporting ......................................................... 2.2

How Financial Statements Are Used ................................................................... 2.3

Financial Reporting Goals of the Course .............................................. 2.4

Why Care About Financial Reporting? ............................................................... 2.4

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TOC ii• User Decision Analysis for Commercial Investment Real Estate

The Basics of Financial Reporting for Real Estate ................................. 2.7

Income Statement ................................................................................................. 2.7

Balance Sheet ........................................................................................................ 2.7

Cash Flow Statement............................................................................................. 2.7

SEC Filings ............................................................................................................ 2.7

Rule Setting and Governing Entities for Financial Reporting ............................. 2.8

Income Statement ........................................................................... 2.10

Key Concepts of the Income Statement ............................................................ 2.10

Application to Corporate Real Estate ................................................................ 2.11

Balance Sheet ................................................................................. 2.12

Balance Sheet Key Concepts .............................................................................. 2.12

Selection of Discount Rate for the User ............................................. 2.14

Individuals, Partnerships, and Sole Proprietors ................................................ 2.14

Corporate Entities ............................................................................................... 2.14

Summary ......................................................................................... 2.16 Activity 2-1: After-tax Weighted Average Cost of Capital ................................. 2.17


Answer Section ................................................................................ 2.25

Activity 2-1: After-tax Weighted Average Cost of Capital ................................. 2.26 Module 2: Self-Assessment Review .................................................................... 2.29

Module 3: Space Acquisition ProcessModule Snapshot ............................................................................... 3.1

Module Goal ......................................................................................................... 3.1

Objectives .............................................................................................................. 3.2

Interests in Real Estate ...................................................................... 3.3

Owner’s Leased-Fee Interest ................................................................................ 3.3

Tenant’s Leasehold Estate .................................................................................... 3.3

The Potential Parties in the Space Acquisition Process ......................... 3.5

Tenant/Purchaser .................................................................................................. 3.5

Tenant/Purchaser Representative ........................................................................ 3.6

Landlord/Seller ..................................................................................................... 3.6

Landlord/Seller Representative ............................................................................ 3.6

Space Planner ........................................................................................................ 3.7

Attorney ................................................................................................................. 3.7

Space Acquisition Process .................................................................. 3.8

User Needs Analysis ............................................................................................. 3.9

Market Research and Survey .............................................................................. 3.11

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User Decision Analysis for Commercial Investment Real Estate • TOC iii

T a b l e o f C o n t e n t s

Tenant Request for Proposal ............................................................................. 3.12

Landlord Proposals ............................................................................................ 3.18

Comparison of Landlord Proposals................................................................... 3.18

Proposal and Counterproposal .......................................................................... 3.18

Proposal Acceptance and Lease Generation ..................................................... 3.18

Lease Document Negotiation and Execution .................................................... 3.19

Provisions for Valid Leases ................................................................ 3.20

Lease Clauses ................................................................................. 3.21

Parties to the Lease ............................................................................................. 3.21

Premise and Building Description ..................................................................... 3.21

Lease Term ......................................................................................................... 3.21

Rent ..................................................................................................................... 3.21

Occupancy and Use ............................................................................................ 3.22

Utilities and Service ............................................................................................ 3.22

Parking Clause .................................................................................................... 3.22

Signage ................................................................................................................. 3.22

Tenant Improvements ........................................................................................ 3.22

Alterations and Improvements ........................................................................... 3.23

Repairs and Maintenance ................................................................................... 3.23

Casualty ............................................................................................................... 3.23

Insurance, Waivers, Subrogation, and Indemnity ............................................. 3.23

Condemnation .................................................................................................... 3.23

Right to Relocate the Premises ........................................................................... 3.24

Options to Renew ............................................................................................... 3.24

Right to Assignment or Sublease ........................................................................ 3.24

Expansion and Contraction Options ................................................................. 3.25

Holdover Clause ................................................................................................. 3.25

Subordination ..................................................................................................... 3.25

Estoppel Certificates ........................................................................................... 3.25

Default and Remedies ........................................................................................ 3.25

Surrender of Premises ........................................................................................ 3.26

Rent Terminology in Leases ............................................................... 3.27

Fixed Rental ........................................................................................................ 3.27

Step Leases .......................................................................................................... 3.27

Indexed Leases ................................................................................................... 3.27

Percentage (Overage) Rent ................................................................................. 3.28

Sample Problem 3-1: Calculating Breakpoint ................................................... 3.28

Activity 3-1: Calculating Percentage Rent ......................................................... 3.29 Operating Expenses ............................................................................................ 3.31

Expense Stops ..................................................................................................... 3.31

Expense Caps ...................................................................................................... 3.32

Expense Pass-Throughs ...................................................................................... 3.32

Common Area Maintenance .............................................................................. 3.33

Gross-up Clause .................................................................................................. 3.33

Due Diligence: A Chance to Investigate the Causes of Risk ............................ 3.33

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TOC iv • User Decision Analysis for Commercial Investment Real Estate


Answer Section ................................................................................ 3.41

Activity 3-1: Calculating Percentage Rent ........................................................... 3.42

Module 3: Self-Assessment Review ................................................................... 3.43

Module 4: Comparative Lease Analysis and Valuing

Leasehold Interests

Module Snapshot ............................................................................... 4.1

Module Goal ......................................................................................................... 4.1

Objectives .............................................................................................................. 4.1

Economic Analysis Terminology ........................................................... 4.2

Base (Contract) Rent ............................................................................................. 4.2 Rate ........................................................................................................................ 4.2

Total Effective Rent .............................................................................................. 4.2

Total Effective Rate ............................................................................................... 4.2

Average Annual Effective Rent ............................................................................. 4.3

Average Annual Effective Rate ............................................................................. 4.3

Discounted Effective Rent .................................................................................... 4.3

Total Cost of Occupancy ...................................................................................... 4.3

Types of Leases .................................................................................. 4.4

Full Service Lease ................................................................................................. 4.5

Modified Gross Lease ........................................................................................... 4.5

Net Lease ............................................................................................................... 4.5

Percentage Rent Lease .......................................................................................... 4.6

Objective Leasing Decisions ............................................................... 4.7Sample Problem 4-1: Lease Comparison ............................................................ 4.7

Activity 4-1: Economic Lease Comparison ........................................................ 4.11

Analyzing Lease Cost ........................................................................ 4.12

Analyzing Multi-Period Leases .......................................................... 4.14

Sample Problem 4-2: Lease B Assumptions ..................................................... 4.14

Activity 4-2: Analyzing Multi-Period Leases ...................................................... 4.19

Comparing Two Leases of Equal Terms ............................................... 4.21

Activity 4-3: Analyzing Occupancy Cost Measures ........................................... 4.24

Principles of Financial Accounting and Reporting for Leases ............... 4.25

Operating Lease Reporting ................................................................................. 4.26

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User Decision Analysis for Commercial Investment Real Estate • TOC v


Determining if a Lease is a Capital Lease ........................................... 4.28

Ownership of the Premises Transfers to the User at the End of the Lease

Term.................................................................................................................... 4.28

The Lease Includes a Bargain Purchase Option ............................................... 4.28

The Lease Term Exceeds 75 Percent of the Remaining Useful Life of

the Premises ........................................................................................................ 4.29

The Present Value of the Minimum Lease Payments Is 90 Percent orMore of the Fair Value of the Premises at the Inception of the Lease ............ 4.29

Sample Problem: 4-3: FAS-13 Lease Analysis-Capital Lease Tests ................. 4.31

Practical Applications and Facts About FAS-13 ................................................ 4.33

Straight-Lining Operating Lease Rent ................................................................ 4.33

Activity 4-4: Analyzing Operating versus Capital Leases ................................... 4.34

Comparing Dissimilar Leases ............................................................ 4.37

Activity 4-5: Comparing Dissimilar Leases ........................................................ 4.38

Refinements in Comparative Lease Analysis ....................................... 4.44

Unequal Terms ................................................................................................... 4.44

Adjustments to Cash Flows ................................................................................ 4.44

Monthly Versus Yearly Discounting .................................................................. 4.45


Answer Section ................................................................................ 4.51

Activity 4-1: Economic Lease Comparison ...................................................... 4.52

Activity 4-2: Analyzing Multi-Period Leases ..................................................... 4.53

Activity 4-3: Analyzing Occupancy Cost Measures .......................................... 4.54

Activity 4-4: Analyzing Operating versus Capital Leases .................................. 4.55

Activity 4-5: Comparing Dissimilar Leases ........................................................ 4.57

Module 4: Self-Assessment Review .................................................................... 4.61

Module 5: Lease Versus Own

Module Snapshot ............................................................................... 5.1

Module Goal ......................................................................................................... 5.1

Objectives .............................................................................................................. 5.1

Leasing ............................................................................................. 5.3

Advantages of Leasing .......................................................................................... 5.3

Disadvantages of Leasing ...................................................................................... 5.4

Owning .............................................................................................. 5.6

Advantages of Owning .......................................................................................... 5.6

Disadvantages of Owning ..................................................................................... 5.6

Comparison Techniques ..................................................................... 5.8

Net Present Value Method ................................................................................... 5.8

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TOC vi• User Decision Analysis for Commercial Investment Real Estate

Internal Rate of Return of the Differential Cash Flows Method ......................... 5.9

Activity 5-1: Methods of Comparing Costs ....................................................... 5.11

Sample Problem 5-1: SAV-A-LOT Stores ....................................................... 5.13

Determining the Impact of Different Alternatives ................................ 5.15

Method 1: Net Present Value Method Using Multiple Discount Rates .......... 5.15

Method 2: Net Present Value Method Using a Single Discount Rate ............. 5.22

Single Discount Rate ........................................................................................... 5.22Sales Price Sensitivity .......................................................................................... 5.25

Method 3: Internal Rate of Return of the Differential Cash Flows

Method ................................................................................................................ 5.29

Activity 5-2: Calculating Costs............................................................................ 5.32

GAAP Accounting Impact on Financial Statements for SAV-A-LOT ........ 5.34

Purchase Alternative ........................................................................................... 5.34

Lease Alternative ................................................................................................. 5.35

Capital Lease Versus Operating Lease ............................................... 5.36


Answer Section ................................................................................ 5.41

Activity 5-1: Methods of Comparing Costs ....................................................... 5.42

Activity 5-2: Calculating Costs............................................................................ 5.43


Module 6: Lease Exit Strategies

Module Snapshot ............................................................................... 6.1

Module Goal ......................................................................................................... 6.1

Objectives .............................................................................................................. 6.1

Valuing Considerations ...................................................................... 6.3

Financial Reporting for Subleasing ...................................................... 6.3

Why Sublease? ....................................................................................................... 6.4

Valuing Leasehold Interest and Subleases ........................................... 6.6

Market Rent Is Higher than Contract Rent ......................................................... 6.6

Market Rent Is Lower than Contract Rent .......................................................... 6.6

Sublease Rent Is Higher than Contract, but Lower than Market ....................... 6.7

Sublease Rent Is Lower than Contract Rent ........................................................ 6.8

Activity 6-1: Leasehold Interests ........................................................................... 6.9

Other Alternatives ............................................................................ 6.10

Sample Problem 6-1: Negotiate a Lease Buyout ............................................... 6.10

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User Decision Analysis for Commercial Investment Real Estate • TOC vii


The Buyout Pendulum ....................................................................... 6.12

Selling Leasehold Positions to a Third Party ....................................... 6.14

Activity 6-2: Do Nothing Versus Sublease and Relocate .................................. 6.15


Answer Section ................................................................................ 6.23

Activity 6-1: Leasehold Interests ........................................................................ 6.24

Activity 6-2: Do Nothing Versus Sublease and Relocate ................................. 6.25


Module 7: Sale-Leaseback Transactions

Module Snapshot ............................................................................... 7.1

Module Goal ......................................................................................................... 7.1 Objectives .............................................................................................................. 7.1

Assessing the Opportunities ............................................................... 7.3

Benefits to the User/Seller.................................................................................... 7.3

Benefits to the Investor ......................................................................................... 7.4

Drawbacks for the User/Seller ............................................................................. 7.4

Drawbacks for the Investor .................................................................................. 7.4

User GAAP Accounting Reporting For Sale Leasebacks ......................... 7.6

Income Statement Impact .................................................................................... 7.6

Balance Sheet Impacts.......................................................................................... 7.6

Cash Flow Statement Impact ................................................................................ 7.7

Sale Impact ............................................................................................................ 7.7

User Economic Analysis .................................................................... 7.10

Net Present Value Method ................................................................................. 7.10

Internal Rate of Return of the Differential Cash Flows Method ...................... 7.11

Sample Problem 7-1: Value Stores, Inc. .......................................................... 7.12

Method 1: Net Present Value Method ............................................................. 7.13

Sales Price Sensitivity .......................................................................................... 7.21

Method 2: Internal Rate of Return of the Differential Cash Flows ................. 7.23

GAAP Accounting Impact .................................................................. 7.26

Conventional Financing .................................................................... 7.27

Sample Problem 7-2: Before- and After-Tax of Borrowed Funds ................. 7.28

Investor Analysis .............................................................................. 7.31

Analysis Process .................................................................................................. 7.32

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TOC viii• User Decision Analysis for Commercial Investment Real Estate

Sale-Leaseback Transaction Summary .............................................. 7.37


Answer Section ................................................................................ 7.39


Module 8: CCIM Interest-Based Negotiations Review

Model

Module Snapshot ............................................................................... 8.1

Module Goal ......................................................................................................... 8.1

Objectives .............................................................................................................. 8.1

Negotiation Overview .......................................................................... 8.3

Discussion Questions ............................................................................................ 8.3

The CCIM Approach and Negotiation Theory ......................................... 8.4

Collaboration versus Competition........................................................................ 8.4

What is Interest-Based Negotiation? ................................................................... 8.6

Step 1: Stakeholder Interests Analysis ................................................ 8.7

Relationships among Stakeholder Interests ......................................................... 8.7

The Importance of Interests to the Stakeholders ................................................ 8.8

Focusing the Conversation on Underlying Interests ............................................ 8.8

Active Listening Skills and Techniques ............................................................... 8.9

The Importance of Nonmonetary Interests ......................................................... 8.9

The Interest Chart ................................................................................................ 8.9 Discussion Topics ............................................................................................... 8.10

Step 2: Brainstorming Actions .......................................................... 8.12

Example Talking Points for a Landlord............................................................. 8.12

Example Talking Points for Tenant ................................................................... 8.13

Step 3: Risk Analysis and Evaluating Fighting Alternatives .................. 8.15

Risk Analysis ....................................................................................................... 8.15

Understanding and Measuring the Consequences of No Deal ......................... 8.15

Implementation of the Three-Step Process: Formulating and

Presenting an Offer .......................................................................... 8.16

Defining Your Bottom Line for Negotiations .................................................... 8.16

Preparing for Counters and Objections ............................................................. 8.17

Summary ......................................................................................... 8.18

Step 1: Who Is Involved and What Do They Need? Determine

Stakeholders, Interests, and Issues ..................................................................... 8.18

St ep 2: What Actions Can Be Taken to Satisfy Everyone’s Needs?

Develop Action Steps and Evaluate Them against Interests ............................. 8.19

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User Decision Analysis for Commercial Investment Real Estate • TOC ix


Step 3: What Happens if No Agreement Is Reached? Determine

Fighting Alternatives (The Consequences of No Solution)............................... 8.19

Implementing the Optimal Strategy ................................................................... 8.20

Case Study 1: Comparative Lease AnalysisCase Study Overview ............................................................................................ 9.1

Case Objectives ..................................................................................................... 9.1

Case Study 1: Comparative Lease Analysis .......................................... 9.3Case Setup ............................................................................................................. 9.3

Task 1-1: Interests Analysis ................................................................................. 9.5

Proposal A ............................................................................................................ 9.7

Proposal B ............................................................................................................. 9.8

Proposal C ............................................................................................................. 9.9

Task 1-2: Complete an Economic Comparison of the Leases ........................ 9.10

Answer Section ................................................................................ 9.11Task 1-1: Interests Analysis ............................................................................... 9.12

Task 1-2: Complete an Economic Comparison of the Leases ........................ 9.12

Case Study 2: Lease versus Purchase AnalysisCase Study Overview .......................................................................................... 10.1

Case Objectives ................................................................................................... 10.1

Lease versus Purchase Analysis ........................................................ 10.3Case Setup ........................................................................................................... 10.3

Task 2-1: Initial Interests and Economic Analyses ........................................... 10.6

Task 2-2: Update Your Interests and Financial Analyses ............................... 10.10

Task 2-3: Determine Actions and Make a Recommendation ........................ 10.13

Answer Section .............................................................................. 10.17Task 2-1: Initial Interests and Economic Analyses ......................................... 10.18

Task 2-2: Update Your Interests and Financial Analyses ............................... 10.21

Case Study 3: Lease BuyoutCase Study Overview .......................................................................................... 11.1

Case Objectives ................................................................................................... 11.1

Case Study 3: Lease Buyout .............................................................. 11.3Case Setup ........................................................................................................... 11.3

Task 3-1: Review Interests Analysis .................................................................. 11.4

Task 3-2: Determine the Present Value of the Owner’s Current Position ..... 11.5

Task 3-3: Determine the Present Value of the Worst-Case Scenario ............. 11.6

Task 3-4: Establish the Owner’s Minimum Buyout Price ............................... 11.7

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TOC x • User Decision Analysis for Commercial Investment Real Estate

Task 3-5: Determine the Present Value of the Tenant’s Current Position ..... 11.8

Task 3-6: Determine the Negotiating Range ..................................................... 11.9

Task 3-7: Develop a List of Possible Actions ................................................. 11.10

Task 3-8: Identify Fighting Alternatives .......................................................... 11.13

Task 3-9: Negotiate .......................................................................................... 11.14

Task 3-10: Post-Negotiation Discussion.......................................................... 11.18

Answer Section .............................................................................. 11.19Task 3-1: Review Interests Analysis ................................................................ 11.20

Task 3-2: Determine the Present Value of the Owner’s Current Position .... 11.20

Task 3-3: Determine the Present Value of the Worst-Case Scenario ........... 11.20

Task 3-4: Establish the Owner’s Minimum Buyout Price .............................. 11.21

Task 3-5: Determine the Present Value of the Tenant’s Current Position ... 11.21

Task 3-6: Determine the Negotiation Range .................................................. 11.21

Task 3-7: Develop a List of Possible Actions ................................................. 11.21

Task 3-8: Identify Fighting Alternatives .......................................................... 11.21

Task 3-9: Negotiate .......................................................................................... 11.21

Case Study 4: Sale LeasebackCase Study Overview .......................................................................................... 12.1

Case Objectives ................................................................................................... 12.1

Case Study 4: Sale Leaseback .......................................................... 12.2Case Setup ........................................................................................................... 12.2

Task 4-1: User Analysis ..................................................................................... 12.5

Task 4-2: Investor Analysis ................................................................................ 12.6

Answer Section ................................................................................ 12.7Task 4-1: User Analysis ..................................................................................... 12.8

Task 4-2: Investor Analysis .............................................................................. 12.10

Index ............................................................................................. 13-1

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In This Module

Module Snapshot ...................................... 1.1

Module Goal ........................................................ 1.1

Objectives ............................................................. 1.1

Overview ................................................... 1.2

User Decisions .......................................... 1.3

Space (User/Tenant) Markets versus Capital

(Investment) Markets................................ 1.5

Space Market ....................................................... 1.5

Capital Market ..................................................... 1.6

Activity 1-1: Rent Setting Using Cap Rate .........1.10

Sources of Debt and Equity Capital ........... 1.12

The Equity Component of Commercial RealEstate .................................................................. 1.12

The Debt Component of Commercial RealEstate .................................................................. 1.14

Summary ................................................ 1.17

Introduction to

User Decision

Analysis

1

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Module 1: Self-Assessment Review .......... 1.18

Answer Section ....................................... 1.21

Activity 1-1: Rent Setting Using Cap Rate ......... 1.22

Module 1: Self-Assessment Review .................. 1.23

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User Decision Analysis for Commercial Investment Real Estate • 1.1

Introduction to User Decision

Analysis Module Snapshot

Module Goal

The material contained in this course addresses occupancy costs from the

user’s perspective. Users of real estate are organizations that use property such

as office and warehouse space, retail stores, or industrial plants for a businesspurpose. The material and case studies in this course cover information about

a variety of user scenarios. By the end of the course, students should be able to

assess occupancy economics from various perspectives, weigh those economics

against any pertinent qualitative factors, and then make decisions that result in

the best overall occupancy decision.

Objectives

Identify the major decisions users face concerning the acquisition, holding

period, and disposition of space.

Explain the interaction of supply and demand in the space market.

Explain the interaction of net operating income (NOI), capitalization rate,

and value in the capital market.

Demonstrate the interaction between the space and capital markets.

Quantify developer profit as determined by the interaction between the

space and capital markets.

Identify the major sources of debt and equity capital.

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1.2 • User Decision Analysis for Commercial Investment Real Estate

Overview

This module describes the course modules and case studies. It lists the major

decisions users face concerning the acquisition phase of space, the holding

period phase of space, and the disposition phase of space. This module also

introduces the space and capital markets and provides an activity demonstrating

a real-world scenario about how they interact. This module concludes with a

brief description of the major sources of debt and equity capital.

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1

•

I n t r o d u c t i o n

User Decisions

At the most basic level, users want space that meets the needs of their business.

This decision could take into account factors such as location, size and layout of

the space, quality of the building, and perhaps proximity to the locations of

suppliers and/or customers.

User decisions can be segmented into three phases:

1.

Acquisition decisions: the set of decisions about occupying the space and

the acquisition mechanism (lease, purchase, or other).

2.

Holding decisions: the set of decisions about financial outlay or changes

while occupying the space.

3.

Disposition decisions: decisions around why, how, and when to dispose of

the space.

Following is a list of the major decisions confronting users:

cquisition Decisions

Should space be acquired?

What type and how much space should be acquired?

Where should space be acquired?

Which space should be acquired?

Which space acquisition entity should be used?

Should the space be leased or purchased?

Which space acquisition process should be used?

Holding Period Decisions for Leased Space

Should discretionary capital expenditures be made?

Should the capital structure of occupancy be changed?

Should the space utilization be changed?

Should the user continue to occupy the space?

Should any lease options be exercised?

Should the lease be renegotiated?

Should the user dispose of the space?

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Holding Period Decisions for Owned Space

Should discretionary capital expenditures be made?

Should the capital structure be changed?

Should the space utilization be changed?

Should the user continue to occupy the space?

Should the property be sold or exchanged?

Disposition Decisions

What should the disposition price be?

What should the disposition method be?

What should the disposition process be?

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Space (User/Tenant) Markets versus Capital

(Investment) MarketsThe previous section listed a number of decisions faced by users of space. The

interaction between the space and capital markets impacts these decisions.

Space Market

At any given point in time, current and potential users of space create a demand

for space in what we sometimes refer to as the space market. Factors such as

economic growth, the demand for products and services from businesses, and

employment growth impact the demand for space. Coupled with the existing

supply of space in the market, the demand for space results in a ―price‖ for the

space, which we refer to as the market rent. Of course, the market rent varies

for different types of space in different markets, and it even can vary

considerably within the same building. The point is that the interaction

between space users and owners of existing space determines market rents and

results in the lease terms offered to tenants.

Figure 1.1 Interaction between Supply and Demand for Space

Figure 1.1 illustrates how the supply and demand for space interact to result in

market rents. The supply curve (S) is quite steep because in the short run it

takes time for new supply to come on the market. Thus, the only way for new

Market Net Rent

NOI

Quantity

Of Space

D

S

Current Market

Net Rent

Current

Occupied

Space

Total

Space

Vacant

Space

Space Market

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supply to be created is to make some of the existing vacant space available to

tenants. Property owners may not be leasing some of this space in anticipation

of higher rents. However, if the price is right, they will make it available. At the

highest rent level, all of the vacant space might be made available, although in

practice this probably never occurs as frictions in the market always result in

vacancy.The demand curve (D) reflects the willingness of tenants to lease more space at

lower rents (such as to make more space available for each employee of an

office building). The intersection of supply and demand results in market rents

and determines the current occupancy of space (quantity occupied). The

difference between this and the available supply is the vacancy.

Capital Market

Just as users are interested in acquiring space in the space market, investors aredeciding whether to acquire buildings that can be leased to these users.

Investors will consider what return they can expect from their investment in real

estate, which depends to a large extent on current market rents and how

investors think those rents will change over time due to fluctuations in the

supply and demand for space in the space market.

Depending on how the expected return on the property compares to other

investment alternatives with similar risk, or, depending on how the expected

risk-weighted return on the property compares to other investment alternatives,

real estate as an investment will be in demand—that is, a demand for capital to

flow into the real estate asset class. This demand must be met by the existing

supply of buildings available for investment, which might include owner-

occupied space since those users could decide to sell their buildings and lease

them back. The interaction between the demand for real estate as an

investment and the existing supply of space results in the value of space in what

is referred to as the capital market. The value for space often is expressed

relative to the NOI that would be expected during the first year of property

ownership. The ratio of NOI to the price investors are willing to pay for the

property is referred to as the capitalization rate, or cap rate . The cap rate is

what investors are willing to pay for a dollar of NOI. The value of the propertyis found as follows:

Value =NOI

Cap Rate

The cap rate provides an important gauge for what investors are willing to pay.

We could say that the cap rate implicitly reflects investors’ expectations of the

NOI and/or value growth, as well as leverage and tax benefits. For example,

investors will be more willing to purchase a property at a lower cap rate (higher

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purchase price compared to current NOI) if they expect the NOI and/or value

to increase over time.

Figure 1.2 illustrates how the relationship between NOI and cap rate

determines the value. As discussed above, conversely, the ratio of the NOI to

the value of the space is the cap rate.

Figure 1.2 Relationship between NOI and Cap Rate

Correlating space market (Figure 1.1) with capital market (Figure 1.2) we cansee how the two markets interact as shown in Figure 1.3. The market rents

determined by the space market establish the NOI that investors realize in the

capital market. For simplicity, we can assume that the leases are absolutely

net — wherein the tenant pays all expenses so the rent is the NOI received. (Also

assume that the property is leased at current market rents.) The cap rate, which

is the ratio of the NOI to the price, (or the slope of the line) determines the

price. The slope of the line would alter due to a change in interest rates or a

more positive outlook for real estate compared to other investments.

Market Net Rent

NOI

Value

Of Space

Cap

Rate

Current Market

Net Rent

Current

Value

Capital Market

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Figure 1.3 Relationship between Space and Capital Markets

An increase in office space demand due to an improvement in the economy, which leads to job growth and more demand for space in office buildings,

would shift the demand curve in Figure 1.2 to the right. This would result in

higher market rents with the same supply curve, which in turn would lead to

higher values with the same cap rate. Profit to developers also would increase

since the gap between value and cost increased. Ultimately, this should lead to

an increase in supply that would shift the supply curve to the right, decreasing

rents and bringing developer profits back to a normal level.

The above discussion illustrates what might happen if demand for space in the

space market increases. A decrease in cap rates in the capital market also could

occur (as a result of a decrease in mortgage rates, for example). This would

cause the slope of the cap rate line to decrease (indicating a lower cap rate).

Note that this would result in higher values for the same NOI and also would

increase developer profits and the incentive for additional development, purely

as a result of changes in capital market conditions.

The main point of this discussion about the space and capital markets is that

although market rents and lease terms are primarily determined in the space

market, and although cap rates and property values are primarily determined in

the capital market, these are two distinct but interrelated markets that are

important to understanding real estate. Real estate values can change becauseof events that impact either market. For example, job growth could increase the

demand for office space, which would increase rent levels, resulting in higher

values at the same cap rate. That is, the increase in values is driven by the space

market. On the other hand, interest rates and the cost of debt capital might

decline; thus, investors might be willing to accept a lower cap rate for the same

NOI. They would bid up the price for real estate, and values would rise

because of the actions of investors in the capital market.

Current

Market

Net Rent

Current

Occupied

Space

Market

Net Rent

(NOI)

Quantity

Of

Space

D

S

Current

Value

Value

Of

Space

Market

Cap

Rate

Market

Net Rent

(NOI)

Space Market Capital Market

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Another point of discussion regarding the interaction between the space and

capital markets is the cost cap rate, sometimes called the cost rent constant.

The market cap rate expresses the relationship of NOI and value as a percent.

The cost cap rate expresses the relationship of NOI and total project cost as a

percent. The spread between the market cap rate and the cost cap rate

determines the developer’s profit.For example, assume that a developer is considering building a project with an

estimated total cost of $1,000,000 and that the market cap rate for comparable

properties is 8 percent. Further assume that the developer’s target spread

between the market cap rate and the cost cap rate is 200 basis points, or 2

percent. In other words, the developer wants the cost cap rate to be 10 percent,

which means that the NOI as a percent of cost would be 10 percent, or

$100,000. The developer’s profit would be the difference between the market

value and the total project cost. In this example, that means a market value of

$1,250,000 ($100,000 NOI ÷ 8 percent) minus the total project cost of

$1,000,000, which equals a developer profit of $250,000. Figure 1.4 illustrates

this concept.

Figure 1.4 Cost versus Value-Rent Setting

It should be clear that real estate analysts must account for factors that impact

both the space market and the capital market. Both markets ultimately can

affect user and investor decisions.

Profit

Net Rent

NOI

Value

Of Space

Cost

Cap Rate

Current

NOI

Current

Value

Market

Cap Rate

Total

Project Cost

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Activity 1-1: Rent Setting Using Cap Rate

A developer is considering building a 20,000 rentable square foot (rsf) office

building with an estimated total project cost of $3,000,000. The developer

wants to know the minimum rent per rentable square foot that must be received

to achieve an acceptable profit based on the following assumptions:

Gross lease with the owner paying all operating expenses

Market cap rate: 7.5 percent

Dev eloper’s minimum spread between the market cap rate and the cost cap

rate: 150 basis points (1.5 percent spread)

Operating expenses as a percent of gross operating income (GOI): 40

percent

Market vacancy rate for comparable buildings: 9 percent

1. Calculate the developer’s cost cap rate.

Market cap rate + cap rate spread = cost cap rate

2. Calculate the minimum net operating income needed to achieve the

acceptable profit.

Cost cap rate × total project cost = minimum NOI needed

3. Gross up the minimum net operating income needed to determine the

potential rental income.

Potential rental income

– Vacancy and credit losses

Gross operating income

– Operating expenses

Net operating income

NOI ÷ (1 – operating expense ratio) – NOI = operating expenses

NOI + operating expenses = GOI

GOI ÷ (1 – vacancy rate) – GOI = vacancy and credit losses

GOI + vacancy and credit losses = PRI

4.

Calculate the minimum rent per square foot (psf) needed to achieve the

acceptable profit.

PRI ÷ building rsf = rent per rsf

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5.

Calculate the developer’s profit, assuming the market will support the rent

calculated in Task 4.

NOI ÷ market cap rate = market value

Market value – total project cost = developer profit

End of activity

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Sources of Debt and Equity Capital

The Equity Component of Commercial Real Estate

Several categories of equity investors target commercial real estate in the United

States, primarily private investors, public real estate investment trusts (REITs),

pension funds, foreign investors, and life insurance companies.

Private Investors and Private Institutions

Private investors are the most significant influence in the equity market. Unlike

stocks and bonds, real estate is a visible and tangible asset. For individuals, the

decision to own property can be based on pride as much as profitability. Real

estate also has the benefit of being more transparent than stocks and bonds,

especially with respect to investment returns and the investment decisionprocess. Individuals can invest in commercial real estate in a variety of ways,

including purchasing individual pieces of property alone or with other private

investors. Some individuals control billions of dollars in capital and invest a

significant amount of that wealth in commercial real estate. Private institutions

include investment banks, mutual funds, mortgage brokers, venture capital

companies, and other private institutions that may provide equity capital for real

estate.

Public REITs

Publicly traded REITs offer an easy way for the average person to invest in

commercial real estate. REITs are companies traded on the stock exchanges

that invest the majority of their assets in real estate. Many retirement plans

include REITs among their fund offerings. A REIT is a means by which many

investors can invest a small amount of capital in a portfolio of real estate

properties. The income generated by a REIT is not subject to corporate

income taxes because REITs are required to distribute a large majority of their

incomes to the shareholders (currently 90 percent).

Although some REITs invest in mortgages, the majority invest equity capital in

commercial real estate. They typically specialize in a particular property type,

but hold a fairly well diversified portfolio of properties in different geographic

areas. Thus, investors in REITs get diversification benefits as well as liquidity.

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Pension Funds

Since pension funds in general are focused on long-term prospects, they are

good candidates for real estate holdings. Pension funds may invest in real estate

directly or through an investment manager that has expertise in purchasing and

managing properties. The investment manager may create a fund for a specific

pension fund or commingle funds from several pension funds to create larger,more diversified portfolios.

Foreign Investors

Foreign investors long have thought of the U.S. as a safe place to put their

money, and as a core asset, U.S. real estate is extremely safe. The amount of

foreign investment in U.S. real estate increased in the 1980s when the

commercial real estate market was in its boom phase.

According to the Association of Foreign Investors in Real Estate (AFIRE),

international investors continue to broaden their allocation of investment funds

around the world and have adopted innovative strategies to acquire real estate

more easily within the most competitive markets. The impact of foreign

investment varies depending on the global dynamics of the various countries,

but the U.S. remains one of the nations attracting significant investment. Just as

U.S. investors can diversify by investing in different property types and

geographic areas in the U.S., foreign investors can diversify by including the

U.S. in their portfolio along with investments in their own country. Similarly,

U.S. investors can diversify by investing in foreign countries. Many institutional

investors in the U.S. invest funds in many other countries.

Life Insurance Companies

Real estate, with its home and farm mortgages, has served as the foundation of

the life insurance industry for nearly 200 years. This history, along with the

billions of dollars the industry has to invest and its long-term and whole-life

policies, has made life insurance companies ideally suited for investing in real

estate, including equity investments.

Although their liabilities have changed somewhat over the years and their

investment in real estate has lessened, life insurance companies in general still

are significantly involved in real estate lending. They also invest a large amount

of funds in acquiring actual property that may be very profitable or is beneficial

in some way for the company to own, whether it is a strategic location or a

popular building that is useful for marketing efforts.

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Public/Private Joint Ventures

The local municipality/ies may offer a variety of financial incentives that provide

either equity capital or additional cash flows during operations. The Economic

Development Corporations or Chambers of Commerce is the immediate

source of information that could explain how you could access programs like:Transportation Development Districts (TDD), Community Improvement

Districts (CID), Neighborhood Improvement Districts (NID), Tax Increment

Financing (TIF), Industrial Revenue Bonds (IRB), Enterprise Zone status and

other unique programs. These are unique to each state and/or municipality.

Some of these programs are paid to the developer as a portion of a sales tax

from retail sales over a long period of time from a designated area of retailers

and continue normally about 20 years or so. Other programs allow for an

allocation of property taxes over a similar time frame. Some programs can

rebate earnings taxes from employees as well. Since each program works

differently for each municipality you need to have a thorough discussion withthe promoters of that particular municipality.

The Debt Component of Commercial Real Estate

The lender composition for debt includes commercial banks, commercial

mortgage-backed securities (CMBS)/government-sponsored enterprises (GSEs)

and related pools, collateralized debt obligations (CDOs), life insurance

companies, and savings institutions.

Commercial Banks

Although commercial banks, by nature, have shifted away from holding long-

term loans, they still make a majority of the initial mortgages. Their capital

sources are primarily short-term deposits, so typically most of their original

loans are sold to other large institutions in the secondary mortgage market.

Commercial banks provide direct contact to the customers/borrowers, and they

often work hand in hand with insurance companies or funds. Banks constantly

adjust their position to lending, and the various stages of the economy come

into play as well. For instance, if interest rates rise or inflation slows, banks

must be conscious of their short-term funds. With that said, banks always will

play a role in real estate lending and investing —the potential money to be made

is too great for them not to.

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Commercial Mortgage-backed Securities and Commercial Real Estate

Collateralized Debt Obligations

CMBS are financial assets that are securitized by mortgages made on

commercial real estate. Commonly issued in the U.S., CMBS work like bonds.

One benefit of CMBS as compared to residential mortgage-backed securities

(MBS or RMBS) is that CMBS more often are protected from prepayment by

prepayment penalties, yield maintenance, or defeasance.

In a CMBS, first mortgages, usually from several different properties diversified

by property type and location, are pooled and held by a trust, which serves as a

pass-through entity for bondholders. Securities with different investment

characteristics are created from the same pool of mortgages. The securities are

given bond ratings (typically AAA through BBB-) based on their priority for

receiving principal payments and payments in the event of default on any of the

mortgages underlying the pool. Some securities are unrated and are the ―first

loss‖ piece, meaning that they are the first to lose money (the last to be paid anyprincipal) in the event of default. Investors can choose their preferred

combination of risk, yield, and duration. The AAA-rated securities have the

lowest risk, but also the lowest expected return. The unrated securities have the

highest risk, but offer the highest expected return.

Commercial real estate collateralized debt obligations (CRE CDOs) are

somewhat similar to CMBS, except they typically have many different types of

mortgages as assets and also may have other securities as part of their asset

pool. For example, they may include mezzanine debt and low-rated CMBS

securities as part of the assets against which new securities are issued.Unfortunately, CDOs were the vehicle used to securitize many of the subprime

mortgages on residential real estate that were made to homeowners with poor

credit ratings. Falling home prices and increasing interest rates in the late 2000s

triggered resets on the adjustable-interest-rate mortgages. Many of these

securities had high credit ratings under the theory that they were diversified,

backed by many residential mortgages, but the drop in home prices and rise in

interest rates affected virtually all of the mortgages. It remains to be seen if the

CDO market will recover as investors have become skeptical of these types of

securities, whether they are backed by residential or commercial mortgages.

Life Insurance Companies

Typically serving as the lender for large loans, life insurance companies provide

billions of dollars in real estate mortgages each year. Most companies utilize

various mortgage brokers throughout the country to originate loans. Life

insurance companies are more interested in holding positions in the

commercial real estate debt market than the equity market, due to the

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regulatory requirements on risk-based capital and the companies’ liability

structures.

Savings Institutions

Originally thought of as home mortgage lenders, savings institutions held long-

term savings deposits, which enabled them to make long-term loans. However,in the early 1980s when real estate values dropped drastically as a result of

significantly increasing interest rates, savings institutions were forced to decrease

their mortgage holdings by more than $25 billion. Lender, or debt, positions

increased from around $1 billion in 1994 to more than $2.5 billion in 2006.

Government-Sponsored Enterprises

GSEs such as the Federal National Mortgage Association (Fannie Mae) and the

Federal Home Loan Mortgage Corporation (Freddie Mac) also play an

important role in mortgage lending and issuing MBS. Both Fannie Mae andFreddie Mac provide multifamily financing for affordable and market-rate

rental housing. GSEs provide financing for apartment buildings,

condominiums, or cooperatives with five or more individual units.

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Summary

We have seen in this module that the interaction between users and investors in

the space and capital markets determines commercial real estate market rents

and values as well developer profits. A variety of sources of debt and equity

capital, both private and public, are available to finance the purchase of real

estate. This allows lenders and equity investors to participate in the

performance of real estate in different ways depending on their risk tolerances.

In subsequent modules and case studies, we will explore various user decision-

making tools and their practical applications.

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Module 1: Self-Assessment Review

To test your understanding of the key concepts in this module, answer the

following questions.

1.

Which of the following is not considered one of the basic phases in user

decisions?

a.

Acquisition

b.

Holding

c.

Legal

d.

Disposition

2. As current and potential users of space create a demand for space due to

such things as economic growth, demand for products and services, or

employment growth, the resultant "price" is referred to as

a. Property value

b. Market rent

c. Asking price

d. Equilibrium

3. Capitalization rate, or cap rate, is

a. Simply a ratio of net operating income to investor value

b. Equal to net operating income divided by value

c. What investors are willing to pay for a dollar of net operating income

d. All of the above

4.

Market rents and lease terms are primarily determined:

a.

By investors

b.

In the space market

c.

In the capital market

d.

In the lease

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5.

The spread between the market cap rate and the cost cap rate is

a.

Vacancy

b.

Rent

c.

Value

d.

Developer's profit

6.

An investment group is evaluating the development of a small, 15,000

rentable square foot medical office building. The estimated project cost,

including an allowance for tenant improvement build out is $4,125,000.

Before proceeding, the investment group has engaged you to determine the

minimum rent per rentable square foot, which must be received in order to

achieve their desired profit. Complete the analysis for them using the

following assumptions:

Full-service lease (with the landlord paying all operating

expenses)


Investment Group's minimum spread between cost cap rate and

market cap rate: 125 basis points

Market operating expenses for comparable buildings: $7.50 per

rentable square foot

Market vacancy for comparable buildings: 8 percent

7.

What is the Investment Group's projected profit, assuming the market will

support the rent calculated in question 6.

End of assessment

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Answer Section

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Activity 1-1: Rent Setting Using Cap Rate

1.

Calculate the developer’s cost cap rate.


7.5% + 1.5% = 9.0%

2. Calculate the minimum net operating income needed to achieve the

acceptable profit.


9% × 3,000,000 = 270,000

3. Gross up the minimum net operating income needed for potential rental

income.

Potential rental income 494,505

– Vacancy and credit losses 44,505

Gross operating income 450,000

– Operating expenses 180,000

Net operating income 270,000


270,000 ÷ (1 40%) 270,000 = 180,000


270,000 + 180,000 = 450,000


450,000 ÷ (1 9%) 450,000 = 44,505


450,000 + 44,505 = 494,505

4.

Calculate the minimum rent per square foot (psf) needed to achieve the

acceptable profit.


494,505 ÷ 20,000 = 24.73

5. Calculate the developer’s profit, assuming the market will support the rent

calculated in Task 4.


270,000 ÷ 0.075 = 3,600,000

Market value – total project cost = developer profit

3,600,000 3,000,000 = 600,000

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1.

Which of the following is not considered one of the basic phases in user

decisions?

c.

Legal

2.

As current and potential users of space create a demand for space due to

such things as economic growth, demand for products and services, or

employment growth, the resultant "price" is referred to as

b. Market rent

3.

Capitalization rate, or cap rate, is

d. All of the above

4.

Market rents and lease terms are primarily determined:

b. In the space market

5. The spread between the market cap rate and the cost cap rate is

d. Developer s profit

6.

An investment group is evaluating the development of a small, 15,000

rentable square foot (rsf) medical office building. The estimated project

cost, including an allowance for tenant improvement build out is

$4,125,000. Before proceeding, the investment group has engaged you to

determine the minimum rent per rentable square foot that must be

received in order to achieve their desired profit. Complete the analysis for

them using the following assumptions:

Full-service lease (with the landlord paying all operating

expenses)


Investment Group's minimum spread between cost cap rate and

market cap rate: 125 basis points

Market operating expenses for comparable buildings: $7.50 per

rentable square foot

Market vacancy for comparable buildings: 8 percent

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a. Calculate the Investment Group's cost cap rate.


7.25 + 1.25 = 8.5%

b. Calculate the minimum net operating income needed to achieve the

Investment Group's acceptable profit.


8.5% × $4,125,000 = $350,625

c.

Gross up the minimum net operating income needed to determine

potential rental income (PRI).

Potential rental income

– Vacancy and credit losses

Gross operating income

– Operating expenses

Net operating income





NOI + operating expense = GOI

NOI: 350,625

Operating expense: 15,000 rsf × $7.50 per rsf = $112,500

350,625 + 112,500 = 463,125


463,125 ÷0 .

9

2 = 5

3

,

39

7 - 463,125 =

4

0,

7

2


463,125 +

4

0,

7

2 = 5

3

,

39

7

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d.

Calculate the minimum rent per square foot (psf) needed to

achieve the acceptable profit.


5

3

,

39

7 ÷ 15,000 = 3

3

.

5

6

7.

What is the Investment Group's projected profit, assuming the market will

support the rent calculated in question 6.


350,625 ÷ 7.25% = 4,836,207

Market value – total project cost = Investment Group profit

4,836,207 4,125,000 = 711,207

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In This ModuleModule Snapshot ...................................... 2.1

Module Goal ........................................................ 2.1

Objectives ............................................................. 2.1

Concepts of Financial Reporting ................. 2.2

How Financial Statements Are Used .................. 2.3

Financial Reporting Goals of the Course ..... 2.4

Why Care About Financial Reporting? .............. 2.4

The Basics of Financial Reporting for Real

Estate ...................................................... 2.7

Income Statement ................................................ 2.7

Balance Sheet ....................................................... 2.7

Cash Flow Statement ........................................... 2.7

SEC Filings ........................................................... 2.7

Rule Setting and Governing Entities forFinancial Reporting .............................................. 2.8

Income Statement .................................. 2.10

Key Concepts of the Income Statement ........... 2.10

Application to Corporate Real Estate ............... 2.11

Special

Considerations

for Cost of

Occupancy

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Balance Sheet ........................................ 2.12

Balance Sheet Key Concepts ............................. 2.12

Selection of Discount Rate for the User ..... 2.14

Individuals, Partnerships, and SoleProprietors ......................................................... 2.14

Corporate Entities .............................................. 2.14

Summary ................................................ 2.16 Activity 2-1: After-Tax Weighted Average Cost

of Capital ............................................................ 2.17


Answer Section ....................................... 2.25

Activity 2-1: After-Tax Weighted Average Costof Capital ............................................................ 2.26


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Special Considerations for

Cost of Occupancy Module Snapshot

Module Goal

This module introduces the special considerations that must be taken into

account when determining the cost of occupancy, specifically financial reporting

requirements and user discount rates. The financial reporting section coversthe fundamental concepts of corporate financial reporting and how they should

be incorporated in any real estate transaction analysis. The section also

explains how real estate transactions can affect a company‘s financial reports

and the importance of accurate and appropriate reporting of these transactions.

The second section of the module addresses user discount rates. Users of real

estate use discount rates for a variety of analyses, such as choosing between

different lease alternatives or deciding whether to own a building rather than

lease space.

Objectives

Explain the general concepts of financial reporting.

List the various ways financial statements are used.

Give a brief overview of the impact of financial reporting on lease, sublease,and sale-leaseback transactions.

Explain the basic reporting components of commercial real estate.

List the rule setting and governing entities for financial reporting.

Identify the financial accounting standard (FAS) regulations that apply to various types of real estate transactions.

Explain the key components of the income statement.

Explain the key components of the balance sheet.

Define opportunity cost.

Calculate the historic and marginal after-tax weighted average costs of capitalfor a corporation.

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Concepts of Financial ReportingThe reporting of an organization‘s overall financial performance is one of the

most important measures of its success. Operations, service, staffing, sales, and

other metrics are important, but financial reporting plots an organization‘s

ultimate health and longevity. The information it contains can drive strategic,investment, purchase, sale, and other key decisions. This holds true for private

and public companies, not-for-profits, and government organizations—basically

any large or small entity doing business.

In general, all organizations adhere to a consistent set of parameters and

guidelines/principles for reporting their financial status and performance results.

That said, in recent history, most notably since 2001, the validity of and

variations in financial reporting have been frequently scrutinized and closely

questioned, in some cases even leading to the demise of organizations. To

bring organizations back to more consistency and validity in reporting, rules andlaws have been revised or overhauled to avoid the issues and/or

misrepresentations that have cost taxpayers and company shareholders billions

of dollars.

The lesson learned from organizations taken to task over their financial

reporting practices is simple: it is absolutely vital to ensure the accuracy and

validity of financial statements and reporting, which should be a clear and

consistent reflection of a company‘s overall health.

It should be noted that the drive to consistency and transparency in financialreporting is a global movement, and is not limited to the U.S. Domestic and

international rule making authorities have been working together, merging

concepts, and collaborating on rulings designed to provide accuracy and validity

in financial reporting.

The role of real estate and real estate transactions within the context of financial

reporting often can be one of the most important for organizations when you

consider that many have extensive real estate holdings. Headquarters,

distribution centers, sales offices, telemarketing and call centers, and

manufacturing plants quickly add up to large real estate holdings, yet real estate

practitioners often misunderstand or overlook the impact of real estate and real

estate transactions on financial statements.

While the practitioner often times strictly views real estate for its investment and

income-generating purposes, the senior management of most organizations sees

real estate as a factor of production—the place where the business happens, not

the business itself. Airplane manufacturers are focused on building airplanes

more than on the large plants in which they are built. Oil refineries are focused

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User Decision Analysis for Commercial Investment Real Estate•

2.3

2 •

S p e c i a l C o n s i d e r a t i o n s

on oil production more than on the physical plant; telecommunications

companies are focused on the service from their representatives rather than on

the centers in which they reside. Given the production factor necessity, real

estate holdings can be one of a company‘s largest asset classes and highest

annual expenses. Thus, the role of the real estate practitioner in accurate

financial reporting can become very important and strategic to his or her clients.

This module is designed to incorporate financial reporting information and

activities to verse students in the mechanics and generalities of reporting so they

understand the role real estate plays and its effect on financials. The

information is targeted to external real estate practitioners—those who represent

companies or businesses—and internal corporate real estate executives advising

senior management. Given the analyses a real estate practitioner routinely

conducts, it is easier to provide the practitioner with a working knowledge of

financial reporting and how to overlay it on his or her analyses than it is to

provide a working knowledge of real estate with its complexities regarding

corporate financial clients. Once educated, the practitioner will be in the

position to look at real estate from an overall financial perspective and to make

decisions or recommendations with that complete perspective.

How Financial Statements Are Used

At a very basic level, financial reporting acts as a common financial language of

business. It ensures that all companies play by the same rules and use the same

units of success. Although different industries may vary, when a company

reports earnings of $1 per share or a certain dollar amount of net equity, by andlarge everyone understands exactly what each metric means. This is the

information investors, lenders, regulators and others use to determine a

company‘s value and to make buying, selling , and other decisions.

For a company, financial reporting is a valuable tool in monitoring and

measuring performance. By using the information, management can see what

strategies may be working and those that may need to be re-evaluated. Financial

performance also is used to set reward targets for management and employees.

The real estate practitioner (whether internal to the company or retained as aconsultant) can play a key role by first understanding the financial drivers and

targets and then accurately planning and executing real estate activities to help

achieve those goals.

Real estate can be one of the most important and largest items on a company‘s

financial re ort et real estate ractitioners fre uentl misunderstand its im act.

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Financial Reporting Goals of the Course After completing this course, students should be able to better assist clients by

Ensuring that the goals of real estate transactions are aligned with the client‘s

overall financial goals. Understanding and communicating the impact of common real estate

transactions on an organization‘s financials and reports.

Understanding how to overlay financial reporting considerations on top of

real estate economic analyses to drive the best decisions and timing for

common transactions: leases, subleases, sale leasebacks, and conventional

purchases and sales.

Why Care About Financial Reporting?

Corporate real estate tenants or owners (users) occupy the vast majority of all

real estate. As mentioned above, that real estate is often a substantial line item

on financial reports. Wall Street, regulators and the broader investment

community (lenders, banks, and shareholders) judge company leaders based on

the financial data in these reports. Regardless of a company‘s size, these

stakeholders dislike surprises, good or bad.

Typically, a public company issues its quarterly earnings about 15–45 days into

the quarter following the one they are issuing. That process provides a look at

the past and signals what the next quarter or rest of the year may look like.Often at this time, a company will adjust its projected annual earnings or

provide guidance. When companies miss these projections—in either a positive

or negative way —questions arise about management oversight, abilities, and

intent. How can you prevent this from the real estate perspective? You can

understand the impact of a transaction. The more you understand, the easier it

is to structure a transaction that achieves a company‘s goals.

Consider that one of the most egregious examples of failure or issues in

financial reporting occurred when a Fortune 10 company virtually collapsed in

2001. At a high level, it could be said that the company collapsed due to off-balance-sheet transactions. (Balance sheets are covered in depth in the next

section.) How does this relate to real estate transactions? Negotiating lease

agreements—one of the most common real estate transactions—generally

constitutes an off-balance-sheet transaction, so the link becomes clear. As will

be further explained in the leasing activities of this module, an off-balance-sheet

transaction is neither bad nor incorrect. In fact, it generally is the preferred

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2.5

2 •


classification. However, you, as the real estate expert, need to understand

whether the transaction is on or off balance sheet.

What about subleasing? For example, you have a client who no longer needs

the space the company is leasing, but has a remaining rent obligation of

$100,000,000 over the next 10 years. The client contracts with you to negotiate

a sublease with revenue of $60,000,000 over 10 years. From the real estate

perspective, you have saved your client some $60,000,000 in cash over 10 years,

leaving him with a shortfall of approximately $4,000,000 per year. That news,

however good, is incomplete. Financial accounting rules dictate that your client

must take the present value (PV) of the $40,000,000 loss, which he will

experience over 10 years, and record it immediately as a profit and loss impact.

Once the lease is signed, any loss must be recorded on the income statement.

While the accounting rules may not change your client‘s decision to sublease,

they may change the timing, depending on when they may want to report or

record the loss. Again, this is not good or bad accounting. It simply means that

you, as the expert, need to set or confirm expectations upfront for your client.

In the case of sale leasebacks, assume that your client is looking for ways to

generate cash. You negotiate a sale that generates $100,000,000 on a property

with a book value (adjusted basis) of $40,000,000, resulting in a gain of

$60,000,000. (Note:

Throughout this course, book value is synonymous with

adjusted basis. Purchase Price + Acquisition Costs + Capital Improvements –

Total Cost Recovery Taken – Basis in Partial Sales = Adjusted Basis.) In a

scenario where your client was selling, moving out, and totally divesting, the

company could record an immediate $60,000,000 gain. However, in a sale-

leaseback scenario, accounting procedures dictate that you must recognize the

gain over the life of the lease. In other words, if not appropriately informed by

you, your client's real estate expert, your client believes that they will record a

quick $60,000,000, when it fact it will be closer to $6,000,000, with the rest

coming over the remaining years of the lease.

The examples above contain one of the key maxims of a financial reporting

overlay on real estate analyses: Bad news must be recorded when it becomes

apparent, while good news is reported only when the company derives a

benefit.

Obviously, the impact of real estate transactions can be significant on a

company‘s financial reports. Given the number of high-profile companies who

failed in their financial reporting, auditors and regulators have increased

scrutiny in all areas. If financials are not correct, a company would need to

restate financials—a costly, embarrassing, and often reputation-damaging

exercise. In the worst case, incorrect financials can constitute Securities and

Exchange Commission (SEC) violations, which can result in criminal

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prosecutions for those who attest to a company‘s incorrect financials. The

Sarbanes-Oxley Act of 2002, known as ―SOX,‖ was enacted for publicly held

companies in response to high-profile financial scandals. It is designed to

protect shareholders and the public from accounting errors, inconsistencies and

fraudulent financial practices in companies. It also dictates a level of culpability

and responsibility for executives at both a personal and professional level.

Note that financial reporting rules are not only for public companies. Many

small and medium sized companies are obligated to prepare audited financial

statements for various reasons. For example, a closely held company may

prepare audited financial statements for its investors, or likely would be

required to submit audited financial statements to its lenders in order to comply

with loan covenants. A privately held school may be required to provided

audited financial statements to the state and federal accreditation entities. A

company working in a regulated field (say, insurance or banking), may be

required to prepare audited financial statements. A not-for-profit organizationmight be obligated to prepare audited financial statements to comply with their

charter or funding entities.

Financial reporting rules require that you report bad news when you know itand good news when you benefit from it.

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The Basics of Financial Reporting for Real

EstateFinancial reporting consists of various reports detailing different aspects of a

company‘s financial performance. Collectively, these should reflect the overallfinancial position of the organization. This section addresses the reports most

relevant to real estate and its impact on a compan y‘s reporting.

Income Statement

This document presents the results of an organization‘s operations for a specific

period. It details the revenue, expenses, and net income. The income

statement can be compared to an individual tax return—how much money you

brought in minus deductions equals net income. Obviously, different rules

apply, but the premise is similar.

Balance Sheet

This document presents the status of a company at a specific point in time. It

details a company‘s assets, liabilities, and net equity. It can be compared to a

personal statement of net worth— what you own minus how much you owe.

Cash Flow Statement

This document presents the sources and uses of cash for a specific period. It

details cash flows from operations, as well as investing and financing activities.

It can be compared on a personal level to a checkbook record. The cash flow

statement‘s relevance to real estate lies only in how transactions impact the

income statement and the balance sheet, which then are captured or recorded

on the cash flow statement. There are no stand-alone cash flow impacts.

SEC Filings

Public companies must provide financial reporting to the SEC through filings,

generally on both a quarterly and an annual basis. The most important filings

for this module are the 10-K and the 10-Q.

The 10-K is an annual SEC filing that includes:

Income statement, balance sheet, and cash flow statement as discussed

above

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Footnotes to the financials: The notes where disclosure items are outlined,

and where many real estate lease transactions appear in the financials

Management‘s discussion and analysis: A narrative provided by senior

management to explain their business activities

Auditor‘s opinion letters: The letters from a company‘s internal and

external auditors validating the financials and attesting to the financials‘

accuracy

The 10-Q is similar to the 10-K, but is completed and filed on a quarterly basis.

Rule Setting and Governing Entities for Financial

Reporting

Accounting standards—those common financial practices and principles across

business—largely are set by three bodies: the Financial Accounting Standards

Board (FASB) the American Institute of Certified Public Accountants

(AICPA), and the International Accounting Standards Board (IASB).

Together, these entities provide interpretations and decisions to address

accounting issues. Companies of all sizes are governed by a consistent set of

accounting principles, the generally accepted accounting principles (GAAP).

GAAP rules do not have the force of law; they provide accounting guidelines.

Companies, large and small, must for the most part comply with GAAP rules

for an auditor to attest to sound, accurate financials. Lenders, investors, or

anyone providing funding for the company requires this.

Of these rules, a few drive real estate transactions:

FAS-13: The standards of financial accounting and reporting for leases

FAS-66: The financial accounting and reporting standards for treating

profit or loss on real estate sales

FAS-98: The financial accounting and reporting standards for sale

leasebacks

FAS-146: The financial accounting and reporting standards for subleases

In addition to FASB, AICPA and IASB and their related principles, somegoverning bodies and rules actually do have the force of law: the SEC, the

Public Company Accounting Oversight Board (PCAOB), and SOX, for

example. The SEC, PCAOB, and SOX all are aligned closely with GAAP. In

general, these laws and oversight bodies are in place to enforce appropriate and

accurate financial reporting and to help prevent the crime of intentionally

reporting false information in financials to deliberately mislead investors and

lenders. SOX actually takes that objective a step further by requiring public

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2.9

2 •


companies to maintain accurate and easily accessible business records for a set

period and by prohibiting the destruction or alteration of financial or key

operations records. However, while SOX requires a process for maintaining

those records to be in place, it does not dictate a specific process.

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Income StatementThe income statement consists of two main parts: revenue and expenses.

Revenue is the dollar inflow (money coming into the company) from the

operations of the company (sale of goods and services, dispositions, real estateor property sales, etc.). Expenses are dollar outflow (money going out) for

operations (costs to run the business). From a real estate standpoint, the

building a company purchased does not appear on the income statement;

rather, the purchase is recorded as an asset on the balance sheet (to be

discussed later). However, the expenses related to that building (depreciation,

maintenance, utilities, interest expenses, etc.) do appear on the income

statement. If your client rents rather than owns, then rent as well as

depreciation on his or her tenant improvements (TIs) show up as expenses.

Revenue – expenses = net income*

(*also called net profit, bottom line, net earnings, and profit and loss)

Whether renting or owning, the associated costs — rent payments when leasing orinterest and depreciation costs for owning — all appear as expenses on theincome statement. Purchases appear as assets on the balance sheet.

Key Concepts of the Income Statement

Accrual Versus Cash

As individuals, we are cash-basis taxpayers. If money comes in on January 1,

2011, it is not taxable for 2010. Companies, however, must accrue. When they

earn money, regardless of whether payment is in hand, it must be recorded on

the income statement as revenue. The balance sheet would show a receivable if

payment has not yet been received. Essentially, revenue is recorded when fully

earned, not when the contract is signed or when it is paid.

Conversely, expenses (such as in the form of an electric utility bill) also should

be accrued, assuming an actual check has not yet been written.

Matching Principle

Revenue and expenses must be recorded in the appropriate period. Expenses

must be recorded as they happen, and revenues must be recorded when fully

earned, not before. This prevents companies from using potential future

revenues to bolster current performance, a misrepresentation of the true

financial picture.

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Application to Corporate Real Estate

The Importance of Quarterly Earnings

Given the rules governing when real estate transaction expenses and revenue

are recorded, a company‘s quarterly earnings can drive when a transactionoccurs. If a company must close a transaction to benefit the current period,

management often is prepared to sacrifice ancillary dollars to ensure that the

transaction happens in the period they want.

Free Rent Periods (Early Occupancy) Aren’t Free

For financial reporting, rent expenses are recognized in a manner similar to

total effective net rent (the amount of rent after deductions for landlord

concessions and any tenant-paid build-outs or allowances which is further

defined and explained later in this course). It is recognized straight-line over the

entire term, including any free rent period.

For example, your company or client signs a lease paying a teaser rate of $2 per

square foot (psf), which then increases dramatically to $10 psf. Financial

accounting rules dictate that the company cannot reflect the lower rent expenses

at the beginning of the lease, as this would provide an artificially low view of

expenses in the early portion of the lease. The company must average or

straight-line the rent expense consistently across the life of the lease.

It is important to remember when negotiating on behalf of certain clients that

they may not gain any benefit on their financial statements from a free rentperiod (a consequence of not clearly understanding this is incurring double rent

expense). For instance, your client wants to move, understanding they will be

paying on the old lease, but they think they are getting two or three months free

in the new space. They will be actually recording expenses for both locations.

Sale Transactions Can Create a Gain or Loss Depending on the Book

Value (Adjusted Basis)

When selling a property on behalf of a client, it is important to know the book

value (adjusted basis). For example, your client wants to sell a building for$5,000,000. If the book value is $3,000,000, they will record a gain of

$2,000,000. However, if the book value is $6,000,000, they will record a loss of

$1,000,000. The selling price is the same, but the difference lies in the book

value of the property.

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Balance SheetThe balance sheet contains assets and liabilities.

In the real estate world, assets typically are comprised of any properties owned

as well as any leasehold improvements. In their first year, properties arerecorded at their original purchase price, which includes acquisition costs.

Over time, that asset value is reduced due to depreciation. Leasehold

improvements should go on the balance sheet as assets for whoever paid for

them.

In the business world, assets can be comprised of such things as cash, accounts

receivable, equipment, furniture and fixtures, inventory, and the like.

Liabilities consist of loans, trade payables, any bank line and bond financing,

and real estate loans.

Assets – liabilities = equity

Balance Sheet Key Concepts

Snapshot of a Point in Time

The balance sheet reflects the book values of assets and liabilities at a specific

point in time.

Values of Assets Are Initially Recorded at Original Cost

Assets initially are booked at the original value of what was paid. As that asset

depreciates, the book value on the balance sheet goes down correspondingly,

resulting in reduced asset value on the balance sheet.

Liabilities Are Reflected as of the End of the Year

For example, while you may purchase a building at the beginning of the year,

paying interest and paying down principal leaves you with less liability on the

property cost at year‘s end. The adjusted market value of a property is not

reflected on the balance sheet, largely because it is subject to interpretation.

Real Estate on the Balance Sheet

Most corporations do not purchase real estate for investment purposes or

spend their shareholders‘ dollars to invest in real estate for a return on that

investment. They do spend dollars to acquire real estate as a factor of

production, so financial reporting rules dictate that real estate must be treated as

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2.13

2 •


a cost of doing business on financial statements—listing the book value for that

property as an asset on the balance sheet and correspondingly treating

depreciation and related costs as business expenses on the income statement.

Conservatism Principle

Reporting rules require gains to be recorded when they are earned, while lossesmust be recorded when they are known. Factors such as increases in market

value cannot be recorded as gains; however, known liabilities should be

recorded. For example, signing a contract to deliver professional services for

five years is not realized as an immediate gain, but rather over the five years

when earned. Conversely, settling a lawsuit for $5,000,000 must be reported

immediately upon settlement, even if you will pay it off over time.

Substance Prevails Over Form

A transaction will be classed according to its substance. For example, leases are

largely off balance sheet. However, if certain financial attributes are present, a

lease must appear on the balance sheet. The fact that it is called a lease for real

estate becomes immaterial if the substance of the terms deems its classification

as a capital lease (defined and explained later), or an on-balance-sheet

transaction.

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Selection of Discount Rate for the UserUsers of real estate utilize discount rates for a variety of analyses, such as

choosing between different lease alternatives or deciding whether to own a

building rather than lease space. The discount rate depends on the risk factor

of the cash flows, but it also may depend to some extent on the nature of theuser and their cost of capital.

By users of real estate, we mean companies that are using property for some

business purpose. Their core business is not real estate, and their motivation

for using the real estate is to serve a purpose for their business. They are using

the real estate either as real estate tenants leasing space from an investor or as

real estate owners occupying the space.

Choosing the appropriate discount rate is mandatory to make prudent decisions

during discounted cash flow (DCF) analysis, as well as to quantify occupancycosts for users. Users usually fall into two categories—corporate and non-

corporate (individuals, partnerships, or sole proprietors)—and the process for

selecting the discount rate is different for the two. This section briefly explores

the process for each.

Individuals, Partnerships, and Sole Proprietors

Users who fall into this category usually use opportunity cost as the discount

rate for decision making. In the case of users quantifying occupancy costs, the

following questions are asked: ―If I were not using these funds for occupancy

costs, what alternative uses for these funds would I have? What could I earn on

those funds?‖ For instance, one alternative use of the funds is the user‘s

business. The user must decide if it is worth it to give up the opportunity of this

alternative use for occupancy costs.

Corporate Entities

Corporations sometimes use the after-tax weighted average cost of capital as the

discount rate to make financial decisions. Corporations don‘t have any capitalof their own. All of a corporation‘s capital is raised from two sources—debt and

equity —and each of these sources has an associated after-tax cost. The ratio of

debt to equity and the associated after-tax cost of each component are blended

to calculate the after-tax weighted average cost of capital. This rate sometimes is

referred to as a hurdle rate or a threshold rate. A corporation has to earn at

least this hurdle or threshold rate on investments to pay for the capital provided

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2.15

2 •


by the debt and equity sources. This also may be the after-tax cost of any

capital used for occupancy costs.

Commercial banks provide the short-term debt portion of the capital structure,

typically in unsecured short-term notes, and bond investors provide the long-

term debt capital. The equity portion of the capital structure typically is

preferred stock and common stock. The interest paid on the debt, both short

term and long term, is deductible for tax purposes, whereas the dividends paid

to the stockholders are not deductible. The corporation‘s after-tax earnings not

paid to the stockholders in the form of dividends usually are kept at the

corporate level as retained earnings, but this capital still belongs to the common

stockholders.

Interestingly enough, the after-tax weighted average cost of capital has two

opportunity cost components: the opportunity cost of the debt investors who

provided the debt portion of the corporation‘s capital structure and the

opportunity cost of the equity investors who provided the equity portion of thecorporation‘s capital structure.

Corporations may quantify the after-tax weighted average cost of capital using

the historic approach and/or the marginal approach. The historic approach

uses the existing debt-to-equity ratio and the existing capital structure and

quantifies the associated after-tax cost of each source at the time it was raised.

The marginal approach uses the existing debt-to-equity ratio and projects the

after-tax cost of new capital if the corporation went into the capital market today

to raise additional funds.

Corporate Borrowing Rate

Some corporations use their borrowing rate as the discount rate for DCF

analysis for some occupancy decisions. For instance, suppose a company has

decided to lease rather than own space and now is evaluating different leasing

alternatives. No investment in the real estate is involved in this analysis, so the

lease with the lowest PV of the leasing costs is probably the best bet. In this

case, it makes sense to use a cost of debt as the starting point for a discount rate.

Although the cost of debt capital can be used as a starting point when evaluating

lease alternatives from a user‘s perspective, some leases may be riskier than

others and may warrant an adjustment to the discount rate. For example, the

user wants a lease with the lowest PV of expected lease payments, but if a lease

is considered risky, a lower discount rate should be used. It may seem

backward to use a lower discount rate, but from the user‘s perspective the lease

is a cost (liability), not an investment (asset). The user would not want to enter

into a lease that has risky payments unless they were compensated by a lower

lease cost. An analogy is the difference in the interest rate for an adjustable-rate

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mortgage and a fixed-rate mortgage. The borrower has more risk with an

adjustable-rate mortgage and therefore will expect to pay a lower interest rate

than for a fixed-rate mortgage.

SummaryThe discount rate depends on the definition of cash flows being analyzed and

the risk of those cash flows. We have seen that this depends on whether the

cash flows are before or after tax, whether they are leveraged, and whether we

want to discount different components of the cash flows at different rates or use

a single blended rate that captures the risk.

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2.17

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Activity 2-1: After-Tax Weighted Average Cost of Capital

Calculate the historic and marginal after-tax weighted average costs of capital,

and other questions in number 1 below, based on the following assumptions

and using the Excel workbook provided on the CD-ROM.

Corporate tax rate: 34 percent

Sources and Amounts of Capital in 000s)

Short-term bank notes payable: $5,000

Long-term bond debt: $15,000

Preferred stock: $5,000

Common stock: $20,000

Retained earnings: $10,000

Short-term Debt

Historic cost: 8 percent

Projected cost: 8 percent

Long-term Bond Debt

Coupon rate: 7 percent

Par value per unit: $1,000

Market value per unit: $1,050

Maturity: 8 years

Preferred Stock

Coupon rate: 7 percent

Par value per share: $30.00

Market value per share: $30.50

Years unit callable: Five years

Common Stock

Market value per share: $60.00

Current earnings per share: $5.40

Current dividend per share: $1.80

Projected dividend and stock value annual growth rate: 4 percent

Projected holding period: Five years

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1. Answer the following questions based on the above assumptions.

a.

What is the historic after-tax weighted average cost of capital?

b.

What is the before-tax marginal cost of short-term debt?

c. What is the before-tax marginal cost of long-term debt?

d.

What is the before-tax marginal cost of preferred stock?

e.

What is the before-tax marginal cost of common stock?

f. What is the marginal after-tax weighted average cost of capital?

2. Calculate the before tax and after tax weighted average cost of capital based

on the following scenario and assumptions using your handheld calculator

or by using Excel.

Gilbert Martinez and his wife Maria own a small, successful and growing

business. With your help, they have located a building that will allow them to

perfectly accommodate their growth. You referred Gilbert and Maria to a

commercial real estate lender that has provided a financing commitment for a

portion of the real estate purchase price.

Gilbert‘s college roommate Ruben has offered to provide the cash needed for

the down payment through an ‗angel investor‘ loan. This angel investor loan

plus the conventional bank loan will allow Gilbert and Maria to preserve capital

that will be needed to fund their continued growth.

Before proceeding with negotiating the purchase, Gilbert and Maria have asked

you to conduct a before and after tax analysis of the cost of occupancy. To do

so, you'll use their weighted average cost of capital (before and after tax) as the

discount rate.

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2.19

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Assumptions

Marginal tax bracket: 33 percent

Real estate purchase price: $1,255,000

Conventional loan terms:

o

75 percent LTV ratio

o 25-year amortization

o Five year term

o 6.25 percent interest

o No fees

‗ Angel investor‘ loan terms:

o

25 percent of real estate purchase price

o

Unsecured

o

13 percent interest

o

Interest-only payments (monthly)

a.

Before-tax weighted average cost of capital:

b.

After-tax weighted average cost of capital:

3. Calculate the user's discount rate based on the following scenario and

assumptions using your handheld calculator or by using Excel.

Pam and Ted Zinc own the Discovery Preschool and Learning Center. They

purchased the business about seven years ago from the prior operator and have

been leasing the school facility from the prior operator since the purchase. Pamand Ted were approached by the prior operator with an invitation to purchase

the property, or to extend the lease. They contacted you as well as their banker

with this news. You offered to provide an analysis that will allow them to

compare the costs of occupancy of owning versus leasing. To do so, you

explain, you'll use their effective cost of capital (cost of borrowed funds) to

derive the present cost of occupancy of owning and of leasing.

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Their loan proposal calls for a $1,100,000 loan at an 6.25 percent nominal

interest rate, with monthly payment, a 25-year amortization, 5-year term, one

discount point, and the following third part loan costs:

Phase I Environmental Study $2,250

ALTA Survey $2,500Document Preparation $ 500

Appraisal $2,000

Escrow Fees $1,390

Title Insurance, Endorsements $3,700

What is the effective cost of capital (cost of borrowed funds)?

End of activity

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2.21

2 •





1.

Which of the following is not considered a valid rationale for financialreporting?

a. Consistent set of financial status and performance parameters

b. Validity and reliability in financial reporting

c. Income opportunity for accounting and audit firms

d. Avoid cost to taxpayers and company shareholders due tomisrepresentation

2.

An organization using Generally Accepted Accounting Principles (GAAP) isconsidering a lease on a retail center that begins on January 1st that includes

six months of free rent on a lease of five years (a total of 66 months) with

monthly rent of

Year 1: $5,000.00 (months 7-18)

Year 2: $5,150.00

Year 3: $5,305.00

Year 4: $5,465.00

Year 5: $5,630.00

What amount of rent will the company recognize as an expense in year

one?

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3. Your company just executed a sublease on excess space. The office

building has three years remaining on the lease, with annual rent payments

of $240,000 per year (flat). The sublease rent is $150,000 per year (flat)

thereby saving the company considerable rent expense over the next three

years. On real estate decisions such as this, you have been directed to use a

discount rate of 7 percent. From a financial reporting perspective, the rentexpense for this excess office building would be

a. $90,000 net rent expense per year for each of the next three years (with

$150,000 reported as revenue and $240,000 reported as expense)

b.

$720,000 in rent ($240,000 rent per year for three years) is reported

immediately, and $150,000 sublease rent revenue is reported each year

for the next three years

c.

$236,188 rent expense is recorded immediately representing the net

present value of the contract rent less the sublease rent

d.

Nothing is reported, since this is an off balance sheet transaction

4.

You have been asked to provide some basic analysis on a proposed sale

leaseback transaction. The subject property has been owned by the

company for some time, and has a book value of $4,250,000 on the

company's financial statements based on the original purchase price,

acquisition costs less the cost recovery taken to date. The proposed

leaseback is for ten years at $675,000 per year with annual increases of 3

percent. The net sale proceeds from the sale of the property (after payingcosts of sale) would be $8,375,000. You've been asked to provide input as

to the estimate gain on the sale that would be reported on the company

financial statements in the year of the sale:

a.

$8,375,000

b. $4,125,000

c.

$412,500

d.

($262,500)

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2.23

2 •


5.

A typical short term office, industrial or retail lease with normal and

customary rent, terms and conditions would be reported on a company's

financial statements under GAAP:

a. As a footnote to the financial statements

b.

The income statement, showing the entire amount due

c.

The balance statement, showing the entire amount due

d.

The statement of cash flows, showing the entire amount due

6.

A non-corporate user could derive the discount rate to be used for their

user decision analysis from a variety of sources. The most common,

defensible derivation for the non-corporate user (individuals, partnerships

or sole proprietors) would be

a. Their after tax weighted average cost of capital

b. Their opportunity cost

c. Their cost of borrowed funds

d.

The Wall Street Journal prime rate

7.

A corporate user could derive the discount rate to be used for their user

decision analysis from a variety of sources. The most common, defensible

derivation for a corporate user (corporations, public companies) would be

a.

Their after tax weighted average cost of capital

b. Their opportunity cost

c.

Their cost of borrowed funds

d.

The Wall Street Journal prime rate

End of assessment

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2.25

2 •


Answer Section

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Activity 2-1: After-Tax Weighted Average Cost of Capital

Question 1

a.

What is the historic after-tax weighted average cost of capital?

7.29 percent

b.

What is the before-tax marginal cost of short-term debt?

8.00 percent

c. What is the before-tax marginal cost of long-term debt?

6.19 percent

d. What is the before-tax marginal cost of preferred stock?

6.60 percent

e. What is the before-tax marginal cost of common stock?

7.00 percent f. What is the marginal after-tax weighted average cost of capital?

6.01 percent

Question 2

a. What is the before tax weighted average cost of capital?

7.94 percent

Capital CategoryPercent of

Total

Before TaxCost ofCapital

Before TaxWeighted Cost

of Capital

Conventional Loan 75% + 6.25% = 4.69%

Angel Investor Loan 25% + 13% = 3.25%

Before-tax weighted average cost of capital 7.94

b. What is the after tax weighted average cost of capital?

5.32 percent

Before Tax Weighted Costof Capital

Tax RateComplement

After Tax WeightedCost of Capital

4.69% × 67.00% = 3.14%

3.25% × 67.00% = 2.18%

After Tax Weighted Average Cost of Capital 5.32

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2.27

2 •


3. What is the effective cost of capital (effective cost of borrowed funds)?

6.77 percent

How to Solve:

Step 1. Calculate the periodic loan payment based on the full amortization

period, nominal interest rate, and contract loan amount.

Payment = $7,256.36

Step 2. Calculate the balloon payment (if any) based on the nominal interest

rate and the contract amount.

Balloon payment is $992,760.05.

Step 3. Adjust the PV to reflect the loan costs (contract loan amount minus

dollar amount of total loan costs, including lender discount points), and solve

for i (effective cost of borrowed funds).

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Total loan costs:

Loan Points:

Loan Amount Loan Point % Loan Point $

$1,100,000 × 1.0% = $11,000

Other loan costs:

Phase I Environmental Study $ 2,250.00

ALTA Survey $ 2,500.00

Document Preparation $ 500.00

Appraisal $ 2,000.00

Escrow Fees $ 1,390.00

Title Insurance, Endorsements $ 3,700.00

TOTAL 12,340.00

Dollar amount of total loan costs: total loan points + other loan costs:

$11,000 = $12,340 = $23,340

Contract loan amount minus total loan costs:

$1,100,000 - $12,340 = $1,076,660

Effective cost of borrowed funds (cost of capital): 6.77 percent

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2.29

2 •



1. Which of the following is not considered a valid rationale for financial

reporting?

c. Income opportunity for accounting and audit firms

2. What amount of rent will the company recognize as an expense in year

one?

57,927.27

Proposed Lease Costs:

Months Monthly Rent Annual Rent

1-6 $0 $0

7-18 $5,000.00 $60,000.00

19-30 $5,150.00 $ 61,800.00

31-42 $5,305.00 $63,660.00

43-54 $5,465.00 $65,580.00

55-66 $5,630.00 $67,560.00

Total Rent: $318,600.00

Average Monthly Rent: $318,600 ÷ 66 Months = $4,827.27 per month

Year One Straight Line Rent Expense:

12 Months × Average Monthly Rent

12 × $4,827.27 = $57,927.27

3. Your company just executed a sublease on excess space. The office

building has three years remaining on the lease, with annual rent payments

of $240,000 per year (flat). The sublease rent is $150,000 per year (flat)

thereby saving the company considerable rent expense over the next three

years. On real estate decisions such as this, you have been directed to use a

discount rate of 7 percent. From a financial reporting perspective, the rent

expense for this excess office building would be

c.

236,188 rent expense is recorded immediately representing the net

present value of the contract rent less the sublease rent

Contract Sublease Differential

Year 1 $240,000 $150,000 $90,000

Year 2 $240,000 $150,000 $90,000

Year 3 $240,000 $150,000 $90,000

Net present value of the differential at 7 percent discount rate: $236,188

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4. You have been asked to provide some basic analysis on a proposed sale

leaseback transaction. The subject property has been owned by the

company for some time, and has a book value of $4,250,000 on the

company's financial statements based on the original purchase price,

acquisition costs less the cost recovery taken to date. The proposed

leaseback is for ten years at $675,000 per year with annual increases of 3percent. The net sale proceeds from the sale of the property (after paying

costs of sale) would be $8,375,000. You've been asked to provide input as

to the estimate gain on the sale that would be reported on the company

financial statements in the year of the sale:

c. 412,500

Net sale proceeds $8,375,000

— Property book value/adjusted basis $4,250,000

= Gain on sale of asset $4,125,000

Gain on sale ÷ leaseback term = gain to be recognized per year

$4,125,000 ÷ 10 years = $412,500

5. A typical short term office, industrial or retail lease with normal and

customary rent, terms and conditions would be reported on a company's

financial statements under GAAP:

a. As a footnote to the financial statements

6.

A non-corporate user could derive the discount rate to be used for their

user decision analysis from a variety of sources. The most common,

defensible derivation for the non-corporate user (individuals, partnerships

or sole proprietors) would be

b.

Their opportunity cost

7.

A corporate user could derive the discount rate to be used for their user

decision analysis from a variety of sources. The most common, defensiblederivation for a corporate user (corporations, public companies) would be

a.

Their after tax weighted average cost of capital

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Module Goal ........................................................ 3.1

Objectives ............................................................. 3.2

Interests in Real Estate ............................. 3.3

Owner‘s Leased-Fee Interest ............................... 3.3

Tenant‘s Leasehold Estate ................................... 3.3

The Potential Parties in the Space

Acquisition Process ................................... 3.5

Tenant/Purchaser ................................................ 3.5

Tenant/Purchaser Representative ....................... 3.6

Landlord/Seller .................................................... 3.6

Landlord/Seller Representative ........................... 3.6

Space Planner ...................................................... 3.7

Attorney ................................................................ 3.7

Space Acquisition Process ......................... 3.8

User Needs Analysis ............................................ 3.9

Market Research and Survey ............................. 3.11

Tenant Request for Proposal ............................ 3.12

Landlord Proposals............................................ 3.18

Comparison of Landlord Proposals .................. 3.18

Proposal and Counterproposal ......................... 3.18

Space

Acquisition

Process

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Proposal Acceptance and Lease Generation .... 3.18

Lease Document Negotiation and Execution ... 3.19

Provisions for Valid Leases ....................... 3.20

Lease Clauses ........................................ 3.21

Parties to the Lease ............................................ 3.21

Premises and Building Description ................... 3.21

Lease Term ........................................................ 3.21

Rent .................................................................... 3.21 Occupancy and Use ........................................... 3.22

Utilities and Service ........................................... 3.22

Parking Clause ................................................... 3.22

Signage ................................................................ 3.22

Tenant Improvements ....................................... 3.22

Alterations and Improvements .......................... 3.23

Repairs and Maintenance .................................. 3.23

Casualty .............................................................. 3.23

Insurance, Waivers, Subrogation, andIndemnity ........................................................... 3,23

Condemnation ................................................... 3.23

Right to Relocate the Premises .......................... 3.24 Options to Renew .............................................. 3.24

Right to Assignment or Sublease, Novation...... 3.24

Expansion and Contraction Options ................ 3.25

Holdover Clause ................................................ 3.25

Subordination..................................................... 3.25

Estoppel Certificates .......................................... 3.25

Default and Remedies ....................................... 3.25

Surrender of Premises ....................................... 3.26

Rent Terminology in Leases ...................... 3.27

Fixed Rent .......................................................... 3.27

Step Leases ......................................................... 3.27

Indexed Leases .................................................. 3.27

Percentage (Overage) Rent ................................ 3.28

Sample Problem 3-1: Calculating Breakpoint .. 3.28

Activity 3-1: Calculating Percentage Rent ........ 3.29

Operating Expenses ........................................... 3.31

Expense Stops .................................................... 3.31

Expense Caps ..................................................... 3.32

Expense Pass-Throughs ..................................... 3.32

Common Area Maintenance ............................. 3.33

Gross-up Clause ................................................. 3.33

Due Diligence: A Chance to Investigate theCauses of Risk .................................................... 3.33


Answer Section ....................................... 3.41

Activity 3-1: Calculating Percentage Rent.......... 3.42


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Space Acquisition Process

Module Snapshot

Module Goal

Acquiring space whether via a lease or purchase often can be a prolonged

balancing act, with a user‘s needs and goals on one side and the landlord/seller‘s

on the other. Although office, industrial, and retail space are different, by and

large, commercial space acquisition via lease or purchase follows the same

general process and principles regardless of the property type.

The two parties—landlord/seller and user/tenant/purchaser—engage in requestsfor proposals, proposals, and counterproposals and eventually come to an

agreement that theoretically best meets everyone‘s business objectives.

Depending on the circumstances, the space acquisition process might take as

little as a few days, or could stretch out for many months. Many parties are

involved in the space acquisition process, but essentially all are working for one

of the two key parties: the tenant/purchaser or the landlord/seller.

At different times and in different situations, real estate professionals may act as

(or on behalf of) either the user/tenant/purchaser or the landlord/seller.

Depending on the size of the user‘s company or in some cases the size or scale

of the space being acquired, the real estate professional may be asked to play

the role of negotiator, space planner, or even construction manager. As such,

this module is designed to provide students with a high level understanding of

the entire space acquisition process, including the roles, responsibilities and

expectations of the key parties.

Each phase of the space acquisition process—from the search for space to final

occupancy —has its own nuances and details. Understanding those aspects will

enable the professional to best advise and support an internal or external client,

avoid many negotiating issues, and ultimately achieve the individual and unique

business goals and objectives of the user.

Students should leave this module better prepared to manage the space

acquisition process in a manner that best meets the user‘s goals and objectives

for acquiring space.

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3.2 •User Decision Analysis for Commercial Investment Real Estate

Objectives

Identify real property interests.

Describe the roles and responsibilities of the different parties involved in

the space acquisition process. List the major phases in the space acquisition process.

Explain the major components of a user needs analysis.

Explain the key business points that should be included in a tenant‘s request

for proposal (RFP).

Identify and explain the components necessary for a valid lease.

Explain the major provisions of leases (lease clauses).

Explain rent terminology used in commercial leases.

Calculate the natural breakpoint and the amount of percentage (overage)

rent called for in a specific retail lease provision.

Explain the important business points that should be included in a letter of

intent to purchase.

Identify the components of the purchase due diligence process.

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3

•

S p a c e A c q u i s i t i o n

Interests in Real Estate

A lease is a legal agreement between a tenant and a landlord for the possession

and use of real estate. The lease agreement defines the contractual relationship

between the real estate owner and the user of the space. The lease document

specifies the rights and obligations of both the owner and user and legally

divides the bundle of rights in real estate into two interests.

The owner‘s group of rights and obligations is called the leased-fee interest, and

the tenant‘s group is called the leasehold interest. The owner‘s interest in a

property, without consideration of leases, is called the fee-simple interest.

Owner’s Leased-Fee Interest

In return for permitting the tenant to use the property, the owner receives:

Rental payments

The right to repossess the space when the lease ends

The conveyance of some of the owner‘s rights to tenant(s) affects the property‘s

value. The value of the periodic rental payments plus the value of the property

at the end of the lease term (the reversion) constitute the leased-fee interest,

which can be sold or mortgaged depending on the lease terms.

(Note:

The terms Interest and Estate are synonymous. For example, Leased-

Fee Interest has the same meaning as Leased-Fee Estate).

Tenant’s Leasehold Estate

The primary value of the lease to the tenant is the right to occupy and use the

space. However, because the tenant must pay rent according to the lease, the

leasehold estate has additional value to the tenant if the contract rent is less than

the current market rent for similar space elsewhere. (Contract rent is the actual

amount required under the existing lease. Market rent is the rent being paid for

comparable space over time periods comparable to the contract rent.)

The value of this leasehold interest is equal to the present value (PV) of thelease payments if the tenant were paying a market rental rate minus the PV of

the below-market lease payment the tenant actually is paying. (The process for

quantifying the value of the difference between market rent and contract rent is

covered in detail in a subsequent module.)

PV of contract rent – PV of market rent = leasehold value

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The concept of a leasehold interest is similar to valuing the benefit of having a

below-market interest rate on a fixed-rate mortgage. The value of the below-

market rate financing is equal to the PV of an otherwise similar loan at market

rates, minus the PV of the payments on the below market rate existing

mortgage.

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3

•


The Potential Parties in the Space

Acquisition ProcessMany participants are involved in the space acquisition process, and all of them

ultimately support either the tenant/purchaser or the landlord/seller. Thenumber and roles of participants many times will depend on the size and scale

of the transaction. Large companies may have on-staff space planners, or they

may engage a third-party architectural, construction, and/or construction

management firm as they move through the process. Small companies may rely

on a landlord‘s resources to help them define and construct what they need.

In a general sense, the following participants are involved in the process.

Tenant/Purchaser

The tenant/purchaser can be considered a buyer or shopper because they are

in the market for something specific—office, industrial, or retail space—for their

business. To make a sound user decision, the tenant/purchaser and those

representing the tenant/purchaser‘s interest should

Understand the budget set by the user prior to looking for space.

Know the geographic area that best serves the user‘s needs.

Understand how the proposed space integrates with the user‘s business

objectives.

Be able to clearly articulate the user‘s needs for the space.

Be knowledgeable about the necessary infrastructure any building must

have in order to be considered.

Negotiate terms that meet the user‘s needs with the best price and

maximum flexibility possible.

A number of factors can affect the ability of the tenant/purchaser to negotiate

successfully or from a position of strength, including market conditions,

availability of space in a geographic area, company credit rating, size, timing and

so on.

The tenant/purchaser should begin the initial outreach and search for space

well in advance of when they will need the space. Those embarking on a space

acquisition project within a compressed timeframe likely will find themselves at

a disadvantage, driven by the short-term need to get into a space quickly rather

than having time to methodically and intelligently locate the best possible space

and to negotiate advantageous terms. The tenant/purchaser must understand

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3

•


addition, this real estate professional must stay on top of the marketplace to

advise the landlord on the rental rates and terms of transactions being done by

the building‘s competition.

The seller‘s representative is engaged by the seller to market the seller‘s

building. This also requires an in-depth knowledge of the product to know if it

will match a prospective purchaser‘s needs. In addition, this real estateprofessional must stay on top of the marketplace to advise the owner on the sale

prices and terms of transactions being done by other sellers in the area.

Space Planner

The space planner is engaged to help plan and lay out how the space should be

designed, constructed and finished in order to best meet the needs of the

tenant/purchaser, while at the same time ensuring that the construction does not

adversely affect existing building systems.

It is typical for the landlord to engage an architectural firm for the space

planning purpose. If the user has very specific needs, then the user might

engage a separate architectural firm to help determine their unique

requirements, calculate the user‘s square footage needs and help identify which

prospective building‘s floor plate and internal systems will best accommodate

those needs. Most users purchasing space to occupy do their final space

planning during the due diligence contingency period.

Attorney Attorney involvement becomes appropriate when the landlord and tenant enter

lease negotiations. Landlords typically have a standard lease for their properties

that is designed to protect their interests; therefore, the tenant should engage

their own legal counsel when lease negotiations begin to protect the user‘s

interests. The tenant rep should work with tenant‘s counsel regarding the cause

and effect of certain clauses in the lease document. Users must remember that

a lease is a legal, binding contract; thus, it is important that the user engage legal

counsel.

When users are purchasing space to occupy, attorney involvement usuallycommences during the purchase agreement negotiation phase. The attorney

usually stays involved through the closing and transfer of title.

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Space Acquisition Process

Each lease negotiation has its own characteristics as determined by the property

type and parties involved, but the overall process can be generally

compartmentalized into phases. Some occur in sequence, while other steps in

the process will overlap. The phases typically are

1. User needs analysis

2. Market research, including physical tours of buildings

3. Tenant RFPs, including initial space plans for promising buildings

4. Landlord proposals

5. Proposal comparison and analysis

6.

Proposal and counterproposal

7.

Proposal acceptance and lease generation

8.

Lease document negotiation and execution

As illustrated in Figure 3.1, the space acquisition steps differ slightly depending

on whether the user is planning to lease or to purchase.

Figure 3.1 User Space Acquisition Process

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3

•


User Needs Analysis

A user needs analysis is a critical first step once the need for space has been

determined. The needs analysis captures such details as the user‘s physical,

geographic, budget, timing and various subjective requirements. The needs

analysis represents the user‘s must-have requirements, as well as its wish list.These criteria subsequently are integrated with the financial analysis in order to

make the final space acquisition decision.

A thorough needs analysis can take a considerable amount of upfront planning

and work, but this advance investment typically will save time and dollars later

in the process. The needs assessment is the opportunity for the user to detail

everything that will be important in making the final occupancy decision. An in-

depth needs analysis forces the user to think through various aspects of their

future space usage and articulate pertinent information about their operational

requirements, and ultimately, this information will help define the type of spacethat is most suitable for the user.

The information that should be included in a needs analysis is as follows:

An overview of the business, its history as well as the business plans and

objectives of the tenant‘s/purchaser‘s company

◘ A short paragraph about the type of business can assist a

tenant/purchaser rep or landlord/seller to better craft an agreement

suited to the type of business and its potential future needs.

Space requirements◘

How much space does the business need?

◘

How will the space be used?

◘

Does the space need to be contiguous, or can different work groups be

on different floors or even different locations?

◘ How many offices and of what sizes are needed for executives and

middle managers? Who gets a window office?

◘ For industrial users, what kind of power, clear height, bay depth,

proximity to freeways, railways, etc. is required?

◘

Do any corporate required standards or color schemes exist?◘

Are open work areas required, and if so what sizes are the cubicles?

◘

Taking into consideration the length of the lease term being

contemplated, what is the projected growth for office space, open space,

and conference room space?

◘ Regarding employee placement, which departments need to be near

each other?

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◘ Will the business grow quickly, necessitating expansion? Conversely,

could it possibly need to consolidate space?

Over standard requirements

◘

Does the company require anything more than the typical space needs?

(Some examples are higher-than-building standard improvements forcertain areas, such as the reception area and main conference room, or

the need for above-standard janitorial service for an employee-dense use

such as a call center.)

Location needs

◘ Must the space be in a particular geographic area or part of town?

◘ Where are the company‘s employees or customers? (If the

tenant/purchaser does not know, the tenant/purchaser rep can offer to

perform an employee or customer scatter map. Overlay the results on

typical office, industrial, or retail geographic sectors to show the user where the space search should take place.)

◘ What image does the company want to project?

◘ Do any state, county or local incentives benefit the user (tax increment

financing or sales tax and revenue bonds)?

◘

For retail users, demographics, traffic counts, zoning

Timing

◘ How quickly does the user need to occupy the space?

◘

Will a corporate officer need to tour potential buildings during the

evaluation process?

◘ Who will sign the documents (corporate official or local officer)?

Flexibility needs

◘ Does the tenant/purchaser need an exit strategy?

◘ Does the tenant/purchaser need expansion space? If so, how much and

when?

Parking needs

◘ What employee parking ratio is needed?

◘

Is more-than-typical visitor parking required?

◘ Is reserved employee parking required?

◘

Is covered parking necessary?

◘

Does the tenant/purchaser have any unusual parking requirements

(such as for trucks or vans)?

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3

•


Budget/cost imperatives

◘

Does the user have to stay within any specific budget parameters?

◘

Who has final say over the budget —the tenant/purchaser or a corporate

entity located outside the market? If the latter, do they have a good

understanding of local market conditions and pricing?

◘

Will financing be used?

Deal breakers

◘ Is a major competitor located in the same building or area?

Miscellaneous employee and space information

◘

What is the company‘s male-to-female ratio?

◘ What are the common area needs?

◘

Does the company have aging or disabled employees?

Market Research and Survey

Once the user‘s needs are analyzed, the tenant/purchaser rep then moves to the

market research phase. Multiple potentially suitable options are identified and

presented based on the criteria set forth in the needs analysis, including

location, spacing requirements, budget, usage, and workforce. This phase is

where the tenant/purchaser rep‘s knowledge of the market and familiarity with

local brokers and landlords becomes very important. A tenant/purchaser who

fails to engage a tenant/purchaser rep may miss suitable properties, fail tounderstand the supply and demand dynamics of the marketplace, and/or

overlook potential tax incentives.

The market survey involves much more work than simply punching up a survey

on the local commercial property database. For example, verification should

be done to confirm that the advertised space has the potential to meet the

tenant‘s/purchaser‘s needs. During research and verification, the

tenant/purchaser rep can enlighten the prospective landlord‘s/seller‘s agent

about the space requirements and some of the specific nuances of the user‘s

requirements. Sample floor plans, if available, should be included in the

building survey presentation. Buildings or spaces that meet the

tenant‘s/purchaser‘s needs are compiled, analyzed and compared.

Once the tenant/purchaser rep has narrowed the possibilities, tours of

appropriate properties are arranged. A photo or description of a property

doesn‘t replace a site visit. Site visits allows the user the opportunity to

understand aspects such as the building‘s ingress and egress, the views from the

proposed floors, the image projected by the building‘s lobby and common

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areas, the amenities located in or near the building, the condition of the parking

lot, the landscaping, and drive-up appeal. The primary goal of site visits is to

further narrow the selection, leaving only those buildings with which the tenant

user will move into the RFP phase or the purchaser user will move into the

letter of intent phase.

Tenant Request for Proposal

The user needs analysis and the market survey set the stage for the negotiation

process, which begins by sending RFPs to appropriate landlords. Ideally by this

time, the user has narrowed the search to no more than four or five alternatives.

The RFP is designed to put all landlords on a level playing field by informing

them of all of the tenant‘s space and transaction requirements. Clearly written

to the benefit of the tenant, this document sets forth, in detail, business points

important to the user.

This is the stage where initial space plans or test fit plans are done. Space

planning is essential for both the landlord and the tenant because the results set

forth a design that can be quantified in terms of finishes, electrical outlets,

amount of drywall, etc. Once quantified, the plan can be sent for preliminary

construction bids.

Understanding the actual construction cost is critical to the negotiation process

because this knowledge determines the direction of the negotiations. The

tenant must know whether the desired construction is within or over the tenant

improvement (TI) allowance being offered. If a landlord will not increase the

allowance to cover an overage, then the tenant must factor in tenant-paid TIs,

which will affect a building‘s financial impact once the tenant rep completes the

cost of occupancy analysis.

Key Components of a Request for Proposal

A well-constructed RFP lays out the salient business points early in the leasing

process. The give-and-take of an RFP and the resulting landlord proposals can

Help the tenant gain market insight (from the various responses received).

Provide a good understanding of the landlord‘s position and whatconcessions they may or may not be willing to make.

Articulate issues that are critical from the tenant ‘s perspective.

Most importantly, avoid points of contention at the eleventh hour that could

derail a final agreement.

All RFPs are unique to the specific leasing situation. However, the following

sections should be addressed in any RFP.

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Client Description. This brief description of the tenant‘s business establishes

credibility and gives potential landlords an understanding of the potential use

for the space. This is a good place to reference the company‘s website, so the

landlords can do further research.

Space Requirement. This section sets forth the estimated space that the tenant

needs. Additionally, it could include a breakout of the interior workings of thespace by function. For instance, such information for an office user could be:

Reception area: 10 × 12 feet

Executive offices: Three at 15 × 20 feet each

Open area: Large enough to house 18 cubicles that are 8 × 8 each

Break room: Must have a minimum 8-foot counter, hot/cold water sink,

dishwasher, automatic plumbing line to the refrigerator, icemaker,

automatic-fill coffee maker, upper and lower cabinets

Purpose of Space. This section includes detailed and specific usage

information. For example, if the space is to be used for a call center, the

business‘s hours of operation probably won‘t match the building‘s hours of

operation or parking requirements will be significant. Landlords need to

understand the space use in order to properly respond, similarly, tenants need

to know if the building can accommodate the business use. If the building

cannot or will not accommodate the use, it is eliminated from consideration.

Load Factor. This section requests that the landlord state the multi-floor load

or add-on factor. If the tenant can utilize at least one full floor and part of

another, ask for both the multi-floor and the single-floor load factors.

Location Within the Building.

This section requests information about which

suites or floors can accommodate their space requirements. For instance, if

multiple floors are available in the prospective building, the tenant may prefer

the highest floor if it offers the best views. However, the landlord may not

propose the highest floor because the floor below is also available, or, the

landlord may not want to break up a large block of contiguous space on a

certain floor for the tenant‘s smaller square footage requirement. The

landlord‘s reluctance to give the tenant the desired floor can become a

negotiation point.

Primary Lease Term.

This section details the tenant‘s desired timing and lease

duration needs. For example, the tenant wishes to sign a five-year lease and take

occupancy on a certain date.

Rental Rate. This section asks the landlord to set forth their most competitive

rental terms. The section also clarifies they type of lease, such as a full-service

lease, or a gross lease. The RFP asks for the estimated cost of expenses And

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may ask for a breakdown of operating expenses for the last three years and the

building‘s occupancy during each of those y ears.

Existing Lease Assumption. If the tenant is locked into an existing lease, the

RFP may inquire if the landlord is willing to pick up the user‘s existing lease

obligation. The existing lease obligation could be handled a number of ways,

including asking the landlord for a specific dollar amount to be paid to thetenant to cover the current lease, or requesting a free rent period for the

overlapping time while the tenant is still paying rent on the existing space. In an

overdeveloped market, landlords are more likely to grant this than when space

is at a premium. Other factors playing into this decision include the tenant‘s

credit rating and company size, as well as the length of time the tenant is willing

to lease the space. (Note:

This section would not be included in the RFP if the

tenant does not have an existing lease.)

Beneficial Occupancy. The beneficial occupancy period, sometimes known as

early occupancy or fit-up period is the time period the tenant needs to installsystems, set up furniture, or accomplish other tasks before the business can

operate. The RFP should request stipulating the time period allowed, and what

amount of rent, if any, would be charged for this time, and, depending on the

type of lease, what amount of operating expense, if any, would be charged.

Tenant Improvements.

The TI section is one of the most important sections of

the RFP. It requests the amount of money (or allowance) the landlord will

provide for the tenant to build out the space to meet the user‘s specifications

and needs. The negotiations in this section also force the user to balance their

construction needs with the dollars the landlord will allow.

To clearly negotiate the TI allowance, the RFP should request the TI allowance

dollar amount, as well as a description of the existing conditions (sometimes

called shell condition) in the space prior to the application of any TI dollars.

The RFP also should state what is to be excluded from the TI allowance. For

example, ―the cost of initial space plans, construction documents, and

construction management shall not be a deduction from the TI allowance.‖

The RFP also should request a preliminary space planning meeting with either

the tenant‘s space planner or those employed by the landlord. The space

planner will design the space to the tenant‘s specifications, and the sketches

then may be sent for preliminary construction bids to contractors of the

landlord‘s and/or tenant‘s choosing. The responding bids will let the tenant

know if the TI allowance will cover the necessary build-out. This information

may direct the tenant to prioritize another building or attempt to negotiate a

greater TI allowance.

When comparing the landlord‘s proposals, the tenant must determine which

landlord is offering the best overall TI allowance. A simple comparison

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between dollar amounts may not be sufficient. Other factors, such as the

existing space conditions and how given allowances are to be applied are also

important determining factors.

Options to Renew. This section of the RFP lays out the user‘s desired options

for renewing the lease, including the rent that will be paid upon renewal, or how

the rent will be determined at renewal as well as the terms of the renewal noticethat the landlord requires.

Refurbishment Allowance/Improvement Package.

This section requests

clarification of an allowance (if any) for space improvements at some point later

in the lease or at renewal time. Items for refurbishment could include new

carpet, paint, or other basic enhancements.

Expansion Options.

Expansion options, like renewal options, are for the

benefit of the tenant and can be detrimental to the landlord. Such options

essentially ask the landlord to hold space off the market to accommodate the

tenant‘s future expansion, or, if space becomes available, an option mightprovide the tenant the first right to the expansion space. Generally speaking,

expansion options constrain landlords regarding effectively marketing (and

generating rental income) on that expansion space; therefore, the landlord may

refuse to allow for expansion options. The tenant must understand the

constraints an expansion clause causes and be prepared to negotiate.

Operating Expense, and Operating Expense Caps/Stops. Operating expenses

are another important component of the negotiation because they represent a

cost center to the tenant. Stops and caps (defined later in this course) may be

cumulative, year to year, or partial. The purpose of the RFP is to define whatcurrent and historic operating expense has been, and how the landlord

proposes to pass through expenses to the tenant. For instance, will all building

expenses be passed directly through to the tenant (NNN Lease), or will

expenses be passed through once the expenses exceed a certain dollar amount

(expense stop)?

Concession Package. When negotiating lease terms, owners and potential

tenants typically focus their attention on contract rents. However, owners

sometimes will offer tenants rental concessions, such as several months of free

or reduced rent or free parking. Rental concessions are more prevalent in

overbuilt markets because leasing space is more difficult during those

conditions. This section asks the landlord to provide details as to any

concessions that might be provided, such as free rent.

Note:

Later in this course, the method for calculating occupancy cost with free

rent periods or reduces rent periods using generally accepted accounting

principles (GAAP) is defined.

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Technology Requirements. This section describes the user‘s technology needs

such as for server rooms, a satellite on the roof, raised floors, antennas, etc.

Construction. Assuming that some construction is needed to ready the space

for occupancy and that the tenant is paying for part of it, the tenant may wish to

reserve the right to bid out the work. Some landlords have the benefit of

construction managers on staff, even so the tenant should have the right toensure that the work is being done to a quality and price that‘s fair to both

landlord and tenant.

Space Planning. This section addresses who pays for the space planning and

who actually serves in that role. Often a landlord will want their own staff, while

the tenant may want a third party. This all must be agreed on, including the

cost and timing.

Management Company.

The RFP should request as much information as

possible about the property management company.

Moving Expenses.

This section will determine if the landlord is willing to help

defray the costs of the tenant moving to the new location.

Right to Terminate. Some users wish to negotiate the right to terminate the

lease early for various reasons. If this is a must-have requirement for the user, it

should be clearly stated in the RFP. Since this clause is detrimental to the

landlord, this section would determine the cost (sometimes called the early

termination penalty) as well as the notice period and any other terms. Lenders

and potential buyers for a building will view a right-to-terminate clause as a

potential decreased income stream. For example, if a tenant signs a five-year

lease with a right to terminate after three years, lenders likely will view the lease

as a three-year income stream.

Holding Over. This section determines the cost of rent if the tenant continues

to occupy the premises after the term of the lease expires.

Relocation of Premises. The landlord will want the right to relocate the tenant

should the landlord secure another tenant who needs a contiguous amount of

space that infringes on the original tenant‘s space. This section defines the

items the tenant wishes to retain if relocated, such as a view, lobby exposure, or

a certain floor level. Relocation clauses might contain provisions for the

landlord to reimburse the tenant for relocation costs, such as reprinting

stationary and business cards.

Parking. The parking requirements of the tenant, and the parking capacity of

the proposed premises are defined in this section. Parking is an area that could

eliminate a building if the tenant needs can‘t be met. This section should solicit

information on the parking ratio and how it is applied to all tenants, and in

certain markets, the ratio or number of covered parking spaces and the cost.

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ADA Americans with Disabilities Act). The RFP should request

representation of the building‘s ADA compliance, and should clarify which

party is obligated for ADA compliance.

Janitorial.

This section would state the premises level or frequency of janitorial

service, and state the tenant‘s janitorial requirements if they are over and above

typical service.

Amenities. The RFP should list any special tenant needs, such as meeting

facilities, storage, fitness facilities, and the like.

Landlord Proposals

The landlord proposal is the landlord‘s response to the tenant‘s RFP. At a

minimum, the response should deal with the basic business points of the lease:

rent, length of term, space size, TIs, move-in date, amenities, and common

areas. Optimally, the proposal should mirror the RFP and answer all keypoints raised in the RFP. If the landlord does not plan to accommodate given

requests, the response should clearly indicate this. When the landlord is silent

on an issue, the tenant rep should get clarification from the landlord rep.

Comparison of Landlord Proposals

Once responses to the RFPs are received by the tenant rep, they are compared

and analyzed. At this point, the field of prospective spaces is narrowed even

further as the review and analysis determines which alternatives are not able to

meet critical needs of the user. The methods used in the economic measure

and comparison of the leases are discussed in a subsequent module.

Proposal and Counterproposal

At this stage, subject matter expertise, analysis, communication and negotiation

skills come into play as each alternative is further clarified, negotiated, and

prioritized. The ultimate goal is to secure through negotiation the lowest cost of

occupancy in the premises that best meets the needs of the user.

Proposal Acceptance and Lease Generation

When the tenant has made a final choice, the next step is generating a lease. At

this juncture, some tenants choose to interject a letter of intent (LOI) in

advance of a lease by reducing the agreed upon proposal to a mutually executed

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non-binding letter. If used, the LOI articulates the business points agreed to by

both parties.

Lease Document Negotiation and Execution

In this phase, the tenant and landlord negotiate clauses in the lease document,and the point and extent of legal counsel involvement is determined by each

individual party. When negotiating a lease, it is typical to expect several

iterations before arriving at the final document. It is standard procedure for a

tenant or tenant rep to note desired revisions and return the lease to the

landlord. The parties should engage an attorney to review the lease, since it is a

binding legal agreement.

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Provisions for Valid Leases

No single uniform ‗standard‘ version of a lease exists. Building owners

customize leases to fit their specific circumstances and properties. However,

the requirements of valid leases are similar to the requirements for valid

contracts. If the required elements appear in the lease, then it is valid.

Commercial leases can be from one to more than 50 pages.

Despite the wide variation of commercial leases, valid and enforceable leases

usually contain the following elements:

Names of owners and tenants: All parties to the lease should be clearly

identified, and indicate their acceptance by signing the document.

Description of property: Descriptions include street addresses and

recorded plats in urban areas and government rectangular survey system

and metes and bounds in rural areas.

Consideration: This requirement usually is met by the tenant‘s promise to

pay rent in exchange for the right to occupy the premises, and the owner‘s

inability to occupy the premises during the lease term.

Legality of objective: The objective of the lease must not violate any

federal, state, or local law.

Offer and acceptance: These are statements to the effect that the owner

offers and agrees to lease the property to the tenant under certain terms and

conditions, and that the tenant accepts and agrees to lease the property from

the owner under those same terms and conditions.

Written form: In most states, leases for longer than one year must be in

writing to be valid and enforceable.

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Lease Clauses

Most commercial leases contain the following sections.

Parties to the LeaseThis section must clearly identify the legal entities that are taking on landlord

and tenant accountabilities. When the tenant is leasing on behalf of a

corporation, the lease document will contain assurance that the tenant is

authorized to enter in to the lease on behalf of their corporation. The same

authority language is required of the landlord.

Premises and Building Description

This section references and/or describes the premises and property including,for instance, the suite number and the square footage being leased. An exhibit

in the lease most likely depicts the area. This section also sets forth the total

size of the building and the physical address. The lease should contain a legal

description of the site on which the building is situated, typically contained in an

exhibit to the lease.

Lease Term

The lease term states the timeframe in which the tenant has exclusive rights tooccupy the leased space and provides the specific or conditional start date

(commencement and/or occupancy) and end date (termination). This section

sets forth when the landlord will start charging the tenant rent. A definition of

substantial completion of improvements also is one of the items included in this

section.

Rent

This section details the amount to be paid, when it will be paid, and what makes

up rent. It also documents any penalties and/or interest incurred in the event oflate payments. In many leases, the rent has provisions to be escalated, or

increased over some set period. Contract rent is determined by a number of

provisions within a lease. The section that follows, Rent Terminology in

Leases, describes these provisions in detail.

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Occupancy and Use

This provision dictates the agreed-to use of the space, as well as all laws and

regulations pertaining to its use. This section protects the landlord and other

tenants in the property from any actions the tenant might take that would be

detrimental to the property, damage the building or increase insurance rates.

Utilities and Service

This section specifies which utilities the landlord will provide and which the

tenant is responsible for. To protect against service interruptions, the lease

might include language requiring the landlord to make all reasonable attempts

to prevent interruptions and to compensate the tenant if they occur. This

section also details the landlord‘s position regarding acceptable and excessive

utility use. The lease should be very clear on the normal, or base, utility useincluded in the utilities payments and how ―excessive‖ is defined.

Parking Clause

This clause ensures that the tenant will have ample, agreed-upon parking for

employees and customers. Reserved or assigned parking and the costs (if any)

are included in this section of the lease.

SignageThis section discloses the Landlord‘s policy, restrictions, terms and conditions

on the type and size of signs they allow tenants to erect.

Tenant Improvements

The TIs laid out in the landlord‘s final proposal are stated in more detail in the

lease. The ―base building‖ or shell is typically defined, and all terms and

conditions relating to TIs detailed, along with any applicable plans or space

planner drawings. This section also should include payments terms for TIs. Insome instances, a separate addendum to the lease, many times referred to as a

work letter further defines the process and procedure of tenant improvement

completion.

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Alterations and Improvements

This section generally sets parameters around any changes the tenant chooses

to make to the space beyond the agreed-upon TIs. This section governs

responsibility for alterations made to the space during the term of the lease,

landlord‘s approval of plans, and the disposition of the improvements at theend of the term.

Repairs and Maintenance

This section might include roles of responsibility and definitions of levels of

repair and maintenance, and what are considered operating expenses versus

capital expense.

Casualty

This section describes the rights and obligations of the tenant and landlord if

the property is damaged or destroyed from events such as fire, flooding,

hurricane or earthquake. The section details whether or how the lease will be

continued or stopped in such an event and explains what causes would trigger

any rights or obligation as well as insurance. The section provides for a timeline

for repairs, relocation, or other steps needed to enable the tenant to continue

conducting business.

Insurance, Waivers, Subrogation, and Indemnity

This section sets forth the types of insurance that each party must carry and the

limits of required coverage. The section might explain responsibility for

damages to the property, premises, tenant or the tenant‘s visitors.

Condemnation

Condemnation is an order allowing private property to be taken and used for

the public—for example, when a city condemns property to widen a road. Affected parties will be compensated for their loss. This section of the lease

determines the outcome of the lease as well as any consideration that might be

paid in the event of a complete or partial condemnation.

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Right to Relocate the Premises

This clause defines under what conditions (if any) that allows the landlord to

relocate the tenant‘s premises. Large tenants sometimes can strike the clause,

but small tenants generally don‘t have this leverage. Consequently, this section

defines the conditions and consideration for relocations, such as

reimbursement of any expenses incurred, such as printing new signs or new

stationary, or other requirements such as lobby exposure, the same view and

amenities.

Options to Renew

Many commercial leases grant a tenant the right, but not the obligation, to

renew their lease for pre-specified periods after the initial lease term expires.

Sometimes the renewal rental rate is specified in the initial lease contract, butmore frequently the right to renew is at a rent equal to market rates at the time

the renewal option is exercised. Renewal options are valuable to tenants

because they ensure that the tenant can stay and operate their business in the

same space.

Right to Assignment or Sublease, Novation

Unless prohibited or limited by the lease, the tenant has the right to sublet or

assign all or a portion of its leasehold interest to another tenant (sub-tenant). If

the tenant subleases its space, a further division of interests in the property

results. In a sublease, the tenant conveys part of its leasehold interest to a

subtenant, while retaining an interest in the property. The sublease could

involve a partitioning of space, with the subtenant occupying part of the original

tenant‘s space, or it could involve a sublease of the entire property for a portion

of the original tenant‘s term.

In a sublease, the original tenant remains obligated to pay rent to the landlord

and must collect rent from the subtenant, who has no obligation to the landlord.

If the original tenant transfers all interest in the lease to the subtenant, it is

generally referred to as a lease assignment. It is important to note that the

original tenant still remains liable for the obligations of the lease unless the

tenant is specifically released from obligations by the owner through a novation.

A novation is a mutual agreement between all of the parties to substitute a new

agreement in place of the existing agreement, terminating the old agreement.

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Expansion and Contraction Options

Most businesses seek growth. This section, if included in the lease, allows the

tenant the right to occupy additional space in the property, after a specified

notice period, at then market rental rates. In some cases, the owner will agree

to give a tenant the right of first refusal when space becomes available in thebuilding. If additional contiguous space cannot be provided in a reasonable

timeframe, the owner may agree to relocate the tenant within the property as

soon as possible.

For a user expecting to expand, (and if the expansion is critical for the user), the

lease should provide for cancellation, after reasonable notice, if suitable

expansion or relocation opportunities are not made available by the owner. .

Holdover Clause

This section delineates the terms, conditions and rent if the tenant needs to stay

in the space after the lease terminates.

Subordination

This lease clause explains the conditions under which the tenant agrees that the

lease document will be subordinate to any deed of trust, mortgage, ground

lease, or master lease.

Estoppel Certificates

This provision defines how the landlord will request and how the tenant will

comply with a request for execution of an estoppel certificate. An estoppels

certificate is a written, signed statement setting forth for another parties benefit

(such as a lender or purchaser) that certain facts are correct, such as that a lease

exists, there are no defaults, and that rent is paid to a certain date. The

landlord generally needs this documentation for refinancing or selling the

building.

Default and Remedies

This clause lays out the landlord‘s rights in the event of any default on the part

of the tenant , and further, defines the tenant‘s rights in the event of any default

on the part of the landlord.

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Surrender of Premises

The purpose of this clause is to prevent the tenant from vacating the space in a

damaged condition. The section defines those items that the landlord requires

to be removed or restored.

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Rent Terminology in Leases

A commercial lease may call for the following:

A fixed amount of contract rent over the entire lease term

Rental payments that change, or step up, by set amounts or percentages atgiven dates (step leases)

Variable levels of contract rent based on changes in an index (indexed

leases)

Variable amounts of monthly rent based on a percentage of the tenant‘s

gross sales receipts (percentage leases)

Periodic changes in contract rent based on pre-negotiation

Fixed Rent

Contract rents are fixed (don‘t increase) for the duration of the lease.

Step Leases

Contract rents change by preset amounts or percentages on predetermined

dates, such as every year or every five years. Although the lease payments vary

over the lease term, all payments are determined at the beginning of the lease

agreement. Thus, unless the tenant defaults, all lease payments are known with

certainty when the lease is signed.

Indexed Leases

Contract rent is indexed (tied) to movements in a pre-specified index, usually

the consumer price index. For example, if general inflation in the U.S.

economy was 3 percent in 2010, monthly lease payments for the year 2011 will

be increased 3 percent over their 2010 level. Indexation prevents inflation

from eroding the real value of the tenant‘s lease payments and more likely is

included in long-term leases. If all else is the same, owners would prefer toinclude this protection against inflation in their commercial leases because, in

effect, indexation passes any inflation risk from the owner to the tenant.

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Percentage (Overage) Rent

Percentage rent is additional rent (over a base rent amount) that tenants pay to

the owner based on the tenant‘s sales over a certain dollar amount. This clause

frequently is found in shopping center leases in which an owner manages and

promotes the entire center and therefore should share in the tenant‘s profits

and risk. Percentage rent usually is calculated and paid on an annual basis.

A natural sales threshold or natural breakpoint is

Natural breakpoint =Annual base rent

Overage rate

Sample Problem 3-1: Calculating Breakpoint

If the annual base rent is $120,000 and the (sales percentage) overage rate is 4

percent, then the breakpoint is $3,000,000 (120,000 ÷ 0.04). At sales of this

amount or below, the tenant pays only the base rent. At sales above this

amount, however, the tenant must pay 4 percent of the overage. Thus, if the

tenant had sales of $3,500,000, the overage rent would be calculated as follows:

Total sales $3,500,000

− Breakpoint − $3,000,000= Excess sales $500,000

Excess sales $ 500,000

× Overage percentage × 0.04= Overage rent $ 20,000

The total (annual) rent would be $140,000. Some typical overage rates include:

grocery stores, 2.5 percent; drug stores, 3.5 percent; and restaurants, 4 percent.

Because the owner is sharing in the upside potential of the tenant‘s business,

this clause is valuable to the owner. To abstract something of value from the

tenant, the owner must give something of value. That something is a base rent

that is lower than it would be in the absence of the overage rent clause.

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Activity 3-1: Calculating Percentage Rent

A 60,000 sf recently completed freestanding building is leased to a national

credit discount retailer. The lease has a percentage clause and includes the


Base rent: $15 psf

Base lease term: 20 years

Percentage rent: 3 percent of sales above the natural breakpoint

1.

Calculate the natural breakpoint (threshold) in sales.

Base rent ÷ overage rate = natural breakpoint

2.

Determine the year the tenant will begin paying percentage rent.

The tenant estimates first year sales at $400 psf, escalating at a rate of 5

percent annually.

Premises square feet×

sales per square foot = year one sales

Year one sales× (1 + annual sales growth rate) = year two sales

Year two sales× (1 + annual sales growth rate) = year three sales

Year three sales× (1 + annual sales growth rate) = year four sales

Year four sales × (1 + annual sales growth rate) = year five sales

Year five sales× (1 + annual sales growth rate) = year six sales

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3. Calculate the amount of percentage rent the tenant will pay in the first year

of percentage rent.

Total sales – natural breakpoint = amount of sales subject to percentage rent

Amount of sales subject to percentage rent × percent amount = percentage rent

End of activity

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Operating Expenses

The lease document specifies who is responsible for the payment of operating

expenses.

Under a gross lease, the tenant pays the owner a gross amount for rent. From

this amount, the owner then pays the operating expenses (property taxes,

insurance, maintenance, utilities, janitorial, and security costs). Gross (or full-

service) leases are used primarily in multitenant office buildings.

In a net lease, the tenant pays all or some of the operating expenses. The first

net usually obligates the tenant to pay annual property taxes. In a net-net lease,

the tenant pays both property taxes and hazard/fire insurance. In a triple-net

lease, the tenant is also responsible for its proportionate share of operating

expenses. The lease terms should be examined carefully, as the definition of a

net lease varies from market to market. Generally, however, a net lease

includes property taxes, insurance, and operating expenses.

For a given level of rent, owners clearly prefer to pass as much risk and

responsibility for operating expenses to tenants as possible. However, the

extent to which owners and tenants share the payment of operating expenses

depends on the current standard in the market and the relative bargaining

power of the two parties.

Many commercial leases contain alternative treatments (compromises) of

operating expenses. These alternatives may require owners to pay operating

expenses up to a given maximum amount (expense stops); or, may allow

owners to pass certain operating expenses through to the tenant (expense pass-throughs); or, may allow the owner to charge the tenant for some or all of

operating cost increases after lease commencement (base year expense stop).

When applying lease terminology such as gross, full service, or net to leases, it is

important to understand that most leases are hybrids of these lease types.

Note:

Although operating expenses may be referenced in the rent section, in

the majority of leases operating expenses are treated as a separate provision

given their complexity and importance.

Expense Stops

With some commercial leases, the owner may add an expense stop clause. In

this situation, the owner pays operating expenses up to a specified amount,

usually stated as an amount per square foot of rentable space in the building.

Expenses in excess of the expense stop are passed through to tenants based on

their percentage of occupancy in the building.

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For example, an office lease may state that a tenant will pay $18 per rentable

square foot (rsf) per year and that the owner will pay all operating expenses

associated with the property —so long as expenses do not exceed $4 per rsf of

building area. If the building has 50,000 sf of rentable area, then this clause

obligates the owner to pay the first $200,000 in annual operating expenses ($4 ×

50,000). Any amount over $200,000 will be paid by the tenants based on thepercentage of the building‘s rentable area or the sf that the tenant occupies.

This clause effectively limits—or stops—the owner‘s operating expense exposure

at $200,000.

Although expense stops appear to benefit owners by limiting their exposure to

greater-than-expected operating expenses, this owner benefit comes at the

tenants‘ direct expense. Thus, in a competitive rental market, ow ners must give

knowledgeable tenants something of value in exchange for the expense stop

clause, which can be a lower contract rental rate if competitive leases in the

market do not contain expense stops.

Expense Caps

With some commercial leases, the tenant may add an expense cap clause. In

this situation, the tenant pays certain operating expenses up to a specified

amount, usually stated as an amount psf. Expenses in excess of the expense cap

are paid by the owner.

In some cases, the tenant‘s expense cap is combined with the landlord‘s

expense stop. In this application, the tenant‘s expense cap may be expressed as

a limit to the amount a landlord‘s expense stop category (such as property taxes,

for example) may increase in any given year.

Expense Pass-Throughs

The landlord may pay some, if not all, operating expenses and then pass them

through to the tenants. This is especially true in multitenant office buildings

and retail shopping centers. In retail properties, a tenant‘s share of these

expense pass-throughs is based on the gross leasable area (GLA) of the tenant‘s

store as a proportion of the GLA of the entire shopping center. In officeproperties, the pass-through is based on the tenant‘s rentable area as a

percentage of the building‘s total rentable area.

As with expense stops, owners must give knowledgeable tenants something of

value in exchange for expense pass-through, which can be a lower contract

rental rate if competitive leases in the market do not contain pass-throughs.

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Common Area Maintenance

A common expense pass-through in commercial leases is common area

maintenance (CAM) expenditures, or the costs associated with maintaining the

common areas of a property, such as hallways, lobbies, outside areas, and

parking lots. These costs may be included in a gross lease or excluded in a netlease, but in either case they usually are calculated on the percentage of rentable

space the tenant occupies. If maintenance costs or taxes increase, CAM clauses

benefit owners because the increase is passed on to the tenants. Tenants also

benefit, at least in theory, to the extent that monies collected for CAM cannot

be used for other expenses, helping ensure that the property is properly

maintained. As with any expense pass-through, the contract rent is lower than it

would be in the absence of a CAM clause.

Gross-up Clause Another consideration is whether current market conditions allow the landlord

to insert a gross-up clause, in which the landlord increases the expenses as if the

building was 95–100 percent occupied, even if the building is not. That is, if

the building is not fully occupied, this provision allows the landlord to gross up

or overstate the expenses as if the building is fully occupied (or 95 percent

occupied or the agreed-upon occupancy). The result is that since the actual

expense of operating the property is grossed up to an amount that the landlord

believes the operating expense would be if the building were 95 percent or fully

occupied, the amount that the tenant must pay increases.

Due Diligence: A Chance to Investigate the Causes of

Risk

All risks can be categorized as avoidable, unavoidable, or acceptable. If a risk is

neither avoidable nor acceptable, then logically the property also is not

acceptable. Risks that are accepted must be priced, but the astute real estate

user first will shift or avoid risks that are manageable. Understanding what types

of risk are present and potentially manageable requires a careful analysis of the

entire space acquisition process, from needs assessment to move in to move

out.

Much of this analysis occurs during due diligence. Once a tentative purchase

contract has been written, the buyer must assess all possible modifications and

adjustments based on the detailed discovery learned during due diligence. This

must be accomplished quickly, as few sellers will a long period of time—even on

a large property —for the completion of due diligence.

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Four types of due diligence frequently used in the real estate acquisition

process:

Market due diligence

Property due diligence

People due diligence

Contractual due diligence

Market Due Diligence

Reasonable assumptions behind the pro forma are critical. As such, it is

important to conduct or secure market research reports that verify and confirm

current as well as forecast supply data. Data sources such as CoStar, LoopNet,

STDBonline, and others provide much of the information required for

analysis, while vendors such as REIS and Torto Wheaton provide actual

market forecasts. These, along with broker reports, are possible sources toconfirm general and local market trends.

Relevant market information may include any of the following elements:

Demographic trends

◘

Population and growth rates

◘

Households, household sizes and distributions, and growth rates

◘ Aging profiles and other segments as appropriate

◘ Specific target market analysis for a subject property

Economic base trends

◘ Key employer trends

◘ Key industry trends

◘ Pro-business or anti-growth political environments and economic

incentives to relocate

◘

Regional competitiveness

Rental rates, vacancy rates, absorption history, and new supply coming

online

◘

By MSA◘

By submarket and subject property peer group

◘ Forecast of occupancy, rents, and vacancy rates

◘ Realistic view of the competitive advantages of the subject property

versus peer property

Transportation trends and analysis

◘

By mode, highway, major plans, and interchanges

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◘

Parking access in the subject property area

Property Due Diligence

Property due diligence can be broken into three subgroups: ownership and

description, tenants and leases, and operations, management, and third-party

contracts.

Ownership and Description.

This analysis should uncover the following

information:

Title search and abstract verifying ownership, authority to transfer, and

ability to secure title insurance

Property tax records, mortgage liens, and mechanics liens, if any

The accurate as-built survey of the building, equipment, and land

◘ Required repairs and estimates

◘

Photos and economic life of major components

Sf (or meters) of gross space by floor

Sf of currently leasable space by floor

Sf of common, storage, and unfinished space by floor

Security features and equipment

Environmental studies

◘ Phase 1 environmental report

◘

Mold report and air quality check

◘ Radon check

◘ Green design features and recycling facilities

Americans With Disabilities Act compliance

Zoning and building code conformity and easements

Tenants and Leases.

This phase of property due diligence assumes that a

multi-tenant property is being acquired by the user, with the user occupying a

portion of the property and involves an inventory of all tenants and industry

trends, including: Tenant quality, credit, size requirements, and special needs and TIs

Propensity of existing tenants to move

Lease terms, rental rates, and expense pass-through features for each tenant

compared to the market

Auditable records, if appropriate

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Tenant mix and the impact of that mix, if any, on the property‘s success

Operations, Management, and Third-Party Contracts. In this phase, the

purchaser should survey the quality and price of existing service contracts

compared to the market, as well as the efficiency of building operations (energy,

HVAC, ability to retrofit, etc.).

People Due Diligence

This category of review is unusual as part of the due diligence process, but the

point is to determine whether or not contracts are binding and whether or not

all critical elements are as represented. It overlaps with the due diligence items

previously listed, but it helps further delve into the information already

obtained. Questions to answer during this process include:

Who really is signing all contracts and transfers?

Is their authority to sign clear and unambiguous? What is the track record of the brokers, owners, and parties involved

regarding their follow through on verbal or written agreements?

Are known risks, such as pending repairs, enforceable or backed in any

way?

Are escrow accounts and trustworthy people involved in monitoring the

process of eliminating contingencies?

Will deferred payments be used in any way?

Will personal guarantees be used?

Who is in charge of fixing problems? How much time do they have?

What if they don‘t resolve the problem?

Contractual Due Diligence

Several important contracts may arise during the real estate purchasing process,

including a letter of intent, a more detailed purchase contract, a revised

purchase contract, a preparation of deeds, numerous leases and service

contracts, mortgage liens, and more. The buyer must take into account how

time delays will impact costs and clearly detail how disputes will be resolved.Good contracts include mathematical examples showing what will happen in

the event of problems.

Key questions during this phase include:

What are the deadlines for each step prior to closing? (This includes

document and lease reviews, inspections, and certifications.)

Who is responsible for each unresolved issue?

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Who will take charge of resolving disputes?

How will time delays affect the price and terms of the agreement?

How will closing costs be allocated (i.e., to brokers, leasing commissions,

lawyers, title costs, surveys, appraisals, or inspections)?

The purpose of due diligence is to discover in detail any problems that exist onthe property that may affect returns and liabilities in the future. Once problems

are discovered, the buyer and seller may work out an agreement detailing who

shares the cost or risk of the concern or problem. It is not uncommon for

price adjustments and escrow accounts to be used to mitigate such concerns.

For example, a repair is not yet complete, but the seller assures the buyer that it

will be finished by closing. The logical agreement would allow for a generous

escrow account to be set up if the purchase occurs and title is transferred before

the repairs are complete. Once the repairs are paid, the seller would receive

the balance of the escrow account.

Needless to say, the process of deducting actual costs and the timing of repair

completion, penalties, and responsibilities for notifications and oversight should

be clearly documented in written contracts.

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1. An owner‘s interest in a property that is leased is called:

a. Fee simple interest

b. Leasehold interest

c. Leased fee interest

2.

Percentage rent clauses typically are found in what property type?

a.

Officeb.

Industrial

c.

Retail

3. Common area maintenance charges refer to

a. The costs to maintain all common areas of a property that are passed onproportionately to tenants.

b. The costs to maintain the exterior of a property.

c.

Those expenses and charges in operating a property that are considerednormal, or common.

4. The term ―pure gross lease‖ means that a tenant is responsible for some

portion of operating costs.

a. True

b. False

5.

The term ―triple-net lease‖ means that a tenant pays rent, plus its

proportionate share of operating expenses, insurance, and property taxes.

a.

True

b.

False

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6.

The term ―expense stop‖ refers to a predetermined maximum amount that

an owner will pay annually or per square foot toward operating expense.

a.

True

b.

False

7.

The term ―expense cap‖ refers to a predetermined maximum amount or

maximum annual increase that a tenant will pay toward an operating

expense.

a.

True

b.

False

8. A lease renewal option is an obligation by a tenant to renew its lease at the

end of its term.

a. True

b. False

9. The method for calculating a retail tenant‘s natural breakpoint for

percentage rent is to divide the annual base rent by the overage rate.

a. True

b.

False

10.

Renewal options typically are beneficial to the

a.

Tenant

b.

Owner

11.

If the annual base rent for a retail tenant occupying 10,000 square feet is

$100,000 and the overage rate is 5 percent of gross sales, what is the tenant‘s

natural breakpoint on gross sales before paying percentage rent?

a.

$ 500,000

b.

$2,000,000

c.

$1,000,000

d.

None of the above

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12. If the tenant in question 10 is paying percentage rent on gross sales of

$2,500,000, what is the effective triple-net rental rate to the owner, including

percentage rent and base rent?

a.

$14.00

b.

$10.00

c.

$12.50

d.

$13.00

13. In reference to questions 10 and 11, if the tenant enjoyed gross sales of

$2,375,420, what is the tenant‘s percentage rent excluding its base rent?

a. $22,623

b. $118,771

c.

$43,598

d. $18,771

14.

A retail tenant has a lease with stepped rates beginning at $15 psf (triple-net)

in year one, with $0.75 psf escalation every two years. What is the base

rental rate in year three?

a. $15.75

b. $16.50

c.

$15.50

d.

$15.00

15.

An office tenant with a lease indexed to the consumer price index

anticipates an inflation rate of 3 percent annually over the life of the lease,

and the year one base rental rate is $10 psf annually. What is the

anticipated base rental rate in year three?

a.

$10.61

b.

$11.50

c.

$10.30

d.

$10.93

End of assessment

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Answer Section

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Activity 3-1: Calculating Percentage Rent

1.

Calculate the natural breakpoint (threshold) in sales.

Base rent ÷ overage rate = natural breakpoint

900,000 (60,000 15.00) 0.03 = 30,000,000

2. Determine the year the tenant will begin paying percentage rent.

The tenant estimates first year sales at $400 psf, escalating at a rate of 5

percent annually.

Premises square feet × sales per square foot = year one sales

60,000 400.00 = 24,000,000

Year one sales × (1 + annual sales growth rate) = Year two sales

24,000,000 1.05 = 25,200,000

Year two sales × (1 + annual sales growth rate) = Year three sales

25,200,000 1.05 = 26,460,000

Year three sales × (1 + annual sales growth rate) = Year four sales

26,460,000 1.05 = 27,783,000

Year four sales × (1 + annual sales growth rate) = Year five sales

27,783,000 1.05 = 29,172,150

Year five sales × (1 + annual sales growth rate) = Year six sales

29,172,150 1.05 = 30,630,758

The tenant will begin paying percentage rent in year six.

3.

Calculate the amount of percentage rent the tenant will pay in the first year

of percentage rent.

Total sales–

natural breakpoint = amount of sales subject to percentage rent 30,630,758 30,000,000 = 630,758


630,758 × 3% = 18,923

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1.

An o wner‘s interest in a property that is leased is called:

c. Leased fee interest

2.

Percentage rent clauses typically are found in what property type?

c. Retail

3. Common area maintenance charges refer to

a. The costs to maintain all common areas of a property that are passed

on proportionately to tenants.

4. The term ―pure gross lease‖ means that a tenant is responsible for some

portion of operating costs.

b.

False

5. The term ―triple-net lease‖ means that a tenant pays rent, plus its

proportionate share of operating expenses, insurance, and property taxes.

a.

True

6.

The term ―expense stop‖ refers to a predetermined maximum amount that

an owner will pay annually or per square foot toward operating expense.

a. True

7.

The term ―expense cap‖ refers to a predetermined maximum amount ormaximum annual increase that a tenant will pay toward an operating

expense.

a. True

8.

A lease renewal option is an obligation by a tenant to renew its lease at the

end of its term.

b. False

9. The method for calculating a retail tenant‘s breakpoint for percentage rent

is to divide the annual base rent by the overage rate.

a. True

10. Renewal options typically are beneficial to the

a. Tenant

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11. If the annual base rent for a retail tenant occupying 10,000 square feet is

$100,000 and the overage rate is 5 percent of gross sales, what is the tenant‘s

natural breakpoint on gross sales before paying percentage rent?

b. 2,000,000

Natural breakpoint =

Annual base rent

Overage rate

Natural Breakpoint =100,000

5%

100,000

= 2,000,000 5%

12.

If the tenant in question 10 is paying percentage rent on gross sales of$2,500,000, what is the effective triple-net rental rate to the owner, including

percentage rent and base rent?

c. 12.50


$2,500,000 – $2,000,000 = $500,000


$500,000 × 5% = $25,000

Base rent + percent rent = total rent$100,000 + 25,000 = $125,000

Total rent ÷ premises square footage = rental rate

$125,000 ÷ 10,000 sf = $12.50/sf

13. In reference to questions 10 and 11, if the tenant enjoyed gross sales of

$2,375,420, what is the tenant‘s percentage rent (excluding its base rent)?

d. 18,771


$2,375,420 – $2,000,000 = $375,420


$375,420 × 5% = $18,771

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14.

A retail tenant has a lease with stepped rates beginning at $15.00 per square

foot (triple-net) in year one, with $0.75 per square foot escalation every two

years. What is the base rental rate in year three?

a.

15.75

Year One: $15.00

Year Two: $15.00 (No increase)

Year Three: $15.75 ($15.00 + $0.75 per square foot increase)

15.

An office tenant with a lease indexed to the consumer price index

anticipates an inflation rate of 3 percent annually over the life of the lease,

and the year one base rental rate is $10 per square foot annually. What is

the anticipated base rental rate in year three?

a.

10.61

Year One: $10.00

Year Two: $10.30 ($10.00 × 1.03% increase)

Year Three: $10.61 ($10.30 × 1.03% increase)

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Module Goal ........................................................ 4.1

Objectives ............................................................. 4.1

Economic Analysis Terminology .................. 4.2

Base (Contract) Rent ............................................ 4.2

Rate ....................................................................... 4.2

Total Effective Rent ............................................. 4.2

Total Effective Rate ............................................. 4.2

Average Annual Effective Rent ........................... 4.3

Average Annual Effective Rate ............................ 4.3

Discounted Effective Rent ................................... 4.3

Total Cost of Occupancy ..................................... 4.3

Types of Leases ......................................... 4.4

Full Service Lease ................................................ 4.5

Modified Gross Lease ......................................... 4.5

Net Lease ............................................................. 4.5

Percentage Rent Lease ......................................... 4.6

Objective Leasing Decisions ....................... 4.7

Sample Problem 4-1: Lease Comparison ........... 4.7

Activity 4-1: Economic Lease Comparison ....... 4.11

Comparative Lease

Analysis

and Valuing

LeaseholdInterests

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Analyzing Lease Cost ............................... 4.12

Analyzing Multi-Period Leases .................. 4.14

Sample Problem 4-2: Lease B Assumptions .... 4.14

Activity 4-2: Analyzing Multi-Period Leases ..... 4.19

Comparing Two Leases of Equal Terms ...... 4.21

Activity 4-3: Analyzing Occupancy Cost

Measures ............................................................ 4.24

Principles of Financial Accounting and

Reporting for Leases ............................... 4.25

Operating Lease Reporting................................ 4.26

Determining if a Lease is a Capital Lease .. 4.28

Ownership of the Premises Transfers to theUser at the End of the Lease Term .................. 4.28

The Lease Includes a Bargain PurchaseOption ................................................................ 4.28

The Lease Term Exceeds 75 Percent of the

Remaining Useful Life of the Premises ............ 4.29 The Present Value of the Minimum Lease

Payments Is 90 Percent or More of the Fair Value of the Premises at the Inception of theLease ................................................................... 4.29

Sample Problem 4-3: FAS-13 Lease Analysis—Capital Lease Tests ............................................ 4.31

Practical Applications and Facts about FAS-13 ........................................................................ 4.33

Straight-Lining Operating Lease Rent ............... 4.33

Activity 4-4: Analyzing Operating versus CapitalLeases ................................................................. 4.34

Comparing Dissimilar Leases ................... 4.37

Activity 4-5: Comparing Dissimilar Leases ....... 4.38

Refinements in Comparative Lease

Analysis ................................................. 4.44

Unequal Terms .................................................. 4.44

Adjustments to Cash Flows ............................... 4.44

Monthly versus Yearly Discounting .................. 4.45


Answer Section ....................................... 4.51

Activity 4-1: Economic Lease Comparison ....... 4.52

Activity 4-2: Analyzing Multi-Period Leases .... 4.53

Activity 4-3: Analyzing Occupancy CostMeasures ............................................................ 4.54

Activity 4-4: Analyzing Operating VersusCapital Leases .................................................... 4.55

Activity 4-5: Comparing Dissimilar Leases ...... 4.57

Module 4: Self-Assessment Review ................... 4.61

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User Decision Analysis for Commercial Real Estate• 4.1

Comparative Lease Analysis

and Valuing LeaseholdInterests

Module Snapshot

Module Goal

The preceding modules provided an introduction to user space acquisition,

including the leasing process, by defining terms and detailing the steps involved

in the process. Using that basic leasing information and terminology as a

platform, this module addresses the cost of occupancy. The process for

completing a financial analysis for a user of space is described, as well as how to

use the financial analysis to compare occupancy alternatives to make effective

decisions.

The goal of this module is to enable students to review the user‟s objective

factors and perform the economic analyses needed to determine the optimal

occupancy decision.

Objectives

Compare and contrast the economics of alternative lease decisions.

Compare and contrast the economics of occupancy alternatives with

different types of leases.

Communicate the impact of common real estate transactions on a user‟s

financial statements and reports. Integrate financial statement and reporting considerations with real estate

occupancy analysis in the user occupancy decision process

These financial or economic factors, coupled with the qualitative considerations

covered in the preceding module, enable the user to take an overall view and

determine the best occupancy structure to enter.

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Economic Analysis Terminology

Some commonly used measures for performing financial analysis and

comparing leasehold interests are defined below. Students should be aware that

some of these terms, especially those describing different lease types are not

always used consistently throughout the industry, and the definitions often vary

from market to market.

Base (Contract) Rent

This is the face, quoted, contract dollar amount of periodic rent. The base rent

is the amount on which future escalations are calculated.

RateThis is the rent expressed as a dollar amount per square foot (psf). The rate

may be expressed on an annual basis or on a monthly basis based on local

market custom and practice.

Rent ÷ premises square footage = rate

Total Effective Rent

This is the base rent adjusted downward for concessions and allowances and

upward for costs that are the responsibility of the user (such as operatingexpense pass throughs). Total effective rent can be measured on an annual

basis for a specific year of the lease, or it can be measured as the total of all cash

flows over the entire term of the lease.

Base (contract) rent

+ Additional costs

– Concessions and/or allowances

Total effective rent

Total Effective Rate

This is the total effective rent over the entire lease term divided by the square

footage of the leased premises.

Total effective rent ÷ premises square footage = total effective rate

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L e a s e A n a l y s i s ,

L e a s e h o l d I n t e r e s t s

Average Annual Effective Rent

This is the total effective rent over the entire term of the lease divided by the

number of years in the lease term.

Total effective rent ÷ lease term (years) = average annual effective rent

Average Annual Effective Rate

This is the average annual effective rent divided by the square footage of the

leased premises.

Average annual effective rent ÷ premises square footage = average annual effective rate

Discounted Effective Rent

This is the sum of all discounted cash flows over the entire term of the lease, with the cash flows discounted to the present value (PV) at the user‟s discount

rate.

Total Cost of Occupancy

This is the total of all actual out-of-pocket costs to the user necessary to take

occupancy of a space. In other words, it is the total effective rent plus or minus

additional costs or allowances that are not attributable to the lease, such as

telephone hook-up or stationery. When such adjustments are addressed in the

lease or in the transaction between the owner and the user, they may be

included in the calculations of total effective rent or rate.

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Types of Leases

As the user compares their interests and needs analysis with the various

landlord proposals, consideration must be given to subjective interests and

criteria, which will help narrow the property choices. Such criteria include

location, amenities, visibility, signage, parking, transportation, traffic flow,

expansion capabilities—essentially all interests and factors not driven by costs.

Those interests then must be combined with the financial analyses to make the

final determination. The financial pieces must take into account the user‟s

available cash, borrowing capacity, and financial situation, as well as alternative

uses for the cash. These factors drive the type of occupancy the user might

consider entering.

For example, Property A might have an overall lower cost of occupancy than

Property B, but it requires a higher upfront cash outlay. The user‟s financial

situation may not be able to accommodate that upfront cost, or it may be moreprudent for the user to preserve or otherwise use the capital. Thus, the user

may determine that the best decision is to enter the more expensive lease with

less upfront costs. If the user‟s business is young and projected to have

increased cash flow, the user might decide to defray some of the lease costs

until later in the business‟s lifecycle. The user also might decide to enter the

more expensive alternative if that choice better meets the user‟s subjective

interests. The bottom line is that the choice with the lowest cost of occupancy

may not always be the best decision for the user.

The various types of leases, with one exception, are defined primarily by whichoperating expenses are included in the base rent —in other words, which

operating expenses the landlord pays and which operating expenses the user

pays. Given that lease terminology and included expenses vary from market to

market, landlord to landlord, and even building to building, it is extremely

important for the user to understand exactly which operating expenses will be

included as part of the base rent and which operating expenses will be paid in

addition to the base rent.

Leases can be viewed on a continuum. At one end is the full service lease

(sometimes referred to as a gross lease), in which all operating expenses are

included in the base rent (the landlord pays the operating expenses). Moving in

the continuum next is a modified gross lease, in which the user is responsible

for paying some of the operating expenses, and the landlord is responsible for

paying the balance. On the other end of the continuum is net leases (or triple-

net or absolute-net leases), in which the user pays all operating expenses in

addition to the base rent.

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Full Service Lease

These leases typically are used for multitenant office buildings in which all

operating expenses are included as part of the rent. This includes costs such as

property taxes, property insurance, repairs, maintenance, management fees,

utilities, and janitorial service. An expense stop often is utilized to set a ceilingon expenses paid by the landlord.

Modified Gross Lease

Sometimes called flex or industrial gross, these leases typically are seen in small

office, service, or warehouse buildings (sometimes called showroom buildings)

or R&D (research and development). While similar to full service, a modified

gross lease includes fewer operating costs in the base rent. For example,

depending on the lease structure, a modified gross lease may include propertytaxes but not insurance, or vice versa. It‟s especially important for the user to

understand exactly which operating expenses are included in the base rent and

which expenses must be paid in addition to base rent. As a rule of thumb, if

the property is not a multitenant office or industrial building, the user will pay

electricity directly to the utility provider and coordinate their own janitorial

service. Modified gross leases generally are applicable for single-story buildings

with separate electrical meters, enabling the utilities provider to separately meter

and directly charge each tenant.

Net Lease

These typically are used for large warehouse or industrial properties, retail

buildings, and office properties in some markets. With a net lease, the user

pays all operating expenses in addition to the base rent, on a pro rata basis.

The cost, sometimes referred to as the triple nets, includes property taxes,

property insurance, and common area maintenance (CAM). As in the

modified gross lease described above, the user typically pays their own utilities

(with the possible exception of water) and janitorial directly to the provider.

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Percentage Rent Lease

The one exception to the continuum of standard leasing types is a percentage

rent lease, which typically is found only in retail leases. Percentage rent leases

usually are structured as net leases, but in addition to the triple-net costs such as

property taxes, insurance, standard operating expenses, utilities, and janitorial

service, the tenant also pays the landlord a predetermined percentage of their

retail sales above a defined breakpoint (as described in Module 3).

Note: Regardless of the lease structure, the user ultimately pays operating

expenses either as part of their base rent or in addition to their base rent.

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Objective Leasing Decisions

In many instances, subjective factors enable a user to narrow occupancy

choices. A comparative financial analysis then provides objective measures to

determine the best occupancy alternative for the user‟s needs. On one hand,

the comparative financial analysis can determine the least cost of occupancy.

On the other hand, the financial analysis can be utilized to place a comparative

value on the amenities and subjective factors.

Sample Problem 4-1: Lease Comparison

Your client is considering proposals from two similar buildings for a five-year

lease, both are 3,500 rentable square feet (rsf) in size. Potential Lease A is

being offered at $17.50 per rsf for the first year of the term, with annualincreases of 3.0 percent. Lease B is being offered at $17 per rsf for year one,

with $0.50 per rsf annual bumps in the rent for each year thereafter. Lease B

also is offering four months free at the beginning of the term. (Assume, for

simplicity, that the lease payments are made annually at the end of each year.)

Your client has asked for your help in evaluating the two lease proposals and in

making a selection. What should you do to help your client reach a decision?

1. Determine the cash inflows and outflows on both lease alternatives:

Lease A

Lease B

EOP $ EOP $

0 ($0) 0 ($0)

1 $61,250 1 $39,667

2 $63,088 2 $61,250

3 $64,980 3 $63,000

4 $66,930 4 $64,750

5 $68,937 5 $66,500

Total: $325,185 $295,167

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2. Derive total effective rents and rates from lease cash flows for each

alternative.

a. Annual effective rate = each year‟s cash flow † rsf

A B

Effective Rate Year 1 17.50 11.33

Year 2 18.03 17.50

Year 3 18.57 18.00

Year 4 19.12 18.50

Year 5 19.70 19.00

b. Total effective rent = cash flow totals

A B

Total effective rent $325,185 $295,167

c. Total effective rate = total effective rent ÷ total rsf

A B

Total effective rate $92.91 psf $84.33 psf

d.

Average annual effective rent = total effective rent ÷ number of lease

term years

A B

Average annual effective rent $65,037 per year $59,033 per year

e.

Average annual effective rate = average annual effective rent ÷ total rsf

A B

Average annual effective rate $18.58 psf per year $16.87 psf per year

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Establish with the user the most important economic units and issues.

Determine which measures are most meaningful, whether total effective

rent or average annual effective rent is more important, whether the user

prefers to pay more at the beginning or at the end of the lease term, and

whether TIs, free rent, or low-base rent is most important to the user.

However, stress that discounted effective rent (present cost of occupancy) isthe most accurate unit of comparison because it adjusts for the magnitude

and timing of the cash flows.

Make the lease term length the same for all alternatives to ensure a useful

value comparison. When comparing the value of leases with unequal

terms, an assumption must be made about the future terms of a shorter

lease to make the terms comparable.

Make the units (useable or rentable) the same for valid comparisons.

Remember that rentable area most commonly is used for office buildings.

However, since the buildings being compared may have different commonarea (load) factors, converting the numbers to useable square foot (usf) rates

may provide the truest comparison on a sf basis.

Compute the annual occupancy costs.

Note that income-tax considerations, GAAP accounting and financial reporting

may alter the relative advantages of various lease options. High level

consideration of those issues is discussed later in this module and in Module 5.

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Activity 4-1: Economic Lease Comparison

1.

The term “effective rent ” includes downward adjustments for concessions

and allowances and upward adjustments for tenant-paid costs and expenses.

a.

Trueb. False

2.

The term “total effective rent ” refers to the total rent paid by a user over

only the first year of a multiyear lease.

a. True

b.

False

3.

The term “total effective rate” refers to the total effective rent divided by thetotal rentable square feet occupied by a user.

a.

True

b. False

4.

The term “average annual effective rent ” is equal to the total effective rent

divided by the number of years in the term of the lease.

a.

True

b. False

5. The term “average annual effective rate” is equal to the average annual

effective rent divided by the number of years in the term of the lease.

a.

True

b.

False

6.

The term “discounted effective rent ” takes into account the time value of

money by discounting future lease payments to a present value at a

prescribed discount rate.a.

True

b. False

End of activity

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Analyzing Lease Cost

In the previous example, no consideration was given to additional leasing costs

or allowances—base rent equaled effective rent. However, most commercial

leases are not so simple. In completing a more in-depth analysis, all cash flows

(costs to the user) must be included to determine the total effective rent.

The basic formula for calculating the effective rent cost of occupancy is

Base (contract) rent

+ Additional costs

– Concessions and/or allowances

Total Effective Rent (or Rate if divided by sf)

Cost of occupancy may include items that are not strictly leasing costs or that

are not a result of the negotiated lease agreement between the owner and user.

In this course, some of these costs are included in calculating effective rent or

rate, and some are excluded. Examples of costs that are excluded are expense

items that are the same for the user no matter which space is chosen, such as

the cost of new stationery. Also keep in mind that effective rent to the owner is

not the same as effective rent to the user because some of the expenses

incurred by the user are not paid to the owner (i.e., phone hook up, moving

expenses), and some of the occupancy costs incurred by the owner are not

incurred by the user.

In calculating effective rent or rate, it is necessary to include cost, concession,and allowance items separately because they may occur or be incurred at

different times during the life of the lease.

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The analysis must be adapted for the circumstances of each lease, as follows:

Basic (contract) rent

+ Amortized percentage rent (retail only)

+ Amortized TIs (as additional rent)

+ Parking

+ Real estate taxes

+ Operating expenses

+ Total TIs

+ Moving expenses

+ Existing lease buyout

+ Moving costs

– Rent concession

– Parking stop

– Real estate tax stop– Operating expense stop

– TI allowance

– Amortized TIs

– Moving expense allowance

– Existing lease buyout allowance

Effective rent paid by the user

Where cost and concession items completely or partly cancel out each other,they can be entered separately into the tally or netted and shown as a net cost or

net allowance. Because rental rates, expenses, and allowances normally are

quoted on a psf basis, all expense and allowances items must be converted to

the same unit basis (rentable or useable area) to complete the lease analysis.

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Analyzing Multi-Period Leases

Obviously, calculating costs for the remaining years of a multi-period lease is

more complicated than calculating costs for a single-period lease, but it is

extremely important. Following are the two additional factors that come in to

play.

Rent escalators: Items such as base rent, operating expenses, and property

taxes typically increase by predetermined amounts at stated intervals or by a

constant annual percentage.

Expense stops: The owner may agree to pay operating expense to a certain

level, the expense stop, beyond which the tenant is responsible for paying

the future increases incurred. The most common determination of an

expense stop is via a base year expense stop, wherein the owner agrees to

pay for expenses in the actual amounts incurred in the base year (usually thefirst calendar year) of the lease term. In future years, the tenant is

responsible for paying expenses that exceed the base year expense stop

amount.

Sample Problem 4-2: Lease B Assumptions

The information provided previously in Sample Problem 4-1 was as follows:

Your client is considering proposals from two similar buildings for a five-year

lease; both are 3,500 rentable square feet (rsf) in size. Potential Lease A is

being offered at $17.50 per rsf for the first year of the term, with annual

increases of 3.0 percent. Lease B is being offered at $17 per rsf for year one,

with $0.50 per rsf annual bumps in the rent for each year thereafter. Lease B

also is offering four months free at the beginning of the term. (Assume, for

simplicity, that the lease payments are made annually at the end of each year.)

Assume that year one of Lease B in Sample Problem 4-1 has the following

additional cost and allowance adjustments:

Operating expenses are $7 per rsf and are expected to grow 3 percent per

year.

Property taxes are $2 per rsf and also are expected to grow 3 percent per

year.

The landlord‟s proposal incorporates an operating expense stop of $7 per

rsf, and a property tax expense stop of $2 per rsf.

TIs will cost $18 per rsf, of which the landlord will pay $12 per rsf.

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Parking costs are $43.75 per covered parking space per month over the

term of the lease, and the user plans on having 10 covered parking spaces.

The user must pay a $27,000 early termination fee to cancel its current

lease. The new landlord will give the user $12,000 to help with the current

lease buyout.

The user‟s moving costs are estimated at $15,000. The landlord will give

the user the first four months free and provide the user with a moving

allowance of $7,000.

Additional details are on the Lease Summary on the following page.

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Lease B Summary:

Measurement Rentable square feet (rsf) 3,500

Rent Base Rental Rate $17 psf per year

Rent adjustment $0.50 psf per year

Tenant Expenses Operating expenses $7 psf per year

Property taxes $2 psf per year

TI costs $18 psf

Parking (10 spaces)$43.75/space/

month

Termination fee for existing lease $27,000

Moving expenses $15,000

Landlord Allowances TI allowance $12 psf

Free rent (four months) $19,833

Owner’s contribution to user’s lease termination fee $12,000

Owner’s contribution to user’s moving expenses $7,000

Term 5 years

Operating expense growth rate 3 percent per year

Operating Expense stop $7 psf

Property tax growth rate 3 percent per year

Property tax expense stop $2 psf

User’s discount rate 10 percent

To estimate the total effective rent for the five-year lease term, first tally all items

to a single total for each year of the lease (using total costs rather than dollars

per square foot).

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Lease B: Annual Cash Flows – User’s erspective

Year 0 1 2 3 4 5

Base rent $59,500 $61,250 $63,000 $64,750 $66,500

+ Operating expenses 24,500 25,235 25,992 26,772 27,575

– Landlord’s operating expense stop 24,500 24,500 24,500 24,500 24,500

+ Property taxes 7,000 7,210 7,426 7,649 7,879– Landlord’s property tax expense stop 7,000 7,000 7,000 7,000 7,000

+ Net TPTI* $21,000

+ Parking 5,250 5,250 5,250 5,250 5,250

+ Net Existing Lease Buyout 15,000

+ Net Moving Expenses 8,000

– Free rent 19,833

= Total Effective Rent $44,000 $44,917 $67,445 $70,168 $72,921 $75,704

*TPTI = Tenant-paid tenant improvements

Given these cash flows, the total effective rent and rate, average annual effective

rent and rate, and discounted effective rent are calculated as follows:

Year 0 $44,000

Year 1 44,917

Year 2 67,445

Year 3 70,168

Year 4 72,921

Year 5 + 75,704

Total effective rent $375,155


Premises square feet ÷ 3,500

Total effective rate $107.19 psf


Lease term ÷ 5 years

Average annual effective rent $75,031

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Average annual effective rent $75,031

Premises square feet ÷ 3,500

Average effective rate $21.44 psf

Present Value: Discounted Effective Rent Analysis

EOY $

0 $44,000

1 $44,917

2 $67,445

3 $70,168

4 $72,921

5 $75,704

PV @ 10% = $290,104 Discounted effective rent or present cost of occupancy

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4 •



Activity 4-2: Analyzing Multi-Period Leases

The landlord and user have entered into additional negotiations over the multi-

period Lease B referenced in Sample Problems 4-1 and 4-2. The user has

engaged you to perform the required occupancy cost calculations for the

negotiated modifications that follow to assist the user in their decision making.

Part One

The landlord ha s agreed to the user‟s request to reduce the annual rent

increases to $0.25 psf per year; however, in consideration for the annual

increase change, the landlord proposes to reduce the free rent period from four

months to two months. Using the worksheet below, calculate the user‟s:


Total effective rate

Average annual effective rent

Average annual effective rate

Discounted effective rent at the user‟s 10 percent discount rate

Lease B: Counter Offer Annual Cash Flows:

Year 0 1 2 3 4 5

Base rent


– Landlord’s operating expense stop

+ Property taxes

– Landlord’s property tax expense stop

+ Net TPTI

+ Parking

+ Net existing lease buyout

+ Net moving expenses

– Free rent

= Total effective rent

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Comparing Two Leases of Equal Terms

You now have effective tools to calculate, measure, and analyze leases costs.

These tools are most reliable if all the compared lease costs are measured in a

consistent fashion.

Next, analyze the revised Lease B proposal (summarized below) and compare it

with the previously proposed Lease A alternative (also summarized below) to

determine which lease proposal is the user‟s least costly option.

Lease A Lease B

Measurement rsf 3,500 3,500

Rent Base rent $17.50 psf $17 psf

Rent adjustment

3.5 percent increase

per year $0.25 psf per year

Tenant expenses Operating expenses $7.50 psf $7 psf

Operating expense growth 3 percent per year 3 percent per year

Property taxes $2.25 psf $2 psf

Property tax expensegrowth

3 percent per year 3 percent per year

TI costs $12 psf $18 psf

Parking (10 spaces) $50/space/month $43.75/space/month

Moving expenses $15,000 $15,000

Landlord allowances TI allowance $12 psf $12 psf

Free rent at beginning of

term0 months 6 months

Landlord’s contribution to

user’s moving expenses

$12,000$7,000

Operating expense stop $7.50 psf $7 psf

Property tax expense stop $2.25 psf $2 psf

Term 5 years

User discount rate 10 percent

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Lease A: Annual Cash Flows

Year 0 1 2 3 4 5

Base rent $61,250 $63,394 $65,613 $67,909 $70,286


– Landlord’s operating

expense stop26,250 26,250 26,250 26,250 26,250

+ Property taxes 7,875 8,111 8,355 8,605 8,863

– Landlord’s property taxexpense stop

7,875 7,875 7,875 7,875 7,875

+ Net TPTI $0

+ Parking 6,000 6,000 6,000 6,000 6,000

+ Net existing lease buyout 3,000

– Net moving expenses 0

= Total effective rent $3,000 $67,250 $70,418 $73,691 $77,073 $80,569

Lease B: Annual Cash Flows

Year 0 1 2 3 4 5

Base rent $59,500 $60,375 $61,250 $62,125 $63,000


– Owner’s operating expense

stop24,500 24,500 24,500 24,500 24,500

+ Property taxes 7,000 7,210 7,426 7,649 7,879

– Owner’s property tax

expense stop7,000 7,000 7,000 7,000 7,000

+ Net TPTI $21,000+ Parking 5,250 5,250 5,250 5,250 5,250

+ Net moving expenses 8,000



Given these cash flows, the total effective rent and rate, average annual effective

rent and rate, and discounted effective rent are calculated on the following page.

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4 •



Lease A Year Lease B

$3,000 0 $29,000

67,250 1 35,000

70,418 2 66,570

73,691 3 68,418

77,073 4 70,296

80,569 5 72,204

$372,001 Total effective rent $341,488

$372,001 ÷ 3,500 sf = $106.29 psf Total effective rate $341,488 ÷ 3,500 sf = $97.57 psf

$372,001 ÷ 5 years = $74,400 Average annual effective rent $341,488 ÷ 5 years = $68,298

$74,400 ÷ 3,500 sf = $21.26 psf Average annual effective rate $68,298 ÷ 3,500 sf = $19.51 psf

PV Analysis

Lease A Lease B

EOP $ EOP $

0 $3,000 0 $29,000

1 $67,250 1 $35,000

2 $70,418 2 $66,570

3 $73,691 3 $68,418

4 $77,073 4 $70,296

5 $80,569 5 $72,204

PV @ 10% = $280,367 PV @ 10% = $260,084

Discounted effective rent or present cost of occupancy

Lease Comparison Summary

Lease A Lease B

Total base rent $328,451 $306,250

Total effective rent $372,001 $341,488

Total effective rate (psf) $106.29 $97.57

Average annual effective rent $74,400 $68,298

Average annual effective rate (psf) $21.26 $19.51Discounted effective rent $280,367 $260,084

Which lease alternative is the most advantageous for the user? Based solely on

economics, Lease B is the obvious choice. However, the cost advantage of B

must be considered with the user‟s interests in mind, including the subjective

and functional differences between the alternative spaces.

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Activity 4-3: Analyzing Occupancy Cost Measures

Use the information on the previous pages regarding Lease A and Lease B to

answer the following questions.

1. Which occupancy cost measure do you feel is most credible for the user?

Why?

2.

If the user prefers to preserve capital for the primary business, which leaseproposal should the user choose? Why?

3.

If the user strongly prefers Lease A due to its more desirable location, but

wants the same occupancy cost as Lease B (as measured in discounted

effective rent), what changes in a counter proposal might the user consider:

a.

In rental rate?

b.

To equalize the present cost of occupancy?

End of activity

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4 •



Principles of Financial Accounting and

Reporting for Leases As introduced in Module 2, there are financial accounting, reporting rules, and

standards specific to leases. These rules and standards must be taken intoaccount by a user when making occupancy decisions. Specific rules and

standards are

FAS-13: The standards of financial accounting and reporting for leases

FAS-146: The standards of financial accounting and reporting for subleases

If an organization uses generally accepted accounting principles (GAAP), the

company‟s balance sheet must account for the lease liability and asset attributes,

depending on whether certain tests are met. If those tests are met, the lease is

classified as a capital lease, and the company is obligated to meet certain

accounting standards, including reporting the lease asset and liability

characteristics on the company‟s balance statement. If all of those tests are not

met, the lease is classified as an operating lease, and the company is not

obligated to formally report the lease asset or liability on their balance

statement. They only are required to include a footnote to their financial

statements providing certain details of the lease obligation.

For many companies, the ramifications of accounting for the lease transaction

on the balance statement (capital lease) versus not (operating lease) can be

significant. Generally speaking, companies prefer lease transactions to be

structured as operating leases to avoid accounting for the lease on the balancestatement. However, if circumstances dictate, many organizations will accept a

capital lease transaction and the requisite balance statement entries depending

on which lease transaction structure is in the company‟s best interests.

The determination of whether a lease is a capital lease versus an operating lease

lies in the proposed lease‟s specific attributes, and the user should clearly

understand those attributes.

For organizations utilizing GAAP, the standards contained in FAS-13 affect

lease accounting. Under GAAP accounting and FAS-13, there are two types of

leases: operating leases and capital leases. Operating leases, which comprisethe vast majority of leases, do not pass any of the GAAP FAS-13 tests for a

capital lease.

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Operating Lease Reporting

Under GAAP, operating leases require the following accounting and reporting:

Rent is entered as an expense on the user‟s income statement.

Rent expense is straight lined over the full term of the lease, including freerent, build-out periods, or rent vacations— virtually the same as total effective

rent as defined earlier, however, the rent reported is net of any expense if

the lease is a full service, gross or modified gross lease.

No lease liability or asset is included on the balance statement.

TIs paid by the tenant are entered on the tenant‟s balance statement as an

asset, less accumulated depreciation.

Tenant improvement depreciation is included as an expense on the user‟s

income statement.

The terms of the lease obligation are reported as a footnote to the financial

statements.

Under GAAP, capital leases have accounting and reporting characteristics

similar to those of a real estate purchase with 100 percent financing, requiring

the following accounting and reporting:

The discounted present value (PV) of the lease is entered as both an asset

and as a liability on the user‟s balance statement. The net rent cash flows,

including free rent periods, are discounted at the user‟s incremental

borrowing rate, which is the market interest rate the user might incur if they

had purchased the premises with the loan term being equivalent to the lease

term. A good surrogate rate is the user‟s revolving credit facility interest

rate.

The capital lease asset and liability are amortized similar to a mortgage with

an imputed interest rate. The amortized portions of the lease payments are

classified on the financial statements as interest, and the “principal” portion

is accounted for as cost recovery amortization. The interest rate generally

used is the user‟s incremental borrowing rate. The “principal” amort izationportion reduces the outstanding balance of the capital lease liability on the

user‟s balance statement.

The interest and cost recovery expense appear on the user‟s income

statement.

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4 •



Additional financial statement entries may be needed to adjust for the

difference between the PV of the lease and the fair market value of the

premises.

The terms of the lease obligation are reported as a footnote to the financial

statements.

Capital leases could be considered an example of substance over form.

Althoug h the document says “lease,” and although the landlord is getting rent,

the user (under GAAP) is required to treat the lease differently than an

operating lease on the user‟s financial statements—including recording the lease

liability and asset on the user‟s balance statement—because the lease terms pass

certain FAS-13 tests.

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Determining if a Lease is a Capital Lease

FAS-13 guidelines state that a lease is a capital lease if it meets any one of four

tests. Familiarization with these tests enables a user to structure a lease

transaction that is the user‟s best interests. In many cases, it is best for the lease

transaction to be an operating lease and not as a capital lease on the user‟s

financial statements.

A lease is defined as a capital lease if the lease terms meet any one of the

following four tests:

1.

Ownership of the premises transfers to the user at the end of the lease term.

2. The lease includes a bargain purchase option wherein it is relatively certain

that the user would exercise the purchase option.

3.

The lease term exceeds 75 percent of the remaining useful life of the

premises.

4.

The present value (PV) of the minimum lease payments is equal to or more

than 90 percent of the fair market value of the leased premises at the

inception of the lease, with the discount rate being the user‟s incremental

borrowing rate.

Each of the four tests is covered in more detail below.

Ownership of the Premises Transfers to the User at theEnd of the Lease Term

Should transfer criteria be a condition of the lease, it clearly would have been

negotiated upfront. Consequently, the user should not be surprised by such

criteria. However, the surprise of a rent-to-own arrangement could be in the

consequential accounting and reporting of the transaction. An end-of-term

ownership transfer falls outside the normal terms and conditions of a lease and

justifiably would be considered a financing agreement, since at the end of the

lease term, the tenant would own the “leased” property.

The Lease Includes a Bargain Purchase Option

It must be relatively certain that the user would exercise the purchase option.

This is much more typical in equipment leases than in real estate transactions.

(It should be noted that the capital lease tests apply not only to real estate

leases, but to other asset leases such as equipment, vehicles, pipelines, or oil

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4 •



tankers.) A bargain purchase option may come into play if the property is a

special-purpose asset.

The Lease Term Exceeds 75 Percent of the Remaining

Useful Life of the Premises

The useful life of properly maintained real estate (not the same as the real

estate tax life) can be indeterminate. For example, the Empire State Building

was completed in 1931, but it still is substantially leased and fully functional due

to continual maintenance and ongoing upgrades. Thus, its useful life arguably is

indefinite.

This capital least test rarely is met in real estate leases, since real property

typically is maintained and updated to keep it viable. This test more typically is

met in equipment leases. A property that is considerably substandard in the

market may meet this test when coupled with a long-term lease of, perhaps,

more than 10 years.

One way to determine if the 75 percent remaining useful life test is met is to

determine if the property is performing at market. That is: is the property

renting at a market rent? If the property is demanding rents well below market,

then useful life may be an issue. For example, if an industrial building is renting

for $3 psf annually in a market where other industrial buildings are

commanding more than $8 psf annually, then the subject property may be

substandard, with some functional obsolescence creating a question as to its

viability and remaining useful life. If, however, the property is commanding

rents comparable in the market, then it can be considered a performingbuilding, which most likely has been and will continue to be maintained,

therefore having an almost indefinite life.

The Present Value of the Minimum Lease Payments Is

90 Percent or More of the Fair Value of the Premises at

the Inception of the Lease

Arguably, this capital lease test is the most pertinent for real estate users. FAS-

13 includes the following guidelines when calculating the PV of the user‟sproposed minimum lease payments:

Include net rent only. Do not include operating expenses such as

electricity, water, and property taxes. In a full service or gross lease, it is

appropriate to deduct the base year expense stop or a market estimate of

the operating expenses. All free rent periods must be included in addition

to the scheduled rent once rent payments begin.

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Include rent only to the earliest termination option date.

Include any early termination fees.

Discount the cash flows at the user‟s incremental borrowing rate. This is

the rate that the user would incur if they purchased the property with a loan

term similar to the lease term. The interest rate on the user‟s revolving

bank line is a possible surrogate for the incremental borrowing rate if an

incremental borrowing rate is not readily available or feasible.

Once the PV of the user‟s lease cash flows is determined, that PV then is tested

against (or compared to) 90 percent of the fair market value of the premises.

FAS-13 provides the following guidance for determining the premise‟s fair

market value:

The value is as of the inception of the lease. Inception generally is defined

as when the user takes occupancy of the premises, assuming TIs need to be

completed. Otherwise, such as in the case of an extension, it is uponmutual execution of the lease document.

The fair market value is based on the premises being occupied and

stabilized with the subject lease in place. As such, vacancy, free rent, or

other concessions should not be factored into the value.

Comparable sales are appropriate determinates of fair market value.

The FAS-13 capital lease test compares the PV of the user‟s lease cash flows

against 90 percent of the fair market value of the premises at inception of the

lease. If the PV of the user‟s lease cash flows is equal to or greater than 90

percent of the fair market value of the premises, the lease is accounted for as acapital lease. If the PV of lease cash flows is less than 90 percent of the fair

market value of the premises, the lease is accounted for as an operating lease.

To illustrate, an empty building may be worth $100 psf; however, once a credit

tenant signs a long-term net lease, the value of the building increases since

future cash flow uncertainties have been reduced. Value can be determined by

the property‟s ability to generate cash flow.

If a building is empty and the market assumes continued vacancy for the next

two years, the value is affected substantially by the two-year vacancy and related

costs of putting a tenant in the building. However, if the proposed lease werein place, the value would be much higher. FAS-13 stipulates that the market

value determination should be calculated as if the subject lease was already in

place, and the property stabilized.

A user can estimate market value based on comparable sales of similar

buildings with similar credit tenants or by deriving an appropriate cap rate range

from comparable sales to apply to the subject lease.

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Sample Problem 4-3: FAS-13 Lease Analysis—Capital

Lease Tests

A user is considering signing a 20-year lease because it is in the best interest of

the company to control the property for the long term due to the equipment to

be installed in the facility. Plus, the user is very attracted to the lower rental rate

that will accompany the long-term lease, which will assist with initial cash flow

concerns.

Given the longevity of the lease, initial calculations show that the lease cash

flows meet the PV test for a capital lease. The user is concerned that the lease

liability on the balance statement would dramatically affect the user‟s ability to

borrow additional funds, which are greatly needed for the user‟s growing

business operations.

To convert the potential lease classification from a capital lease to an operating

lease, the user is considering proposing alternatives in a counter offer to the

property owner.

As shown in counter proposal alternatives one and two below, the user

proposes termination clauses at differing points in the lease term. The early

termination provisions and related termination fees affect the capital lease PV

test results, thus changing the lease from a capital lease to an operating lease.

Assumptions

Leased space size in rentable square feet (rsf): 40,000

Annual psf lease rate: $25

Rent escalation percentage rate applied at the end of every five years: 10

percent

Beginning annual rent: $1,000,000

User's incremental borrowing rate: 6.75 percent

Proposed termination penalty for alternative one: $2,000,000

Proposed termination penalty for alternative two: $1,000,000

Comparable value of buildings with similar credit tenants: $250 psf

Estimated fair market value of leased space (sf × value/sf): $10,000,000

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Alternatives:

1. Original Proposal: 20-year non-cancellable term

2. Counter Proposal Option 1: 20 years with an early termination option at

the end of year seven with a $2,000,000 early termination penalty

3.

Counter Proposal Option 2: 20 years with an early termination option atthe end of year 11 with a $1,000,000 early termination penalty

Original Proposal

Counter Proposal

Alternative 1

Counter Proposal

Alternative 2

Fair Value $10,000,000 $10,000,000 $10,000,000

90% of Fair Value $9,000,000 $9,000,000 $9,000,000

Lease PV $12,064,768 $6,833,522 $8,480,562

Classification Capital Lease Operating Lease Operating Lease

Year 0 $0 $0 $0

1 $1,000,000 $1,000,000 $1,000,000

2 $1,000,000 $1,000,000 $1,000,000

3 $1,000,000 $1,000,000 $1,000,000

4 $1,000,000 $1,000,000 $1,000,000

5 $1,000,000 $1,000,000 $1,000,000

6 $1,100,000 $1,100,000 $1,100,000

7 $1,100,000 $3,100,000 $1,100,000

8 $1,100,000 $1,100,000

9 $1,100,000 $1,100,000

10 $1,100,000 $1,100,000

11 $1,210,000 $2,210,000

12 $1,210,000

13 $1,210,000

14 $1,210,000

15 $1,210,000

16 $1,331,000

17 $1,331,000

18 $1,331,000

19 $1,331,000

20 $1,331,000

Note:

Highlighted rows are the years in which the 10 percent rent escalation

begins.

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Practical Applications and Facts about FAS-13

Because of their off-balance-sheet accounting, operating leases are generally the

preferred transaction for a user. Longer leases have more years of net rent to

discount, which increases their chance of passing the capital lease classification

test. Thus, the FAS-13 calculations should be done early in the transaction toresolves questions such as

Are the comps reasonable or too conservative? For example, is the user

applying an 8 percent cap rate when the user should be using a market rate

of 6 percent, which results in a higher building value?

Can the term be shortened?

Can a termination clause be added?

Prior to signing, many leases still can be structured (or restructured) to achieve

the desired accounting impact. However, it is difficult to change the structureand accounting after the lease document is signed. Some users are fine with

capital leases because the longer lease term (typically more prone to capital

lease classification) reflects the user‟s best interests and business needs.

It should be noted that all land or ground leases are classified as operating

leases unless the lease terms allow for a transfer of ownership at the end of the

lease term.

Straight-Lining Operating Lease Rent

FAS-13 GAAP guidance requires a user to straight line the rent expense evenly

over the period (lease term) benefited in an Operating Lease. The complicated

accounting rules applying to the treatment of various landlord concessions,

allowances, and tenant-paid expenses are beyond the scope of this review, but

in practice a user can preliminarily calculate the impact of rent expense on the

income statement in the same manner as total effective net rent. In other

words, the calculation for straight lining the rent expense per GAAP is very

similar to the calculation for total effective rent and average annual effective

rent. However, in GAAP, the rent component of the expense is essentially only

the net rent, wherein operating expenses are deducted from the total effectiverent and average annual effective rent. Thus, it becomes the average annual

effective net rent. The operating expenses are recognized (expensed) on the

income statement in the month that they are incurred, per GAAP.

Straight-line rent =Total effective net rent

= Average annual effective net rentLease term (years)

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Activity 4-4: Analyzing Operating versus Capital Leases

A long-term friend and real estate client of yours calls. He asks, “Do you have

some time to take a quick look at a lease extension proposal that my landlord

just dropped off and give me some advice?” You respond, “Absolutely ! Tell

me what you are trying to do, what your objectives are.”

He explains, “I plan on being in this building for the long haul. It‟s perfect.

We‟re all set up. We‟ve been here going on 10 years. It‟s the right size and the

right location, and the employees like it here.”

He goes on, “It‟s well maintained, and nothing needs to be done to the place.

Besides, moving would be a royal pain. I‟ll e-mail you the landlord‟s proposal.

He kept the rent flat for the first five years like we requested. Buddy, I‟m

ha ving lunch with my three other shareholders in a couple hours. We‟re

working on some financing for the company right now. Sorry, but can you get

me something to share with them at lunch? I‟ll owe you big time.”

Before hanging up, at your request, he transfers you to Michelle Landing, the

company‟s chief financial officer, who promises to e-mail you the answers to

your information requests. She adds, “We‟re trying to finalize a new credit

facility for the company, so make sure the lease isn‟t a capital lease. That would

really throw off our debt ratios.”

The primary business points of the lease extension proposal are as follows:

Term: 15 years

Size: 24,350 rsf Lease type: full service

TI allowance: none, as is

Base year: year one of the lease extension

Base year expense stop: $7.45 per rsf

Extension year one starting rent: $24

Increases: flat for five years, 12 percent increase at the start of year six, 3

percent per year thereafter

Michelle Landing‟s e-mail gives you the answers to your information requests:

The company‟s banker says that if they were to buy the building with a 10-

to 15-year loan, the borrowing rate would be 7 percent.

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Given the corporate structure, the company‟s accounting and financial

reporting is conducted using GAAP, and their marginal tax rate is 35

percent.

No other costs, such as TIs, would be incurred by the company.

Her recommended before- and after-tax discount rates for analyzing

company expenditures such as this are 7 percent and 6.25 percent

respectively.

Your research in the local commercial property information exchange database

reveals the following:

Market rents for similar properties in the submarket are in the range

proposed by the landlord.

The annual market rent increase is 3 percent.

Current investment sales for similar properties with similar local credit

tenants indicate that a 9 percent cap rate is reasonable.

What should you do to provide some quick advice to your friend and client?

1.

Is the proposed rent reasonable?

2. What is the approximate fair value of the premises with the lease extension

in place (to the nearest thousand)?

Using the grid on the following page, calculate the following:

3. What is the total effective rent for the extension proposal?

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4. What is the total effective net rent for the extension proposal?

Year Gross (Full Service) Rent

—

Expense Stop = Net Rent

1

2

34

5

6

7

8

9

10

11

12

1314

15


5. If the lease was classified as an operating lease, what rent amount would be

expensed annually per GAAP?

6. Is the proposed lease a capital lease?

If so, why? If not, why not?

7.

What recommendations would you make to your friend/client to modify

the proposal to better meet the company‟s objectives?

End of activity

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Comparing Dissimilar Leases

Depending on the types of spaces under consideration, as well as the user‟s

needs and interests, users may choose to compare different types of properties,

which may mean different lease structures as well.

The desire for a user to look at dissimilar property types can be driven by

current market conditions, such as the availability of certain types of space in

the user‟s desired location area, the relative costs of various types of space, and

other factors. For example, in some situations, a business may migrate from an

office building to a flex situation or from an industrial space to a research and

development (R&D) park.

In some market areas, different owners of the same property type might offer

their space under differing types of leases. For example, one office building

owner may offer their space on a full service lease basis, while another owner in

the same market might offer their office space on a net lease basis.

The following activity provides an opportunity to compare dissimilar properties

and leases.

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Activity 4-5: Comparing Dissimilar Leases

Renaissance Computer Systems (RCS) is a 20-year-old company that repairs

and upgrades mainframe and midsize computer systems. RCS owns a

headquarters facility in Maryland, where they conduct administrative functions

as well as complete computer repair and system upgrades.

RCS leases their regional facility in Dallas, and the lease terminates in 10

months. The company also occupies 12,000 sf in a flex/R&D building, of

which regional administrative services and sales operations occupy 7,000 sf, and

the remaining 5,000 sf is used as a work area for the company‟s technicians who

perform computer repair and upgrade work.

The market for space in the area is soft, and you, as broker for RCS, inform

your client that it‟s a good time to find other suitable locations and negotiate an

aggressive deal. RCS has directed you to conduct a search for facilities within a

five-mile radius of their current facility and no more than one-half mile from anentrance/exit of a major freeway. They also inform you that renewing the lease

in their current location is a strong possibility, provided that the space is

refurbished with new carpet, paint, and some minor electrical and lighting

modifications.

After extensively searching the market, reviewing the results with the RCS

leadership, and touring the finalists, RCS authorizes you to submit requests for

proposals (RFPs) to the three buildings that appear to most closely satisfy their

needs and interests.

1.

The current RCS location in Building A of InfoTech Park (12,000 sf): Inthe current modified gross lease, most operating expenses are included in

the base rent, with a base year expense stop. The tenant is directly

responsible for electric and janitorial costs.

2.

The Chambers Building (11,500 rsf): This is a multistory office building.

The space RCS is considering is on the first floor and has a separate

delivery entrance that would be suitable for incoming delivery and outgoing

shipping of computer systems. The building owner uses a full service lease

with all operating expenses included in the base rent. Operating expense

increases are paid by the user via a base year expense stop.3.

Building G of InfoTech Park (14,000 sf): This is an office/warehouse

building that has an office area and an air-conditioned work area that are

sufficient to accommodate RCS‟s needs with only minor modification. The

space has an additional 2,000 sf of non-air-conditioned space that RCS

doesn‟t immediately need, but can make use of in the future. Building G

utilizes a net lease with the tenant paying a base rent plus their

proportionate share of property taxes, insurance, and common area

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maintenance (CAM). The tenant is directly responsible for electric and

janitorial costs.

You complete custom RFPs for each of the three alternatives, and you receive

proposals from each landlord. After some preliminary negotiations, you

believe that you have arrived at the best terms from each, as shown in the

summaries above and the following additional information:

Operating expense increase at InfoTech A and Chambers: 3 percent per

year

Property tax increase at InfoTech G: 2 percent per year

CAM and insurance increases at InfoTech G: 3 percent per year

Janitorial increase at InfoTech A and InfoTech G: 3 percent per year

Electric increase at all buildings: 4 percent per year

All rents are flat for the first five years User‟s discount rate: 9 percent

Lease Term is 5 years

Proposed Terms

InfoTech Building A

Chambers

Building

InfoTech Building G

Size 12,000 sf 11,500 sf 14,000 sf

Base rental rate year one $12 psf $16 psf $6 psf

Operating expense base year one $4.50 psf $8 psf NA

First-year property taxes NA NA $2.20 psf

First-year CAM expense NA NA $2.50 psf

First-year insurance expense NA NA $0.85 psf

First-year janitorial expense $1.20 psf NA $1.10 psf

Electric expense $2.20 psf NA $1.70 psf

Total TI cost $7 psf $14 psf $6 psf

Landlord TI allowance $6 psf $12 psf $4 psf

Moving costs NA $3.50 psf $3 psf

Landlord moving allowance NA $2 psf $1.50 psf

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Calculate the occupancy cost measures for each of the three alternatives using

the tables below, and then answer the questions that follow.

Alternative Analysis

InfoTech Building A Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Base rent

+ Parking


— Operating expensestop

+ Property tax

— Property tax stop

+ CAM expense

— CAM expense stop

+ Insurance expense

— Insurance expensestop

+ Janitorial

— Janitorial expensestop

+ Electricity expense

— Electricity expense

stop

+ Total TI cost — TI allowance

+ Moving cost

— Moving costallowance

+ Lease buyout cost

— Lease buyout

allowance

— Free rent

= Total cost of occupancy

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Chambers Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Base rent

+ Parking

+

Operating expenses

— Operating expense stop

+ Property tax

— - Property tax stop

+ CAM expense

— CAM expense stop

+ Insurance expense

— Insurance expense stop

+

Janitorial

— Janitorial expense stop

+ Electricity expense

— Electricity expense stop

+ Total TI cost

— TI allowance

+ Moving cost

— Moving cost allowance

+ Lease buyout cost

— Lease buyout allowance

— Free rent

= Total cost of occupancy

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1.

Complete the following comparison table of occupancy cost measures.

InfoTech A Chambers InfoTech G


Total effective rate

Average annual effective rent

Average annual effective rate

Discounted effective rent

(present cost of occupancy)

2.

If the discount rate was increased, would the resulting discounted effective

rent make InfoTech A more or less preferable?

3.

In this situation, why is the analysis of rate (total effective or average annual)

not as important or reliable?

Group discussion:

Since these are three dissimilar types of buildings, what

other considerations should RCS take into account when making their final

decision?

End of activity

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Refinements in Comparative Lease Analysis

Unequal Terms

Useful comparisons are difficult if the terms of the alternative leases vary. For

example, if one proposed lease term is five years and the other is eight years,

the analyst must make an adjustment for the shorter-term lease. Following are

several ways to make this adjustment:

Ask the landlord offering the shorter-term lease to suggest informal terms

for an additional three years, and estimate the cash flows on the five-year

lease as if it were for eight years.

Estimate the market rates at the end of the five-year lease term, and

calculate the additional three years using estimated rates, expenses, and

growth factors.

Carry the terms of the five-year lease through eight years using the same

growth factors as in the first five years.

Divide the eight-year lease into two leases, one of five years and one of three

years. Use the terms of the three-year lease as the terms of the estimated

three years of the original five-year lease.

Adjustments to Cash Flows

The preceding examples have considered only a few of the items that might

affect the cost of occupancy. In actual practice, many other factors also must be

considered, such as

Security deposits (cash outflow at the beginning of the term and inflow at

the end)

Key fees (cash outflow at the beginning of the term and inflow at the end)

Early termination cost (early termination fee paid to the landlord from theuser) or gain (early termination fee paid from the landlord to the user) from

terminating the previous lease (sandwich lease)

Value of sublease or option rights

Percentage rent (retail property)

Timing of concession payments

Cost recovery and depreciation on TIs (income tax consequences)

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Consistent with current practice, cash flow before tax has been used in all

examples. Incorporating taxes may alter the attractiveness of one occupancy

decision versus another.

Monthly versus Yearly Discounting

Because rents are paid monthly rather than yearly, it is more accurate to

discount monthly rather than annual cash flows. For instance, a user enters into

a five-year lease with the following assumptions:

Size: 5,000 sf of rentable area

Base rent rate: $16 psf, net, with annual escalations of 4 percent and free

rent for the first six months

10 percent discount rateAnnual Lease Cash Flows

Year 0 1 2 3 4 5

Rent $80,000 $83,200 $86,528 $89,989 $93,589

– Free rent 40,000 ----- ----- -----

Totals $40,000 $83,200 $86,528 $89,989 $93,589

PV (Present Cost of Occupancy) Using Annual Discounting

EOP $

0 ($0)

1 $40,000

2 $83,200

3 $86,528

4 $89,989

5 $93,589

PV = $289,709

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Module 4: Self-Assessment ReviewTo test your understanding of the key concepts in this module, answer thefollowing questions.

1.

A landlord is proposing to lease 15,000 sf to a user for five years at a flat

annual triple-net rental rate of $10 psf, with $4.35 in annual operating

expenses with no increase expected in the annual operating expenses.

Tenant improvements are expected to cost $7,500, with the owner

contributing $5,000 to the costs of tenant improvements. The user‟s

moving costs are estimated at $2,500. What is the user‟s total effective

rent?

a.

$1,076,250

b.

$1,081,250

c. $760,000

d.

$755,000

2.

Using the information from question 1, what is the average annual effective

rate?

a.

$10.13

b. $14.35

c. $10.07

d.

$14.42

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3. A user is negotiating a five-year lease on a 12,700-sf office. The landlord is

proposing a $13.50 base rental rate in year one, with the user paying all

operating expenses that exceed the owner‟s expense stop of $4.00 psf in

year one. Assuming operating expenses are equal to $4.00 psf in year one

and are anticipated to escalate 4 percent annually over the life of the lease,

how much additional cost for operating expenses would the user pay in yeartwo?

a. $2,032

b.

$8,890

c.

$4,233

d. $7,823

4. From the information in question 3, assume the total costs of tenant

improvements in year zero are equal to $8.00 psf, and the owner is willing

to contribute only $5.00 psf. Assuming no additional owner contribution

for tenant improvements, what dollar amount would the user have to pay

toward the costs of tenant finish?

a.

$101,600

b. $38,100

c.

$7,620

d.

$50,800

5. From the information in questions 3 and 4, assuming the user had moving

costs of $5,000, what is the total amount the user has to contribute in year

zero?

a.

$43,100

b.

$14,310

c. $11,110

d. $25,872

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6.

From the information in questions 3 through 5, how could you handle the

user-paid costs in year zero?

a.

Negotiate to amortize the entire cost over the life of the lease.

b. Amortize a portion of the cost over the life of the lease and have the

user pay the difference.

c. Have the user pay the entire amount up front.

d. Any of the above.

7. Comparative lease analysis is useful to

a. Help a client select a property or space

b.

Isolate costs of subjective factors

c. Assist in negotiating the terms of a lease

d. All of the above

8. As seen from the user‟s perspective, a lease has the following before-tax

cash flows. What is the present value of the following before-tax cash flows

when using a 10 percent discount rate?

Cash Flow

n $

0 ($4,700)

1 (87,387)

2 (89,407)

3 (92,536)

4 (95,542)

5 ($99,365)

a.

($326,412)

b.

($375,323)

c. ($354,511)

d. ($368,633)

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9. From the information in question 8, and assuming 7,282 rsf, what is the

user‟s total effective rent?

a. $468,937

b. $457,832

c.

$459,001

d. $479,720

10. From the information in questions 8 and 9, what is the user‟s total effective rate?

a.

$59.32

b.

$68.76

c. $64.40

d. $63.33

11. From the information in questions 8 through 10, what is the user‟s average

annual effective rent?

a.

$96,732

b.

$93,787

c. $87,340

d. $101,843


annual effective rate?

a.

$12.26

b.

$11.48

c. $13.64

d. $12.88

End of assessment

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Answer Section

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Activity 4-1: Economic Lease Comparison

1. The term “effective rent ” includes downward adjustments for concessionsand allowances and upward adjustments for tenant-paid costs and expenses.

a.

True

2. The term “total effective rent ” refers to the total rent paid by a user overonly the first year of a multiyear lease.b. False

3. The term “total effective rate” refers to the total effective rent divided by thetotal rentable square feet occupied by a user.a. True

4. The term “average annual effective rent ” is equal to the total effective rentdivided by the number of years in the term of the lease.a. True

5. The term “average annual effective rate” is equal to the average annualeffective rent divided by the number of years in the term of the lease.b. False

6.

The term “discounted effective rent ” takes into account the time value ofmoney by discounting future lease payments to a present value at aprescribed discount rate.a. True

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Activity 4-2: Analyzing Multi-Period Leases

Part One

Total effective rent:376,321

Total effective rate: 107.52

Average annual effective rent: 75,264

Average annual effective rate:21.50

Discounted effective rent at 10 percent:293,114

Lease B: Counter Offer Annual Cash Flows

Year 0 1 2 3 4 5

Base rent 59,500 60,375 61,250 62,125 63,000

+Operatingexpenses 24,500 25,235 25,992 26,772 27,575

– Landlord’s

operating expensestop

24,500 24,500 24,500 24,500 24,500

+ Property taxes 7,000 7,210 7,426 7,649 7,879

– Landlord’s

property tax

expense stop

7,000 7,000 7,000 7,000 7,000

+ Net TPTI 21,000

+ Parking5,250 5,250 5,250 5,250 5,250

+Net existing leasebuyout 15,000

+Net movingexpenses

8,000

– Free rent 9,917

= Total effective rent 44,000 54,833 66,570 68,418 70,296 72,204

Part Two

Total effective rent:341,488

Total effective rate:97.57

Average annual effective rent:68,298

Average annual effective rate: 19.51

Discounted effective rent at 10 percent: 260,084

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Lease B: Revised Counter Offer Annual Cash Flows

Year 0 1 2 3 4 5

Base rent 59,500 60,375 61,250 62,125 63,000


– Landlord’s operating

expense stop

24,500 24,500 24,500 24,500 24,500

+ Property taxes 7,000 7,210 7,426 7,649 7,879

– Landlord’s property tax

expense stop7,000 7,000 7,000 7,000 7,000

+ Net TPTI 21,000

+ Parking 5,250 5,250 5,250 5,250 5,250

+ Net existing lease buyout 0

+ Net moving expenses 8,000


= Total effective rent $29,000

35,000 66,570 68,418 70,296 72,204

Activity 4-3: Analyzing Occupancy Cost Measures

1.

Which occupancy cost measure do you feel is most credible for the user?

Why?

Answers m ay vary based on subjective interpretation.

Discounted effective rent (PV) takes into consideration the time value of the

occupancy expense

2.

If the user prefers to preserve capital for the primary business, which lease

proposal should the user choose? Why?

Proposal A. The upfront (time period zero) cost is 3,000 versus 29,000

for Proposal B.

3.

If the user strongly prefers Lease A due to its more desirable location, but

wants the same occupancy cost as Lease B (as measured in discounted

effective rent), what changes in a counterproposal might the user consider:

a.

In rental rate?

The discounted effective rent for Lease A would be equalized with

Lease B by reducing the starting rental rate to 15.97 psf or less.

b.

To equalize the present cost of occupancy?

Answers will vary.

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Activity 4-4: Analyzing Operating Versus Capital Leases

1. Is the proposed rent reasonable?

Based on the research review of the market rents, it appears that the

proposed rent of 24.00 psf is reasonable.

2. What is the approximate value of the premises with the lease extension in

place (to the nearest thousand)?

Based on a 9 percent market cap rate and a first year net rent of 402,933

(year one full service rent of 24 less 7.45 in operating expenses equals

16.55 psf net rent), the premise‟s value is approximately 4,478,000.

3.

What is the total effective rent for the extension proposal?

10,425,430

Year Gross (Full Service) Rent

1 $584,400

2 $584,400

3 $584,400

4 $584,400

5 $584,400

6 $654,528

7 $674,164

8 $694,389

9 $715,220

10 $736,677

11 $758,777

12 $781,541

13 $804,987

14 $829,13615 $854,011

Total effective rent 10,425,430

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4. What is the total effective net rent for the extension proposal?

7,704,317

Year

Gross (Full

Service) Rent Expense Stop Net Rent

1 $ 584,400 $181,408 $402,992.50

2 $584,400 $181,408 $402,992.50

3 $584,400 $181,408 $402,992.50

4 $ 584,400 $181,408 $402,992.50

5 $584,400 $181,408 $402,992.50

6 $654,528 $181,408 $473,120.50

7 $674,164 $181,408 $492,756.34

8 $694,389 $181,408 $512,981.26

9 $715,220 $181,408 $533,812.92

10 $736,677 $181,408 $555,269.53

11 $758,777 $181,408 $577,369.84

12 $781,541 $181,408 $600,133.16

13 $804,987 $181,408 $623,579.38

14 $829,136 $181,408 $647,728.99

15 $854,011 $181,408 $672,603.08

Total effective rent $10,425,430 7,704,317

5.

If the lease was classified as an operating lease, what rent amount would be

expensed annually per GAAP?

513,621

Total effective net rent ÷ lease term (years) = average annual effective net rent

$7,704,317 ÷ 15 = $513,621

6.

Is the lease a capital lease? If so, why? If not, why not?

Yes. 90 percent of the market value (question 2) is approximately

4,030,000.

The PV of the net rent (discounted net rent) at the user‟s incremental

borrowing rate of 7 percent is 4,440,179. Since the PV of the net rent is

more than 90 percent of the market value, the lease is classified as a capital

lease.

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7.

What recommendations would you make to your friend/client to modify

the proposal to better meet the company‟s objectives?

The user should consider an early termination provision in the lease

extension, perhaps at the end of year five and/or the end of year 10 with a

negotiated early termination fee that would bring the discounted net rent to

below the 90 percent market value threshold.

Activity 4-5: Comparing Dissimilar Leases

Infotech Building A Year Year 1 Year 2 Year 3 Year 4 Year 5

Base rent $144,000 $144,000 $144,000 $144,000 $144,000

Parking - - - - -

+ Operating expense 54,000 55,620 57,289 59,007 60,777

— Operating expensestop (54,000) (54,000) (54,000) (54,000) (54,000)

+ Property tax - - - - -

— Property tax stop - - - - -

+ CAM expense - - - - -

— CAM expense stop - - - - -

+ Insurance - - - - -

— Insurance expensestop - - - - -

+ Janitorial 14,400 14,832 15,277 15,735 16,207

— Janitorial expensestop - - - - -

+ Electricity expense 26,400 27,456 28,554 29,696 30,884

—

Electricity expense

stop - - - - -

+ Total TI cost $84,000

— TI allowance (72,000)

+ Moving cost -

— Moving costallowance -

+ Lease buyout cost -

—

Lease buyout

allowance -

— Free rent

= Total effective rent 12,000 184,800 187,908 191,120 194,439 197,869

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4 •



Infotech Building G Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Base rent $84,000 $84,000 $84,000 $84,000 $84,000

Parking - - - - -

+ Operating expense - - - - -

—

Operating expense

stop

- - - - -

+ Property tax 30,800 31,416 32,044 32,685 33,339


+ CAM expense 35,000 36,050 37,132 38,245 39,393


+ Insurance 11,900 12,257 12,625 13,003 13,394

—

Insurance expense

stop - - - - -

+ Janitorial 15,400 15,862 16,338 $ 16,828 17,333

—

Janitorial expensestop

- - - - -

+

Electricity expense

23,800 24,752 25,742 26,772 27,843

—

Electricity expense

stop - - - - -


—

TI allowance

(56,000)

+

Moving cost

42,000

—

Moving costallowance (21,000)


—

Lease buyoutallowance -

—

Free rent

=


49,000 200,900 204,337 207,880 211,534 215,301

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4 •




1.

A landlord is proposing to lease 15,000 sf to a user for five years at a flat

annual triple-net rental rate of $10 psf, with $4.35 in annual operating

expenses with no increase expected in the annual operating expenses.

Tenant improvements are expected to cost $7,500, with the owner

contributing $5,000 to the costs of tenant improvements. The user‟s

moving costs are estima ted at $2,500. What is the user‟s total effective

rent?

b. 1,081,250

Year Year 1 Year 2 Year 3 Year 4 Year 5

Base rent $150,000 $150,000 $150,000 $150,000 $150,00

Parking - - - - -

+ Operating expense $65,250 $65,250 $65,250 $65,250 $65,250

— Operating expensestop - - - - -

+ Property tax - - - - -


+ CAM expense - - - - -


+ Insurance - - - - -

— Insurance expensestop - - - - -

+ Janitorial - - - - -

—

Janitorial expense

stop - - - - -

+ Electricity expense - - - - -

—

Electricity expense

stop - - - - -


— TI allowance ($5,000)

+ Moving cost $2,500

—

Moving cost

allowance -


—

Lease buyout

allowance -

— Free rent


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2. Using the information from question 1, what is the average annual effective

rate?

d. 14.42

Total effective rent ÷ lease term (years) = average annual effective rent

$1,081,250 ÷ 5 = $216,250

Average annual effective rent ÷ premises sf = average annual effective rate

$216,250 ÷ 15,000 = $14.42

3.

A user is negotiating a five-year lease on a 12,700-sf office. The landlord is

proposing a $13.50 base rental rate in year one, with the user paying all

operating expenses that exceed the owner‟s expense stop of $4.00 psf in

year one. Assuming operating expenses are equal to $4.00 psf in year oneand are anticipated to escalate 4 percent annually over the life of the lease,

how much additional cost for operating expenses would the user pay in year

two?

a. 2,032

Year 1 operating expense psf $4.00

Year 2 operating expense psf $4.16 (Increase of 4%)

Difference psf: $0.16

Monthly difference $2,032.00

4.

From the information in question 3, assume the total costs of tenant

improvements in year zero are equal to $8.00 psf, and the owner is willing

to contribute only $5.00 psf. Assuming no additional owner contribution

for tenant improvements, what dollar amount would the user have to pay

toward the costs of tenant finish?

b. 38,100

Premises size (sf) 12,700

TI cost psf $8.00

TI allowance psf $5.00

Net TPTI psf $3.00

Net TPTI $38,100 (12,700 × $3.00)

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4 •



5.

From the information in questions 3 and 4, assuming the user had moving

costs of $5,000, what is the total amount the user has to contribute in year

zero?

a. 43,100

Net TPTI $38,100Moving expense $5,000

Total period zero cost $43,100

6.

From the information in questions 3 through 5, how could you handle the

user-paid costs in year zero?

d. Any of the above

7.

Comparative lease analysis is useful to

d.

All of the above

8. As seen from the user‟s perspective, a lease has the following before-tax

cash flows. What is the present value of the following before-tax cash flows

when using a 10 percent discount rate?

Cash Flow

n $

0 ($4,700)

1 (87,387)

2 (89,407)

3 (92,536)

4 (95,542)

5 ($99,365)

c. ( 354,511)

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9. From the information in question 8, and assuming 7,282 rsf, what is the

user‟s total effective rent?

a.

468,937

Year 0 ($4,700)

Year 1 (87,387)

Year 2 (89,407)

Year 3 (92,536)

Year 4 (95,542)

Year 5 (99,365)

Total effective rent ($468,937)

10.

From the information in questions 8 and 9, what is the user„s total effective

rate?

c. 64.40

Total effective rent ÷ premises sf = total effective rate

$468,937 ÷ 7,282 = $64.40


annual effective rent?

b.

93,787

Total effective rent ÷ lease term in years = average annual effective rent

$468,937 ÷ 5 = $93,787

12.

From the information in questions 8 through 11, what is the user‟s average

annual effective rate?

d. 12.88

Average annual effective rent ÷ premises sf = average annual effective rate

$98,787 ÷ 7,282 = $12.88

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Module Goal ........................................................ 5.1

Objectives ............................................................. 5.1

Leasing .................................................... 5.3

Advantages of Leasing ......................................... 5.3

Disadvantages of Leasing ..................................... 5.4

Owning ..................................................... 5.6

Advantages of Owning ......................................... 5.6

Disadvantages of Owning .................................... 5.6

Comparison Techniques ............................ 5.8

Net Present Value Method .................................. 5.8

Internal Rate of Return of the Differential CashFlows Method ...................................................... 5.9

Activity 5-1: Methods of Comparing Costs ...... 5.11

Sample Problem 5-1: SAV-A-LOT Stores ....... 5.13

Determining the Impact of Different

Alternatives ............................................ 5.15

Method 1: Net Present Value Method UsingMultiple Discount Rates .................................... 5.15

Lease

Versus Own

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Method 2: Net Present Value Method Using aSingle Discount Rate .......................................... 5.22

Future Sales Price Sensitivity ............................. 5.25

Method 3: Internal Rate of Return of theDifferential Cash Flows Method ....................... 5.29

Activity 5-2: Calculating Costs ........................... 5.32

GAAP Accounting Impact on Financial

Statements for SAV-A-LOT ........................ 5.34

Purchase Alternative .......................................... 5.34

Lease Alternative ................................................ 5.35

Capital Lease versus Operating Lease ....... 5.36


Answer Section ....................................... 5.41

Activity 5-1: Methods of Comparing Costs ..... 5.42

Activity 5-2: Calculating Costs Answers ............ 5.43


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Lease Versus Own

Module Snapshot

Module Goal

After identifying a need for space, the corporation or individual must decide

whether to buy or lease. Both options have advantages and disadvantages, and

each has a particular cost. However, the respective cost of leasing or buying is

not the only indicator of which option to choose. For example, even if the cost

to buy the property exceeds the cost to lease, the final choice may be to incur

the higher purchasing costs to gain the advantages of ownership. This module

explores the advantages and disadvantages associated with leasing, buying, and

covers the different methods used to compare costs.

Objectives

Recognize the critical factors, both financial and nonfinancial, that influence

the lease versus own decision.

Compare and contrast leasing versus owning as a means of maximizing the

physical and/or economic use of a property.

Calculate and interpret net present values (NPVs) of leasing versus owning.

Calculate and interpret the yield (internal rate of return) of the differential

cash flows after tax from leasing and owning.

Calculate and explain the sale price point of indifference where the NPVs

of leasing and owning are the same.

Measure the impact of generally accepted accounting principles (GAAP)

reporting on the user’s financial statements.

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NOTES

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5 •

L e a s e v e r s u s O w n

Leasing

Leasing is a means of obtaining the physical and partial economic use of a

property for a specified period without obtaining an ownership interest. The

lease contract is a legal document in which the owner (lessor) agrees to allow the

tenant (lessee) to use the property for the specified time and under specified

conditions. In return, the lessee agrees to make periodic payments to the

lessor.

As with other business decisions, leasing affords a user certain advantages and

disadvantages.

Advantages of Leasing

Availability of Cash Most lease arrangements have fewer restrictions than loan

agreements, providing flexible financing. Leasing is well suited to piecemeal

financing. A firm that is acquiring assets over time may find it more convenient

to lease than to negotiate loan terms or to sell securities each time the firm

makes a new capital outlay.

Financial Flexibility Leasing can provide more flexibility for owners who may

need cash to invest in their business (inventories, salaries, or equipment). It

may be more prudent and profitable to use their financing capabilities to run

the business than to invest in real estate to house the business. Avoiding a

down payment frees that money for other uses. Opportunity costs and capital

costs are important investor (and user) considerations.

Additional Tax Deductions

Since lease payments are fully tax deductible and

reflect rent paid for both the land and improvements, the lessee can deduct the

cost of rent paid for the land. In an ownership position, cost recovery is not

allowed on the land portion of the investment. If the lease is a net lease and the

lessee pays operating expenses in addition to rent, the operating expenses are

deductible as well.

Source of Financing Leasing is often the only available source of financing for

a small or marginally profitable firm since the title to leased property remains

with the lessor, reducing the lessor’s risk in the event of the firm’s failure. If thelessee does fail, the lessor can recover the leased property. Also, leasing is said

to provide 100 percent financing, while most borrowing requires a down

payment. Because lease payments typically are made in advance of each

period, this 100 percent financing is diminished by the amount of the first

required lease payment.

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Low Risk of Obsolescence It may be possible for the lessee to avoid some of

the risks of obsolescence associated with ownership. The lessor charges a lease

rate based on its required rate of return on the investment property, provided it

is less than or equal to market lease rates. The net investment is equal to the

cost of the asset minus the present value (PV) of the expected salvage value at

the end of the lease. If the actual salvage value is less than originally expected,the lessor bears the loss.

Stability of Costs Leasing tends to stabilize the lessee’s expenses. Because

lease payments are a continual periodic outlay, earnings tend to appear more

stable when assets are leased rather than owned. This can be very important to

businesses that strictly monitor cash flows or have seasonal cash flows. The

ability to anticipate costs accurately is very important to many businesses.

Spatial Flexibility/Mobility

Leasing can provide more flexibility if a business

expands or contracts. It also provides more mobility if a business needs or

wants to relocate.

Technology Leasing allows a commercial user to respond to technological

changes more quickly. Some businesses must be on the cutting edge of

technology, and moving may be the most efficient way to accomplish that goal.

Location Leasing allows the user to be at a premier location that otherwise

would be unaffordable.

Focus Leasing allows the user to concentrate on his primary business without

the distraction of managing real estate.

Disadvantages of Leasing

Cost For a firm with a strong earnings record, good access to financing, and

the ability to take advantage of the tax benefits of ownership, leasing is often a

more expensive alternative. Individuals and small firms may find that leasing

and borrowing terms are approximately equal.

Loss of the Asset’s Salvage Value In real estate, this loss can be substantial. A

lessee may have difficulty obtaining approval for property improvements on

leased real estate if the improvements substantially alter the property or reduce

its potential range of uses. Although the lessee considers the improvementsimportant —such as technological changes necessary to the business, physical

changes to accommodate staff, or cosmetic changes to impress customers—the

lessor may be reluctant to allow them.

Contractual Penalties If a leased property becomes obsolete or if the capital

project financed by the lease becomes uneconomical, the lessee is legally

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5 •


obligated to keep paying the lease and may not cancel it without paying a

penalty.

Appreciation Leasing does not provide participation in property appreciation.

Control Leasing does not allow control of other tenants. New neighboring

tenants may not conform to the type of image the lessee seeks, or they may

create demands on the physical plant that the lessee was not anticipating.

Operational Control The lessee has no control over business amenities. The

lessor may cancel the lease on an inexpensive sandwich shop that was attractive

to the lessee’s employees. Communal amenities such as conference rooms may

be closed and leased for profit. New building personnel may not provide the

same level of service as the lessee originally enjoyed.

Changes

The lessee may have to accept changes to the space that the lessor

wants, but the lessee opposes. For example, the lessor may decide to install

new lighting to lower costs, but the lessee may find this unnecessary and a

disruption to his business.

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Owning

Owning is a means of obtaining the full economic use of a property for an

unspecified period in the form of an ownership interest. If an owner is also a

user, physical use of the property is obtained as well. Owners generally are free

to use the property as they wish, even though they may be obligated to a

mortgagee.

Just as leasing can have distinct advantages and disadvantages, so can owning.

Consider the following elements when making the decision to own.

Advantages of Owning

Tax Savings The owner of a property is entitled to the tax savings resulting

from cost recovery rules and mortgage interest expense deduction during the

holding period and when the property is sold.

Appreciation The owner of an asset, a building in particular, is entitled to all

of the appreciation in value.

Income If a portion of the property is rented, income from the lessees can be

used to pay the mortgage on the property, f und the owner’s principal business,

or be used for other investments.

Control The user or investor who owns a building has, within the limits of the

law, freedom to operate the building as the user sees fit. Controlling the

appearance of a site and taking advantage of the prestige of its location may beimportant to certain businesses. Other owners, perhaps nearing the end of

their holding period, may wish to keep expenses low. Ownership also allows

some control of costs.

Disadvantages of Owning

Initial Capital Outlay Down payments to acquire the property may divert cash

that could be used to finance the company’s operations or other investments.

Financing Often a company’s ability to obtain a loan not only depends on itsfinancial condition, but also on the financial marketplace.

Financial Liability

A mortgage loan or a deed of trust can affect the balance

sheet (by increasing long-term debt) and the related debt restrictions sometimes

required by a lender.

Legal Compliance Compliance with changes in laws or zoning may be

unforeseen, costly, and unavoidable.

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5 •


Risks Risks to ownership include potential damage, obsolescence, and the

inability to sell at preferred prices at the right time.

Health and Safety Liability The owner is liable for the safety and well-being of

tenants, employees, and the public within and outside of the building.

Inflexibility Space may be inflexible and cannot be enlarged or reduced

depending on business fluctuations or other forces.

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Value Line Chart

(Negative NPV/PV)

Positive NPV/PV

Lesser

NPV/PV

Greater

NPV/PV

( $ 5 0 , 0

0 0 )

( $ 4 0 , 0

0 0 )

( $ 3 0 , 0

0 0 )

( $ 2 0 , 0

0 0 )

( $ 1 0 , 0

0 0 )

$ 0

$ 1 0 , 0

0 0

$ 2 0 , 0

0 0

$ 3 0 , 0

0 0

$ 4 0 , 0

0 0

$ 5 0 , 0

0 0

Comparison Techniques

The two methods of comparing leasing and owning costs are the NPV method

and the internal rate of return (IRR) method. The NPV method compares the

NPVs of the cash flows for each of the alternatives. The IRR method calculates

the IRR on the difference between the owning and leasing cash flows. Since the

tax situations of owning and leasing are dissimilar, use cash flow after tax

(CFAT) in both methods. CFAT refers to the amount of money left after

accounting for all operating expenses, including property taxes, financing costs,

and income tax obligations. Regardless of which method is used, the holding

period for the leasing and owning alternatives must be the same.

Net Present Value Method

This method reduces each alternative to its periodic cash flows after tax. Applying the user’s appropriate after-tax discount rate, an NPV is calculated for

each alternative. Corporate users typically use their after-tax weighted average

cost of capital as the discount rate, while non-corporate users typically use their

after-tax opportunity cost. Once the PVs or NPVs are calculated for each

alternative, compare the values. The greater value is always the better

economic choice.

The following value line chart shows that values increase as you move from left

to right.

Figure 5.1 Value Line Chart

For example, if an NPV analysis indicates that one alternative result in an NPV

of ($40,000) and another alternative results in an NPV of ($30,000), the correct

choice would be the alternative that results in an NPV of ($30,000). As shown

in the previous chart, ($30,000) is farther to the right than ($40,000) and

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5 •


therefore is the greater value. The value of ($30,000) is greater than ($40,000),

even though in raw numbers, 40,000 would be greater. As a practical matter, in

this example the fact that both NPVs are negative means that the user is giving

up something for either choice. The lesser amount given up is the better

choice. In other words, giving up $30,000 is better than giving up $40,000.

Also look at the comparison in terms of the cost associated with eachalternative. A cost of $30,000 is a better choice than a cost of $40,000.

Consider another example of an NPV analysis in which one alternative result in

an NPV of $10,000 and another alternative result in an NPV of $20,000. The

NPV of $20,000 is the better choice. The chart shows that $20,000 is farther to

the right than $10,000 and therefore is the greater value. The fact that both

alternatives result in a positive NPV indicates that a positive economic benefit is

associated with either choice. The greater economic benefit of $20,000 is the

better choice.

Consider a last example of an NPV analysis in which one alternative result in anNPV of ($20,000) and another alternative result in an NPV of $10,000. The

NPV of $10,000 is the better choice. As shown in the chart, $10,000 is farther

to the right than ($20,000) and therefore is the greater value. Even though in

terms of raw numbers, 20,000 would be greater than 10,000, $10,000 is a

greater value than ($20,000). This example indicates that one alternative results

in the user giving up $20,000, but in the other alternative, the user receives a

positive economic benefit of $10,000. Receiving a positive economic benefit of

$10,000 is a better choice than giving up $20,000.

If applied correctly, NPV/PV can be a useful tool for users when making

economic decisions. The correct application is to choose the greater value, or

the one that is farther to the right on the value line. In the case of negative

values, the greater value is also the lesser cost. In other words, choose the value

on the right, and you will always be right.

Internal Rate of Return of the Differential Cash Flows

Method

The IRR method subtracts the lease alternative’s periodic cash flows after tax

from the own alternative’s periodic cash flows after tax and calculates an IRR ofthis differential. This IRR is after tax and is compared to the user’s appropriate

after-tax discount rate. This method allows the user to identify the discount

rate/opportunity cost at which the costs to own or lease are equal. When the

decision maker’s opportunity cost is higher than this equilibrium rate, it will be

cheaper to lease.

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5 •


Activity 5-1: Methods of Comparing Costs

1. The two methods of comparing leasing and owning costs are the net present

value method and the future value (method.

a. True

b.

False

2. The net present value method compares the net present values of the after-

tax cash flows for each of the alternatives.

a. True

b. False

3.

When using the net present value method, the user provides the discount

rate to be applied to the cash flows, not the broker or any other individual.

a.

True

b.

False

4.

When evaluating the net present values of leasing and owning, the

alternative with the lowest cost represents the best alternative.

a.

True

b.

False

5. The internal rate of return method calculates the internal rate of return of

the differential cash flows between owning and leasing and then compares

the internal rate of return of the differential to the user’s appropriate

discount rate.

a.

True

b.

False

6.

If the internal rate of return of the differential cash flows is greater than the

user’s appropriate discount rate, then the user should buy (own) instead of

lease.

a.

True

b.

False

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7. If the internal rate of return of the differential cash flows is less than the

user’s opportunity cost, then the user should lease instead of buy (own).

a. True

b. False

8.

If the internal rate of return of the differential cash flows is equal to the

user’s opportunity cost, then the user should evaluate the subjective aspects

of buying (owning) or leasing.

a. True

b. False

End of activity

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5 •


Sample Problem 5-1: SAV-A-LOT Stores

SAV-A-LOT Stores is one of the largest small-box discount retailers in the

country, with more than 8,000 stores in 40 states. Your real estate department

has identified a recently completed 8,000 square foot (sf) freestanding building

that is very similar to their prototype store and would take very little retrofittingto adequately serve as one of their outlets. The identified property is owned by

a developer who built it on speculation and will sell or lease the building with a

long-term lease. The SAV-A-LOT Chief Executive Officer (CEO) has asked

your department to recommend the optimum method to acquire the space.

The Chief Financial Officer (CFO) wants to know the impact each of the

acquisition alternatives would have on the corporate financial statements. The

CFO thinks that if the building is purchased, it should not be encumbered with

any debt financing. The CFO also thinks that if they choose to lease, the lease

should be an operating lease for at least 15 years. The CFO is amenable toincluding an early termination clause in the lease to avoid it being categorized as

a capital lease. A termination clause at the tenant’s option allows the tenant to

terminate the lease at the end of 10 years by paying a penalty in the amount

equal to the eleventh year’s rent.

User Information

Ordinary income tax rate: 34 percent

Capital gains tax rate: 34 percent

Cost recovery recapture tax rate: 34 percent

After-tax weighted average cost of capital: 7 percent

After-tax discount rate applied to leasing cash flows after tax: 5 percent

After-tax discount rate applied to ownership annual cash flows after tax:

6.75 percent

After-tax discount rate applied to ownership sale proceeds after tax (SPAT):

9 percent

Incremental borrowing rate: 6 percent

Anticipated occupancy period: 15 years

Purchase Information

Acquisition price: $1,400,000

Acquisition costs: $50,000

Improvement allocation: 75 percent

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Useful life of improvements: 39 years

Annual growth rate in value to calculate disposition price: 2 percent

Projected disposition cost of sale (percent of disposition price): 3 percent

Available Financing Information

Maximum loan amount (loan-to-purchase price): 75 percent

Interest rate: 6 percent

Amortization period: 20 years

Loan term: 20 years

Payments per year: 12

Loan costs (percent of loan amount): 2 percent

Leasing Information

Base lease term: 15 years

Rents payable annually at end of year

Rent in years 1 through 15: $15 per square foot (psf) absolute net

First five-year option: $17 psf absolute net

Second five-year option: $19 psf absolute net

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5 •


Determining the Impact of Different

AlternativesThe two analytical approaches to comparing the costs of owning and leasing are

the NPV method and the IRR of the differential method.The NPV method discounts the after tax occupancy costs using an appropriate

discount rate. In order to recognize future sale proceeds risk in the NPV

method, two discount rates can be used; one for the annual after tax cash flows,

and another for the SPAT cash flow.

In comparing leasing and owning alternatives for SAV-A-LOT Stores, three

methods will be utilized:

NPV method using multiple discount rates

NPV method using a single discount rate

IRR of the differential cash flows method

Method 1: Net Present Value Method Using Multiple

Discount Rates

Use the NPV method using multiple discount rates to compare the purchase

and lease alternatives to determine which is preferable for SAV-A-LOT Stores.

Lease Alternative1. Calculate the annual cash flows after tax from leasing for each year of the

projected occupancy period. To calculate after-tax cash flows, first calculate

the tax reduction by multiplying the annual lease cost by the tax bracket,

and then subtract the tax reduction from the annual lease cost. Use the

following models to make this calculation:

Annual leasing cost (pre-tax)

× Tax bracket

Annual tax savings


– Annual tax savings

Annual leasing cost (after tax)

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2. Calculate the NPV of the cash flows after tax from the lease alternative using

the 5 percent after-tax discount rate applied to the leasing annual cash flows

after tax.

n

(1)

Annual Lease

Payments

(2)

Tax Savings

(1) × 34%

Cash Flow

After Tax

(1) (2)

0 $0 $0 $0

1 ($120,000) ($40,800) ($79,200)

2 ($120,000) ($40,800) ($79,200)

3 ($120,000) ($40,800) ($79,200)

4 ($120,000) ($40,800) ($79,200)

5 ($120,000) ($40,800) ($79,200)

6 ($120,000) ($40,800) ($79,200)

7 ($120,000) ($40,800) ($79,200)

8 ($120,000) ($40,800) ($79,200)

9 ($120,000) ($40,800) ($79,200)

10 ($120,000) ($40,800) ($79,200)

11 ($120,000) ($40,800) ($79,200)

12 ($120,000) ($40,800) ($79,200)

13 ($120,000) ($40,800) ($79,200)

14 ($120,000) ($40,800) ($79,200)

15 ($120,000) ($40,800) ($79,200)

NPV @ 5% = ( 822,069)

Purchase Alternative

1. Calculate the annual cash flows after tax from ownership for the projected

occupancy period. Since the owner will occupy the building, there will be

no rental income, so zero is used for the NOI. Since the user is acquiring

the property without any debt financing, the only deduction from NOI to

calculate each year’s taxable income is the cost recovery. Remember that

the first and last years of the projection reflect the midmonth convention for

cost recovery.

The CFAT are positive, even though there is no income. This positive cash

flow results from the tax savings attributable to the cost recovery deduction.

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5 •


Following is the cash flow analysis worksheet (CFAW) for years one through

five.

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Following is the CFAW for years six through ten.

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5 •


Following is the CFAW for years 11–15.

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2. Calculate the sale proceeds after tax at the end of the holding period, using

the Alternative cash sales worksheet (ACSW).

Alternative Cash Sales Worksheet

SAV-A-LOT Stores, Inc.-Disposition Mortgage Balances

End of Year: 11 12 13 14 15

Principal Balance - 1st Mortgage

Principal Balance - 2nd Mortgage

TOTAL UNPAID BALANCE

Calculation of Sale Proceeds

PROJECTED SALES PRICE $1,884,000

CALCULATION OF ADJUSTED BASIS:

1 Basis at Acquisition

$1,450,000

2 +Capital Additions

3 -Cost Recovery (Depreciation) Taken $415,925

4 -Basis in Partial Sales

5 =Adjusted Basis at Sale $1,034,075

CALCULATION OF CAPITAL GAIN ON SALE:

6 Sale Price $1,884,000

7 -Costs of Sale $56,520

8 -Adjusted Basis at Sale (Line 5) $1,034,075

9 -Participation Payment on Sale

10 =Gain or (Loss) $793,405

11 -Straight Line Cost Recovery (limited to gain) $415,925

12 -Suspended Losses

13 =Capital Gain from Appreciation

$377,480

ITEMS TAXED AS ORDINARY INCOME:

14 Unamortized Loan Fees/Costs (negative)

15 +

16 =Ordinary Taxable Income

CALCULATION OF SALES PROCEEDS AFTER TAX:

17 Sale Price $1,884,000

18 -Cost of Sale $56,520

19 -Participation Payment on Sale

20 -Mortgage Balance(s)

21 +Balance of Funded Reserves

22 =Sale Proceeds Before Tax $1,827,480

23 -Tax (Savings): Ordinary Income at 34% of Line 16

24 -Tax: Straight Line Recapture at 34% of Line 11 $141,415

25 -Tax on Capital Gains at 34% of Line 13 $128,343

26 =SALE PROCEEDS AFTER TAX $1,557,722

The statements and figures herein, while not guaranteed, are secured from sources we believe authoritative.

Copyright© 2009 by the CCIM Institute

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5 •


3.

a) Calculate the NPV of the annual CFAT from ownership using the 6.75

percent after-tax discount rate applied to the ownership annual cash flows

after tax.

b) Calculate the NPV of the sale proceeds after tax using the 9 percent after-

tax discount rate applied to the ownership sale proceeds after tax.

c) Add the two NPVs to quantify the total NPV of the ownership alternative.

n

Annual Cash

Flows

n

Sale Proceeds

After Tax

Net Present Value

of Ownership

0 ($1,450,000) 0 $0

1 $9,085 1 $0

2 $9,480 2 $0

3 $9,480 3 $0

4 $9,480 4 $0

5 $9,480 5 $06 $9,480 6 $0

7 $9,480 7 $0

8 $9,480 8 $0

9 $9,480 9 $0

10 $9,480 10 $0

11 $9,480 11 $0

12 $9,480 12 $0

13 $9,480 13 $0

14 $9,480 14 $0

15 $9,085 15 $1,557,722

NPV @ 6.75% ( 1,362,795) + NPV @ 9.00% 427,654 = ( 935,141)

Summary of the Net Present Value Method Using Multiple Discount

Rates

Compare the calculated NPVs of the own and lease alternatives. Assuming that

the appropriate after-tax discount rates were used, the alternative that produces

the greater NPV (lower cost) is the better economic alternative.

NPV of owning: ($935,141)

NPV of leasing: ($822,069)

In this case, both NPVs are negative, so the lesser negative is the greater NPV,

which is ($822,069), the leasing alternative. In other words, expending $822,069

in occupancy costs is more desirable than expending $935,141.

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Method 2: Net Present Value Method Using a Single

Discount Rate

The second method used to compare the purchase and lease alternatives is the

NPV method using a single discount rate.

Lease Alternative

1. Calculate the annual cash flows after tax from leasing for each year of the

projected occupancy period. To calculate after-tax cash flows, first calculate

the tax reduction by multiplying the annual lease cost by the tax bracket,

and then subtract the tax reduction from the annual lease cost. Use the

following models to make this calculation.


× Tax bracket

Annual tax savings


– Annual tax savings

Annual leasing cost (after tax)

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5 •


2.

Calculate the NPV of the cash flows after tax from the lease alternative using

the after-tax weighted average cost of capital as the discount rate (7 percent).

n

(1)

Annual Lease

Payments

(2)

Tax Savings

(1) × 34%

Cash Flow

After Tax

(1) (2)

0 $0 $0 $0

1 ($120,000) ($40,800) ($79,200)

2 ($120,000) ($40,800) ($79,200)

3 ($120,000) ($40,800) ($79,200)

4 ($120,000) ($40,800) ($79,200)

5 ($120,000) ($40,800) ($79,200)

6 ($120,000) ($40,800) ($79,200)

7 ($120,000) ($40,800) ($79,200)

8 ($120,000) ($40,800) ($79,200)

9 ($120,000) ($40,800) ($79,200)

10 ($120,000) ($40,800) ($79,200)11 ($120,000) ($40,800) ($79,200)

12 ($120,000) ($40,800) ($79,200)

13 ($120,000) ($40,800) ($79,200)

14 ($120,000) ($40,800) ($79,200)

15 ($120,000) ($40,800) ($79,200)

NPV @ 7% = ( 721,347)

Purchase Alternative

Use the same first two steps as for the NPV comparison using multiple discount

rates. To reiterate, they are as follows:

1.

Calculate the annual cash flows after tax from ownership for the projected

occupancy period. Since the owner will occupy the building, there will be

no rental income. Remember that the first and last years of the projection

reflect the midmonth convention for cost recovery.

The cash flows after tax are positive, even though there is no income. This

positive cash flow results from the tax savings attributable to the costrecovery deduction.

2. Calculate the SPAT at the end of the holding period.

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3. Then, calculate the NPV of the annual cash flows after tax from ownership

and the after-tax cash flow from disposition using the after-tax weighted

average cost of capital as the discount rate (7 percent).

n

Annual Cash

Flows

Sale Proceeds

After Tax

0 ($1,450,000)

1 $9,085

2 $9,480

3 $9,480

4 $9,480

5 $9,480

6 $9,480

7 $9,480

8 $9,480

9 $9,480

10 $9,480

11 $9,480

12 $9,480

13 $9,480

14 $9,480

15 $9,085 + $1,557,722

NPV @ 7.00% ( 799,576)

Summary of the Net Present Value Method Using a Single Discount

Rate

Compare the two NPVs of the own and lease alternatives using a single discount

rate. Assuming the appropriate after tax discount rate was used, the alternative

that produces the greater NPV (lower cost) is the better economic alternative.

NPV of owning: ($799,576)

NPV of leasing: ($721,347)

In this case, both NPVs are negative, so the lesser negative is the greater NPV, which is ($721,347), the leasing alternative. In other words, expending

$721,347 in occupancy costs is more desirable than expending $799,576.

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5 •


Future Sales Price Sensitivity

The NPV comparisons previously described are only as good as the

assumptions that are used. The assumption used to forecast the projected sale

price for the ownership alternative arguably is the least predictable number in

the entire analysis. Historic rates of inflation may not support the assumptionsnecessary to achieve the sale price at the end of the holding period. Therefore,

it is necessary to calculate the future reversionary value (sale price) essential to

make the leasing and owning decision economically equivalent. With that

information, the analyst then can evaluate the average rate of inflation necessary

to achieve the sale price at which the lease versus-own decision is economically

equal.

When calculating the indifferent sale price, whereby the owning alternative and

leasing alternatives are mathematically equal, it is important to recognize

whether the adjustment to the forecast sale price needs to be adjusted up ordown to balance the two alternatives. Recognizing whether the forecast sale

price is higher or lower than necessary to balance the two alternatives will

dictate the sign convention when inputting the information into a financial

calculator, which effects whether the resulting FV is positive or negative.

A positive FV to the differential cash flows will increase the sale price, and a

negative FV of the differential cash flows will decrease the sale price.

As a rule of thumb, if the cost of the own alternative is less than the cost of the

lease alternative (making the own alternative the more desirable alternative), the

sale price is higher than is necessary to balance the two alternatives. Conversely,if the cost of the own alternative is more than the cost of the lease alternative

(making the lease alternative the more desirable alternative), then the

reversionary SPAT is too low.

Therefore, the proper methodology to use when calculating the indifferent sale

price is to subtract the PV of the lease alternative from the PV of the own

alternative to derive the PV of the differential T-bar.

A simple method for remembering the proper methodology is the acronym

“OLD,” or Own – Lease = Differential.

The following process illustrates how to determine the sale price at the end of

the occupancy period for the ownership alternative to make the two NPVs

equal (sale price point of indifference).

Ultimately, if the user believes the property will appreciate over the holding

period to a value greater than the sales price point of indifference, then the user

should own. On the other hand, if the user anticipates that the property value

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at the end of holding period will be less than the sales price point of

indifference, then the user should lease.

The sale price sensitivity analysis assumes a given discount rate. In order to

arrive at a sale price where the user is indifferent about the decision to lease or

own, the analyst must balance the PVs of the respective leasing and owning cash

flows. This is done by leaving the respective cash flows unchanged andadjusting the sales price. In order to accomplish this task, the first step is to

identify the differential cash flows from the leasing and owning alternatives, then

compound the PV of the differential at that given discount rate over the holding

period. The steps to calculate the sale price at the end of the holding period to

make the two NPVs equal are as follows:

1.

Calculate the difference between the NPV of owning and the NPV of

leasing by subtracting the NPV of the lease alternative from the NPV of the

own alternative.

2.

Calculate the future SPAT adjustment (the increase or decrease) needed at

the end of the holding period to equalize the two NPVs. This results in the

calculation of an incremental amount of sale proceeds after tax (SPAT)

necessary to balance the two alternatives, (not the entire SPAT necessary to

calculate the PV of the ownership cash flows). The incremental change in

SPAT then needs to be ―grossed up‖ (in the following steps) to reflect the

amount of tax paid on gain and costs of sale. To make this incremental

SPAT adjustment calculation, calculate the FV of the difference in NPVs

calculated in Step 1 using the appropriate single discount rate as the annual

compounding rate.

Note: if the cost of the owning alternative is less than the cost of the leasing

alternative, the reason the cost of owning is less than the cost of leasing is

because the forecast sale price is higher than an indifferent sale price.

Therefore, a downward adjustment to the forecast sale price is needed in

order to mathematically balance the two alternatives. Input a positive value

into PV and compound forward over the holding period using the given

discount rate. The resulting negative FV represents the incremental

downward adjustment needed to SPAT.

3. The incremental adjustment needs to be grossed up to account for the

incremental capital gains tax obligation.

Calculate the capital gains tax on the sale proceeds after-tax incremental

adjustment calculated in Step 2, and then add the resulting tax amount to

the sale proceeds after-tax incremental adjustment calculated in Step 2 to

determine the sale proceeds before tax (SPBT) incremental adjustment

needed to equalize the two NPVs. Following is the model for making this

calculation:

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5 •


SPAT adjustment (Step 2) – SPAT adjustment = Tax

(1 – tax rate)

SPAT adjustment (Step 2)

+ Tax (Step 3)

SPBT adjustment

4. The SPBT incremental adjustment needs to be grossed up again to account

for the incremental costs of sale.

Calculate the cost of sale on the SPBT incremental adjustment calculated in

Step 3, and then add the resulting costs of sale amount to the SPBT

incremental adjustment to determine the sale price adjustment needed to

equalize the two NPVs. Following is the model for making this calculation:

SPBT adjustment (Step 3) – SPBT adjustment = Cost of sale

(1 – Cost of sale percentage)

SPBT adjustment (Step 3)

+ Cost of sale (Step 4)

Sale price adjustment

5.

Add the sale price adjustment calculated in Step 4 to the originally forecastsale price to arrive at the indifferent sale price. Calculate the sale price

needed to equalize the two NPVs using the following model.

Original forecast sale price

+ Sale price adjustment (Step 4)

SPAT adjustment needed to equalize the NPVs

The following illustrates the sales price point of indifference using the outcome

of Sample Problem 5-1:NPV of the own alternative ($799,576)

– NPV of the lease alternative ($721,347)

Difference in the NPVs ($78,230)

↓

Compounded 15 years at 7%

↓

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SPAT adjustment to equalize the NPVs $215,838

+ SPAT adjustment [$215,838 ÷ (1 – 34%) – $215,838] $111,189

SPBT adjustment to equalize the NPVs $327,027

+ Cost of sale on SPBT adjustment [$327,027 ÷ (1 – 3%) –

$327,027]$10,114

Sale price adjustment needed to equalize the NPVs $337,141

+ Original projected sale price $1,884,000

Sale price needed to equalize the NPVs (rounded to the

nearest $1,000)$2,221,000

Calculate the growth rate necessary to achieve the sale price point of

indifference.

The ultimate decision whether to lease or buy depends on the client’s

assessment of future market trends and the rates of inflation over the projected

holding period. By calculating the growth rate necessary to achieve the point ofindifference, the client can make an informed choice of whether to lease or

buy.

If the client feels the rate of inflation over the holding period will exceed the

calculated growth rate, the decision to buy is simple. Equally, if the client feels

the rate of inflation over the holding period will not meet or exceed the

calculated growth rate, the decision to lease is equally simple.

Purchase price 15 years End of year 15 sale price

$1,400,000 $2,221,000

Annual growth rate in value needed to equalize the NPVs: 3.12 percent

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5 •


Method 3: Internal Rate of Return of the Differential

Cash Flows Method

The IRR of the differential cash flows method is another way to compare the

own and lease alternatives. The NPV methods previously illustrated compare

the NPV of each alternative using a given discount rate or rates. The alternative

that creates the highest NPV (the lowest net present cost of occupancy) is the

better alternative.

The IRR of the differential method utilizes the periodic CFAT for each (lease

or own) alternative to determine the differential cash flows. These differential

cash flows are simply the difference between the own alternative after tax cash

flows and the lease alternative after tax cash flows.

Own - Lease = Differential

n n n

Period 0 Initial Investment Period 0 Period 0 Costs Period 0 Difference

Year 1 CFAT of Own Year 1 CFAT of Lease Year 1 Difference




Year 5 CFAT of Own + SPAT Year 5 CFAT of Lease Year 5 Difference

Once the differential cash flows are calculated, the IRR of the differential cash

flows is calculated. This IRR identifies the after-tax yield on the capital if it isinvested in the ownership alternative. This rate of return is then compared to

the user's opportunity cost:

If IRR > Opportunity cost, then buyIf IRR < Opportunity cost, then lease

If IRR = Opportunity cost, then revert to subjective factors

If the user chooses to purchase, they are relinquishing the opportunity to invest

the funds required for the purchase in an alternative investment such as their

core business.

The future cash flows after tax attributable to this investment in the ownershipalternative are the difference between the future cash flows after tax of the

ownership alternative and the future cash flows after tax of the lease alternative.

The IRR of the differential cash flows calculates the after-tax yield on this

investment when choosing to own instead of lease. This differential cash flow

yield then can be compared to after-tax yields available in alternative

investments, particularly the user's core business. If alternative investments can

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generate a higher after-tax yield, the user should lease instead of own, allowing

the utilization of the capital for a higher yielding use.

The process to determine the IRR of the differential is as follows:

1. Reduce the two alternatives to their periodic cash flows after tax as

previously illustrated in the NPV methods.

2.

Subtract the periodic lease cash flows after tax from the continue-to-own

periodic cash flows after tax to determine the differential cash flows after

tax.

3.

Calculate the IRR of the differential cash flows.

The results for SAV-A-LOT Stores are summarized in the following T-bar:

n Ownership – Leasing = Differential

0 ($1,450,000) – $0 = ($1,450,000)1 $9,085 – ($79,200) = $88,285

2 $9,480 – ($79,200) = $88,680

3 $9,480 – ($79,200) = $88,680

4 $9,480 – ($79,200) = $88,680

5 $9,480 – ($79,200) = $88,680

6 $9,480 – ($79,200) = $88,680

7 $9,480 – ($79,200) = $88,680

8 $9,480 – ($79,200) = $88,680

9 $9,480 – ($79,200) = $88,680

10 $9,480 – ($79,200) = $88,68011 $9,480 – ($79,200) = $88,680

12 $9,480 – ($79,200) = $88,680

13 $9,480 – ($79,200) = $88,680

14 $9,480 – ($79,200) = $88,680

15 $9,085 + $1,557,722 – ($79,200) = $1,646,007

IRR of the Differential = 6.42%

The 6.42 percent IRR of the differential (after-tax yield of the funds invested in

the purchasing alternative) is less than the corporation’s 7 percent after-tax weighted average cost of capital (generally the yield the corporation earns in

their core business), so the lease alternative is the better alternative.

The 6.42 percent IRR of the differential indicates the after-tax yield on the

$1,450,000 invested in the owning alternative. The corporation’s after-tax cost

of capital of 7 percent indicates that its threshold after-tax target yield for

investments is 7 percent. If the corporation does in fact have earning

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5 •


opportunities at a yield higher than 6.42 percent, it is better off taking the

$1,450,000 that would be available if they lease instead of purchase and placing

it in a higher yielding investment.

The following chart illustrates the rate crossover point where both alternatives

are equal. As illustrated, the crossover point on the chart is the same rate as

calculated in the IRR of the differential analysis.

Discount Rate NPV of Ownership NPV of Leasing

0.00% $249,137 ($1,188,000)

2.00% ($171,455) ($1,017,662)

4.00% ($480,246) ($880,576)

6.00% ($708,479) ($769,210)

8.00% ($878,285) ($677,911)

10.00% ($1,005,439) ($602,401)

12.00% ($1,101,266) ($539,420)

14.00% ($1,173,941) ($486,460)16.00% ($1,229,406) ($441,576)

18.00% ($1,272,003) ($403,253)

20.00% ($1,304,925) ($370,297)

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Activity 5-2: Calculating Costs

Refer to the following cash flows and residual sale proceeds, assuming the

property has no capital appreciation and is sold for $11,400,000. Based on the

following after-tax cash flows and using a 10 percent after-tax discount rate,

calculate the following:

Own - Lease = Differential

n n n

Period 0 ($2,280,000) Period 0 $ - Period 0 (S2,280,000)

Year 1 ($685,968) Year 1 ($660,000) Year 1 (S25,968)

Year 2 ($688,107) Year 2 ($660,000) Year 2 (S28,107)

Year 3 ($4694,063) Year 3 ($660,000) Year 3 (S34,063)

Year 4 ($700,613) Year 4 ($660,000) Year 4 (S40,613)

Year 5 ($707,819) Year 5 ($660,000) Year 5 (S47,819)

Year 6 ($715,746) Year 6 ($726,000) Year 6 $10,254

Year 7 ($724,465) Year 7 ($726,000) Year 7 $1,535

Year 8 ($734,056) Year 8 ($726,000) Year 8 (S8,056)

Year 9 ($744,606) Year 9 ($726,000) Year 9 (S18,606)

Year 10 ($759,485) + 3,513,029 Year 10 ($726,000) Year 10 $3,479,544

PV = ____________ PV = ___________ IRR = ____________

1. What is the internal rate of return of the differential cash flows?

2. Based solely on the internal rate of return of the differential, which

alternative should the user choose? Why?

3.

What is the present value of the own alternative?

4. What is the present value of the lease alternative?

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5 •


5. What is the present value of the differential cash flows?

6. In order to balance the two alternatives, the sale price of $11,400,000

needs to be adjusted up or down? Why?

7.

What is the future value of the present value of differential cash flows

when reinvesting at the user's opportunity cost of 10 percent over theten-year projected holding period?

8. After grossing up the incremental adjustment to sale proceeds after tax

to account for the tax and costs of sale, what is the adjustment to the sale

price?

9.

What is the indifferent sale price?

End of activity

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5 •


impact that mortgage financing might have on the company’s financial picture is

in the debt-to-equity ratio. If the loan to value ratio of the mortgage financing is

greater than the company’s debt -to-equity ratio prior to the purchase of the real

estate, then the company’s overall debt -to-equity ratio would be increased.

Lease Alternative

Balance Sheet

There is no impact on the balance sheet if the lease is structured as an

operating lease. The lease payments are footnoted on the balance sheet, but

not listed as a primary liability. Therefore, no change in the st ockholder’s

equity is caused by the lease.

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Capital Lease versus Operating Lease

Several criteria are used to determine whether a lease is an operating lease or a

capital lease. One of the main tests is whether the PV of the primary term’s

base rent payments exceeds 90 percent of the fair market value. The discount

rate used to calculate this PV is the user’s incremental borrowing rate. The fair

market value in the lease-versus-purchase analysis is the purchase price if

purchased. The PV is the cash flows from the early termination structure,

including any penalty for termination.

Based on the 90 percent criteria, this lease is an operating lease.

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5 •



1.

When is it appropriate to consider owning rather than leasing?

a. When a user is considering utilizing space for a short term due to rapidgrowth and expansion requirements.

b.

When a user’s opportunity cost is higher than the internal rate of returnof the differential cash flows

c.

When a user is considering a long-term lease

d.

When the user’s available capital is limited

2.

A user is evaluating whether to own or lease and is using a 10 percentopportunity cost to evaluate the alternatives. Based only on the after tax

cash flows for each alternative described below, which alternative is best for

the user?

n Own Lease = Difference

0 ($100,000) ($10,000) ($90,000)

1 (37,864) (35,000) (2,864)

2 (39,766) (36,750) (3,016)

3 (41,569) (38,588) (2,981)

4 (43,871) (40,517) (3,354)

5 $147,653 ($42,543) $190,196

PV = PV = IRR =

a. Lease, since the cost of leasing is greater than owning

b. Own, since the cost of buying is greater than leasing

c. They are equal and the decision should be based on subjective issues

d.

Own, since the internal rate of return of the differential is greater than

the user’s opportunity cost

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3. Referring to Question 2, another reason is

a. The cost of the owning alternative is greater than that of leasing

b. The present cost of owning is less than that of leasing

c. The internal rate of return of the leasing alternative is greater than the

user’s opportunity cost d. The net present value of the difference is less than the initial investment

of the lease alternative

4. To determine the annual tax reduction for leasing:

a. Multiply the annual rent paid to the owner by the user’s tax bracket

b. Multiply the annual rent paid to the owner by the tenant’s opportunitycost

c. Subtract cost recovery from original basis

d. Subtract the user’s tax rate from the annual rent paid to the owner

5.

To calculate a user’s after-tax cost of leasing:

a.

Subtract the user’s costs of operations from its costs of leasing

b.

Multiply its pretax leasing costs by its marginal tax rate

c.

Subtract its annual tax reduction from the annual rent paid to the owner

d.

Subtract interest deductions and cost recovery from net operatingincome

6. To calculate the after-tax costs of owning you must account for

a. The initial investment, interest deductions, cost recovery, mortgagebalance, and proceeds of sale

b. The security deposit, moving costs, parking charges, base rent, andoperating expenses

c. The down payment, pretax occupancy costs, and capital appreciation

d. The initial investment, tenant finish allowance, cost recovery, and sales

price

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5 •


7.

The term ―adjusted basis‖ is determined by

a.

Subtracting all cost recovery taken from the original basis of theproperty, less the loans

b.

Subtracting the improvements from the original purchase price

c.

Calculating the total cost recovery taken, less the straight-line

depreciation

d. Basis at acquisition, plus capital additions, less cost recovery taken,minus partial sales

8.

When comparing the present value costs of leasing and owning, the

preferred alternative is the one with the lower cost.

a.

True

b.

False

9.

A crossover chart shows:

a.

The relationship between the costs from leasing and owning at differentdiscount rates

b.

The point of indifference, which is the same as the internal rate ofreturn of the differential cash flows

c.

The leasing and ownership alternatives in graph form

d.

All of the above

10. The internal rate of return point of indifference (crossover point) isimportant because:

a.

When the internal rate of return of the indifference is less than theuser’s opportunity cost, it should lease

b.

When the internal rate of return of the indifference is greater than theuser’s opportunity cost, the user should buy

c.

It is the rate of return to the user if the property were owned

d.

All of the above

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11.

What is the significance in calculating the sales price point of indifference?

a.

Determining the sales price required to make the leasing and owningalternatives equal

b.

To measure the average annual growth rate necessary to achieve the saleprice point of indifference against the historic inflation rate

c.

To help determine whether the leasing or owning alternative ispreferred

d. All of the above

12. The calculation of the sales price point of indifference:

a.

Is an important component in comparative lease analysis

b.

Requires the analyst to recalculate the total cost-recovery deductionstaken over the life of the investment

c.

Ignores whether the price paid for the property at acquisition is atmarket, below market, or above market

d. Is the only important measure in lease-versus-own analysis

End of assessment

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5 •


Answer Section

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Activity 5-1: Methods of Comparing Costs

1.

The two methods of comparing leasing and owning costs are the net present

value method and the future value method.

b.

False

2.

The net present value method compares the net present values of the after-

tax cash flows for each of the alternatives.

a. True

3.

When using the net present value method, the user provides the discount

rate to be applied to the cash flows, not the broker or any other individual.

a. True

4.

When evaluating the net present values of leasing and owning, thealternative with the lowest cost represents the best alternative.

a. True

5. The internal rate of return method calculates the internal rate of return for

the differential cash flows between owning and leasing and then compares

the internal rate of return of the differential to the user’s appropriate

discount rate.

a. True

6. If the internal rate of return of the differential cash flows is greater than the

user’s appropriate discount rate, then the user should buy (own) instead of

lease.

a. True

7. If the internal rate of return of the differential cash flows is less than the

user’s opportunity cost, then the user should lease instead of buy (own).

a. True

8.

If the internal rate of return of the differential cash flows is equal to theuser’s opportunity cost, then the user should evaluate the subjective aspects

of buying (owning) or leasing.

a. True

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5 •


Activity 5-2: Calculating Costs Answers

1. What is the internal rate of return of the differential cash flows?

3.58 percent

2.

Based solely on the internal rate of return of the differential, whichalternative should the user choose? Why?

The internal rate of return of the differential is 3.58 percent. Since the

user’s after-tax opportunity cost is 10 percent and the ownership

alternative now yields only 3.58 percent, the user should lease the

property.

3.

What is the present value of the own alternative?

5,284,181

4.

What is the present value of the lease alternative?

4,210,764

5.

What is the present value of the differential cash flows?

1,073,418

6. In order to balance the two alternatives, the sale price of $11,400,000

needs to be adjusted up or down? Why?

It needs to be adjusted up. The present value of owning is 1,073,418

more expensive than the lease alternative.

Since the only positive cash flow of either alternative is the sale proceeds

after tax, the only way to lower the costs of owning are to increase the

reversionary sale proceeds after tax by increasing the sale price at the

end of the holding period.

7.

What is the future value of the present value of differential cash flows

when reinvesting at the user's opportunity cost of 10 percent over the

ten-year projected holding period?

2,784,169

8.

After grossing up the incremental adjustment to sale proceeds after tax

to account for the 34 percent capital gains tax and 7 percent for cost of

sale, what is the adjustment to the sale price?

2,784,169 ÷ 0.66 = 4,218,438 to gross up for taxes

4,218,438 ÷ 0.93 = 4,535,954 to gross up for cost of sale

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9. What is the indifferent sale price?

4,535,954 + 11,400,000 = 15,935,954


1.

When is it appropriate to consider owning rather than leasing?

c. When a user is considering a long-term lease

2. A user is evaluating whether to own or lease and is using a 10 percent

opportunity cost to evaluate the alternatives. Based only on the after taxcash flows for each alternative described below, which alternative is best forthe user?

n Own Lease = Difference

0 ($100,000) ($10,000) ($90,000)

1 (37,864) (35,000) (2,864)

2 (39,766) (36,750) (3,016)

3 (41,569) (38,588) (2,981)

4 (43,871) (40,517) (3,354)

5 $147,653 ($42,543) $190,196

PV =( 136,801)

PV =( 155,271)

IRR =13.99%

d. Own, since the internal rate of return of the differential is greater than

the user’s

opportunity cost

The internal rate of return of the differential cash flows is 13.99 percent,

greater than the user’s opportunity cost of 1 percent.

3.

Referring to Question 2, another reason is

b. The present cost of owning is less than that of leasing

4.

To determine the annual tax reduction for leasing:

a. Multiply the annual rent paid to the owner by the user’s tax bracket

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5. To calculate a user’s after-tax cost of leasing:

c. Subtract its annual tax reduction from the annual rent paid to the owner

6. To calculate the after-tax costs of owning you must account for

a.

The initial investment, interest deductions, cost recovery, mortgage

balance, and proceeds of sale

7.

The term ―adjusted basis‖ is determined by

d. Basis at acquisition, plus capital additions, less cost recovery taken,

minus partial sales

8.

When comparing the present value costs of leasing and owning, thepreferred alternative is the one with the lower cost.

a. True

9.

A crossover chart shows:

d. All of the above

10.

The internal rate of return point of indifference (crossover point) isimportant because:

d. All of the above

11.

What is the significance in calculating the sale price point of indifference?

d. All of the above

12.

The calculation of the sale price point of indifference:

c.

Ignores whether the price paid for the property at acquisition is at

market, below market, or above m arket

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Module Goal ........................................................ 6.1

Objectives ............................................................. 6.1

Valuing Considerations .............................. 6.3

Financial Reporting for Subleasing ............. 6.4

Why Sublease? .................................................... 6.4

Valuing Leasehold Interest and Subleases .. 6.6

Market Rent Is Higher than Contract Rent ........ 6.6

Market Rent Is Lower than Contract Rent ......... 6.6

Sublease Rent Is Higher than Contract, butLower than Market .............................................. 6.7

Sublease Rent Is Lower than Contract Rent ....... 6.8

Activity 6-1: Leasehold Interests ........................ 6.9

Other Alternatives ................................... 6.10

Sample Problem 6-1: Negotiate a LeaseBuyout ................................................................ 6.10

The Buyout Pendulum .............................. 6.12

Lease Exit

Strategies

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Selling Leasehold Positions to a Third

Party ...................................................... 6.14

Activity 6-2: Do Nothing versus Sublease andRelocate .............................................................. 6.15

Module 6: Self-Assessment Review ........... 6.18

Answer Section ....................................... 6.23

Activity 6-1: Leasehold Interests ....................... 6.24

Activity 6-2: Do Nothing versus Sublease andRelocate .............................................................. 6.25


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Lease Exit Strategies

Module Snapshot

Module Goal

In the previous modules, leases were examined from the standpoint of the

user’s occupancy cost. The analyses focused on decision-making between

several similar and dissimilar lease options. However, just as understanding

occupancy cost economics is a critical part of deciding between various leases,

understanding them once a user is occupying the space is equally important.

In this module, the decision to lease has been made, and the focus is on the value of the lease, which may change as market conditions change. Similarly,

the user’s need for space may change as business needs change. The module

contains information and activities designed to help the user value the property

and maximize that value by subleasing all or part of the space. Within the

activities, the value of a lease (or sublease) is evaluated under conditions where

market rents are both higher and lower than contract rent. Decisions about

when and whether to sublease, as well as whether to negotiate a lease buyout

also are discussed.

Objectives

Calculate the value of leasehold and sub-leasehold interests.

Explain the implications when market rent is higher or lower than the

contract rent.

Recognize the optimal time to sublease.

Identify and explain the components of sublease analysis.

Determine leasehold interests.

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E x i t S t r a t e g i e s

As a result of one or more of the factors, a tenant can find themselves in a

situation where subleasing or assigning all or part of their existing space is

desirable. In general terms:

In a sublease, the subtenant signs an agreement with the primary tenant, and

any and all rights of the subtenant flow through the primary tenant. The

subtenant does not necessarily obtain or exercise all the rights that the

primary tenant has, and the subtenant is in a subordinate position with

respect to the lease or leasehold interest.

In an assignment, the parties (landlord and primary tenant) assign the lease

and all rights and obligations to the assignee. Thereafter, the assignee

obtains all the rights and obligations that the primary tenant had. In most

cases, the landlord will want to retain the primary tenant as an added

guarantor to the assignment.

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Valuing Leasehold Interest and Subleases

The following section delineates an owner’s various options regarding leasehold

interest and subleases.

Market Rent Is Higher than Contract Rent

In this situation, a lessee is renting space at a rate that is lower than current

market rates. For example, two years ago the tenant leased a property for 10

years at $50,000 per year, but the market rent of comparable space is now

$60,000 per year. Thus, the contract rent is below current market and

represents a positive value to the lessee.

The value of the leasehold interest at 10 percent is the PV of the differential

cash flow calculated by subtracting the contract rent from the market rent.

EOY Market Rent – Contract Rent = Difference

1 $60,000 – $50,000 = $10,000

2 $60,000 – $50,000 = $10,000

3 $60,000 – $50,000 = $10,000

4 $60,000 – $50,000 = $10,000

5 $60,000 – $50,000 = $10,000

6 $60,000 – $50,000 = $10,000

7 $60,000 – $50,000 = $10,000

8 $60,000 – $50,000 = $10,000

Present value @ 10.00% = $53,349

The value of the leasehold interest is the value of the lessee’s interest if the

lessee entered into a sublease at the market rate. Even if the lessee’s leasehold

is nonmarketable, the lessee is enjoying the value of the differential in the form

of a rent “bargain.”

Market Rent Is Lower than Contract Rent

In this situation, a lessee is renting space at a rate that is higher than current

market rates. For instance, two years ago the tenant leased a property for 10

years at $50,000 per year, but the annual market rent of comparable space is

now $40,000. Thus, the contract rent is above current market rent and

represents a negative value to the lessee.

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EOY Market Rent

– Contract Rent = Difference

1 $40,000 – $50,000 = ($10,000)

2 $40,000 – $50,000 = ($10,000)

3 $40,000 – $50,000 = ($10,000)

4 $40,000 – $50,000 = ($10,000)

5 $40,000 – $50,000 = ($10,000)

6 $40,000 – $50,000 = ($10,000)

7 $40,000 – $50,000 = ($10,000)

8 $40,000 – $50,000 = ($10,000)

Present value @ 10.00% = ($53,349)

The PV of the rent differential is the amount the lessee is committed to pay

above market rates. It is costing the lessee this amount in rent to stay in place

rather than move to an alternative location and pay current market rents.

Sublease Rent Is Higher than Contract, but Lower thanMarket

The contract rent is below market, and the original lessee (who leased two years

ago) wants to move and realize some of the value of his leasehold interest. In

this case, the lessee may be able to find a sandwich lessee, commonly called a

sublessee, to lease their space at a rate that is lower than the market rate (in this

case, $48,000 per year), but higher than the contract rate (in this case, $45,000

per year). The sublease lease term would be eight years.

EOY Sublease Rent

– Contract Rent = Difference

1 $48,000 – $45,000 = $3,000

2 $48,000 – $45,000 = $3,000

3 $48,000 – $45,000 = $3,000

4 $48,000 – $45,000 = $3,000

5 $48,000 – $45,000 = $3,000

6 $48,000 – $45,000 = $3,000

7 $48,000 – $45,000 = $3,000

8 $48,000 – $45,000 = $3,000

Present value @ 10.00% = $16,005

The primary lessee maintains the value of the sublease, which is the PV of the

differential between the contract rent and the sublease rent. The sublessee in

this case has a similar interest, since the market rent is still above the sublease

rent. The value of the sublessee’s interest is the differential between the

sublease rent and the market rent.

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Activity 6-1: Leasehold Interests

1. A primary lessee has five years remaining on a lease on a 7,500 square foot

retail space. The lease rate is $11 per square foot, escalating at 2 percent

per year. The market rate for similar space is $12 per square foot and is

expected to remain flat for the next five years. What is the present value of

the primary lessee’s leasehold interest with the user’s 9.5 percent cost of

capital as a discount rate? (Round to the nearest dollar.)

2. If a sublessee signs a five-year sublease with the primary lessee from

question one for $11.50 per square foot, escalating at 2 percent per year,

what is the present value of the leasehold interest to the primary lessee using

a 9.5 percent discount rate? (Round to the nearest dollar.)

3.

If the primary lessee from question one must move in order to expand, but

the only sublease rent the sublessee will pay is a flat rate of $10.50 psf for

five years, how much does it cost the primary lessee to get out of the space

(in present value dollars using a 9.5 percent discount rate? (Round to the

nearest dollar.)

End of activity

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Other Alternatives

Examining the current market and owner and user motivations is important

when determining whether to negotiate a lease buyout.

Sample Problem 6-1: Negotiate a Lease Buyout

A tenant is interested in buying out the remaining term on their lease because

they want to move to a different location. They currently are paying a flat rent

of $200,000 per year on a net lease, and the lease expires in five years. The

market rent on their space for a five-year net lease with no steps or other

adjustments is $150,000 per year. Thus, the tenant is paying a lease premium

of $50,000 per year. How much should they offer to buy out their lease if their

cost of capital is 7 percent, (which they will use as the discount rate)?

Because the tenant is paying a lease premium, the owner of the property will

lose $50,000 per year if the tenant leaves early —assuming the space can be

leased to someone for $150,000 per year. The tenant obligated to pay the extra

$50,000 per year probably would be willing to pay the present value of this

amount, discounted at the 7 percent cost of capital. Therefore:

EOY Market Rent – Contract = Difference

1 $150,000 – $200,000 = ($50,000)

2 $150,000 – $200,000 = ($50,000)3 $150,000 – $200,000 = ($50,000)

4 $150,000 – $200,000 = ($50,000)

5 $150,000 – $200,000 = ($50,000)

Present value @ 7.00% = ($205,010)

The $205,010 reflects the fact that the tenant has a negative leasehold value

(because they are paying above-market rents) and would have to pay to be

removed from the lease obligation.

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However, it should be noted that the lease obligates the tenant to pay the full

$200,000 per year, and the owner may not be willing to accept only $205,010.

Thus, the tenant may have to pay as much as the PV of the $200,000, which

would be calculated as follows:

EOY Contract

1 $200,000

2 $200,000

3 $200,000

4 $200,000

5 $200,000

Present value @ 7.00% $820,039

If the tenant can sublease the space for $150,000 per year, they would be losing

$50,000 per year. Therefore, they should be willing to pay $205,010. Of

course, it could take time to find someone to sublease the space plus additionalcosts to put the tenant in place, such as leasing commissions and tenant

improvements.

The amount the tenant might have to pay likely depends on whether they can

sublease and what they can negotiate with the owner. Another factor in the

sublease is any owner motivation for allowing the tenant to terminate the lease

early such as accommodating another existing tenant’s expansion needs or the

desire to convert the building to a higher and better use. Many other economic

and subjective factors can enter into this type of analysis.

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Thus, the timing of the lease, the relationship of contract rent to market rent,

and the user’s business needs all contribute to pushing the pendulum to one

side or the other.

Factors to consider when subleasing include the following:

The time remaining on the lease term

How much of the total space square footage is to be subleased

The costs associated with subleasing

The cost of demising the space in a partial sublease situation

Tenant improvement (TI) costs and who will pay for them

Marketing and leasing costs (commissions)

The time it will take to sublease

The sublease rent, whether a premium over existing rent or a loss

Whether the lease calls for the landlord to share in any profits on a sublease

Relocation costs and the costs of new space if subleasing 100 percent of the

existing space

Any charges the landlord may have for processing sublease paperwork

Subleasing also carries the following risks that should be considered:

Absorption/re-lease risk: The length of time it will take to find a sublessee

is unknown.

Rental rate risk: Even if the contract rent is below market, it may benecessary to sublease at below-contract rent.

Tenant quality risk: It may not be possible to find a high-quality tenant.

Lease term risk: A sublessee may want a shorter or longer lease than that of

the primary lease.

Lease agreement risk: A sublessee may want concessions, allowances, and

other features that are not provided in the primary lease.

TI risk: The sublessor may have to pay fit-out or retrofit costs for the

sublessee.

To advise a client who is considering subleasing a space currently occupied, it is

wise to account for some of these risks. This can be done by bracketing the

values of the potential sublease with a range of rental rates, absorption times,

and TI costs.

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Selling Leasehold Positions to a Third Party

Users also should be aware of the possibility of selling their leasehold positions

to parties other than the owner, such as institutional investors. Typically, with

positive cash flow from a sublease, a lessee might sell the interest for the

following reasons:

To obtain relief from the liabilities of administering the sublease

To convert the leasehold position to a lump sum, rather than taking it as

cash flow over time

To convert the value of the leasehold from ordinary income to capital gain

Even if the user wants to stay in place, the owner may be motivated to buy out

the lease and re-lease it to the user at a higher rate, allowing the user to convert

leasehold equity into capital in return for higher rent payments. Thus, the

owner ends up with a property that is worth more and is easier to sell.

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Activity 6-2: Do Nothing versus Sublease and Relocate

Just a few months after Consolidated Mortgage (CM) signed a new five-year

lease for 10,000 sf of class A office space at the top of the market, the market

dramatically changed, resulting in a dramatic slowdown in CM’s business as well

as an overall slump in office space demand. CM has asked you, as their broker,to market their current space (all or part) for sublease.

As a result of your superior marketing efforts, you have identified a potential

subtenant who would like to take all of CM’s space for the remaining term at a

rental rate that is less than CM’s contract rent. If CM accepts this offer, they

will need to relocate to smaller space elsewhere. However, they expect to take

advantage of the lower market rates themselves and move to class B space to

save additional facilities expense.

Your assignment is to determine whether CM is better off economically by

entering into the sublease at a loss and relocating to smaller, less expensivespace, or if they should stay in place and pay out their current contract rent for

the remaining four years of lease term.

CM’s Current Lease Sublease Terms CM’s New Location

Term 4 years remaining 4 years remaining 4 years for comparison

Size 10,000 sf 10,000 sf 7,000 sf

Base rent $22 psf $18 psf $15 psf

Base rent increase None None None

Operating expenses $9.70 $9.70 $7.50

Operating expense stop $9.00 $9.70 $7.50

Sublease commission 4% of base rent Paid by Landlord

Relocation costs $30,000

Tenant improvements$2 psf paid bySublessor

None needed

Additional assumptions are as follows:

Operating expense growth rate: 3 percent

CM’s discount rate: 8.5 percent

Current Lease Period 0 Year 1 Year 2 Year 3 Year 4

Base rent

Operating expense

Operating expense stop

Total

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Sublease Period 0 Year 1 Year 2 Year 3 Year 4

Base rent

Operating expense

Operating expense stop

Tenant improvementsCommission

Total

New Location Period 0 Year 1 Year 2 Year 3 Year 4

Base rent

Operating expense

Operating expense base

Relocation costs

Total

1. What is the present value cost of the do-nothing scenario (CM chooses to

not enter into the sublease and to stay in their current office space for the

remaining four years of the lease term)?

2. What is the present value cost of occupancy of the sublease-and-relocate

scenario?

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3.

Which alternative is preferable from an economic perspective? By how

much?

Current Lease Sublease

=

Net Cost

PV @ 8.5% = PV @ 8.5% = PV @ 8.5% =

New Lease

PV @ 8.5% =

End of activity

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1.

When the contract rent of a sublease is higher than the contract rent of theprimary user, the sublease has a positive value to the owner.

a. True

b.

False

2.

When the market rent for a sublease is higher than the contract rent, the

sublease has a positive value to the user.

a.

True

b. False

3. When the market rent is lower than the contract rent, the user may bemotivated to accept a below-market sublease and pay the loss for thefollowing reason:

a. The user needs more or less square footage

b. The user prefers a buyout to relocate to higher quality space

c.

The user’s alternative lease rate is substantially below its existing rate

d. All of the above

4.

An owner may elect to buy out a user’s lease when:

a.

The terms of the lease are comparable to market terms

b.

The user wants better space

c. The owner wants a better-quality user

d.

The user needs less space

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5. If a user indicates a desire to relocate when market rents are higher thantheir contract rent, the owner may elect to negotiate a ____________ to re-

lease at a profit.

a.

Renewal option

b.

Buyout

c. Expansion option

d. Contraction provision

6. A user has three years remaining on a 5,000 square foot lease, payable at$10 per square foot gross that escalates at 5 percent annually. The marketrate for comparable space is $12 per square foot gross but is expected toremain flat for the next three years. If the user elected to sublease, what is

the value of the lease to the primary user when the present value of thedifferential cash flows is discounted at 9 percent?

a.

$18,231

b. $16,598

c. $19,251

d.

$27,228

7. An industrial user has four years remaining on a 10,000 square foot lease with a current rate of $6 per square foot triple-net, which escalates at 4

percent annually over the remaining term. The user wants to relocate sinceit needs an additional 10,000 square foot that cannot be accommodated at

its present location. A sub-user offers to pay $6 per square foot triple-net without escalation through the term. Without regard to the operatingexpenses, what is the present value of the differential cash flows whendiscounted at 10 percent?

a. ($10,779)

b.

($15,644)

c.

($8,629)

d. ($11,437)

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8. When the contract rent to a user is in excess of current market rents, the

differential between what the user actually pays and the market rentsrepresents the excess amount above market rents that the user is paying to

stay in the space as opposed to relocating to new space.

a.

True

b.

False

9.

When a user is paying rents in excess of market rents, it may elect to

a.

Negotiate a rent reduction in return for extending the term of its lease

b. Negotiate a rent reduction by expanding the space occupied

c. Negotiate a buyout based on its present value of the cash flowdifferential

d.

All of the above

10. A 3,000 square foot user with two years remaining on its lease has expresseda desire to relocate in order to expand. The lease provides for rental

payments of $36,000 in year one and $37,800 in year two. Using theowner’s 15 percent cost of capital what is the discounted value of the user’s

outstanding lease obligation?

a. ($69,639)

b.

($43,283)

c.

($59,887)

d. ($47,821)

11.

Referencing Question 10, assume the owner could re-lease the space

immediately to a new two-year user willing to pay $42,000 in year one and$43,260 in year two. How much additional rent would the owner collect

under the new lease?

a. $11,900

b.

$14,650

c.

$11,460

d. $10,380

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12. From the information in Question 11 and using the owner’s 15 percent

opportunity cost, what is the present value of the new lease?

a. $43,652

b. $69,233

c.

$77,459

d. $64,266

13.

From the information in questions 10 through 12, assume the total cost to

the owner to attract the new user, including tenant finish and movingallowance, is $7,500. What is the internal rate of return of the cash flowdifferential between the revenue from the existing lease and the proposedlease?

a.

34.23 percent

b. 26.54 percent

c. 15.00 percent

d.

8.67 percent

14. When comparing the internal rate of return of the differential cash flows to

the owner’s desired rate of return, should the owner elect to release theexisting user and enter into a new lease under the terms proposed?

a. Yes, because the owner may be able to negotiate a buyout with the

existing user

b.

Yes, because the present value of the differential exceeds the costs to

obtain the new lease

c.

Yes, because the internal rate of return of the differential exceeds the

owner’s opportunity cost of capital

d.

All of the above

End of assessment

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Answer Section

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Activity 6-1: Leasehold Interests

1.

A primary lessee has five years remaining on a lease on a 7,500 square foot

retail space. The lease rate is $11 per square foot, escalating at 2 percent

per year. The market rate for similar space is $12 per square foot and is

expected to remain flat for the next five years. What is the present value of

the primary lessee’s leasehold interest with the user’s 9.5 percent cost of

capital as a discount rate? (Round to the nearest dollar.)

The present value of the primary lessee’s leasehold interest is 17,051.

2. If a sublessee signs a five-year sublease with the primary lessee from

question one for $11.50 per square foot, escalating at 2 percent per year,

what is the present value of the leasehold interest to the primary lessee using

a 9.5 percent discount rate? (Round to the nearest dollar.)

The present value of the primary lessee’s leasehold interest is 14,932.

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3.

If the primary lessee from question one must move in order to expand, but

the only sublease rent the sublessee will pay is a flat rate of $10.50 psf for

five years, how much does it cost the primary lessee to get out of the space

(in present value dollars using a 9.5 percent discount rate? (Round to the

nearest dollar.)

The cost would be 26,146.

Activity 6-2: Do Nothing versus Sublease and Relocate


Base rent ($220,000) ($220,000) ($220,000) ($220,000)

Operating expense ($97,000) ($99,910) ($102,907) ($105,994)

Operating expense stop $90,000 $90,000 $90,000 $90,000

Total ($227,000) ($229,910) ($232,907) ($235,994)


Base rent $180,000 $180,000 $180,000 $180,000

Operating expense $97,000 $99,910 $102,907 $105,995

Operating expense stop ($97,000) ($97,000) ($97,000) ($97,000)

Tenant improvements ($20,000)

Commission ($28,800)

Total ($48,800) $180,000 $182,910 $185,907 $188,995

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Base rent ($105,000) ($105,000) ($105,000) ($105,000)


Operating expense base $52,500 $52,500 $52,500 $52,500

Relocation costs ($30,000)

Total ($30,000) ($105,000) ($106,575) ($108,197) ($109,868)

1. What is the present value cost of the do-nothing scenario (CM chooses to

not enter into the sublease and to stay in their current office space for the

remaining four years of the lease term)?

( 757,147)

2. What is the present value cost of the sublease-and-relocate scenario?

Present value of the sublease net cost + present value of the new lease = new cost

of occupancy (sublease and relocate)

( 202,753) + ( 381,291) = ( 584,044)

3.

Which alternative is preferable? By how much?

Sublease and relocate

( 584,044) ( 757,147) = 173,103

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Current Lease + Sublease = Net Cost

0 $0 0 ($48,800) 0 ($48,800)

1 (227,000) 1 180,000 1 (47,000)

2 (229,910) 2 182,910 2 (47,000)

3 (232,907) 3 185,907 3 (47,000)

4 (235,995) 4 188,995 4 (47,000)

PV @ 8.5% = ( 757,147) PV @ 8.5% = 554,394 PV @ 8.5% = ( 202,753)

New Lease

0 ($30,000)

1 (105,000)

2 (106,575)

3 (108,197)

4 (109,868)

PV @ 8.5% = ( 381,291)

Compute the present value (PV) of the sublease-and-relocate scenario:

PV of the sublease net cost ( 202,753)

+ PV cost of the new lease (381,291)

Total cost of the sublease-and-relocate scenario ( 584,044)

– PV cost of the current lease (757,147)

Net cost/benefit of sublease and relocate 173,103


Base rent ($220,000) ($220,000) ($220,000) ($220,000)


Operating expense stop $90,000 $90,000 $90,000 $90,000

Total - ($227,000) ($229,910) ($232,907) ($235,994)

Net present value = ( 757,147)

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Base rent ($105,000) ($105,000) ($105,000) ($105,000)Operating expense ($52,500) ($54,075) ($55,697) ($57,368)

Operating expense base $52,500 $52,500 $52,500 $52,500

Relocation costs ($30,000)

Total ($30,000) ($105,000) ($106,575) ($108,197) ($109,868)

Net present value ( 381,291)

Current lease cost ( 757,147)

– Sublease cost (554,394)

Net Sublease cost ( 202,753)

+ New lease cost (381,291)

Net cost/benefit of sublease and relocation ( 584,044)

Current lease cost( 757,147)

– Net cost of sublease and relocation (584,044)

Net cost/benefit of sublease and relocation ( 173,103)


Base rent $180,000 $180,000 $180,000 $180,000

Operating expense $97,000 $99,910 $102,907 $105,995

Operating expense stop ($97,000) ($97,000) ($97,000) ($97,000)

Tenant improvements ($20,000)

Commission ($28,800)

Total ($48,800) $180,000 $182,910 $185,907 $188,995

Net present value 554,394

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1. When the contract rent of a sublease is higher than the contract rent of theprimary user, the sublease has a positive value to the owner.

b.

False

2.

When the market rent for a sublease is higher than the contract rent, the

sublease has a positive value to the user.

a. True

3. When the market rent is lower than the contract rent, the user may bemotivated to accept a below-market sublease and pay the loss for the

following reason:

d. All of the above

4.

An owner may elect to buy out a user’s lease when:

c. The o wner wants a better-quality user

5. If a user indicates a desire to relocate when market rents are higher thantheir contract rent, the owner may elect to negotiate a ____________ to re-

lease at a profit.

b. Buyout

6. A user has three years remaining on a 5,000 square foot lease, payable at$10 per square foot gross, which escalates at 5 percent annually. The

market rate for comparable space is $12 per square foot gross but isexpected to remain flat for the next three years. If the user elected tosublease, what is the value of the lease to the primary user when the present value of the differential cash flows is discounted at 9 percent?

c. 19,251

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7. An industrial user has four years remaining on a 10,000 square foot lease

with a current rate of $6 per square foot triple-net, which escalates at 4percent annually over the remaining term. The user wants to relocate since

it needs an additional 10,000 square foot that cannot be accommodated atits present location. A sub-user offers to pay $6 per square foot triple-net without escalation through the term. Without regard to the operating

expenses, what is the present value of the differential cash flows whendiscounted at 10 percent?

a. ( 10,779)

8.

When the contract rent to a user is in excess of current market rents, the

differential between what the user actually pays and the market rentsrepresents the excess amount above market rents that the user is paying to

stay in the space as opposed to relocating to new space.

a. True

9. When a user is paying rents in excess of market rents, it may elect to

d. All of the above

10. A 3,000 square foot user with two years remaining on its lease has expresseda desire to relocate in order to expand. The lease provides for rentalpayments of $36,000 in year one and $37,800 in year two. Using theowner’s 15 percent cost of capital what is the discounted value of the user’s

outstanding lease obligation?

c. ( 59,887)

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11. Referencing Question 10, assume the owner could re-lease the spaceimmediately to a new two-year user willing to pay $42,000 in year one and

$43,260 in year two. How much additional rent would the owner collect

under the new lease?

c. 11,460

Current Lease New Lease

Year 1 $36,000 $42,000

Year 2 $37,800 $43,260

Total $73,800 $85,260

New Lease Total: $85,260

+ Current Lease: $73,800

Additional Rent: 11,460

12. From the information in Question 11 and using the owner’s 15 percent

opportunity cost, what is the present value of the new lease?

c. 69,233

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13. From the information in questions 10 through 12, assume the total cost to

the owner to attract the new user, including tenant finish and movingallowance, is $7,500. What is the internal rate of return of the cash flow

differential between the revenue from the existing lease and the proposedlease?

a.

34.23 percent

14. When comparing the internal rate of return of the differential cash flows tothe owner’s desired rate of return, should the owner elect to release the

existing user and enter into a new lease under the terms proposed?

d. All of the above

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Module Goal ........................................................ 7.1

Objectives ............................................................. 7.1

Assessing the Opportunities ...................... 7.3

Benefits to the User/Seller ................................... 7.3 Benefits to the Investor ........................................ 7.4

Drawbacks for the User/Seller ............................ 7.4

Drawbacks for the Investor ................................. 7.4

User GAAP Accounting and Reporting For

Sale Leasebacks ....................................... 7.6

Income Statement Impact ................................... 7.6

Balance Sheet Impact .......................................... 7.6

Cash Flow Statement Impact ............................... 7.7

Sale Impact ........................................................... 7.7

User Economic Analysis ........................... 7.10

Net Present Value Method ................................ 7.10

Internal Rate of Return of the Differential CashFlows Method .................................................... 7.11

Sample Problem 7-1: Values Stores Inc. .......... 7.12

Method 1: Net Present Value Method ............ 7.13

Sale Price Sensitivity .......................................... 7.21

Sale-Leaseback

Transactions

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Method 2: Internal Rate of Return of theDifferential Cash Flows...................................... 7.23

GAAP Accounting Impact ......................... 7.26

Conventional Financing ........................... 7.27

Sample Problem 7-2: Before- and After-TaxCost of Borrowed Funds ................................... 7.28

Investor Analysis ..................................... 7.31 Analysis Process ................................................. 7.32

Sale-Leaseback Transaction Summary ...... 7.37

Module 7: Self-Assessment Review ........... 7.38

Answer Section ....................................... 7.39


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Sale-Leaseback Transactions

Module Snapshot

Module Goal

In a sale-leaseback transaction, an investor purchases a property currently

owned and occupied by a user. Simultaneous with the sale, the parties execute

a lease whereby the user leases the property back from the investor. If

structured properly, these sale-leaseback transactions can provide excellent

benefits to both the investor and the user.

Owners/users have used sale-leaseback transactions for decades to free upcapital invested in real estate and convert it to alternative uses, primarily for

their businesses. Property types that lend themselves to sale leasebacks are

freestanding single-occupancy buildings (industrial warehouse/distribution,

research and development facilities, corporate offices) and most types of retail.

Governmental entities also consider sale leasebacks for some of their facilities.

Sale leasebacks can offer an attractive alternative to conventional financing to

raise capital. Conventional financing encumbers the real estate asset when

listed as a primary liability on the balance sheet, whereas the lease from the sale

leaseback, if structured as an operating lease, may be indicated as a footnote

according to generally accepted accounting principles (GAAP). Quite often, if

the facility has been owned for a reasonably long period, the balance sheet can

be improved. An asset at current book value is removed from the balance

sheet and replaced by the cash that is raised from the sale leaseback, which

often is greater than the book value of the asset being sold.

Objectives

Identify the types of owners/occupants (users) who are potential prospects

for sale-leaseback transactions.

List the benefits and drawbacks to the user in a sale-leaseback transaction.

List the benefits and drawbacks to the potential investor in a sale-leaseback

transaction.

Recognize the critical factors, both financial and nonfinancial, that influence

the user’s continue-to-own versus the sale-leaseback decision.

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Calculate and interpret the net present values (NPVs) of the user’s continue-

to-own and the sale-leaseback alternatives.

Calculate and interpret the yield (internal rate of return) of the differential

cash flows after tax from the user’s continue-to-own and the sale-leaseback

alternatives.

Calculate and explain the sales price point of indifference where the NPVs

of the user’s continue-to-own and the sale-leaseback alternatives are equal.

Measure the impact of generally accepted accounting principles (GAAP)

reporting on the user’s financial sta tements if a sale-leaseback is affected.

Calculate and interpret certain measures of investment performance,

including acquisition cap rate, before tax cash on cash, before- and after-tax

internal rate of return (IRR), and capital accumulation for a potential

investor in a sale-leaseback transaction.

Calculate the before- and after-tax cost of borrowed funds if a user elects tofinance or refinance the property the user owns and occupies.

From the investor’s perspective, the sale-leaseback transaction creates an

investment with a tenant already in place and operating a business. Most leases

involved in a sale-leaseback transaction are absolute net, thereby eliminating

most of the property management problems for the investor.

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T r a n s a c t i o n s

Assessing the Opportunities

Who are the potential prospects for the sale-leaseback transaction? A broad

spectrum of users could benefit from a sale leaseback. The following list is

certainly not all-inclusive.

Companies may earn a higher return on capital invested in their primary

businesses rather than in the real estate they occupy.

Many publicly traded companies feel pressure to improve their balance

sheets by removing the real estate and replacing it with cash.

Small, closely held corporations that anticipate the retirement of key

personnel are potential prospects for a sale leaseback. Selling the real estate

prior to selling the business often can maximize the sale proceeds from

both.

National retailers with many outlets can bundle several of their stores in a

portfolio and sell the portfolio to an institutional investor at a price greater

than the store’s individual costs, thereby creating a profit on the sale as well

as attaining acceptable rental rates.

Healthcare companies that have portfolios of owner-occupied real estate

can sell and lease back that space to free up capital for expansion or

operations.

Benefits to the User/Seller

For the seller, a sale leaseback:

Converts a non-liquid real estate asset to cash, while the user retains control

and utilization of the property.

Removes a capital asset at book value from the balance sheet and replaces it

with cash received from the sale. The lease obligation goes on the balance

sheet as a footnote if structured as an operating lease.

Avoids the costs associated with placing conventional debt financing on the

real estate. (Conventional debt financing goes on the balance sheet as aprimary liability.)

Allows the user to effectively depreciate the land because the lease

payments cover the use of the land and the building. The lease payments

are tax deductible.

Offers an ownership exit strategy for a user who might not otherwise be able

to readily sell the real estate.

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Benefits to the Investor

Likewise, for the investor, a sale leaseback:

Secures a stable, long-term income stream.

Acquires an investment with relatively low management intensity.

Provides a tenant that already is sold on the location and committed to the

property.

Provides value appreciation potential.

Can be a hedge against inflation, depending on the lease terms.

Provides cost recovery tax deductibility and also interest if debt financing is

used.

Drawbacks for the User/Seller

In spite of the benefits, a sale leaseback has the following drawbacks:

The tax impact resulting from the sale may be substantial if the property has

been owned for a reasonably long period and the book value is low

compared to the potential market sale price.

Depending on how the lease is written, the user may lose flexibility in

renovating and/or rehabbing the property.

The user loses the ability to sell the real estate as a part of a subsequent saleof the business.

The user may lose the ability to occupy the building at the end of the lease,

including any options.

The user gives up any future property value appreciation.

If the user wants to vacate the property before the end of the lease term, it

may be more difficult to sublease the property than it would be to sell if the

user still owned the property.

Drawbacks for the Investor

Investors in sale-leaseback deals also face a number of real estate risks.

If the tenant defaults and moves out of a single-tenant building, the vacancy

rate is 100 percent.

If debt financing is used, the foreclosure risk increases.

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If the building is special purpose, it may require substantial capital

expenditures to renovate and up fit the building for a new tenant at lease

expiration.

The return from the sale leaseback for a single-tenant building may be less

than that from a multitenant building. However, the risk may be greater for

a multitenant building.

The investor may incur additional unforeseen costs, such as marketing,

repairs and maintenance, holding costs, and leasing commissions.

If the lease is structured at an above-market rent and the tenant vacates, it

could be difficult to re-lease at the same rent.

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User GAAP Accounting and Reporting For

Sale LeasebacksOne financial reporting rule in particular relates to sale leasebacks:

FAS-98: The financial accounting and reporting standards for sale

leasebacks

Income Statement Impact

Sale transactions can create a gain or loss depending on the book value

(adjusted basis). When selling a property as a user in any situation, certainly in

a sale leaseback, it is important to know the book value. For example, a user

can sell a building for $5,000,000. If the book value is $3,000,000, the user will

record a gain of $2,000,000. However, if the book value is $6,000,000, the user will record a loss of $1,000,000. With the same selling price, the difference lies

in the property’s book value (adjusted basis).

Basis at acquisition

+ Capital additions

- Cost recovery (depreciation taken)

- Basis in partial sale

= Adjusted basis at sale

Balance Sheet ImpactReal estate assets are often the largest individual category of operating assets for

a company. When planning the disposition of any assets, a practitioner first

should learn the book value of the property to determine whether the sale will

result in a gain or a loss. The real estate practitioner needs to set or confirm

expectations on the correct impact of that disposition on the company’s

financials.

High market values with low book values (adjusted basis) create an opportunity

to engineer a sale resulting in a gain, including through a sale-leaseback

scenario. A typical user real estate disposition ordinarily occurs because theclient doesn’t need the property anymore. In a sale leaseback disposition,

however, a low book value/high market value situation enables the company to

sell at a higher value than the book value, thus actually realizing the market

increase, albeit over the life of the lease. This allows the user to capture the real

estate’s v alue over time, ultimately appearing as a gain on financials.

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As discussed, a lease appears on the balance sheet as a capital lease if certain

financial attributes are present. To companies, the difference between on-

balance-sheet and off-balance-sheet transactions can be significant. By and

large, companies prefer lease agreements to be off balance sheet, but if

circumstances dictate, it may be desirable to accept an on-balance-sheet lease

transaction.

When planning the disposition of a piece of p roperty, one of the real estate analyst’s

first questions should be: What is the book value? This will determine whether the

sale is a gain or loss.

Cash Flow Statement Impact

The cash flow statement details the sources and uses of cash from operations,

investing, and financing activities. The cash flow statement’s relevance to real

estate lies only in how transactions impact the income statement and the

balance sheet, which then are captured or recorded on the cash flow statement.

There are no stand-alone cash flow impacts.

Sale Impact

A sale of real estate removes the land, building, and debt from the balance

sheet, and the ownership expenses cease to impact the income statement.

Consider the following example:

Company X purchased a piece of property for $5,000,000, with 20 percent

allocated to the land. The company put $1,000,000 down and secured a

$4,000,000 loan at 7 percent interest and a 20-year amortization. After five

years, the company sells the property for $6,000,000 and moves out. If the

building’s depreciation over 40 years is $100,000 per year:

Book value (adjusted basis) at sale: $4,500,000

Loan balance: $3,500,000 (rounded)

Gain on sale: $1,500,000 ($6,000,000 – $4,500,000)

Cash proceeds: $2,500,000 ($6,000,000 – $3,500,000)

This transaction impacts the balance sheet as follows:

A $4,500,000 decrease in assets; as the real property is removed from the

balance sheet.

A $2,500,000 increase in assets; as the cash proceeds are recorded.

A $3,500,000 decrease in liabilities; as the loan payoff is recorded.

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This transaction impacts the income statement as follows:

The gain or loss on the disposition is reflected on the income statement.

Any depreciation expense for the building ceases upon the sale.

The interest expense on the loan ceases upon payoff.

Under GAAP the gain on the sale through a sale leaseback is recognized over

the life (term) of the lease. For example, if a sale with a 10-year leaseback has a

$60,000,000 gain over book value, then the company will report a $6,000,000

gain each year for 10 years. It’s a very simple concept, but contrary to what

typically is done for taxes. If the sale results in a loss to book value, then the

loss is recognized on the financial statements immediately.

For example, assume a company built a facility for a total improvement cost of

$80,000,000 plus $2,000,000 for the land the facility is situated on. The

$80,000,000 facility was depreciated via straight-line over 40 years at $2,000,000

per year. After 21 years, the remaining book value is $40,000,000 ($82,000,000– $42,000,000 of depreciation). The company now wishes to raise

$100,000,000 in cash, but still needs the facility for at least the next 10 years. A

sale leaseback is proposed and approved under terms as follows:

Sale value $100,000,000

– Net book value 40,000,000

Pre-tax gain on sale $60,000,000

Term of lease back: 10 years

Annual effective lease rent: $10,000,000

Annual depreciation during ownership: $2,000,000

Gain recognized straight-line over the life of the lease: $6,000,000

Annual lease expense ($10,000,000)

+ Annual depreciation expense avoided 2,000,000

+ Annual deferred gain recognition from sale 6,000,000

Annual net impact on income statement ($2,000,000)

The impact on the balance sheet is as follows:

Cash: $100,000,000 increase

Real estate: ($40,000,000) decrease

Deferred gain to be recognized over 10-year lease: $60,000,000 increase

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Why is the gain taken over the life (term) of the lease? Financial accounting

standards require the deferred gain to be done in order to prevent the sale price

from being manipulated by increasing the lease rate artificially, which would

increase the current year’s earnings from the sale proceeds while creating a

burden on future years’ earnings with a higher lease expense.

Sale leasebacks generally fall into two categories for corporate users: strategic ortactical.

Strategic sale leasebacks are used to raise cash. The company still has a long-

term need for the facility, but the user wants to use the property to raise capital

from outside the usual sources. Sale leasebacks also are done when large,

unrealized gains can be harvested along with the cash. This is why most

corporations execute a sale leaseback. Although operating expenses increase,

the company still receives significant revenue through the gain recognized over

the lease term.

Tactical sale leasebacks are done when a company plans to exit all or a portionof a facility in the foreseeable future. The sale leaseback gives the user the

ability to walk away at the end of its need for the facility, while still capturing

some of the value of its tenancy in the sale. The investor is more oriented

toward the repositioning or redevelopment opportunity than a traditional

―coupon-clipping ‖ net lease buyer. The investor gets to control the property

and have substantial time during the lease term to pre-market space that will

become available or time to design and develop the future use for the property.

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User Economic Analysis

In making the sale-leaseback decision, a user has two primary alternatives to

analyze:

1.

Continue to own for a projected occupancy period

2. Sell and leaseback for the same projected occupancy period

The two approaches to compare the two alternatives are the NPV method and

the IRR of the differential cash flows method.

Net Present Value Method

The NPV method reduces each alternative to its periodic cash flows after tax.

Applying the user’s appropriate after-tax discount rate, an NPV is calculated for

each alternative. Corporate users typically use their after-tax weighted averagecost of capital as the discount rate, while non-corporate users typically use their

after-tax opportunity cost. Once the present values (PVs) or NPVs are

calculated for each alternative, the resulting values are compared. The greater

value is always the better choice.

The value line chart that follows shows that as you move from left to right, the

values increase.

Figure 7.1 Value Line Chart

For example, if an NPV analysis indicates that one alternative results in an NPV

of ($40,000) and another alternative results in an NPV of ($30,000), the correctchoice is the latter alternative. As shown in the previous chart, ($30,000) is

farther to the right than ($40,000) and therefore is the greater value. The value

of ($30,000) is greater than ($40,000), even though 40,000 is greater in raw

numbers. As a practical matter in this example, the fact that both NPVs are

negative means that the user would be giving up something for either choice.

Thus, the lesser amount given up is the better choice. In other words, giving up

$30,000 is better than giving up $40,000. Also look at the comparison in terms

Value Line Chart

(Negative NPV/PV)

Positive NPV/PV

V

( $ 5 0 , 0

0 0 )

( $ 4 0 , 0

0 0 )

( $ 3 0 , 0

0 0 )

( $ 2 0 , 0

0 0 )

( $ 1 0 , 0

0 0 )

$ 0

$ 1 0 , 0

0 0

$ 2 0 , 0

0 0

$ 3 0 , 0

0 0

$ 4 0 , 0

0 0

$ 5 0 , 0

0 0

Greater

NPV/PV

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of the cost associated with each alternative. A cost of $30,000 is a better choice

than a cost of $40,000.

Consider another example in which one alternative results in an NPV of

$10,000 and another alternative results in an NPV of $20,000. The NPV of

$20,000 is the better choice. The chart shows that $20,000 is farther to the

right than $10,000 and therefore is the greater value. The fact that bothalternatives result in a positive NPV indicates a positive economic benefit

associated with both. The greater economic benefit of $20,000 is the better

choice.

Consider a last example in which one alternative results in an NPV of ($20,000)

and another alternative results in an NPV of $10,000. The NPV of $10,000 is

the better choice. As shown in the chart, $10,000 is farther to the right than

($20,000) and therefore is the greater value. Even though 20,000 is greater than

10,000 in terms of raw numbers, $10,000 is a greater value than ($20,000).

One alternative results in the user giving up $20,000, but in the other alternativethe user receives a positive economic benefit of $10,000, which is a better

choice than giving up $20,000.

If applied correctly, NPV/PV can be a useful tool for users when making

economic decisions. The correct application is to choose the greater value—or

the one that is farther to the right on the value line. In the case of negative

values, the greater value is also the lesser cost. In other words, choose the value

on the right, and you will always be right.

Internal Rate of Return of the Differential Cash FlowsMethod

This method subtracts the periodic cash flows after tax of the sale-leaseback

alternative from the periodic cash flows after tax of the continue-to-own

alternative and calculates an IRR of this differential. This IRR is after tax and is

compared to the user’s appropriate after-tax discount rate.

In a sense, this IRR quantifies the after-tax cost of the funds generated from the

sale leaseback, which can be compared to the after-tax cost of funds that may be

available from other sources.

Even if the cost of funds that could be raised from the sale leaseback is more

expensive than funds that could be raised from other sources, the sale-leaseback

alternative still could be the better choice depending on the impact to the

balance sheet or other business variables, such as the availability of other capital

sources, or the intended use of the funds to be raised.

The IRR of the differential cash flows also indicates the after-tax yield on the

capital left invested in the ownership alternative if the user continues to own and

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occupy the real estate. This yield can be compared to the yield on alternative

investment opportunities that may be available, such as investing in the core

business.

Sample Problem 7-1: Values Stores Inc.

The following sample problem illustrates the analysis process for a potential

sale-leaseback transaction from both the user/seller perspective and the investor

perspective. The user’s analysis is illustrated first, followed by the investor’s

analysis.

Analysis Setup

Five years ago, Value Stores Inc. (VSI) purchased a freestanding 50,000 square

foot (sf) retail building for $3,500,000 plus $20,000 in acquisition costs. VSI

currently uses the building as a retail sales outlet. The original allocation for

improvements was 80 percent. The useful life for cost recovery was 39 years.

The company acquired the property on the first day of the tax year and used

midmonth convention for the cost-recovery deduction for the first year of

ownership. VSI acquired the property without any debt financing.

The current annual sales volume at this location is above the company average

for its stores. Because of this store’s superior location, the company’s

management feels that it will continue to perform well for the foreseeable

future.

The company is trying to determine the best use of its capital. Should the

company continue to own and leave the capital invested in the real estate, or

should it perform a sale leaseback and place the generated funds in its primary

business? The company is looking at a 10-year occupancy period.

User nalysis ssumptions

Projected occupancy period: 10 years

Corporate tax rate for all sources of income including capital gains and cost-

recovery recapture: 34 percent

VSI’s after-tax weighted average cost of capital: 12 percent

Sale price if sold today: $4,000,000

Cost of sale if sold today: 4 percent

Annual growth rate in value forecast for the next 10 years: 3 percent (The

end of year [EOY] 10 sale price is rounded to the nearest thousand.)

EOY 10 cost of sale: 4 percent

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Leaseback terms: 10-year absolute net lease, with annual lease payments

payable at the end of the year

Years one through five lease payments: based on a 9.5 percent cap rate of

the sale price

Years six through 10 lease payments: escalated with a one-time increase in

year six of 12 percent

Method 1: Net Present Value Method

First, use the NPV method to compare the continue-to-own alternative with the

sale-leaseback alternative to determine which is preferable.

Continue-to-Own Alternative

1.

Calculate the annual cash flows after tax from ownership for the projected

occupancy period. Since the building will be occupied by the owner, there

will be no income, so use zero for the net operating income (NOI). Since

the user acquired the property without any debt financing, the only

deduction from NOI to calculate each year’s taxable income is the cost

recovery. Note that the first year of the projection reflects a full-year cost

recovery since VSI already owns the building and isn’t using the midmonth

convention. The last year of the projection reflects the midmonth

convention for cost recovery. Note also that the cash flows after tax are

positive, even though there is no income. This positive cash flow results

from the tax savings attributable to the cost-recovery deduction.

The cash flow analysis worksheets (CFAW) for years one through five and

years six through 10 follow.

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* The book value of improvements after five years of cost-recovery deductions

Cash Flow Analysis Worksheet

Property Name 50,000-sf Retail Building Purchase Price

Prepared For Value Stores, Inc. Plus Acquisition Costs

Prepared By Plus Loan Fees/Costs

Date Prepared Less Mortgages

Equals Initial Investment

Mortgage Data Cost Recovery Data

1st Mortgage 2nd Mortgage Improvements Personal Property

Amount Value $2,458,003*

Interest Rate C. R. Method SL

Amortization Period Useful Life 39

Loan Term In Service Date Jan. 2002

Payments/Year Future Sale Date Dec. 2011

Periodic Payment Recapture

Annual Debt Service Investment Tax

Loan Fees/Costs Credit ($$ or %)

Taxable Income

End of Year: 1 2 3 4 5

1 Potential Rental Income

2 Vacancy & Credit Losses

3 = Effective Rental Income

4 + Other Income (Collectable)

5 = Gross Operating Income

6 Operating Expenses

7 = NET OPERATING INCOME

8 Interest – 1st Mortgage

9 Interest – 2nd Mortgage

10 Participation Payments

11 Cost Recovery – Improvements $72,202 $72,202 $72,202 $72,202 $72,202

12 Cost Recovery – Personal Property

13 Amortization of Loan Fees/Costs

14 Leasing Commissions

15 = Real Estate Taxable Income (72,202) (72,202) (72,202) (72,202) (72,202)

16 Tax Liability (Savings) at 34% (24,549) (24,549) (24,549) (24,549) (24,549)

Cash Flow

17 NET OPERATING INCOME (Line 7)

18 Annual Debt Service



21 Funded Reserves

22 =CASH FLOW BEFORE TAXES

23 Tax Liability (Savings) (Line 16) (24,549) (24,549) (24,549) (24,549) (24,549)

24 =CASH FLOW AFTER TAXES $24,549 $24,549 $24,549 $24,549 $24,549

Copyright © 2002 by the CCIM Institute


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Property Name 50,000-sf Retail Building Purchase Price

Prepared For Value Stores, Inc. Plus Acquisition Costs

Prepared By Plus Loan Fees/Costs

Date Prepared Less Mortgages

Equals Initial Investment


1st Mortgage 2nd Mortgage Improvements PersonalProperty

Amount Value $2,458,003

Interest Rate C. R. Method SL

Amortization Period Useful Life 39

Loan Term In Service Date Jan. 2002

Payments/Year Future Sale Date Dec. 2011

Periodic Payment Recapture

Annual Debt Service Investment Tax

Loan Fees/Costs Credit ($$ or %)

Taxable Income

End of Year: 6 7 8 9 10 11

1 Potential Rental Income


3 = Effective Rental Income


5 = Gross Operating Income


7 = NET OPERATING INCOME

8 Interest – 1st Mortgage


10 Participation Payments11 Cost Recovery – Improvements $72,202 $72,202 $72,202 $72,202 $69,189


13 Amortization of Loan Fees/Costs


15 = Real Estate Taxable Income (72,202) (72,202) (72,202) (72,202) (69,189)

16 Tax Liability (Savings) at 34% (24,549) (24,549) (24,549) (24,549) (23,524)

Cash Flow

17 NET OPERATING INCOME (Line 7)

18 Annual Debt Servi ce



21 Funded Reserves

22 =CASH FLOW BEFORE TAXES

23 Tax Liability (Savings) (Line 16) (24,549) (24,549) (24,549) (24,549) (23,524)

24 =CASH FLOW AFTER TAXES $24,549 $24,549 $24,549 $24,549 $23,524



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2. Calculate the sale proceeds after tax at the end of the holding period. In

this calculation, the total cost recovery taken includes that from the time of

acquisition five years ago to today, as well as (plus) the total cost recovery

taken for the projected occupancy period of 10 years. In this sample

problem, cost recovery taken doesn’t affect the result since the analysis is

for a corporate entity. Thus, all gain is taxed at the corporate tax rate. Inthe case of an individual or sole proprietorship, it would have an impact

since different sources of gain are taxed at different rates.

The alternative cash sales worksheet (ACSW) for the continue-to-own

alternative follows.

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* This represents 15 years of cost recovery.

Continue-to-Own Alternative Alternative Cash Sales Worksheet

Mortgage Balances


Principal Balance 1st Mortgage

Principal Balance 2nd Mortgage


6 7 8 9 10



(At _________% cap) (At _________% cap) (At ________% cap)


1 Basis at Acquisition $3,520,000

2 + Capital Additions

3 Cost Recovery (Depreciation) Taken 1,077,004*4 Basis in Partial Sales

5 = Adjusted Basis at Sale 2,442,996


6 Sale Price 5,376,000

7 Costs of Sale 215,040

8 Adjusted Basis at Sale (Line 5) 2,442,996

9 Participation Payment on Sale

10 = Gain or (Loss) 2,717,964

11 Straight Line Cost Recovery (Limited to Gain) 1,077,004

12 Suspended Losses

13 = Capital Gain From Appreciation 1,640,960


14 Unamortized Loan Fees/Costs (Negative)15 +

16 = Ordinary Taxable Income


17 Sale Price 5,376,000



20 Mortgage Balance(s)

21 + Balance of Funded Reserves

22 = Sale Proceeds Before Tax 5,160,960

23 Tax (Savings): Ordinary Income

at 34% of Line 16

24 Tax: Straight Line Recapture

at 34% of Line 11 366,18125 Tax on Capital Gains

at 34% of Line 13 557,926

26 = SALE PROCEEDS AFTER TAX: $4,236,852

Copyright © 2002 by the CCIM InstituteThe statements and figures herein, while not guaranteed, are secured from sources we believe authoritative.

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3. Calculate the NPV of the annual cash flows after tax from ownership and

the after-tax cash flows from disposition using the corporation’s after-tax

weighted average cost of capital as the discount rate.

NPV of the Continue-to-Own Alternative

EOY

0 $0

1 24,549

2 24,549

3 24,549

4 24,549

5 24,549

6 24,549

7 24,549

8 24,549

9 24,54910 $23,549 + $4,236,852

NPV @ 12% = $1,502,529

Sale-Leaseback Alternative

1. Calculate the EOY zero cash flow after tax. This cash flow after tax is the

sale proceeds after tax (SPAT) from the proposed sale of the sale-leaseback

transaction. Note that this is a positive cash flow as a result of the cash to

be received by the user if the user completes the sale-leaseback transaction.

The ACSW for the sale-leaseback alternative follows.

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2.

Sale-Leaseback Alternative Alternative Cash Sales Worksheet

Mortgage Balances


Principal Balance 1st Mortgage



6 7 8 9 10



(At _________% cap) (At _________% cap) (At ________% cap)



2 + Capital Additions3 Cost Recovery (Depreciation) Taken 354,984

4 Basis in Partial Sales







10 = Gain or (Loss) 674,984

11 Straight Line Cost Recovery (Limited to Gain) 354,984

12 Suspended Losses

13 = Capital Gain From Appreciation 320,000


14 Unamortized Loan Fees/Costs (Negative)

15 +

16 = Ordinary Taxable Income


17 Sale Price 4,000,000



20 Mortgage Balance(s)

21 + Balance of Funded Reserves

22 = Sale Proceeds Before Tax 3,840,000


at 34% of Line 16


at 34% of Line 11 120,695

25 Tax on Capital Gains

at 34% of Line 13 108,800



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2. Calculate the annual cash flows after tax from leasing for each year of the

projected 10-year occupancy period. Use the following models to make this

calculation.

(Annual lease payment)

× Tax rate(Annual tax savings)

(Annual lease payment)

– (Annual tax savings)

(Annual cash flow after tax from leasing

3. Calculate the NPV of the cash flows after tax from the sale-leaseback

a lternative using the corporation’s after-tax weighted average cost of capital

as the discount rate.

Sale-Leaseback Cash Flows and NPV

EOY

Sale Proceeds

After Tax Today

Lease

Payment (Tax Savings) =

(Cash Flow

After Tax)

0 $3,610,505 $0 $0 $3,610,505

1 (380,000) (129,200) (250,800)

2 (380,000) (129,200) (250,800)

3 (380,000) (129,200) (250,800)

4 (380,000) (129,200) (250,800)

5 (380,000) (129,200) (250,800)

6 (425,600) (144,704) (280,896)

7 (425,600) (144,704) (280,896)

8 (425,600) (144,704) (280,896)

9 (425,600) (144,704) (280,896)

10 ($425,600) ($144,704) ($280,896)

NPV @ 12% = $2,131,870

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Net Present Value Method Summary

After calculating the NPVs of the continue-to-own alternative and the sale-

leaseback alternative, compare the two NPVs. The alternative that produces

the greatest NPV is the better alternative.

NPV of continue to own: $1,502,529

NPV of sale leaseback: $2,131,870

Assuming the after-tax weighted average cost of capital is known (12 percent in

this case); the alternative that produces the greatest positive financial benefit is

the sale leaseback. In both alternatives, a positive financial benefit is created.

Based on the assumptions used in this sample problem, the sale-leaseback

alternative produces a positive financial benefit of $2,131,870 compared to

$1,502,529 produced by the continue-to-own alternative.

Sale Price Sensitivity

The NPV comparison, as in any analysis, is only as good as the assumptions

used, and the assumption used to forecast the projected sale price for the

continue-to-own alternative is the least predictable number in the entire

analysis.

For a more comprehensive analysis, the user should next determine the sale

price at the end of the occupancy period of the continue-to-own alternative that

would make the two NPVs exactly equal (the sale price point of indifference).

If the user thinks the property will appreciate over the holding period to a value

greater than the sales price point of indifference, then the user should continue

to own. Conversely, if the user thinks the property value at the end of holding

period will be less than the sales price point of indifference, then the user

should sell and leaseback.

The sales price sensitivity analysis assumes a given discount rate. Use the

following steps to calculate the sale price at the end of the holding period to

make the two NPVs equal:

1. Calculate the difference in the two NPV alternatives by subtracting the NPV

of the sale-leaseback alternative from the NPV of the continue-to-ownalternative.

2. Calculate the sale proceeds after tax adjustment needed at the end of the

holding period to equalize the two NPVs. To make this calculation,

compute the future value (FV) of the difference in NPVs calculated in Step

1 for the holding period using the after-tax weighted average cost of capital

as the annual compounding rate.

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3. Calculate the tax on the sale proceeds after-tax adjustment calculated in Step

2 and add the tax amount to the sale proceeds after-tax adjustment to

determine the sales proceeds before tax (SPBT) adjustment needed to


SPAT adjustment (Step 2) – SPAT adjustment = tax

(1 – Tax rate)

SPAT adjustment (Step 2)

+ Tax (Step 3)

SPBT adjustment

4. Calculate the cost of sale on the SPBT adjustment calculated in Step 3 and

add the SPBT adjustment to determine the sale price adjustment needed to


SPBT adjustment (Step 3) – SPBT adjustment = cost of sale

(1 – Cost of sale percentage)

SPBT adjustment (Step 2)

+ Cost of sale (Step 4)

Sale price adjustment

5.

Calculate the sale price needed to equalize the two NPVs using the

following model:

Original forecast sale price

+ Sale price adjustment (Step 4)

SPAT adjustment needed to equalize the NPVs

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NPV of the continue-to-own alternative $1,502,529

– NPV of the sale-leaseback alternative 2,131,870

Difference in NPVs ($629,341)

↓


↓

SPAT adjustment to equalize the NPVs $1,954,638

+ SPAT adjustment [$1,954,638 ÷ (1 – 34%) – $1,954,638] $1,006,935

SPBT adjustment to equalize the NPVs $2,961,572

+ Cost of sale on SPBT adjustment [$2,961,572 ÷ (1 – 4%) – $2,961,572] $123,399

Sale price adjustment needed to equalize the NPVs $3,084,971


Sale price needed to equalize the NPVs (rounded to the nearest $1,000) $8,461,000

Lastly, calculate the growth rate (i) of the value today (PV) to the sales price

point of indifference (FV) over the anticipated holding period (n).

If the value today is $4,000,000 and the EOY 10 sale price is $8,461,000, the

annual growth rate in value needed to equalize the NPVs is 7.78 percent.

Method 2: Internal Rate of Return of the Differential

Cash Flows

The IRR of the differential cash flows method is another way to compare thecontinue-to-own alternative with the sale-leaseback alternative. The NPV

method previously illustrated compares the NPV of each alternative using a

given discount rate. The alternative that creates the highest NPV is the better

alternative. Essentially, the NPV determines the capital raised through the sale

leaseback decision.

The IRR of the differential method also uses the periodic cash flows after tax

for each alternative as calculated in the NPV method, but it doesn’t use a given

discount rate for the analysis. Rather, it determines the discount rate that would

make the NPVs of the two alternatives equal. Once this discount rate (the IRRof the differential cash flows) is determined, the user compares this rate to the

after-tax weighted average cost of capital. Essentially, the IRR of the differential

method determines the cost of the capital raised through the sale leaseback

decision.

In essence, the IRR of the differential is the after-tax cost of the funds generated

from the sale in a sale-leaseback transaction. If this rate is lower than the after-

tax weighted average cost of capital (or the marginal cost of capital from

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alternative sources), the user should choose the sale leaseback and use the

funds received to earn a yield that is higher than the cost. Conversely, if the

IRR of the differential is higher than the weighted average cost of capital, the

user should continue to own the property and look to the capital market for

funds to invest. This strategy would have a lower cost than the funds that could

be raised through a sale leaseback.The IRR of the differential cash flows also identifies the after-tax yield on the

capital invested in the continued ownership of the real estate. If the

corporation doesn’t perform the sale leaseback, it is giving up the opportunity

to use the capital that could be generated in an alternative investment.

Therefore, this is the amount it is investing in the real estate from today

forward. The future cash flows after tax attributable to this real estate

investment is the difference between the future cash flows after tax of the sale-

leaseback alternative and the future cash flows after tax of the continue-to-own

alternative.

The IRR of the differential cash flows calculates the after-tax yield on this

investment in the real estate. This yield then can be compared to after-tax

yields available in alternative investments, particularly the core business. If

alternative investments can generate a higher after-tax yield, the corporation

should take the capital out of owned real estate through a sale-leaseback

transaction.

The process to determine the IRR of the differential cash flows is as follows:

1.

Reduce the two alternatives to their periodic cash flows after tax as

previously illustrated in the NPV method.

2. Subtract the sale-leaseback periodic cash flows after tax from the continue-

to-own periodic cash flows after tax to determine the differential cash flows

after tax.

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3.

Calculate the IRR of the differential cash flows.

EOY Ownership Leaseback = Differential

0 $0 $3,610,505 ($3,610,505)

1 24,459 (250,800) 275,349

2 24,459 (250,800) 275,349

3 24,459 (250,800) 275,349

4 24,459 (250,800) 275,349

5 24,459 (250,800) 275,349

6 24,459 (280,896) 305,445

7 24,459 (280,896) 305,445

8 24,459 (280,896) 305,445

9 24,459 (280,896) 305,445

10 $23,524 + $4,236,852 ($280,896) $4,541,273

IRR of the differential = 9.09%

The 9.09 percent IRR of the differential (the after-tax cost of the funds that can

be raised from the sale leaseback) is less than the corporation’s 12 percent aft er-

tax weighted average cost of capital (the after-tax cost of funds that could be

raised by going to the capital markets and maintaining their current debt-to-

equity ratio). Thus, the sale-leaseback alternative is the less expensive source of

funds.

The 9.09 percent IRR of the differential also indicates the after-tax yield on the

$3,610,505 invested in the real estate from today forward if the company

continues to own the real estate. The corporation’s after-tax cost of capital of12 percent indicates that its threshold after-tax target yield for investments is 12

percent. If the corporation has earning opportunities at a yield higher than 9.09

percent, it is better off taking the $3,610,505 that would be available from the

sale of the real estate and placing that money in a higher yielding investment.

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GAAP Accounting Impact

Use the models of the operating lease versus capital lease test and the following

assumptions to determine the impact of a sale leaseback on the income

statement and balance sheet.

Assumptions

PV of minimum lease payments: $2,653,091

Percentage of fair market value (must be less than 90 percent to be an

operating lease): 66.33 percent

Impact on Income Statement

GAAP pre-tax gain to be recognized annually per FAS-98 $67,498

− GAAP straight-line annual rent expense (average annual effective netrent)

402,800

+ GAAP future annual cost recovery avoided due to sale 72,202

Annual impact of sale leaseback on income statement ($263,100)

Balance Sheet Impact (Asset Side)

Cash raised from sale leaseback $3,610,505

+ Deferred gain recognized over the term of the lease 674,985

− Book value of property sold (adjusted bas is at the time of sale) 3,165,015

Net change in stockholder’s equity $1,120,475

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Conventional Financing

Another source to raise capital for an owner/occupant to consider is

conventional mortgage financing. If the property is encumbered with

conventional financing, the user may consider refinancing. If the property has

no debt on it, the user may consider placing a conventional loan on the

property. Conventional financing goes on the balance sheet as a primary

liability, whereas the lease obligation from a sale leaseback, if structured as an

Operating Lease, may be footnoted.

The amount of capital that can be raised from conventional financing may be

more or less than the amount that can be raised from the sale leaseback,

depending on the tax impact of the sale in the sale-leaseback transaction.

Financing or refinancing using conventional debt financing is not a taxable

event, whereas the sale in the sale-leaseback transaction is taxable.

The previous analysis of the sale-leaseback transaction compared the given

after-tax cost of capital that could be raised from the capital markets (after-tax

weighted average cost of capital) with the calculated after-tax cost of capital that

could be raised from the sale leaseback. To compare conventional financing as

an alternative, the owner must determine the amount of capital that can be

raised from conventional financing, as well as the after-tax cost of the borrowed

funds, using the following steps:

1.

Determine the loan amount. In the case of an owner-occupied building,

the loan amount usually is determined from the lender’s loan-to-value

(LTV) ratio underwriting criteria. The value typically is determined by acertified appraisal, and the lender will loan a percentage of the appraised

value. The percentage of the value that the lender will loan is influenced by

the type and condition of the building, as well as the borrower’s credit

strength. The proposed sale price in the sample problem is $4,000,000.

Assume that $4,000,000 is the appraised value, and the lender’s LTV ratio

criteria is 70 percent for this type of property a nd VSI’s credit strength.

The gross loan amount would be

Value $4,000,000

× LTV ratio 70%

Gross loan amount $2,800,000

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2. Determine the after-tax cost of the funds to be borrowed based on the


Interest rate: 8.5 percent


Loan term: 10 years


Loan costs: 2 percent of gross loan amount, including all costs

associated with the acquisition of the loan

The process to calculate the after-tax cost of borrowed funds is as follows:

1. Calculate the periodic payments based on contract loan amount, nominal

interest rate, and full amortization period.

2. Calculate the balloon payment, if any, based on the contract loan amount

and nominal interest rate.

3. Change the PV to reflect the loan costs (contract loan amount less the dollar

amount of the loan costs [net loan amount]).

4.

Solve for i, which is the before-tax cost of borrowed funds.

5.

Reduce the before-tax cost of the borrowed funds by the user’s marginal tax

rate to determine the after-tax cost of borrowed funds using this model:

Before tax cost of funds × (1 – marginal tax rate) = after-tax cost of

borrowed funds

Sample Problem 7-2: Before- and After-Tax Cost of

Borrowed Funds

A 20-year, $2,800,000 loan at 8.5 percent interest with monthly payments and

two discount points will have a higher effective cost to the borrower because the

points represent prepaid interest. The earlier payoff at the EOY 10 versus the

EOY 20 also increases the borrower’s effective cost.

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Steps to solve:

1.

Solve for payment with n based on the 20 year amortization.

2.

Calculate the balloon payment at the EOY 10 by changing n to the shorter

term.

3. Determine the dollar amount of the points.

$2,800,000 × 0.02 = $56,000

4.

Determine the net loan proceeds.

$2,800,000 – $56,000 = $2,744,000

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5. Change the PV to reflect the discount points and solve for I/YR (before-tax

cost of the borrowed funds).

6.

If the investor’s marginal tax rate is 34 percent, use the following model to

solve for the investor’s after-tax effective cost of the borrowed funds:

Before-tax effective cost of borrowed funds × (1 – marginal tax rate) = after-tax

effective cost of borrowed funds

8.84% × (1 – 34%) = 5.83%

Using conventional debt financing, the user could raise $2,744,000 (the

$2,800,00 gross loan amount less $56,000 loan costs) at an after-tax cost of 5.83

percent compared to raising $3,610,505 from the sale leaseback at an after-tax

cost of 9.09 percent. Both of these after-tax costs are less expensive than raising

the capital from the capital markets at the user’s weighted after-tax cost of 12

percent. The sale leaseback would generate $866,505 more than the

conventional financing, but at a higher after-tax cost.

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Investor Analysis

No matter how the transaction is structured to the user’s benefit, it also must

meet the investor’s minimum criteria for investment performance. The

investor analysis of the sale-leaseback transaction measures the following

investment performance criteria:

Acquisition capitalization rate

Before-tax cash on cash

Before-tax IRR

After-tax IRR

The same sale-leaseback structure used for VSI in the previous user analysis

will be used for the investor analysis with the investor assumptions added.

Investor Analysis Assumptions

Tax rate for ordinary income: 40 percent

Tax rate for capital gain: 15 percent

Tax rate for cost-recovery recapture: 25 percent

Purchase price: $4,000,000




Midmonth convention for cost recovery will be used for the years of

acquisition and disposition.

Acquisition occurs on the first day of the tax year, and disposition occurs on

the last day of the tax year.

The NOI for year 11 is forecast to be 12 percent greater than the year 10

NOI. This forecast assumes that a 12 percent increase in rents every five

years under the lease terms is realistic in the market.

The EOY 10 disposition price is determined by capitalizing the EOY 11

NOI at 9.5 percent. (Round the sale price to the nearest thousand.) Use

$5,018,000.

Disposition cost of sale: 4 percent

Maximum LTV ratio: 75 percent

Minimum debt service coverage ratio (DSCR): 1.20

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Interest rate on loan: 8.5 percent


Loan term: 20 years

Loan payments per year: 12

Loan costs: 2 percent of loan amount

Analysis Process

1. Determine the potential loan amount available to purchase the property.

Calculate the loan amount using the LTV ratio by multiplying the purchase

price by the lender’s maximum LTV ratio criteria.

Value (purchase price) $4,000,000

× Maximum LTV ratio 75%

Loan amount $3,000,000

Calculate the loan amount using the DSCR method. First, divide the first-

year NOI by the lender’s maximum DSCR criteria to determine the

maximum annual debt service (ADS) the lender will allow. Next, divide the

ADS by 12 months to determine the maximum monthly payment the

lender will allow. Then, using the monthly payment calculated as PMT, the

lender’s required interest rate as i, and the lender’s allowed amortization

period as n, solve for PV. The PV is the loan amount available using the

DSCR method for calculating the loan amount.

NOI : $380,000= ADS: $316,667

DSCR: 1.20

ADS: $316,667= Monthly payment: $26,388,89

12 months

EOM

0 (3,040,814)

1 26,388.89

↓ ↓

240 26,388.89

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Compare the two loan amounts and choose the lesser amount (round down

to the nearest thousand). This typically is the loan amount available to

purchase the property. In this case, it is $3,000,000.

2. Calculate the before- and after-tax annual cash flows for each year of the

holding period using the Cash Flow Analysis Worksheet.


Property Name VSI Purchase Price $4,000,000

Prepared For Investor Analysis Plus Acquisition Costs 30,000

Prepared By Plus Loan Fees/Costs 60,000

Date Prepared Less Mortgages 3,000,000

Equals Initial Investment $1,090,000



Amount $3,000,000 Value $3,224,000

Interest Rate 8.50% C. R. Method SL

Amortization Period 20 Useful Life 39

Loan Term 20 In Service Date Jan. 2002

Payments/Year 12 Future Sale Date Dec. 2011

Periodic Payment $26,034.70 Recapture

Annual Debt Service 312,416 Investment Tax

Loan Fees/Costs $60,000 Credit ($$ or %)

Taxable Income


1 Potential Rental Income $380,000 $380,000 $380,000 $380,000 $380,000


3 = Effective Rental Income 380,000 380,000 380,000 380,000 380,000


5 = Gross Operating Income 380,000 380,000 380,000 380,000 380,000

6 Operating Expenses7 = NET OPERATING INCOME 380,000 380,000 380,000 380,000 380,000

8 Interest – 1st Mortgage 252,709 247,432 241,688 235,436 228,632



11 Cost Recovery – Improvements 79,214 82,663 82,663 82,663 82,663


13 Amortization of Loan Fees/Costs 3,000 3,000 3,000 3,000 3,000


15 = Real Estate Taxable Income 45,077 46,905 52,649 58,901 65,705

16 Tax Liability (Savings) at 40% 18,031 18,762 21,060 23,560 26,282

Cash Flow

17 NET OPERATING INCOME (Line 7) 380,000 380,000 380,000 380,000 380,000

18 Annua l Debt Serv i ce 312,416 312,416 312,416 312,416 312,41619 Participation Payments


21 Funded Reserves

22 = CASH FLOW BEFORE TAXES 67,584 67,584 67,584 67,584 67,584

23 Tax Liability (Savings) (Line 16) 18,031 18,762 21,060 23,560 26,282

24 = CASH FLOW AFTER TAXES $49,553 $48,822 $46,524 $44,023 $41,302



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Property Name VSI Purchase Price $4,000,000

Prepared For Investor Analysis Plus Acquisition Costs 30,000

Prepared By Plus Loan Fees/Costs 60,000

Date Prepared Less Mortgages 3,000,000

Equals Initial Investment $1,090,000



Amount $3,000,000 Value $3,224,000

Interest Rate 8.50% C. R. Method SL

Amortization Period 20 Useful Life 39

Loan Term 20 In Service Date Jan. 2002

Payments/Year 12 Future Sale Date Dec. 2011

Periodic Payment $26,034.70 Recapture

Annual Debt Service 312,416 Investment Tax

Loan Fees/Costs $60,000 Credit ($$ or %)

Taxable Income

End of Year: 6 7 8 9 10 11

1 Potential Rental Income $425,600 $425,600 $425,600 $425,600 $425,600 $476,672


3 = Effective Rental Income 425,600 425,600 425,600 425,600 425,600 476,672


5 = Gross Operating Income 425,600 425,600 425,600 425,600 425,600 476,672


7 = NET OPERATING INCOME 425,600 425,600 425,600 425,600 425,600 476,672

8 Interest – 1st Mortgage 221,226 213,166 204,393 194,844 184,452



11 Cost Recovery – Improvements 82,663 82,663 82,663 82,663 79,214


13 Amortization of Loan Fees/Costs 3,000 3,000 3,000 3,000 3,000


15 = Real Estate Taxable Income 118,711 126,771 135,544 145,093 158,934

16 Tax Liability (Savings) at 40% 47,484 50,709 54,218 58,037 63,574

Cash Flow

17 NET OPERATING INCOME (Line 7) 425,600 425,600 425,600 425,600 425,600

18 Annua l Debt Serv ice 312,416 312,416 312,416 312,416 312,416



21 Funded Reserves

22 = CASH FLOW BEFORE TAXES 113,184 113,184 113,184 113,184 113,184

23 Tax Liability (Savings) (Line 16) 47,484 50,709 54,218 58,037 63,574

24 = CASH FLOW AFTER TAXES $65,699 $62,475 $58,966 $55,147 $49,610



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3.

Calculate the before- and after-tax sale proceeds at the end of holding

period using the ACSW.

VSI Investor Analysis Alternative Cash Sales Worksheet

Mortgage Balances


Principal Balance 1st Mortgage $2,940,293 $2,875,309 $2,804,580 $2,727,600 $2,643,815


TOTAL UNPAID BALANCE $2,940,293 $2,875,309 $2,804,580 $2,727,600 $2,643,815

6 7 8 9 10

$2,552,625 $2,453,374 $2,345,351 $2,227,779 $2,099,815

$2,552,625 $2,453,374 $2,345,351 $2,227,779 $2,099,815



(At 9.5% cap) (At _________% cap) (At ________% cap)



2 + Capital Additions

3 Cost Recovery (Depreciation) Taken 819,732

4 Basis in Partial Sales







10 = Gain or (Loss) 1,607,012

11 Straight Line Cost Recovery (Limited to Gain) 819,732

12 Suspended Losses

13 = Capital Gain From Appreciation 787,280


14 Unamortized Loan Fees/Costs (Negative) (30,000)

15 +

16 = Ordinary Taxable Income (30,000)


17 Sale Price 5,018,000



20 Mortgage Balance(s) 2,099,815

21 + Balance of Funded Reserves22 = Sale Proceeds Before Tax 2,717,465


at 40% of Line 16 (12,000)


at 25% of Line 11 204,933

25 Tax on Capital Gains

at 15% of Line 13 118,092



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4. Calculate the acquisition cap rate, which is the first-year NOI divided by the

purchase price.

First-year NOI: $380,000= Acquisition cap rate: 9.50%


5.

Calculate the before-tax cash on cash, which is the first-year cash flow beforetax divided by the initial investment.

First-year cash flow before tax: $67,584= Before-tax cash on cash: 6.20%

Initial investment: $1,090,000

6.

Calculate the before- and after-tax IRRs.

Before-tax IRR After-tax IRR

EOY EOY

0 ($1,090,000) 0 ($1,090,000)

1 67,584 1 49,553

2 67,584 2 48,822

3 67,584 3 46,524

4 67,584 4 44,023

5 67,584 5 41,302

6 113,184 6 65,699

7 113,184 7 62,475

8 113,184 8 58,966

9 113,184 9 55,147

10 $113,184 + $2,717,465 10 $49,610 + $2,406,440

IRR = 14.96% IRR = 11.68%

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Sale-Leaseback Transaction Summary

After completing the user and the investor analyses, examine the summaries to

see if they meet both parties’ minimum requirements.

User Summary

NPV of the continue-to-own alternative: $1,502,529

NPV of the sale-leaseback alternative: $2,131,870

IRR of the differential cash flows: 9.09 percent

EOY 10 projected sale price of the continue-to-own alternative: $5,376,000

EOY 10 sale price point of indifference: $8,461,000

Annual growth needed to achieve the sale price point of indifference: 7.78

percent

Investor Summary

After-tax cost of available debt financing: 5.27 percent

Acquisition cap rate: 9.50 percent

Before-tax cash on cash: 6.20 percent

Before-tax IRR: 14.96 percent

After-tax IRR: 11.68 percent

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1.

A user who bought an office building five years ago for $1,000,000 now isconsidering a sale-leaseback. A recent appraisal pegs the value today at

$1,250,000. The user owes $600,000, has taken $102,000 in cost recovery,

and is a C-corporation taxed at 34 percent. Costs of sale are estimated at 8

percent. If the user sells the property today, how much after-tax cash would

be generated?

a.

$252,000

b.

$464,320

c.

$638,460

d.

$898,000

2. The user in the previous problem can refinance the office building under

the following terms:

70% loan-to-value ratio 20-year amortization

11% interest Monthly paymentsCost to refinance: $35,500

How much will the user receive in net loan proceeds if the user goes ahead with the refinance?

a.

$839,500

b.

$875,000

c.

$364,500

d.

$239,500

End of assessment

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Answer Section

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1. A user who bought an office building five years ago for $1,000,000 now is

considering a sale-leaseback. A recent appraisal pegs the value today at

$1,250,000. The user owes $600,000, has taken $102,000 in cost recovery,

and is a C-corporation taxed at 34 percent. Costs of sale are estimated at 8percent. If the user sells the property today, how much after-tax cash would

be generated?

b.

464,320

6 Sale Price $1,250,000 Recent appraised value


9

- Cost Recovery

Taken ($102,000)

11 = Adjusted Basis $898,000

12 Sale Price $ 1,250,000

13 - Costs of Sale ($100,000) 8 percent

14 - Adjusted Basis ($898,000) From line 11 above

16 = Gain $252,000

As a corporation, gain from appreciation and gain f

Recapture are taxed at the same rate

23 Sale Price $1,250,000

24 - Costs of Sale ($100,000)

26 - Mortgage Balance ($600,000)

28 = SPBT $550,000

31 - Tax on Capital Gain ($85,680) at 34%

32 = SPAT $464,320

2. The user in the previous problem can refinance the office building under

the following terms:

70% loan-to-value ratio 20-year amortization11% interest Monthly payments

Costs to refinance: $35,500

How much will the user receive in net loan proceeds if the user goes ahead with the refinance?

d. 239,500

$1,250,000 Appraised value

× 70% LTV

= $875,000 Loan Amount

- ($35,500) Loan Costs

= $839,500 Net New Loan Proceeds

- ($600,000) Existing Loan Payoff

= $239,500 Net Loan Proceeds

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Module Goal ........................................................ 8.1

Objectives ............................................................. 8.1

Negotiation Overview ................................. 8.3

Discussion Questions .......................................... 8.4

The CCIM Approach and Negotiation

Theory ...................................................... 8.4

Collaboration versus Competition ...................... 8.4

What Is Interest-Based Negotiation? .................. 8.6

Step 1: Stakeholder Interests Analysis ........ 8.7

Relationships Among Stakeholder Interests ....... 8.7

The Importance of Interests to the

Stakeholders ......................................................... 8.8

Focusing the Conversation on UnderlyingInterests ................................................................ 8.8

Active Listening Skills and Techniques .............. 8.9

The Importance of Nonmonetary Interests ....... 8.9

The Interest Chart ............................................... 8.9

Discussion Topics .............................................. 8.10

CCIM

Interest-Based

Negotiations

Review Model

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Step 2: Brainstorming Actions ................... 8.12

Example Talking Points for a Landlord ........... 8.12

Example Talking Points for Tenant .................. 8.13

Step 3: Risk Analysis and Evaluating Fighting

Alternatives ............................................ 8.15

Risk Analysis ...................................................... 8.15

Understanding and Measuring the

Consequences of No Deal ................................. 8.15

Implementation of the Three-Step Process:

Formulating and Presenting an Offer ........ 8.16

Defining Your Bottom Line for Negotiations .. 8.16

Preparing for Counters and Objections ............ 8.17

Summary ................................................ 8.18

Step 1: Who Is Involved and What Do They

Need? Determine Stakeholders, Interests, and

Issues .................................................................. 8.18

Step 2: What Actions Can Be Taken to Satisfy

Everyone’s Needs? Develop Action Steps andEvaluate them Against Interests ........................ 8.19

Step 3: What Happens if No Agreement Is

Reached? Determine Fighting Alternatives

(The Consequences of No Solution) ................ 8.19

Implementing the Optimal Strategy .................. 8.20

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CCIM Interest-Based

Negotiations Review Model Module Snapshot

Module Goal

In today’s commercial real estate environment, a purely transactional approach

to negotiation that favors short-term hardball tactics over long-term relationships

does not make sound business sense. A more sophisticated and successfulapproach to the practice of commercial real estate emphasizes negotiation skills

that enable practitioners to leverage relationships for sustainable results. This

module reviews the CCIM Interest-based Negotiations Model.

Objectives

Discuss the philosophy and reasoning behind the interest-based approach

to negotiations.

Discuss the role creativity plays in negotiation.

List the three steps of the CCIM Interest-based Negotiations Model.

Identify the basic methodology for each step of the CCIM Interest-based

Negotiations Model.

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NOTES

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N e g o t i a t i o n s R e v i e w

Negotiation Overview

Negotiation is not a game of tactics in which each side tries to outmaneuver the

other. It is not a competition. Negotiation is not poker; it is not even chess.

Negotiation is what real estate practitioners do when debating deals andagreements with those who want to buy, sell, or lease property, but it

encompasses much more than your own decision-making skills. Negotiation is

the process we use to try to influence the decision-making of others through

communication and presentation. For purposes of this course, the term

“negotiation” is defined broadly to include any situation in which you are trying

to persuade someone to do something.

Most experienced commercial real estate practitioners have found a negotiation

method that works for them. For some, negotiation is something they have to

do, but it is not something they enjoy or even particularly core to their work.

For others, negotiation is the most valuable work they perform for their clients.

Regardless of their specialty, most commercial real estate practitioners negotiate

on a day-to-day basis. They negotiate with clients and potential clients, with

business partners and affiliates, with work colleagues, subordinates, and bosses,

and of course in their personal lives with spouses, children, family members,

and friends.

In the field of commercial real estate, research has shown that successful

practitioners negotiate on a daily basis in a manner that supports quality

decision-making for their clients. In particular, they bring unique value to

clients by developing deals that satisfy their clients’ needs. They do so by

Negotiating in a principled manner

Communicating openness, authenticity, and creativity

Presenting critical information in a clear manner

The industry is driven by relationships between people—brokers and clients,

buyers and sellers, and renters and landlords— who demand high-quality,

interpersonal interactions. Thus, effective negotiation skills (broadly defined)

are essential.

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Discussion Questions

What types of negotiations do you typically do?

How do you prepare for those negotiations?

What makes a negotiation successful?

The CCIM Approach and Negotiation Theory

Collaboration versus Competition

A tension often experienced in professional relationships is the perceived trade-

off between satisfying our own needs and satisfying the needs of others. Asdepicted below, we often compromise our needs to satisfy the needs of others

or ask other people to sacrifice their needs so we can meet ours. In addition to

resulting in suboptimal outcomes for both sides, this approach actually can

harm relationships, as compromises may lead to dissatisfaction,

misunderstandings, and even conflict.

Figure 8.1 Approach to Negotiation

A more effective approach to negotiation follows a different path. As suggested

by the diagram, instead of seeking compromise— where each party makes

sacrifices to achieve limited gains— we can use creativity to find imaginative ways

to simultaneously satisfy our own needs and the needs of others, leaving

compromise as a last resort.

The Key

Find creative ways to satisfy their

needs in exchange for things that

satisfy your needs.

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In other words, the interest-based approach enables you to use creativity to

satisfy the interests of others even as you negotiate to satisfy your own interests.

The interest-based approach to negotiation recognizes that a collaborative

style—rather than a confrontational, positional, or competitive approach—builds

relationships and generates sustainable, long-term outcomes.

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What Is Interest-Based Negotiation?

Sometimes referred to as principled negotiation, collaborative negotiation, or

win-win negotiation, in the context of commercial real estate, interest-based

negotiation includes the following aspects:

People make decisions based on their own interests (or needs).

The key to successful negotiating is finding creative and effective ways to

satisfy those interests (yours and theirs).

Before accepting or rejecting a deal, both parties understand how the

proposed deal (and alternatives to the deal) will satisfy (or harm) their

critical interests.

The CCIM approach focuses on interest-based analysis and decision-making

and shares a proven step-by-step approach that has been utilized by world

leaders in negotiation. Those steps are

1. Stakeholder interests analysis: Who is involved and what do they need?

2. Brainstorming actions: What can we do to get them what they need so we

can get what we want?

3. Risk analysis and evaluating fighting alternatives: What happens if we can’t

come to an agreement?

It may be helpful to contrast interest-based negotiation with the approach to

which people frequently resort: negotiating only about price, which often is

referred to as the high-low game. Unlike the high-low game, interest-basednegotiation places no importance on starting high or responding low. It is not

about taking unreasonable positions and sticking to them. It does not focus on

beating the other person or winning a battle of wills.

The interest-based approach to negotiation finds the best way to satisfy your

own interests, which often means finding ways to satisfy others’ interests and

leverage that satisfaction in exchange for what you want. In that sense, it may

feel like win-win, though the interest-based approach to negotiation does not

guarantee a win-win outcome (particularly when the parties may be in very

different places, such as when one side has many options—or leverage—and theother side does not).

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Step 1: Stakeholder Interests Analysis

Step 1 is the foundation of sound decision-making in negotiations. Before

identifying stakeholder interests, it’s helpful to recall several important concepts

and their definitions:

People or organizations with an interest in a negotiation’s outcome are the

stakeholders. Essential stakeholders are those who must agree to the

decision because they have the power to block a deal.

Things or topics the parties care about that the negotiation may affect are

the issues.

The needs or wants that drive the stakeholders’ decision-making are the

interests. Parties to the negotiation may walk away if their critical interests

are not met. Important interests are wants that could be traded (to get a

deal).

To identify stakeholder interests, you may find it helpful to ask yourself the

following question: On the issue of ________, what does ________ need?

The answer to this question is a stakeholder interest. For example, on the issue

of rent, what does the tenant need? The answer is that the tenant wants to

decrease the rent they pay.

Examples of some typical interests are:

Maximizing the return on investment

Minimizing risk

Improving reputation

Obtaining high-quality space

Delaying a deal’s timing

Making efficient use of time

Relationships Among Stakeholder Interests

As you organize data about stakeholder interests, be attentive to relationships

among those interests. Identify three different types of relationships:

1. Interests in common, such as maintaining good relationships

2. Interests that are opposed, such as maximizing (or minimizing) tax relief

3. Interests that are different, but not opposite, such as streamlining (or

maintaining the integrity of) the permitting process

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Organizing this data on stakeholder interests is valuable because the

information can be difficult to juggle in your head, especially during an intense

or high-stakes negotiation. Even in a simple, straightforward negotiation, it can

be difficult to know in advance what interests may hold the key to the deal,

especially when negotiations bog down over obvious issues such as price. By

identifying the relationships among the stakeholders’ interests, strongnegotiators can map out how to present and discuss issues for maximum impact

and persuasive effect. For example, strong negotiators often start with common

interests (low-hanging fruit), move to issues where the stakeholders have

different (but not opposing) interests, and leave for last the issues on which the

stakeholders’ interests are opposed.

The Importance of Interests to the Stakeholders

In addition to identifying relationships among the stakeholders’ interests, you

need to know how important the interests are to each stakeholder. The CCIM

negotiation methodology includes a two-level assessment of importance for

stakeholder interests: critical or important.

Critical interest s drive a stakeholder’s decision-making. If critical interests are

not satisfied, a stakeholder will be disinclined to complete a deal if better

alternatives are available. Critical interests often are deal-breakers if they are

not satisfied.

Important interests are those a stakeholder wants, but they are not necessarily

deal-breakers. Important interests can create value to build momentum toward

a deal. They also present opportunities to create value for one party on a

critical interest, even though one of the other party’s important interests may be

harmed. In such a case, a reciprocal trade-off can be arranged on another issue

that is critical to one side but only important to the other.

Focusing the Conversation on Underlying Interests

When you manage the negotiation dialogue by focusing on other people’s

interests, you have two specific objectives:

1.

Confirm your understanding of the stakeholders’ interests.

2.

Convince your negotiation counterparts that you are attempting to satisfy

their interests.

To accomplish these objectives, listen carefully for the underlying interests that

motivate the other person. Listen for the relationships between your own

interests and the interests of the other party. Be attentive to the importance

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other people attach to specific interests. Finally, consider nonmonetary as well

as monetary interests.

Active Listening Skills and Techniques

When trying to determine a stakeholder’s interests, it is important to rememberactive listening skills and techniques. Effective negotiators listen as well as they

talk, but it’s not enough to just listen— you must prove that you are listening by

paraphrasing what the other person is saying, asking questions, and

acknowledging their interests when you hear them.

The Importance of Nonmonetary Interests

Money isn’t the only important issue in commercial real estate deals. While

nonmonetary issues can be harder to quantify than financial issues, in the real

world, concerns such as reputation, timing, flexibility, and relationships often

drive decision-making. To effectively represent their clients in commercial real

estate deals, practitioners must understand and track qualitative issues just as

they must compute a deal’s financial implications.

Finding additional ways to bring value to a deal is even more important when

you consider the ongoing relationship between the parties. Back-and-forth

squabbles focused entirely on money usually harm relationships. No matter the

outcome, it is difficult to feel good about the other side after battling about

money. On the other hand, if you seek ways to build value in a deal, you can

both build the relationship and generally improve your substantive outcomes.

The Interest Chart

The interest chart is the key deliverable from Step 1. The interest chart:

Captures all of the information needed for an interest analysis (the players,

issues, player interests on each issue, and the importance of each interest)

Shows where parties are aligned and where they are opposed

Creates a roadmap to solutions and shows the root causes of problems

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Part of an interest chart is illustrated below.

Figure 8.2 The Interest Chart

CEO

Company

Executives

Company

Employees

Current

Landlord

Appearance of new space SHOWC SE SHOWC SE SHOWC SE N/A

Timing of move S P S P S P LEVERAGE

Font Style Relationship to Anchor Font Effect Importance

Bold Same interest CAPS underline

CRITICAL

Italic Opposite interestCAPS, no underline

IMPORTANT

Regular Different interest No caps, no underline unimportant

This example summarizes the stakeholders and some of the interests of a

company in search of new office space. Four stakeholders are identified: the

chief executive officer (CEO), company executives, company employees, and

the company’s current landlord. Two issues are listed: the appearance of the

new space and the timing of the move. The CEO’s interest in the appearance

of the new space is to find space that showcases the company and is impressive

to clients. In this scenario, this interest is of critical importance to the CEO (as

indicated by the font style and underlining).

The interest chart will be discussed in detail during the Comparative Lease

Analysis case study.

Discussion Topics

How does this approach in Step 1 compare to how you usually prepare for

negotiations?

What do you see as the benefit, if any, of focusing on the stakeholders’ core

needs?

Do you find it easy or difficult to figure out other people’s interests? What

makes it easy or difficult?

How can you be sure that you understand the interests?

How can you use targeted questioning and active listening to test the

assumptions you made in Step 1?

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Step 1 Conclusion

Step 1 is the foundation of good decision-making and effective negotiating. It

requires good listening skills and an ability to put yourself in someone else’s

shoes. When you have gained a sufficient level of proficiency with Step 1, you

will find that you are rarely surprised in negotiations because people almost

always act in a manner calculated to satisfy their interests—as they understand

their interests.

Thus, when you understand others’ interests, you can anticipate what they will

do in almost any situation because they will try to satisfy interests that you

already have identified.

Although it may be difficult to anticipate what others will do, as with most

disciplines the key is hard work. To reach the highest levels of negotiation

proficiency, you must practice the skill of stakeholder interests analysis on real

negotiations to the point that it becomes second nature to empathize with

others and understand their interests.

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Step 2: Brainstorming Actions

Now that you have completed the foundation of your interests analysis in Step

1, you are ready to move to Step 2, in which you will brainstorm and evaluate

negotiation options. Step 2 builds on the work you did in Step 1.

Step 2 is your opportunity to be creative and solve the problems you identified

in Step 1. Targeted brainstorming, which is focused on satisfying specific

stakeholder interests, can generate breakthrough results, particularly when

impasse seems imminent or inevitable. One strategy is to create actions that

satisfy all interests for each particular issue.

When brainstorming options, consider the following:

Be open to new ideas.

Demonstrate flexibility even as you consider possible options.

Seek more and better ideas from others.

Don’t feel the need to embrace (or propose) every idea. You always have

the option to refine possible actions or disregard actions that do not make

sense.

Evaluate possible actions after brainstorming. Look at each action’s effect

on stakeholder interests. Consider packages of actions, including actions

that may in isolation be unattractive.

After evaluating actions against each respective stakeholder’s interests, you will

create a best-case proposal using the optimal action steps for each party’s

situation and then create talking points to present your proposal.

Example Talking Points for a Landlord

Introduction

The introduction initiates your presentation. The intent is to emphasize that

this is an interest-based proposal that takes into account the needs and goals of

all parties in your negotiation. The introduction should: Propose a framework for an ongoing, mutually beneficial relationship.

Bring substantial value to all involved and promote a cooperative

relationship.

Focus on common interest and address shared goals.

Cover the most important elements of the business relationship.

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Objectives

Stakeholder objectives are derived directly from the critical stakeholder’s issues

and interests. Thus, the landlord’s objectives are:

High: Rent to landlord

Limited: Sublease approval

Tenant pay: Cost of modifications

Specific Actions

This list of actions is a result of evaluating Step 2 brainstorming actions against

the stakeholders’ critical interests. The goal is to propose a package of actions

that satisfies the critical interests of the largest number of stakeholders possible.

Actions for the landlord are:

Increase rent each year by 5 percent, which satisfies his high objective.

Approve a sublease, which satisfies his limited objective.

Make the tenant pay for modifications.

Conclusion

The conclusion should reiterate how the landlord’s critical and important

interests will be satisfied. Invite his feedback and suggestions on how to

improve the proposal and better satisfy common interests. Tell the landlord

that you look forward to discussing further specifics about how to move the

business relationship forward.

Example Talking Points for Tenant

Introduction

The introduction for the tenant also should emphasize that this is an interest-

based proposal taking into account the needs and goals of all parties in your

negotiation. The introduction should:

Propose a framework for an ongoing, mutually beneficial relationship. Bring substantial value to all involved and promote a cooperative

relationship.

Focus on common interest and address shared goals.


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Objectives

In this example, the tenant’s objectives are:

Flexible: Sublease approval

Good: Relationship with landlord

Low: Rent

Automatic: Holdover

ASAP: Tenant possession

Specific Actions

The package of actions for the tenant includes:

An automatic holdover provision

Maintaining the same rent each year, which satisfies his low objective

Scheduling quarterly phone calls to the landlord, which satisfies his good

relationship objective

Obtaining sublease approval, which satisfies his flexible objective

Tenant moving in upon signing, which satisfies his ASAP objective

Tenant making changes if approved by landlord

Step 2 Conclusion

The conclusion also should reiterate how critical and important interests will besatisfied. You should invite feedback and suggestions from the tenant on how

to improve the proposal and better satisfy common interests. Tell him that you

look forward to discussing further specifics about how to move the business

relationship forward.

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Step 3: Risk Analysis and Evaluating Fighting

AlternativesNow that you have completed Steps 1 and 2 of the three-step process, you are

ready to move to Step 3, in which you will predict what each stakeholder maydo if no agreement can be negotiated. Step 3 is the final piece of your analysis.

Although most practitioners don’t want to think about the possibility of not

closing a deal, it is important to consider each stakeholder’s “fighting

alternatives.” As shown in the next section on implementation, sometimes it’s

better to not close a proposed deal, but the only way to be sure is to perform

the Step 3 analysis.

In addition, the Step 3 analysis can be used to educate stakeholders about the

consequences of not coming to an agreement. This can be a powerful tool for

generating agreement, particularly if the fighting alternatives are communicatedin a professional, nonthreatening manner. It’s akin to educating the

stakeholders about risks.

Finally, in the Step 3 risk analysis you may think of other stakeholders or issues

that were missed in Step 1 and update your Step 1 analysis. Similarly, you may

discover that you should return to Step 2 and brainstorm additional actions to

satisfy particular stakeholder interests.

Risk Analysis

During the risk analysis, you should:

Identify fighting alternatives.

Evaluate the consequences of each fighting alternative (for your client and

the other stakeholders).

Respectfully communicate the effects of fighting alternatives on critical

interests when necessary.

Understanding and Measuring the Consequences of NoDeal

In this step, you should define your bottom line and help all stakeholders fully

appreciate the costs of the fighting alternatives.

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Implementation of the Three-Step Process:

Formulating and Presenting an OfferOnce you understand what may happen if you and the other stakeholders do

not come to an agreement, the next step is to return to your list of possibleactions (Step 2) and redefine it further into a best-case proposal based on a

realistic assessment of how to best satisfy your own interests as well as those of

other essential stakeholders. Be creative and flexible as you both design and

communicate your best-case proposal.

A format that is particularly effective and persuasive is to:

Identify how your proposal will satisfy each stakeholder’s interests.

Link specific actions in your proposal to the interests of specific

stakeholders.

Express flexibility if the other stakeholders propose ways to satisfy those

interests more effectively by modifying your proposal without harming your

interests.

To handle counters and objections, remain focused on your bottom line, which

should be based on a realistic assessment of how you can satisfy your interests

unilaterally and how others can satisfy theirs (perhaps harming the interests of

others) in the event you cannot reach agreement.

When you actually communicate your proposal, use your analysis to generate

talking points linking the actions to the other stakeholders’ interests. Do notdepend on the other stakeholders to figure it out. Be explicit.

Defining Your Bottom Line for Negotiations

Select actions to include in your bottom line for negotiations. Consider the

following as you do this

Evaluate how your interests will be affected if you do not come to an

agreement (Step 3: fighting alternatives).

Recognize that you are better off not agreeing to a negotiated deal that

harms your interests than if you pursued your fighting alternatives.

Calibrate your bottom line for negotiations based on that point at which you

are better off not doing a deal.

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Preparing for Counters and Objections

This is an iterative process based on dialogue and joint problem-solving, not a

high-low game. Keep these methods in mind:

Use feedback to enhance your proposal, and explore alternative options.

Work together to improve the proposal, and avoid the outright rejection of

ideas.

Measure counterproposals against your internal interests.

Understand the trade-offs (for example, what you consider critical).

Use feedback to explore different ways to address other stakeholders’

particular needs.

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Summary

Step 1: Who Is Involved and What Do They Need?

Determine Stakeholders, Interests, and Issues

The questions to answer in Step 1 are:

Have you missed anyone who could exert influence (positive or negative)?

Who is essential to closing the deal? Remember to focus on critical

interests.

Are any issues different from what you typically encounter?

Have you considered all issues about which the other stakeholders care?

What are each person’s critical interests?

Are any stakeholder interests in common? Remember to focus on those

first.

Are any stakeholder interests opposed to each other? Leave those for last.

To perform Step 1:

1. Identify the stakeholders, and place the primary stakeholder first on the

interest chart.

2.

Note the primary stakeholders, and identify them by placing an asterisk next

to each.

3. Identify all of the issues, and place them on the chart. To ensure that none

are missed, it is helpful to list each stakeholder and their issues separately.

4. For each issue, work horizontally across the chart, and list each

stakeholder’s interests as they relate to each issue.

5. Determine each issue’s level of importance. Underline critical issues.

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8

•


Step 2: What Actions Can Be Taken to Satisfy

Everyone’s Needs? Develop Action Steps and Evaluate

them Against Interests


Does your proposal not satisfy any critical interests?

Have you brainstormed possible actions focused on satisfying those

interests?

Have you asked others how to more effectively satisfy certain interests?

Have you benchmarked your proposal against best practices?

To perform Step 2:

1. Brainstorm possible actions by reviewing each issue and creating potential

actions that satisfy those issues. Do not filter.

2.

Evaluate each action step by determining whether it helps or harms each

stakeholder’s interests.

3.

Develop a proposal that satisfies the critical interests of the largest number

of stakeholders possible.

4.

Determine whether or not the proposal satisfies all critical interests.5.

Create talking points for the proposal.

Step 3: What Happens if No Agreement Is Reached?

Determine Fighting Alternatives (The Consequences of

No Solution)


Have you considered what everyone may do to satisfy their own interestsunilaterally and potentially harm others’ interests if no deal is reached?

Have you evaluated the effects of those fighting alternatives on each

stakeholder’s interests?

Have you estimated how likely each party is to succeed if they pursue their

fighting alternatives?

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To perform Step 3:

1. For each stakeholder, identify the possible actions that could be taken if no

agreement is reached.

2.

Determine how likely each possible action is to occur.

Implementing the Optimal Strategy

Finally, to come to an agreement that satisfies everyone, consider the following

questions:

Have you discovered any new information about interests, actions, or

fighting alternatives?

Have you calibrated your bottom line against the fighting alternatives?

Have you considered how your proposal satisfies people’s critical interests?

Have you considered how people’s critical interests will be harmed if no

deal is reached?

If someone is being difficult, have you considered communicating directly

or indirectly to the other stakeholders to avoid that person?

Have you documented your work so you can update best practices and

improve future negotiation outcomes?

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In This ModuleCase Study Overview ........................................... 9.1

Case Objectives .................................................... 9.1

Case Study 1: Comparative Lease Analysis .. 9.3

Case Setup ............................................................ 9.3

Task 1-1: Interests Analysis ................................ 9.5 Proposal A ............................................................ 9.7

Proposal B ............................................................ 9.8

Proposal C ............................................................ 9.9

Task 1-2: Complete an Economic Comparisonof the Leases....................................................... 9.10

Answer Section ....................................... 9.11

Task 1-1: Interests Analysis ............................... 9.12

Task 1-2: Complete an Economic Comparisonof the Leases....................................................... 9.12

Case Study 1:Comparative Lease

Analysis

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Case Study 1: Comparative

Lease AnalysisCase Study Overview

This case study examines the process of evaluating and comparing lease

proposals from the user’s perspective. During this case study, you will analyze

and compare the costs of three proposals that meet a user’s needs. You also

will discuss the interests of the stakeholders who represent the user and discuss

how their interests could impact decision making.

Case Objectives

Analyze and compare the costs of three different proposals from a user’s

perspective.

Apply the CCIM Interest-based Negotiations Model to a case study

scenario.

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NOTES

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9 •

C a s e S t u d y 1

Case Study 1: Comparative Lease Analysis

Case Setup

You have been given the assignment to provide analysis and recommendations

regarding prospective office location alternatives for Regional Services

Corporation (“RSC”).

RSC has enjoyed substantial growth over its corporate life and has built a

reputation as an ethical, sound, and conservatively run organization. The

founder and current Chief Executive Officer (CEO)/Chairman of the Board,

Gino Gargantuo, started the company in his parent’s garage almost 40 years ago

while he was in college studying engineering.

An initial public offering seven years ago provided capital for additional

business investments, which have generated extensive growth in recent years.

Gross revenue has tripled, earnings per share have quintupled, and the number

of employees has doubled. This growth has resulted in a need for additional

office space.

RSC entered into a 10-year lease a little more than seven years ago for its

current 10,250 square foot (sf) facility. Although the existing location, market

area, and building suit RSC’s needs and image, the building owner cannot

accommodate any future company growth. Other tenant leases in the building

are long term, and RSC’s heavy parking use has created some consternation

between the landlord and the other tenants.

RSC has formed a Location Selection Committee with which you must consult.

The committee members are

Chief Financial Officer (CFO) Barry Barr

Vice President of Facilities and Operations Linda Loads

Senior Vice President of Marketing Tim Tooten

Audit and Compliance Officer Harry Harden

Vice President of Human Resources Alicia Alvarez CEO/Chairman of the Board Gino Gargantuo

The company’s board of directors has directed the Location Selection

Committee to limit the search to a 10-mile radius of the existing headquarters

office facility. You interviewed each of the Selection Committee members to

develop a needs assessment. Here is what you learned from the Selection

Committee members:

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CEO/Chairman of the Board Gino Gargantuo did not have time to talk

with you. Instead, he sent you an e-mail saying, “Get my people a classy

space and make sure I can bike there from home.”

VP of Facilities and Operations Linda Loads made it clear that a new facility

was long overdue. Linda joined the company shortly after Gino founded it,

and she believes that the right space will improve employee and leadershipmorale. “You just can’t imagine how hard it’s been to make our current

space work,” she said. “I told Gino t o not sign the last lease, but he

wouldn’t listen.” Linda also advised you to not get hung up on the

numbers. “We need space that reflects the vision and success of RSC.”

CFO Barry Barr told you, “I don’t see why we need new space. We already

have a nice building, and we’re locked in for another two and a half years.”

Barry elaborated that new office space is not a good use of the company’s

cash right now, especially if the company must buy out its existing lease to

move. RSC is experiencing a serious cash-flow problem because of its rapidgrowth and new product development commitments. Barry said that you

should find the least expensive space if the company absolutely must move.

He suggested that RSC postpone the move for at least six months until the

macroeconomic picture becomes clearer.

VP of Human Resources Alicia Alvarez claimed that she does not care

about the new space, but when pressed, she admitted, “I would love to see

us have an open floor plan without walled offices.”

Senior Vice President of Marketing Tim Tooten minced no words. “Look,

I need a showcase building with a huge sign and an overwhelming façade.”He claimed that he would bring customers and partners through the new

building every week. “Get us in there as fast as you can.”

Audit and Compliance Officer Harry Harden said that he would like all

dealings to be subject to open bidding where applicable. “Document

everything, and don’t rush anything,” Harry warned you. “Make sure you

check for conflicts.”

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Task 1-1: Interests Analysis

Compile the above information into an Interest Chart (below). Based on the

input you received from the committee members, you have been asked to send

an update report to VP of Facilities and Operations Linda Loads, who will relay

the substance of your report to the Location Selection Committee. It is 10minutes before your update meeting, for which you have two objectives:

1.

Confirm your analysis of the company’s needs.

2.

Obtain the commit tee’s buy -in and approval for your recommended

approach.

To accomplish these objectives, identify the underlying interests that motivate

the other parties. Listen for the relationships between your own interests and

the interests of others. Be attentive to the importance other people attach to

specific interests. Finally, consider nonmonetary as well as monetary interests.

Interests nalysis for the RSC Location Search Committee

Stakeholders

Issues

RSC growth

Appearance of new

space

Timing of move

RSC cash flow

RSC employee

morale

End of task

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In addition to confirming the stakeholders’ interests, during your interviews,

you conducted a Needs Assessment, and also discovered some important

information relating to RSC’s needs for their new space as well as economic

parameters:

Required size: 20,000 sf

Desired lease term: Eight to 10 years

Weighted average before-tax cost of capital: 7 percent

Weighted average after-tax cost of capital: 6.25 percent

Tenant’s incremental borrowing rate: 6.75 percent

Reasonable cap rate to apply to initial base rent: 8 percent

Tenant improvement useful life: 39 years

Minimum building efficiency: 85 percent

Marginal tax rate: 35 percent

The update meeting is held, and you provide your update and assessment

results. Shortly after, VP of Facilities and Operations Linda Loads reports back

to you that the Location Selection Committee was impressed with the

thoroughness and accuracy of your needs assessment. Based on the needs

assessment and the feedback from the Selection Committee, you conduct a

search of available properties using a variety of property databases, including

CCIM.com, LoopNet, CoStar, Catylist, CommercialSource.com, the localMLS, Exceligent, TotalCommercial.com, as well as your proprietary internal

property information database. You send a broadcast e-mail to your

commercial broker contact database and via the CCIM mailbridge system with

the parameters of RSC’s needs.

Your search returns 21 properties. You then drive the defined market area to

search for additional properties and to preview the exteriors and take

photographs of the 21 properties. You conduct some preliminary analysis of

each of the alternatives compared against RSC’s needs. Based on your preview,

you narrow the number of properties to present to the Selection Committee to

three. In response to your RFP, the owners of these three properties each send

a proposal. The highlights of these proposals appear on the following pages as

well as the forecast assumptions you’ve determined are suitable and reasonable

for your analysis.

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Proposal A

Proposal from Owner

Lease term: 10 years

Rentable square feet (rsf): 20,000

Base rent per square foot (psf): $16

Base rent escalation: One-time 10 percent increase at the start of year 6

Rent concession: First six months free

Reserved Parking: 70 spaces at $40 per stall per month

Parking escalation: 3 percent annually

Real estate taxes: $3 psf

Real estate tax stop: $3 psf

Operating expense: $4 psf

Operating expense stop: $4 psf

Tenant improvement (TI) allowance: $25 psf

Moving expense allowance: $3,000

Leasing Commission: 4%

Tenant’s Forecast Assumptions

Annual real estate tax increase: 2 percent

Annual operating expense increase: 3 percent

Total TIs required: $40 psf

Total moving costs: $10,000


Before-tax weighted average cost of capital: 7 percent

After-tax weighted average cost of capital: 6.25 percent

Tenant’s Generally Accepted Accounting Principles (GAAP) Accounting

Requirements


Reasonable cap rate to apply to initial base rent to determine fair market

value: 8 percent

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Proposal B

Proposal from Owner


Rentable square feet: 19,800

Base rent per square foot: $20

Base rent escalation: One-time 8 percent increase at start of year 6

Rent concession: First three months free

Reserved Parking: 75 spaces at $35 per stall per month

Parking escalation: 3 percent annually

Real estate taxes: $2.75 psf

Real estate tax stop: $2.75 psf

Operating expense: $4.50 psf

Operating expense stop: $4.50 psf

TI allowance: $50 psf

Moving expense allowance: $0

Leasing Commission: 4%

Tenant’s Forecast Assumptions Annual real estate tax increase: 2 percent







Tenant’s GAAP Accounting Requirements



value: 8 percent

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9 •

C a s e S t u d y 1

Proposal C

Proposal from Owner


Rentable square feet: 20,500

Base rent per square foot: $14

Base rent escalation: 2 percent annually

Rent concession: None

Parking: None

Parking escalation: N/A

Real estate taxes: $2.50 psf

Real estate tax stop: $2.50 psf

Operating expense: $3 psf

Operating expense stop: $3 psf

TI allowance: $15 psf

Moving expense allowance: $0

Tenant’s Forecast Assumptions

Annual real estate tax increase: 2 percent







Tenant’s GAAP Accounting Requirements



value: 8 percent

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Task 1-2: Complete an Economic Comparison of the

Leases

1.

Use the Comparative Lease Analysis workbook to compare the threeproposals.

2. Based solely on your economic analysis, which proposal would you

recommend? Why?

End of task

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C a s e S t u d y 1

Answer Section

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Task 1-1: Interests Analysis

Answers will vary

Task 1-2: Complete an Economic Comparison of the

Leases

1.

Use the Comparative Lease Analysis workbook to compare the three

proposals.

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C a s e S t u d y 1

Additional solution assistance can be obtained by reviewing the completed

Comparative Lease Analysis Workbook.

2.

Based solely on your economic analysis, which proposal would you

recommend? Why?

Lease C

Lease C has the lowest cost of occupancy using every cost of occupancy

measure

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In This ModuleCase Study Overview ......................................... 10.1

Case Objectives .................................................. 10.1

Case Study 2: Lease versus Purchase ........ 10.3

Case Setup .......................................................... 10.3

Task 2-1: Initial Interests and Economic Analyses .............................................................. 10.6

Task 2-2: Update Your Interests and Financial Analyses ............................................................ 10.10

Task 2-3: Determine Actions and Make aRecommendation ............................................. 10.13

Answer Section ..................................... 10.17

Task 2-1: Initial Interests and Economic Analyses ............................................................ 10.18

Task 2-2: Update Your Interests and Financial Analyses ............................................................ 10.21

Case Study 2: Lease Versus Purchase

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Case Study 2: Lease versus

PurchaseCase Study Overview

This case study allows you to practice the analysis and calculations used in

making a lease-versus-purchase decision. You also will address the impact of

the stakeholders and their interests on the decision-making and negotiation

process. You will have the opportunity to combine your economic analyses

w ith your stakeholders’ interest analyses to generate action plans that form the

basis of a recommendation to lease or purchase.

Case Objectives

Calculate and interpret net present values (NPVs) of the cost of leasing

versus the cost of purchasing.

Calculate and interpret the internal rate of return (IRR) of the differential

cash flows after tax from leasing versus purchasing.

Calculate and explain the sales price point of indifference between the

leasing and purchasing alternatives.

Compare the NPVs of occupancy costs from the user’s perspective and

determine the better alternative.

Calculate and interpret the impact of generally accepted accounting

principles (GAAP) on occupancy alternatives.

Apply the CCIM Interest-based Negotiations Model to a case study

scenario, including communicating and explaining a lease or purchase

recommendation.

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NOTES

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Case Study 2: Lease versus Purchase

Case Setup

You have been contacted by a doctor from a local medical practice, Best

Practices LLC (―Best Practices‖). The practice originally was founded by Dr.

Bob Scotting, a dynamic medical doctor and entrepreneur, who built the

organization from a small single-practitioner family medical practice into a

highly respected medical center with five physician partners (including Dr.

Bob).

The medical center has grown in reputation and services slowly and surely

under Dr. Bob’s leadership. Now the center is the go-to clinic for obstetrics

and gynecology; baby, youth, and adult general-family practice needs; sports

medicine and physical therapy; and geriatric care with a focus on arthritis and joint medicine.

Over the past 15 years, Dr. Bob has added medical specialists to build the

practice. His vision of building a business/medical practice that is "Your Clinic

for Life" has been realized. Five very compatible physician partners are now in

the practice, including Dr. Bob, and all, as Bob demanded, have an equal

ownership share.

The next step in the Best Practices ‖Your Clinic for Life‖ vision is moving into

the ―ideal‖ medical facility. The doctors have been designing that ideal facility

for years. During medical conferences, they toured the best facilities andinterviewed dozens of their peers around the country. They have informally

polled patients to solicit their input on their likes and dislikes. Key employees

and nursing staff have invested in the process as well. Several medical design

specialists have been engaged for various consulting activities and design tasks,

resulting in the final design that the doctor partners affectionately have named

‖Clinic 2.0.‖

A long-time friend of Dr. Bob who is a much-respected developer also has

been very involved in the design and creation of Clinic 2.0. He and the

principals in his firm have provided value engineering suggestions and haveearned the respect and confidence of all the doctor partners. After completing

several rounds of competitive construction bids, the development firm offered a

very interesting proposal: an alternative to either lease or purchase the facility.

This is where you enter the picture. You’ve been asked by the doctor partners

of Best Practices to recommend whether the clinic should lease or purchase the

building. You will report your recommendation to the Management

Committee, which consists of the five doctor partners, Dr. Bob (the chair) with

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whom you have met in the past, and the practice’s controller and office

manager.

After a brief meeting with the partners, you feel confident that they are unified

in their desire to make the best business decision for the clinic. However, they

seem genuinely ambivalent as to whether they should lease or purchase Clinic

2.0. They are looking to you for a thoughtful recommendation.

During an extensive conversation with Best Practices’ Controller, Minnie Liu,

she says that cash flow is strong and that the partnership has been accruing

capital to invest in the new facility for some time. Minnie explains that the

partnership has adopted GAAP as their accounting standard, since their various

banking, insurance, and medical equipment lease relationships require annual

audited financial statements for the practice to maintain their borrowing

capacity (debt/equity ratios), liquidity ratios, and the like.

Minnie recently attended an excellent Certified Public Accountant continuing

education course where she learned about recent financial accounting standards

(FAS) rulings. She clearly understands the accounting rules of a capital lease

and is very concerned about the potential impact of a capital lease on the firm’s

borrowing capacity. The partners have agreed that they will not enter into a

lease that would classify as a capital lease under GAAP accounting guidelines.

Minnie confides that she is leaning toward a purchase. However, she believes

that the projected sale price for any building the clinic might purchase could be

wildly inflated, so any NPV calculations for a purchase would be too optimistic.

―Plus, be sure you add up all the hidden costs of a lease,‖ she warns. ―We may

be much better off purchasing.‖

Minnie also provides some input regarding the partners. She confirms that

each partner earns the same amount from the partnership via their LLC

dividends. She also confirms that each of the partners is in the top federal

income tax bracket and that each owns their share of the limited liability

company, not as a corporation but as individuals. Minnie closes the

conversation by saying, ―These docs pay a lot of taxes.‖

In addition to chatting with Minnie, you also speak with Will Washington, the

office manager, and you sense a bias toward leasing. Will thinks that any good

business should not buy a building because it will be compelled to stay, even ifthe real estate market tanks and it makes operational sense to get out. ―I know

how these things work,‖ Will warns you. ―Easy in, but you never get out.‖

Will confirms that both he and Minnie had contacted their bank relationship

manager, Bryce Donaldson, and that Bryce is expecting your call to obtain

potential financing details. Will and Minnie gave Bryce all of the information

he requested regarding the building, and Bryce already submitted their current

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financial information to the bank’s loan committee. You make a note to call

Bryce upon your return to your office.

Ask Will if he has any input for you on lease terms, since leasing seems to be

his preference. He tells you that he thinks the lease should be long term, such

as 15 or 20 years. One of the reasons for a long-term lease is that it will be a

custom-built facility. ―It is the dream medical office for all the partners,especially Dr. Bob,‖ he says. ―We can’t allow a landlord to hold us hostage five

or 10 years in the future when the lease is up for renewal. We need to lock in

our rent for the long term, so we don’t end up paying too much down the road

when it is time for our lease rene wal.‖

You thank Will for his candid perspectives and advice and go to a meeting with

the developer. The developer provides additional details regarding their cost-

plus construction/sale price proposal, as well as the simple methodology they

used to determine the starting lease rate. Jim Bridges, the developer’s lead

representative, indicates that they are totally ambivalent about whether thedoctors purchase or lease the facility. ―Either way,‖ Jim says, ―we’d love to

work with the doctors. We’d be happy to sell them the facility, or we’d be just

as pleased to have them as tenants. We would be honored to work with them,

and we know how important this facility is to them. This will be a showpiece

for them—and us.‖

Before leaving, Jim asks you to compliment the doctors on their comprehensive

and detailed building plans. Based on those detailed plans and the multiple

bids they had solicited, Jim is very confident in the accuracy of the project’s

cost. He provides the basic formulas that they would apply to determine the

purchase price and the lease rate depending on various lease terms, whether 10,

15, or 20 years.

Your phone call with Bryce, the lender, goes well. Per Will and Minnie’s input,

as well as his knowledge of the loan covenants of the partnership’s existing

credit facilities, Bryce gives you an overview of the loan terms that the loan

committee approved. He promises to e-mail you a copy of the loan

commitment that was based on Will and Minnie’s direction. Based on prior

conversations with the partners, he believes that several of them may prefer a

nonrecourse loan, so Bryce agrees to work on terms for a nonrecourse loan

alternative, which he will present to the loan committee at their meeting next week.

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Task 2-1: Initial Interests and Economic Analyses

The decision analysis is, should Best Practices lease or buy the medical center?

In your analysis, keep in mind that the doctor partners want to know how each

acquisition alternative will impact their partnership’s financial statement s. Although they are ambivalent toward leasing or purchasing, it is important to

them to not negatively affect their banking, insurance, and equipment leasing

relationships on both the partnership’s income statement and its balance sheet.

In addition, they are very curious how each alternative will impact the practice’s

cash flow.

Based on the information you have compiled to date, you complete the

following Interests Chart. After reviewing the Interests Chart, apply the

following information using the Lease Versus Purchase workbook to complete

your initial economic analysis. Remember the partners have identical tax rates.

After completing your initial economic analysis, answer the questions on the

following page.

User Information

Ordinary income tax rate: 35 percent

Capital gains tax rate: 15 percent

Cost recovery recapture tax rate: 25 percent

After-tax weighted average cost of capital: 8 percent

After-tax discount rate applied to leasing cash flows after tax: 8 percent

After-tax discount rate applied to ownership annual cash flows after tax: 8

percent

After-tax discount rate applied to ownership sale proceeds after tax: 8

percent

Incremental borrowing rate: 6.5 percent


Purchase Information

Acquisition price: $9,000,000




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Annual growth rate in value to calculate disposition price: 2 percent

Projected disposition cost of sale (percent of disposition price): 3 percent

Financing Information


Interest rate: 6.5 percent


Loan term: 20 years


Loan costs (percent of loan amount): 2 percent

(The financing information above is based on a loan commitment for a full-

recourse loan.)

Lease Information


Net rent payable annually at the end of the year

Net rent years one through five: cap rate of 7.5 percent applied to

construction/purchase price (excluding acquisition costs)

Net rent increase of 8 percent at beginning of years six, 11, and 16

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Interests Chart for Best Practices LLC

Dr. Bob

Minnie Liu

Controller

Best Practices

Partners

Will Washington

Office Manager

Bryce Donaldson

Banker

Jim Bridge

Developer R

GAAP compliance N/A COMPLY N/A N/A COMPLY N/A

Borrowing capacity PROTECT LEVER GE PROTECT N/A protect adequate

Length of occupancy LONG LONG LONG LONG N/A N/A

Facility design ST TE OF THE RT DEQU TE ST TE OF THE RT ST TE OF THE RT respectable ??

Occupancy (lease v.

purchase)Ambivalent PURCH SE ambivalent LE SE ambivalent N/A

Vision for medical

practiceENH NCE M INT IN PROTECT PROTECT M INT IN N/A

Partners’ income

taxesMINIMIZE protect MINIMIZE N/A N/A N/A

Font Style Relationship to Anchor Font Effect Importance

Bold Same interest CAPS underline CRITICALItalic Opposite interest CAPS, no underline IMPORTANT

Regular Different interest No caps, no underline unimportant

1. Based solely on your economic analysis, without any change in the

proposed purchase or lease terms, which alternative would you initially

recommend? Why?

Using the Interests Chart, how might the initial recommendation benefit or

harm each stakeholder’s interests?

2. How will Best Practices’ GAAP financial statements be impacted?

a. Is the lease a capital lease or an operating lease?

b.

For the lease alternative:i. What is the income statement impact?

ii.

What is the balance sheet impact?

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c.

For the purchase alternative:

i.

What is the income statement impact?

ii.


3. How would each alternative (lease or purchase) impact the practice’s cash

flow?

End of task

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Task 2-2: Update Your Interests and Financial Analyses

You report your preliminary findings to Dr. Bob, the rest of the Best Practices

partners, Minnie and Will.

After a healthy discussion, they all confirm that it would not be in the bestinterests of the business to enter into a capital lease. The potential impact on

the practice’s borrowing capacity could be devastating due to an ongoing

reliance on the bank’s credit facilities for cash flow as payments from myriad

insurance companies are processed. Based on your recommendation, they

direct you to modify the lease term to 15 years to eliminate the capital lease

classification. They also tell you to ask Jim, the developer’s representative, for a

proposal on rental rate and rent escalations for the shorter-term lease.

The financing terms are discussed as well, and the partners direct you to

proceed with the alternative that Bryce prepared for a nonrecourse loan, whichincludes the following terms:

65 percent loan-to-value ratio instead of 75 percent

15-year term instead of a 20-year term (but still a 20-year amortization)

7 percent interest rate instead of 6.5 percent

Although they are looking for an unbiased recommendation from you, the

partners relay their concern about purchasing the building and the amount of

capital it might require.

After the meeting, you contact Jim, who provides the developer’s terms for the15-year lease. Given the shorter term, the starting rent would be based on an 8

percent cap rate, and the increases at years 6 and 11 would be 10 percent

instead of 8 percent. Jim also confirms that the purchase price of $9,000,000

would not change if the partners elected to proceed with the purchase

alternative.

You convey the terms of Jim’s proposal to the partners, Minnie, and Will, and

they agree to the lease terms if their decision is to lease the building.

Based on the new lease and financing information, update both your interest

analysis and your financial analysis. Use the Interests Chart on the followingpage to record changes, and then use the Lease Versus Purchase Workbook to

update your financial analysis. When you have completed both analyses,

answer the questions for Task 2-2.

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Modified User Information

Incremental borrowing rate: 7 percent


Modified Purchase Information

No changes

Modified Financing Information


Interest rate: 7 percent

Loan Amortization: Remains 20 Years

Loan term: 15 years

Modified Lease Information


Net rent years one through five: Cap rate of 8 percent applied to

construction/purchase price

Net rent increase of 10 percent at the beginning of years six and 11

Update the Interest Analysis Chart

Dr. Bob

Minnie Liu

Controller

Best Practices

Partners

Will Washington

Office Manager

Bryce Donaldson

Banker

Jim Bridges

Developer Rep

GAAP compliance N/A COMPLY N/A N/A COMPLY N/A

Borrowing capacity PROTECT LEVER GE PROTECT N/A protect adequate

Length of occupancy LONG LONG LONG LONG N/A N/A

Facility design ST TE OF THE RT DEQU TE ST TE OF THE RT ST TE OF THE RT respectable ??

Occupancy (lease v.

purchase)ambivalent PURCH SE ambivalent LE SE ambivalent N/A

Vision for medical

practiceENH NCE M INT IN PROTECT PROTECT M INT IN

N/A

Partners’ incometaxes

MINIMIZE protect MINIMIZE N/A N/A N/A

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1. Compare the after tax present values of the leasing and purchasing

alternatives.

Present value of leasing: ____________________

Present value of purchasing: ____________________

Which alternative is best? Why?

2. Generate the internal rate of return of the differential between leasing and

purchasing. What does this mean?

3. At what discount rate would the costs of leasing and purchasing be equal?

4.

If Best Practices’ after-tax weighted average cost of capital was 10 percent,

what would you recommend to the partners?

5.

What is the relationship between the internal rate of return of the

differential and the discount rate?

6.

At what future sale price would the costs of leasing and purchasing become

equal?

7.

What is the necessary annual growth rate of the property value to make thecosts of leasing and purchasing equal?

End of task

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Task 2-3: Determine Actions and Make a

Recommendation

Based on the new information, you update the Interests Chart and the financial

analysis (in the prior task). To consider, prepare, and present your findings and

final recommendation, you plot out your action plans, since you are reasonably

confident that you have accurately identified and updated the key stakeholders’

interests.

Your task is to make a lease or purchase recommendation based on the best

interests of the partnership. While incorporating the new information, you

decide to devise as many options as possible to further satisfy the various

stakeholders’ interests. To do so, you decide to brainstorm any other variables

that possibly could be adjusted to equalize the cost of the two alternatives:

leasing or purchasing as well as ways to address the stakeholder's issues and

interests.

A colleague agrees to help you brainstorm possible actions that could satisfy the

interests of one or more stakeholders on each of the issues listed on your

Interests Chart. You tell her that you are particularly interested in equalizing

the costs of leasing and purchasing.

Using the space on the following page, see how many different possible actions

you and your colleague can come up with in 10 minutes. Remember to devise

actions relevant to each issue and focus on equalizing costs. Do not evaluate

the actions; you can do that later. Instead, compile as many actions as you and

your colleague can generate. Again, you are looking for quantity without regard(yet) to quality.

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Brainstorm Possible Actions

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

__________________________________________________________________

Now it is time for you to evaluate the actions you brainstormed to determine

which merit further consideration. To evaluate the actions, you must consider

whether they satisfy or harm the stakeholders’ interests.

Choose several of the potentially highest impact actions and evaluate them.

When you are done evaluating individual actions, group them into packages.

One package of actions should reflect the best case for leasing. Another

package should reflect the best case for purchasing.

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As you evaluate each possible action, consider what interests will be satisfied

and what interests will be harmed. You can use this information to develop

talking points for each stakeholder with whom you will communicate. You can

use the talking points to formulate your communications strategy. As you do

so, consider the following:

Create talking points that link actions in your proposal to the interests ofother stakeholders that those actions will satisfy.

Make explicit how proposal components satisfy each stakeholder’s specific

needs.

Talking Points

Based on your financial analysis and the interests of Best Practices, determine

your final recommendation.

You have compiled the packages of actions that you believe most effectively

satisfy Best Practices’ interests. In anticipation of your presentation, you now

must test your actions against your financial analysis to consider and calculate

any economic impact your packages of actions might have, particularly in

equalizing the PVs of leasing and purchasing. Consider the following questions:

1. Based on the outcome of the analysis (from Task 2-2), what would you

recommend to the partners? Why?

2.

Does your recommendation differ from your initial analysis (from Task 2-

1)? Why or why not?

3. Review the impact on the financial statements that you completed in Task

2-1, Question 2. What has changed? Why?

4. What actions or modifications (that you brainstormed) would you propose

to the partners to equalize the costs of the leasing and purchasing

alternatives?

End of task

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Answer Section

Answers for this analysis are provided within the Excel workbooks Case Study 2

Part 1Solutions.xlsm and Case Study 2 Part 2Solutions.xlsm found on the CD-

ROM.

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Task 2-1: Initial Interests and Economic Analyses

1.

Based solely on your economic analysis, without any change in the

proposed purchase or lease terms, which alternative would you initially

recommend? Why?

The present cost of occupancy (NPV) calculation indicates that the net

present value of the purchase alternative ( 4.3 million in present cost of

occupancy) is more favorab le than the lease alternative ( 4.6 Million in

present cost of occupancy).

In addition, the internal rate of return

of the differential cash flows of 8.83

percent is higher than the user’s discount rate of 8 percent, indicating that

the purchase alternative is favorable as compared to their opportunity cost

or discount rate. In other words, Best Practices, LLC will receive a higher

return on the differential dollars invested in the purchase alternative (8.83

percent) than in their current opportunity cost (8.0 percent).

Also, in reviewing the sale price sensitivity, the annual growth rate 0.82

percent (less than 1 percent) on the surface (without knowing historic

growth trends in this submarket) seems to be a reasonable growth rate that

could be exceeded. In other words, if the annual growth rate (growth of the

purchase price to the future sale price) of 0.82 percent is met, the cost of

purchasing and leasing is the same; however, if we feel that the annual

growth rate of 0.82 percent will be exceeded, then purchase alternative is

more favorable – the more we feel the growth rate will be exceeded, the

more favorable we feel the purchase alternative.

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2.

How will Best Practices’ GAAP financial statements be impacted?

a.

Is the lease a capital lease or an operating lease?

It is a capital lease.

The fair market value of the leased space is 9,000,000, and the FASB

defined threshold to determine whether the lease is a capital lease is 90

percen t of the fair market value, or 8,100,000.

The present value of the m inimum net lease payments discounted at the

u

ser’s

incremental borrowing rate of 6.5 percent is 8,133,206, which is

greater than the threshold, therefore classifying the lease as a capital

lease.

b.

For the lease alternative:

i.

What is the income statement impact?

Since Best Practices, LLC uses generally accepted accounting

principles (GAAP) in preparing their audited financial statements,

a net rent expense of 760,406 per year would be recognized. Even

though the rent begins in year one at 675,000 and increases 8

percen t each five years reaching 850,306 during the last five years

of the lease term, the twenty years of net rent is averaged to derive

the average annual effective net rent of 760,405.

ii.


Since this is classified as a capital lease, the discounted present

value of the lease is entered as both an asset and as a liability on

Best Practices’ balance statement. The net rent cash flows, are

discounted at the user’s incremental borrowing rate

.

The capital lease asset and liability are amortized similar to a

mortgage. The amortized portions of the lease payments are

classified on the financial statements as interest, and the

―principal‖ portion is accounted for as cost recovery amortization.

The ―principal‖ amortization portion reduces the outstanding

balance of the capital lease liability on Best Practices’ balance

statement.

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The terms of the lease are reported as a footnote to the financial

statements.

c. For the purchase alternative:

i. What is the income statement impact?

Best Practices income statement would include a) cost recovery of

169,164 in the first and last year of ownersh ip, and 176,531 for

years two though 19; b) an interest expense for each year of

ownersh ip, c) loan costs of 135,000 amortized over the 20-year

term of the loan, or 6,750 per year, and d) the gain recognized

once the property is sold.

ii. What is the balance sheet impact?

There would be a reduction in cash equal to the amount of cash

needed to m ake the acquisition.

The acquisition basis allocated as land and building improvements

would be added the year of acquisition, and the improvements

would be reduced annually equal to the cost recovery taken that

year.

The 135,000 in loan costs would be added as an asset, then

amortized over the 20-year term of the loan.

The mortgage of 6,750,000 used to acquire the property would be

added as a liability the year of acquisition, and reduced each year

equal to the principal amortization that year.

At the year of disposition, the land and improvement assets would

be eliminated, as would be any unam ortized loan costs. The loan

balance would be paid off. The sales proceeds would increase the

cash on the balance statement.

3. How would each alternative (lease or purchase) impact the practice’s cash

flow?

Lease cash flows after tax would be about 439,000 in year one.

Purchase cash flows after tax would be about 391,000 in year one, saving

more than 48,000 in year one, however, almost 2.6 million in cash would

be needed to acqu ire the property.

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Task 2-2: Update Your Interests and Financial Analyses

1. Compare the after tax present values of the leasing and purchasing

alternatives.

Present value of leasing: 4,314,768

Present value of purchasing: 3,916,919

Which alternative is best? Why?

Purchasing is the best alternative because the present cost of occupancy of

3,916,919 is cheaper than the present cost of leasing of 4,314,768.

2. Generate the internal rate of return of the differential between leasing and

purchasing. What does this mean?

The internal rate of return of the differential between leasing and

purchasing is 8.95 percent which is higher than Best Practices’ after tax

weighted average cost of capital of 8 percent. This means that Best Practices

will earn a higher return on the differential capital invested in the purchase

alternative than their opportunity cost.

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3. At what discount rate would the costs of leasing and purchasing be equal?

8.95 percent

4. If Best Practices’ after-tax weighted average cost of capital was 10 percent,

what would you recommend to the partners?

They should lease, because they would be better off using the capital

needed for the purchase in their business – or other opportunities they have

generating 10 percent.

5.

What is the relationship between the internal rate of return of the

differential and the discount rate?

The internal rate of return of the differential is generated from the cash of

ownership less the cash flows of leasing. The internal rate of return of the

differential is the yield on the additional capital required for the purchase

alternative.

The discount rate may be derived by calculating the users weighted average

cost of capital typically for corporate users) or by calculating the user’s

borrowing rate (typically for individual users).

The internal rate of return of the differential is compared to the user’s

discount rate in making occupancy decisions.

6. At what future sale price would the costs of leasing and purchasing become equal?

10,111,000

7. What is the necessary annual growth rate of the property value to make the

costs of leasing and purchasing equal?

0.78 percent annual growth rate

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Case Objectives .................................................. 11.1

Case Study 3: Lease Buyout ..................... 11.3

Case Setup .......................................................... 11.3

Task 3-1: Review Interests Analysis .................. 11.4 Task 3-2: Determine the Present Value of the

Owner‟s Current Position .................................. 11.5

Task 3-3: Determine the Present Value of theOwner‟s Worst -Case Scenario .......................... 11.6

Task 3-4: Establish the Owner‟s MinimumBuyout Price ....................................................... 11.7

Task 3-5: Determine the Present Value of theTenant‟s Current Position ................................. 11.8

Task 3-6: Determine the Negotiating Range ..... 11.9

Task 3-7: Develop a List of Possible Actions . 11.10

Task 3-8: Identify Fighting Alternatives ......... 11.13

Task 3-9: Negotiate .......................................... 11.14

Task 3-10: Post-Negotiation Discussion ........ 11.18

Answer Section ..................................... 11.19

Task 3-1: Review Interests Analysis ............... 11.20

Task 3-2: Determine the Present Value of theOwner‟s Current Position ................................ 11.20

Case Study 3:Lease Buyout

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Task 3-3: Determine the Present Value of the Worst-Case Scenario ....................................... 11.20

Task 3-4: Establish the Owner‟s MinimumBuyout Price ..................................................... 11.20

Task 3-5: Determine the Present Value of theTenant‟s Current Position ............................... 11.21

Task 3-6: Determine the Negotiating Range.. 11.21

Task 3-7: Determine a List of Possible Actions .............................................................. 11.21

Task 3-8: Identify Fighting Alternatives ......... 11.21

Task 3-9: Negotiate ......................................... 11.21

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Case Study 3: Lease Buyout

Case Study Overview

This case study covers the lease buyout analysis process for a major tenant that

wants to buy out the remainder of its lease. It includes a buyout negotiation

between the building owner and the tenant based on the owner‟s minimum and

the tenant‟s maximum buyout price.

This case study uses present value (PV) techniques to evaluate the existing

lease‟s worth as well as the est imated value of the best-, most-likely, and worst-

case scenarios for the buyout. It looks at the situation from both the owner‟s

and the tenant‟s point of view.

The five major components to this case study are

Review the stakeholders‟ interests analysis

Complete the financial analysis

Develop action steps

Identify fighting alternatives

Conduct successful interest-based negotiation

Case Objectives

Apply all three phases of the CCIM Interest-Based Negotiations Model.

Calculate the PV of the lease contract as is, and perform the same

calculations for different scenarios.

Use the PVs to determine a recommended buyout price range.

Analyze and quantify the tenant‟s obligation under the existing lease.

Prepare for and complete a buyout negotiation.

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NOTES

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Case Study 3: Lease Buyout

Case Setup

You are the trusted asset manager for an astute investor, George Lu, whose realestate investment portfolio includes a 24,000 square foot (sf)

warehouse/showroom through his LLC, Lu‟s Investments. A credit corporate

tenant, Accent Manufacturing Inc. (AMI) leases the building. Although eight

years remain on the 20-year lease, the Chief Executive Officer (CEO) of AMI,

Bob Roberts Jr., called his long-time friend George Lu and requested to be

released from the lease. Bob confides that AMI may be acquired by a larger

company and that AMI‟s operations in George‟s building would be

consolidated into one of the acquiring company‟s locations.

As subleasing is not allowed under the lease terms, AMI‟s only exit option is tobuy out of the lease. “I don‟t want to soak a friend, but in this economy, every

dollar counts,” George tells you. “Get me as much as you can, but do it fast. If

we‟re going to get a comparable tenant, I don‟t want to wait. I don‟t think I

should bear this kind of risk just to help a friend. If the economy slips further,

I could be in for a long wait to land a top-notch tenant, and I might have to

really drop the rent. Plus, I don‟t want to come out of pocket to make

improvements for a new tenant. AMI has got to get all of their custom

equipment out of there and leave the building as it was before they moved in.”

As you lea ve George‟s office, he says, “One more thing. I can‟t stand some of

Bob‟s people at AMI. I wouldn‟t mind having a tenant whose senior peopledon‟t whine about everything.”

Based on your previous interactions with AMI, you understand George‟s

concern. AMI constantly asks for “just a little favor,” and those little favors add

up, especially when you factor in the headache of dealing with a whiny tenant.

You recall that the original lease negotiation 12 years ago was contentious. It

seemed that they negotiated every paragraph of the lease document. You

remember that George said they kept “nibbling” on him.

You call Will Cruz, AMI‟s chief operating officer (COO), to learn more about

AMI‟s motivations to get out of the lease. Will tells you that his compa ny is

exploring acquisition and that it‟s still “hush-hush.” Toward the end of your

conversation, Will offers whatever help AMI can provide to locate a new

tenant. “I know we haven‟t always been the most cooperative in the past,” Will

admits. “I will personally make sure we do whatever we can to help.

Terminating this lease is important to the company.”

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Task 3-1: Review Interests Analysis

Who is involved in this scenario, and what do they need? Using the

information provided in the case study setup, stakeholders, interests, and issues

are summarized in the following Interests Chart.

Remember, to develop any interest chart:

1. Identify the stakeholders and place the primary stakeholder first on the

interest chart.

2. Note primary stakeholders, and identify them by placing an asterisk next

to each.

3. Identify all issues, and place them on the chart. To ensure that none are

missed, it is helpful to list each stakeholder and their issues separately.

4. For each issue, work horizontally across the chart, and list each

stakeholder‟s interests as they relate to that issue.

5. Determine each issue‟s level of importance. Underline critical issues.

George Lu AMI

George’s relationship with Bob Jr. SUPERFICIAL GOOD

Timing of buyoutASAP ASAP

Whether to do the buyoutDEPENDS YES

Relationship with tenantNO HEADACHES N A

Prospective tenant STRONG CREDIT N/A

RiskAVOID ??

Constant nibblingEND EXPLOIT

New tenant improvementsAMI PAYS

LU P YS

Buyout priceMAXIMIZE

MINIMIZE

Only two stakeholders are listed. Do you think Will Cruz should be included

in this chart? Why/why not? Are any other stakeholders involved at this point?

As you move forward in the case study, you may come across other influentialstakeholders, but at the onset of our analysis, we will focus on the two main

stakeholders.

End of task

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Task 3-2: Determine the Present Value of the Owner’s

Current Position

Using the following worksheet, calculate the PV of the owner‟s position with the

existing lease in place. Calculate it annually using the following assumptions:

General Assumptions

Owner‟s opportunity cost: 12 percent

Existing Lease

Lease size: 24,000 sf of rentable space.

Lease term: Eight years remaining on an original 20-year lease

Current base rent: $20,000 per month with no future escalation

Tenant „s portion of fixed expenses: $1,500 per month

Tenant‟s variable expenses: $2,500 per month

Owner‟s portion of fixed expenses: $1,000 per month

Fixed and variable expenses are expected to increase 3 percent annually.

Subleasing is not allowed.

Owner’s Position with Existing Lease Worksheet

EOY Rent Expenses = NOI

1 − =

2 − =

3 − =

4 − =

5 − =

6 − =

7 − =

8 − =

NPV @ 12% =

End of task

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Worst-Case Scenario

Based on your knowledge of the market, you inform the owner that the best-,

most-likely, and worst-case scenarios for the building, if vacant, are as follows:

Best case:

It will take six months to re-lease the building at $12 per square

foot (psf) with a 2 percent annual escalation in rent and the same allocation

and escalation of operating expenses as projected in the existing lease.

Most likely case: It will take one year to re-lease the building at $10 psf with

a 1 percent annual escalation in rent and the same allocation and escalation

of operating expenses as projected in the existing lease.

Worst case: It will take three years to re-lease the space at $8 psf with no

escalation in rent and the same allocation and escalation of operating

expenses as projected in the existing lease.

The owner agrees with your market assumptions, but wants to take a

conservative approach and asks you to use the worst-case scenario in developing

your recommendation of a minimum buyout price to accept from the tenant.

Use the following worksheet to calculate the PV of the worst-case scenario.

Worksheet for Task 3-3


1 − =

2 − =

3 − =

4 − =

5 − =

6 − =

7 − =

8 − =

NPV @ 12% =

End of task

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Task 3-4: Establish the Owner’s Minimum Buyout Price

Calculate the minimum buyout price you will recommend to the owner.

PV of current position

− PV of worst-case scenario

Recommended minimum buyout price

End of task

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Task 3-5: Determine the Present Value of the Tenant’s

Current Position

As the asset manager representing the owner in the lease buyout negotiations, it

would be helpful to know the maximum buyout cost the tenant could pay and

remain in the same liability position. The tenant‟s cost of capital is 9 percent.

Calculate the PV cost of the tenant‟s remaining obligation under the lease term.

Assume that the tenant vacates the space immediately, and although they will

continue to pay their rent obligation and fixed expenses, they will not have to

pay the variable expenses. Use the lease assumptions from Task 3-1 and the

following worksheet to determine the present value at 9 percent.


EOY Rent Fixed Expenses = Annual Cost

1 + =2 + =

3 + =

4 + =

5 + =

6 + =

7 + =

8 + =

NPV @ 9% =

End of task

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Task 3-6: Determine the Negotiating Range

From your analysis, you have established the owner‟s minimum and the

tenant‟s maximum buyout prices. Quantify the negotiating range for the buyout

using the following model:

Tenant’s maximum price

− Owner’s minimum price

Negotiating range

End of task

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Task 3-7: Develop a List of Possible Actions

Based on your knowledge of the economic impacts of the lease buyout, you

brainstorm a list of actions that you think will effectively satisfy the interests of

George and/or the interests of AMI. Notice that each action satisfies an issue of

at least one stakeholder.

Review the list of actions, and then add any missing actions. To brainstorm

new actions, review each issue in the interests analysis chart, and create

potential actions that satisfy each issue. (Ignore for now the columns headed

GL and AMI.)

List of Possible Actions

Action GL AMI Comments

Keep George and Bob out of contentious

negotiations

Check in regularly with George and Bob

Take less money in deference to friendship

Close the deal within 30 days

Close the deal when a new tenant located

Coordinate the search for a new credit tenant

Document agreement in bullet points first

Confirm interim understandings with e-mails

AMI pays for new tenant improvements (TIs)

George pays for new TIs

Identify current market rents and lease terms

Compute best, most likely, and worst case re-leasing

economic scenarios

Within your groups, determine whether each action harms or helps each

stakeholder.

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Talking Points

Using the evaluation of possible actions against respective stakeholder interests,

a preliminary set of talking points for George Lu was created. Talking points

represent the highlights of a best-case proposal that meets the needs of your

own and your negotiating partner‟s situation.

Talking Points for George Lu

Introduction

The introduction should

Propose a framework for an ongoing, mutually beneficial relationship.

Bring substantial value to all involved and promote a cooperative

relationship.

Focus on common interests and address shared goals. Cover the most important elements of the business relationship.

Objectives

George‟s objectives are

Avoid: Risk

Superficial: George‟s relationship with Bob Jr.

No headaches: Relationship with tenant

Strong credit: Prospective tenant

End: Constant nibbling

AMI pays: New TIs

Specific Actions

AMI pays for new TIs.

Check in regularly with George and Bob, which satisfies the objectives to

maintain George‟s relationship with Bob, maintain the relationship with

AMI, and end constant nibbling.

Close the deal when a new tenant is located. ( Note

: This action harms the

ASAP: Timing of buyout objective.)

Confirm interim understandings with e-mails that satisfy the objective to end

the constant nibbling.

Coordinate the search for a new credit tenant, which satisfies the objectives

to avoid risk and obtain a strong credit tenant.

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Document the agreement in bullet points first, which satisfies the objective

to end constant nibbling.

Keep George and Bob out of contentious negotiations that satisfy the

objectives to maintain George‟s relationship with Bob, maintain the

relationship with AMI, and end constant nibbling.

Conclusion

The conclusion should reiterate how George‟s critical and important interests

will be satisfied. Invite his feedback and suggestions on how to improve the

proposal and better satisfy common interests. Tell him that you look forward

to discussing further specifics about how to move the business relationship

forward.

End of task

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Task 3-8: Identify Fighting Alternatives

Fighting alternatives are those things stakeholders will do to satisfy their interests

or potentially harm the interests of other stakeholders if no agreement is

negotiated (sometimes referred to as the consequence of no agreement). These

may or may not happen, but you must predict the likelihood that a givenfighting alternative, if attempted, actually will occur.

While the fighting alternatives are Step 3, they occur iteratively with Step 2.

Even though they may not occur, they must be considered prior to developing

the negotiation proposal.

Use the table below to organize the fighting alternatives in this scenario. For

each fighting alternative, identify the associated stakeholder.

Fighting Alternative Stakeholder

End of task

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Task 3-9: Negotiate

You now will be given the authority to negotiate a lease buyout in a role as

either:

Trusted advisor of George Lu

or

Corporate real estate negotiator for AMI

You will receive some private information that defines your role as a

representative for one of the two parties. Based on the information

provided:

1. Update your Interests Chart accordingly.

2. Expand your list of possible action steps, and evaluate them based on

whether or not they harm or satisfy your stakeholder.

3.

Update your talking points.

4.

Revisit and update your fighting alternatives as needed.

5. Negotiate.

Update Your Interests Chart

Based on the new information you received, update the interest chart for this

case.

George Lu AMI

George’s relationship

with Bob Jr. SUPERFICIAL GOOD

Timing of buyoutASAP ASAP

Whether to do the

buyout DEPENDS YES

Relationship with

tenant NO HEADACHES N A

Prospective tenantSTRONG CREDIT N/A

RiskAVOID ??

Constant nibblingEND EXPLOIT

New tenant

improvements AMI PAYS

LU P YS

Buyout priceMAXIMIZE

MINIMIZE

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Expand the List of Action Steps and Create Talking Points

Expand the list of possible actions from Task 3-7 to include any new actions

you devise. Evaluate the new actions in the same manner that you evaluated the

actions in Task 3-7. Do you think the action would satisfy or harm the interests

of each of the stakeholders?

List of Possible Actions

Action GL AMI Comments

Keep George and Bob out of contentious

negotiations

Check in regularly with George and Bob

Take less money in deference to friendship

Close the deal within 30 days

Close the deal when a new tenant located

Coordinate the search for a new credit

tenant

Document agreement in bullet points first

Confirm interim understandings with e-

mails

AMI pays for new tenant improvements

(TIs)

George pays for new TIs

Identify current market rents and lease

terms

Compute best, most likely, and worst case

re-leasing economic scenarios

After evaluating the new actions, select those you would include in a best-case

proposal that you will communicate to your negotiating partner to start

negotiations. Develop your talking points accordingly. Use the information

about which actions will harm or satisfy each stakeholder‟s interests to develop

key talking points for communicating with that stakeholder. Use the following

template to organize your talking points.

Talking Points for

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<stakeholder>

Introduction

This section provides some language you may find useful in initiating your

presentation. The intent is to emphasize that this is an interest-based proposal

taking into account all parties‟ needs and goals.

Propose a framework for an ongoing, mutually beneficial relationship.

Bring substantial value to all involved, and promote a cooperative

relationship.

Focus on common interest, and address shared goals.


Objectives

Stakeholder objectives are derived directly from the critical stakeholder‟s issues

and interests. In this example, one of the issues is the buyout price. AMI‟s

interest (or objective) is to minimize the buyout price, whereas George‟s is to

maximize buyout price.

Specific Actions

This list of actions results from evaluating the actions against each stakeholder‟s

critical interests. The goal is to propose a package of actions that satisfies the

critical interests of the largest number of stakeholders possible.

Conclusion

The conclusion should reiterate how the stakeholder‟s critical and important

interests will be satisfied. Invite his feedback and suggestions on how to

improve the proposal and better satisfy common interests. Tell him that you

look forward to discussing further specifics about how to move the business

relationship forward.

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Update Fighting Alternatives

Based on the additional information you received about your client, update

your list of fighting alternatives. Include the percentage likelihood of the

fighting alternative occurring.

Fighting Alternative Stakeholder % Probability

Negotiate

Your initial objective for this meeting is to ask questions and identify or confirm

the other party‟s needs. In doing so, you must arrive at an agreement that

satisfies the stakeholders‟ interests.

Remember that your objective is to find creative ways to satisfy the other party‟s

needs so you can satisfy your own or your client‟s needs.

End of task

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Task 3-10: Post-Negotiation Discussion

After completing your negotiation, be prepared to debrief your client by using

the following discussion guidelines:

Did you reach a satisfactory agreement?

How did your solution meet your stakeholder‟s interests?

How did your solution meet the other party‟s interests?

What would you have done differently to achieve a more satisfactory

outcome?

End of task

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Answer Section

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Task 3-1: Review Interests Analysis

Answers will vary.


Current Position

Owner’s Position with Existing Lease Worksheet


1 240,000 − 12,000 = 228,000

2 240,000 − 12,360 = 227,640

3 240,000 − 12,731 = 227,269

4 240,000 − 13,113 = 226,887

5 240,000

− 13,506 = 226,494

6 240,000 − 13,911 = 226,089

7 240,000 − 14,329 = 225,671

8 240,000 − 14,758 = 225,242

NPV @ 12% = 1,127,117

Task 3-3: Determine the Present Value of the Worst-

Case Scenario



1 0 − 30,000 = ( 30,000)

2 0 − 30,900 = ( 30,900)

3 0 − 31,827 = ( 31,827)

4 192,000 − 13,113 = 178,887

5 192,000 − 13,506 = 178,494

6 192,000 − 13,912 = 178,088

7 192,000 − 14,329 = 177,671

8192,00

0

− 14,759

=177,241

NPV @ 12% = 383,074

Task 3-4: Establish the Owner’s Minimum Buyout Price

PV of current position 1,127,117

− PV of worst-case scenario 383,074

Recommended minimum buyout price 744,043

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Task 3-5: Determine the Present Value of the Tenant’s

Current Position Worksheet for Task 3-5

EOY Rent Fixed Expenses = Annual Cost

1240,000

+18,000

=258,000

2 240,000 + 18,540 = 258,540

3 240,000 + 19,096 = 259,096

4 240,000 + 19,669 = 259,669

5 240,000 + 20,259 = 260,259

6 240,000 + 20,867 = 260,867

7 240,000 + 21,493 = 261,493

8 240,000 + 22,138 = 262,138

NPV @ 9% = 1,437,632

Task 3-6: Determine the Negotiating Range

Tenant’s maximum price 1,437,632

− Owner’s minimum price 744,043

Negotiating range 693,589

Task 3-7: Determine a List of Possible Actions

Answers will vary.

Task 3-8: Identify Fighting Alternatives

Fighting Alternative Stakeholder

Declare bankruptcy AMI

Refuse to pay rent AMI

Spread rumors about AMI Lu

on’t allow buyout Lu

Task 3-9: Negotiate

Talking Points for AMI

Objectives

Good: George‟s relationship with Bob Jr.

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ASAP: Timing of buyout

Minimize: Buyout price

Specific Actions

Close deal within 30 days, which satisfies the timing of buyout objective.


objective to maintain the relationship between the two.

Take less m oney in deference to friendship, which satisfies the objective to

maintain the relationship between George and Bob as well as minimizes the

buyout price.

Talking Points for George Lu

Objectives

Avoid: Risk

Superficial: George‟s relationship with Bob Jr.

No headaches: Relationship with tenant

Strong credit: Prospec tive tenant

End: Constant nibbling

AMI pays: New TIs

Specific Actions

AMI pays for new T Is.

Check in regularly with George and Bob, which satisfies the objectives to

maintain George‟s relationship with Bob maintain the relationship with

AMI, and end constant nibbling.

Close the deal when a new tenant is located. Warning: This action harms

the following interest: ASAP: Timing of buyout.)

Confirm interim understandings with e-mails that satisfy the objective to end

constant nibbling.

Coordinate the search for a new credit tenant, which satisfies the objectives

to avoid risk and obtain a strong credit tenant.

Document the agreement in bullet points first, which satisfies the objective

to end constant nibbling.


objectives to maintain George‟s relationship with Bob maintain the

relationship with AM I, and end constant nibbling.

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Case Objectives .................................................. 12.1

Case Study 4: Sale Leaseback .................. 12.2

Case Setup .......................................................... 12.2

Task 4-1: User Analysis ..................................... 12.5 Task 4-2: Investor Analysis ................................ 12.6

Answer Section ....................................... 12.7

Task 4-1: User Analysis ..................................... 12.8

Task 4-2: Investor Analysis ............................. 12.10

Case Study 4:Sale Leaseback

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Case Study 4: Sale Leaseback

Case Study Overview

This case study analyzes the sale-leaseback transaction from both the user’s and

the investor’s perspectives. Various measures from the user’s perspective are

compared to determine the best alternative for continued occupancy.

In this case study, the user is occupying a property that it owns, and the two

alternatives analyzed for continued occupancy are continue to own and sell and

lease back. This case study explores various investment performance measures

from the investor’s perspective to determine if they meet the investor’s

minimum criteria.

Case Objectives

Determine the net present value (NPV) of the continue-to-own alternative

from a user’s perspective.

Determine the NPV of the sale-leaseback alternative from a user’s

perspective.

Determine the sale price at the end of the holding period of the continue-

to-own alternative that would make the two alternatives equal from a user’s

perspective.

Determine the after-tax cost of the funds that could be raised from the sale

leaseback by calculating the internal rate of return (IRR) of the differential

cash flows from a user’s perspective.

Determine the investment base for the continue-to own-alternative from the

user’s perspective.

Determine return on investment from the continue-to-own alternative by

calculating the IRR of the differential cash flo ws from a user’s perspective.

Integrate generally accepted accounting principles (GAAP) requirementsinto the economic analysis from a user’s perspective.

Determine the acquisition capitalization rate from an investor’s perspective.

Determine the before-ta x cash on cash from an investor’s perspective.

Determine the before-tax IRR from an investor’s perspective.

Determine the after-tax IRR from an investor’s perspective.

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Case Study 4: Sale Leaseback

Case Setup

Under the leadership of Chief Executive Officer (CEO) Alan B. Allen, Acme

Enterprises Inc. (“AEI”), an agri-business company with annual sales in excess

of $250,000,000, owns a 40,000 square foot (sf) office building that is being

used as its corporate home office. They have been in business for more than

40 years, and their Moody’s credit rating is A1.

Alan was brought in from a competing firm eight years ago to grow the business,

and he has increased revenues by 20 percent per year for the last five years.

Now the board of directors is encouraging him to expand into organic farming

support. Research and development (R&D) for their new products is

producing several promising concepts, but so far these products are just in theconceptual stage.

Tim Newman, head of R&D, is a well-known researcher and consultant, and

also teaches at the Agribusiness School at the University of California, Davis.

His decision to join private industry was driven primarily by his belief in the

potential of AEI. He feels strongly that the company can become an industry

leader in innovation in an area that generally has been slow to change. Tim was

given a position on the executive team and has the respect of the board.

AEI’s corporate structure is closely held, with 80 percent of the shares

concentrated in the hands of five stockholders. These shareholders serve as theboard of directors and have been with the company since shortly after its

inception. They are excited about moving into organic farming due to its profit

potential and the prestige the company would receive for being known as an

innovator. John Miller, one of the original founders, articulated the board’s

feelings when he told Tim Newman, “You know, as farmers, we traditionally

have been pretty conservative in our farming practices. While this new

direction is risky, we’re nervous, but excited about the potential to be on the

leading edge of 21st century farming. In addition to being extremely profitable,

we would like to be seen as creating a legacy.”

Alan, Tim, and the stockholders generally agree that they will need funding to

expand their business. Additionally, the original shareholders would like to

enjoy the fruit of their labors.

AEI purchased this building seven years ago for $5,000,000 cash, as well as

$100,000 in acquisition costs. The building has never been encumbered with

debt financing. The original allocation for improvements was 75 percent. The

useful life for cost recovery was 39 years. AEI acquired the property on the first

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day of the tax year and used midmonth convention for the cost recovery

deduction for the first year of ownership.

The company still has a long-term need for the facility, but the chief financial

officer (CFO) is considering using the property to raise capital to expand their

core business. The company needs an analysis performed to help it determine

the impact of a sale leaseback on their cost of occupancy for the next 15 years,as well as the impact on their financial statements under GAAP accounting

rules.

Based on the following assumptions, perform this analysis for the user and the

investor. Generate the solutions for this case using the Sale-Leaseback

Spreadsheet.

User Analysis Assumptions

Corporate tax rate for all sources of income, including capital gains and cost

recovery recapture: 34 percent

AEI’s after-tax weighted average cost of capital: 8 percent

AEI’s incremental borrowing rate: 6.5 percent

Sale price if sold today: $7,000,000

Cost of sale if sold today: 3 percent

Annual growth rate forecast in value for the next 15 years: 2 percent

(Round the forecast sale price to the nearest thousand.)

End of year (EOY) 15 cost of sale: 3 percent Leaseback terms: 15-year absolute net lease with annual lease payments

payable at the end of the year

Years one through five lease payments: based on a 8 percent cap rate of the

sale price

Years six through 10 lease payments: escalated with a one-time increase of

10 percent

Years 11 through 15 lease payments: escalated with a one-time increase of

10 percent

Investor Analysis Assumptions

Before-tax reinvestment rate: 10 percent

After-tax reinvestment rate: 6.5 percent

Tax rate for ordinary income: 35 percent

Tax rate for capital gain: 15 percent

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Tax rate for cost recovery recapture: 25 percent





Midmonth convention for cost recovery will be used for the years of

acquisition and disposition.

Acquisition occurs on the first day of the tax year, and disposition occurs on

the last day of the tax year.

The net operating income (NOI) for year 16 is forecast to be 10 percent

greater than the year 15 NOI. This forecast assumes that a 10 percent

increase in rents every five years under the lease terms is realistic in the

market.

Disposition cap rate applied to year 16 NOI: 8.5 percent (Round the

projected sale price to the nearest thousand, and use $8,769,000 for the

disposition price.)

Disposition cost of sale: 3 percent

Maximum loan-to-value (LTV) ratio: 75 percent

Minimum debt-service coverage ratio (DSCR): 1.20

Interest rate on loan: 8 percent


Loan term: 25 years

Loan payments per year: 12

Loan costs: 2 percent of the loan amount

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C a s e S t u d y 4

Task 4-1: User Analysis

Generate the solutions for this task using the Excel worksheet on your CD-

ROM, and then answer the following questions:

1.

What is the net present value of the continue-to-own alternative?

2.

What is the net present value of the sale-leaseback alternative?

3.

What sale price at the end of the holding period of the continue-to-own

alternative would make the two alternatives equal?

4.

After calculating the internal rate of return of the differential cash flows,

what is the after-tax cost of the funds that could be raised from the sale

leaseback?

5.

What is the present value of the lease payments discounted at the user’s

incremental borrowing rate?

6. Is the proposed leaseback an operating lease or a capital lease?

7. What is the sale leaseback’s annual impact on the income statement?

8.

How much would the stockholder’s equity be improved by the sale

leaseback?

End of task

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Task 4-2: Investor Analysis

Answer these questions using the information provided.

1. What is the maximum loan amount available to acquire the property?

2.

What is the acquisition cap rate?

3. What is the before-tax cash on cash?

4. What is the before-tax internal rate of return?

5. What is the after-tax internal rate of return?

6. What is the after-tax capital accumulation?

End of task

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Answer Section

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Task 4-1: User Analysis

1.

What is the net present value of the continue-to-own alternative?

2,502,550

2.

What is the net present value of the sale-leaseback alternative?

2,577,209

3. What sale price at the end of the holding period of the continue-to-own

alternative would make the two alternatives equal?

9,791,000 (rounded to nearest thousand)

4.

After calculating the internal rate of return of the differential cash flows,

what is the after-tax cost of the funds that could be raised from the sale

leaseback?

The internal rate of return of the differential cash flows is 7.86 percent.

NPV comparison summary:

NPV of continue to own: 2,502,550

NPV of sale leaseback: 2,577,209

Assuming the after-tax weighted average cost of capital is known, in this case

8 percent, the alternative that produces the greatest positive financial benefit

is the sale-leaseback. In both alternatives, a positive financial benefit is

created. Based on the assumptions used in this sample problem, the sale-

leaseback alternative produces a positive financial benefit of 2,577,209

compared to 2,502,550 produced by the continue-to-own alternative.

5.

What is the present value of the lease payments discounted at the user’s

incremental borrowing rate?

5,695,698

6. Is the proposed leaseback an operating lease or a capital lease?

Operating lease

7. What is the sale leaseback’s annual impact on the income statement?

( 361,905)

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8.

How much would the stockholder’s equity be improved by the sale

leaseback?

3,935,513

NPV of the continue-to-own alternative $2,502,550

– NPV of the sale-lease alternative 2,577,209

Difference in the NPVs ($74,659)

↓


↓

Sale proceeds after tax (SPAT) adjustment to equalize the NPVs $236,831

+ SPAT adjustment [$236,831 ÷ (1 – 34%) – $236,831] 358,835

Sale proceeds before tax adjustment (SPBT) to equalize the NPVs $358,835

+ Costs of sale on SPBT adjustment [$358,835 ÷ (1– 3%)

– $3,281,103] 369,933

Sale price adjustment needed to equalize the NPVs $369,933


Sale price needed to equalize the NPVs (rounded to the nearest $1,000) $9,791,000

Value today 15 years EOY 10 sale price

$7,000,000 $9,791,000

The annual growth rate in value needed to equalize the NPVs is 2.26 percent.

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Task 4-2: Investor Analysis

1.

What is the maximum loan amount available to acquire the property?

5,038,000

2.

What is the acquisition cap rate?

8 percent

3. What is the before-tax cash on cash?

4.37 percent

4.

What is the before-tax internal rate of return?

10.62 percent

5.

What is the after-tax internal rate of return?

8.65 percent

6. What is the after-tax capital accumulation?

19,714,213

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• 13.1

Index

A

Accrual, 2.10

Analysis process, 7.32

Attorney, 3.7

Acquisition, 3.5, 3.8

Assets, 2.12

B

Balance sheet, 2.12, 7.6

Base rent, 4.2

Buyout Pendalum, 6.12

C

Capital lease, 4.25

Capital market, 1.6

Cash flow statement, 2.7, 7.7

CCIM Approach and Negotiation

Theory, 8.4

Common area maintenance, 3.33

Comparison techniques, 5.8

Contact rent, 6.6

Conventional mortgage financing,

7.27Corporate entities, 2.14

Cost of occupancy, 4.3

D

Discount rate, 2.14

Dissimilar lease, 4.37

Due diligence, 3.33

E

Economic analysis, 4.2, 7.10

Effective rate, 4.2

Effective rent, 4.2

Expense

Pass-throughs, 3.28

Stops, 3.31

F

Fighting alternatives, 8.15

Financial accounting/reporting, 2.4,

4.25, 6.4

Future sales price, 5.25

G

GAAP accounting, 5.34, 7.6, 7.26

Gross-up clause, 3.33

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I

Income statement, 2.10, 7.6

Indexed Leases, 3.26

Interest-based negotiations, 8.6

Interest chart, 8.9

IRR of the Differential Cash Flows

Method, 5.9, 5.29, 7.11, 7.23

Investor analysis, 7.31

L

Landlord, 3.6Lease

Advantages, 5.3

Clause, 3.21

Cost, 4.12

Decisions, 4.7

Disadvantages, 5.4

Multi-period, 4.24

Term, 3.21

Leasehold interests, 6.4

Leasing, 5.3

M

N

Negotiations, 8.3

Net present value method, 5.8,

5.15, 5.22, 7.10, 7.13

O

Occupancy, 3.22

Operating expenses, 3.31

Owner’s leased fee interest, 3.3

Owning, 5.6

Advantages, 5.6

Disadvantages, 5.6

P

Percentage (Overage) Rent, 3.27

Proposals, 3.18

Purchaser, 3.5

Q

Quarterly earnings, 2.11

R

CCIM CI 103

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