Call a Tenant’s Bluff

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In this article, I will explain and apply commercial real estate concepts; using a real-world situation. Through this example, I will demonstrate the critical importance of working with an experienced, commercial real estate broker (especially) when negotiating the terms of a lease agreement. There are many considerations beyond basic economics that impact and govern the tenant/landlord relationship. If your lease is less than 20 pages, you’re doing it wrong (unless you like paying attorneys’ fees). There’s a saying that goes something like, “if it were not for attorneys, the world would not need attorneys.” A simple lease is a weak lease. An agreement that dictates the relationship between two unrelated parties for a period of multiple years benefits neither party if the terms are left ambiguous and open to interpretation. Ambiguity only benefits attorneys because they charge by the hour. By working with a commercial real estate broker (not agent) and particularly a CCIM, you will have access to market data and deal-structuring expertise that will allow you to negotiate effectively and “Call a Tenant’s Bluff.”

In this scenario, my client is the owner of a commercial property that is currently leased to a tenant with less than 6 months left on a 3-year lease. The tenant has a 5-year renewal option at the then market rate; however, it is capped at 106% of the rent in the final year of the lease term. The owner would like to sell the property and will likely realize a higher sales price if it were sold as an investment property (leased) versus vacant. My client sent me the following (paraphrased) message relating a conversation with the existing tenant:

I spoke with the tenant and they are on the fence and are weighing the decision to 1) stay in place and purchase the building, themselves; 2) renew the lease, but for 3 years not 5 years; or 3) move to another building in the same submarket at a far lower rate with 6 months of free rent and a moving & tenant improvement allowance. The tenant suggested I meet with their broker to discuss terms.

My response:

I would like to address the points we discussed over the phone and included in your email and will send a separate email with my recommendation moving forward.

Tenant weighing decision to stay in place and purchase the building

Most renewal options include a timeframe, expressed in months from the lease termination date, by which the tenant must notify the landlord of its intention to renew. Unfortunately, your lease with the existing tenant does not, which allows them to weigh their decision and keep you in limbo. If they are weighing their decision to stay, I would not put much “weight” in their claim that they are considering purchasing the building. If they truly wanted to stay then buying the building would make sense; however, it should be at the market price for the property as the cost of ownership would significantly decrease their costs of occupancy.

Renew for 3 years (not 5 years)

I would not recommend agreeing to anything less than a 5-year lease. When discounting cash flows, investors must apply a cap rate plus a risk premium to the income stream to ascertain its value. Sales data can be used to determine the market rate for a particular asset type, class, etc. but, at the end of the day, the cap rate is a reflection of what each individual investor is willing to pay for each dollar of net operating income. Because there are multiple years of income the investor must also apply a risk premium to the cap rate to account for the potential loss of that income. Discount rates consider a number of risk factors, including but not limited to: length of lease term, single tenant vs. multi-tenant, size of space, cost of reletting space, difficulty in reletting the space, etc. Based on the fact that our property is a 10,000 SF (actual square footage redacted for confidentiality), single-tenant space, most investors would place a significant risk premium on a 3-year lease from an existing tenant because it strongly indicates that they do not intend to stay long-term. Below is a (relatively) hypothetical example of how the risk associated with a 3-year lease could impact the sales price.

5-Year Lease

  • 10,000 SF x $12.00/NNN = $120,000/year net operating income
  • $120,000/year ÷ 6.5% (hypothetical market cap rate) = $1,846,153.85 Sales Price

3-Year Lease (with added risk premium)

  • 10,000 SF x $12.00/NNN = $120,000/year net operating income
  • $120,000/year ÷ 7% (discount rate) = $1,714,285.71 Sales Price

As you can see, a 3-year lease has the potential to lower the investment value of your property by over $131,868.14.

Tenant moving to another building in the same submarket at a far lower rate with 6 months of free rent and a moving & tenant improvement allowance

I would recommend asking for the address of this supposed location. There are so many contradictions within this assertion that I almost don’t know where to start.

Far lower rate

I ran a search for flex spaces in our submarket from 7,500-12,500 SF and have attached a report showing the available options. In addition, I’ve attached an analytics report on all flex properties within our submarket; showing the average market rent to be $13.46/SF ($12.74/SF for available space). The maximum rent we can charge the existing tenant based on our current lease is $12.50/NNN. If they are looking at another submarket then it’s not “nearby” and is not comparable. If they’re looking at straight warehouse/industrial space they can expect to pay a lower rent but not “far lower.” In addition, if the rent is “far lower” that would be because the space is not built out; meaning there is no (significant) showroom/office portion of the space. If there was the landlord would adjust their rental rate accordingly. I originally used a square footage range of 7,500-12,500 SF but after expanding it to 15,000 SF, identified one property to which they may be referring. The space is 14,419 SF (over 30% larger than our space) and they are asking $9.32/NNN. The space is 60% office and has 3 docks. I spoke with the listing broker and they have not seen demand for that much office and are thus pricing it closer to a straight industrial property. For a tenant with good credit that is willing to sign a 5 to 7-year deal they would be in the $7-$10/SF range in terms of a tenant improvement allowance. At their asking rate the annual rent would be $134,385.08 ($14,385.08 more per year than our property at $12.00/NNN).

6 months free

This amount of rental abatement is not market for industrial spaces. Because flex space is a combination of office and warehouse a tenant may expect a slight increase in the number of months of rental abatement but that would be based on the length of the lease term, proportion of office to warehouse, rental rate, etc. A landlord may be willing to provide 6 months free for a 10-year term but not likely for a 5-year and certainly not for a 3-year.

Moving & tenant improvement allowance

How much? Allowances are based on a number of factors; including but not limited to, length of lease term, rental rate, landlord’s pro forma, etc. If they’re paying a “far lower rate” there’s a high likelihood that there will be “far lower” money the landlord is willing to provide for either a moving or improvement allowance. As mentioned previously, if they are truly being offered a “far lower rate” this would likely be because the property is more warehouse than flex and would require a significant build out to make it comparable to your property.


In summation, based on these points along with the list of current, available options I do not believe this to be an accurate claim. They may be able to find a space that has two of the three, if they are willing to sign a longer-term lease, but not all three and not in this submarket.

Not explicitly addressed in my response but a telling an important point is that the tenant suggested that my client speak with their commercial broker; clearly so that they could receive unbiased advice. After all, this is the impartial party whose appraisal of the leasing market is founded on objective data and not on the fact that they only get paid a commission if the tenant moves or if they’re able to convince my client to pay them if they can convince their own client, the tenant, to renew. Just like landlords (can) take advantage of unrepresented tenants’ lack of experience, expertise, and market knowledge the reverse is also true. My client was unrepresented when they originally negotiated the lease with their tenant; resulting in a renewal option without a notice period and in which the rental rate was capped. They also agreed to a 3-year lease term, which is not long enough for it to be a viable investment sale and is too long for the property to be considered by an owner-user. Commercial real estate decisions should not be made in isolation, but rather should be part of a greater strategy based on the client’s goals and plans. Good commercial real estate brokers, particularly CCIMs, have the analytical tools to help clients formulate said plan and the expertise to structure deals in accordance with it.

Herndon Submarket Q4 2019

Herndon

  • RBA: 12,815,207 SF
  • Vacancy Rate: 15.7%
  • 12 Month Net Absorption: 307,000 SF
  • Average Asking Rent: $31.83
  • 12 Month Rent Growth: 2.8%

Herndon is one of the most exciting submarkets in the DC metro, quietly nestled in the shadow of neighboring juggernaut Reston; however, with the delivery of the 2nd phase of the Silver Line in 2020, Herndon is poised for explosive growth. Historically, Herndon has suffered from an “address stigma,” which is more relative (compared to Reston) than objective. Herndon has over 7,600,000 SF of 4 & 5-Star properties many with prominent visibility along the Dulles Toll Rd and Route-28. Rates for these properties increased by a whopping $1.00/SF (2.86%) from last quarter ($35.02/SF to $36.02/SF) and average rents increased by $0.63/SF (2.02%). Even 3-Star properties saw a $0.20/SF increased from last quarter ($25.73/SF to $25.93/SF). On top of that, Herndon’s metro accessible properties command rates higher than the average market rate for both Reston and Tysons Corner. That’s not all.

Herndon has been plagued by high vacancy since Q1 2016 when the submarket saw a 3.7% jump in the rate in one quarter from 12.5% to 16.2%. Vacancy peaked at 18.7% in Q2 2017 and then fell to 14.5% just 3 quarters later (Q1 2018). Just when things were looking up, vacancy again skyrocketed by 3.7% in 2018; ending the year at 18.2%. The submarket’s rollercoaster ride is the result of large-scale move-outs, the most recent being Time Warner Cable vacating 13820 Sunrise Valley Dr in 2018 when it was acquired by Charter Communications. Herndon has endured stormy weather for nearly 4 years; however, recent and significant leasing activity (including at 13820 Sunrise Valley Dr) has brought vacancy back down to 15.7% and should indicate an end to Herndon’s vacancy woes. Projections have rates dropping to 12.1% in the next 12 months likely due to the delivery of the 2nd phase of the Silver Line.

13820 Sunrise Valley Dr Video (1)

Amazon may have chosen National Landing as the site for its HQ2, but its subsidiary Amazon Web Services (also known as Vadata) is quietly making Herndon its unofficial headquarters in the DC metro. On October 4, 2019, AWS purchased 13600 EDS Dr for $54,000,000. The 400,000 SF office building sits on 57.05 acres along Route 28 (the property was assessed at $80,676,490). The company established One Dulles Tower (13200 Woodland Park Rd) as its east coast hub in 2017 when it leased the entire building (403,622 SF). Remember 13820 Sunrise Valley Dr that contributed to the spike in the submarket’s vacancy rate? AWS leased the entire building (268,240 SF) in May of this year.

The reason for all this is Herndon’s strategic location. The submarket provides access to two major north-south and east-west transportation nodes: Route 28 and the Dulles Toll Rd, respectively. Herndon is situated between two of the largest industrial submarkets in the area: Route 28 North and South. Tech giants like AWS are continually building and leasing more data center space and neighboring Loudoun County and the area known as Data Center Alley is home to the largest concentration of data centers in the world. In addition, Amazon’s disruption of the retail industry has directly benefited the industrial market by increasing the need for storage and distribution space as well as last-mile delivery. Herndon’s proximity to over 47,200,000 SF of industrial inventory and Dulles International Airport along with its inventory of 4 & 5-Star properties make it an ideal choice for Amazon and others.

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With the opening of Herndon’s two metro stations (Herndon Station and Innovation Station) next year, the submarket will be immediately connected to Dulles International Airport and the greater DC region by public transit. Reston and Tysons Corner have already begun syphoning demand from closer-in submarkets (Rosslyn-Ballston Corridor) since phase-1 of the Silver Line delivered because of their relative affordability and new supply of trophy, 4 & 5-Star properties. Herndon has similar quality product and is even more affordable.

Considering these recent developments, it should come as no surprise that Herndon led all Virginia submarkets in sales over the last year with almost $1,000,000,000 deployed over the past 3 years. Despite this, Herndon’s average market cap rate (6.3%) is still above the metro and its average sales price per square foot is below that of Reston and Tysons Corner. As a result, Herndon presents a rare opportunity for investors to “buy low” in a submarket in the early stages of a complete transformation. There are more than two dozen projects proposed and in April 2019 the Town of Herndon approved Penzance Properties’ first mixed-use redevelopment at 555 Herndon Pkwy. This project, located right at the new Herndon Metro Station, will include a high-rise office building and two high-rise residential towers. This is just the beginning for Herndon. The combined forces of the Amazon effect, AWS’ growing office and data center needs, and a regional shift in employment growth into the cyber-security, IT, and high-tech fields could see Herndon join the ranks of Reston and Tysons Corner as one of Northern Virginia’s premier office submarkets.

13600 EDS Dr Video (1) (1) (1) (1)

Using the Income Approach to Value Non-Income-Producing Properties

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No one wants to pay more for something than it’s worth; however, determining what something is worth isn’t always straightforward. The difference between market value and investment value can sometimes blur the lines when appraising or assessing real estate, especially for owner-occupied properties. Market value is defined as a property’s likely sales price in an arm’s length transaction (in a competitive and open market) between a buyer and seller, both acting knowledgeably, prudently, and without compulsion. Investment value is unique to each buyer and, as a matter of perspective, it can include tangible and intangible considerations. As a result, when a buyer is purchasing real property for their own use a subjective element is introduced into an otherwise objective (valuation) process.

There are three main valuation methods used to appraise/assess a property’s value: 1) cost approach, 2) direct capitalization approach, and 3) sales comparison approach. The cost approach is primarily used for insurance purposes because only the value of the improvements are insurable. This method calculates the cost to build an equivalent property (minus depreciation) and then adds the value of the land. The direct capitalization approach is used for income-producing properties and calculates value by “capitalizing” (dividing) a property’s net operating income by the appropriate (cap) rate. Cap rates, expressed as a percent, reflect the return an investor is willing to accept for each dollar of NOI based on an all-cash purchase. For example, an investor that is willing to accept a 10% return would be willing to pay $1,000,000 for a property with a net operating income of $100,000 ($100,000 ÷ 10% = $1,000,000). Market cap rates vary based on property type, age, etc. and are calculated through analyses of recent market sales of income producing properties.

The sales comparison approach compares recently sold properties with similar characteristics to the property being valued, including location (within the same building, project, neighborhood, submarket, market, etc.). Price adjustments are made for differences between the sales comps and subject property to determine a value that is consistent with recent market activity (typically within 6 months). This method is most commonly used to value residential properties, both because of the large number of sales (sample size) and due to the fact that owners enjoy beneficial occupancy of the property (not income-producing). Because owner-occupied commercial real estate also provides beneficial occupancy rather than rental income, the sales comparison approach is also commonly used valuation analyses for such acquisitions.

The biggest problem in using the sales comparison approach to value commercial real estate is the issue of sample size. The number of residential properties exceeds that of all commercial properties (office, retail, flex, and industrial combined) by many orders of magnitude. Leasing makes up the overwhelming majority of commercial transactions and, as a result, there may be few, if any, sales to use as a basis of comparison. This is evident in assessed values that remain the same year after year. Assessors use the direct capitalization (income) approach to assess income-producing real estate, but generally use the sales comparison approach when valuing owner-occupied commercial properties. When there are no comparable sales in the year of assessment or other data to support an increase or decrease in a property’s assessed value remains the same. Because assessors often value properties at an assessment-to-sales ratio (ASR) below 100%, many (brokers and laymen, alike) believe that a property’s assessed value reflects the lowest end of the spectrum in terms of market value. As alluded to earlier, this is not necessarily the case and as certain properties, property types, etc. age and become functionally obsolete, the reverse may be true. A lack of comparable sales may indicate that there is no market for a particular property (type) and is likely evidence of a decline in value and in a property (type) being over-assessed.

As the title of this article suggests, there is a way to use the direct capitalization approach to value for owner-occupied properties. As mentioned previously, most residential transactions involve the purchase and sale of real estate, while leasing dominates commercial real estate. As a result, leasing comps are nearly as numerous, on a proportionate basis, in commercial real estate as sales comps are in residential. In order to use the direct capitalization method to calculate the market value of an owner-occupied commercial property, one must perform a hypothetical investment analysis of the subject property using actual market data, rates, etc.; treating it as if it were being purchased as an income-producing property.

Market Analysis

Prospective buyers and/or brokers must first conduct a search for comparable properties that are available for lease. Search parameters such as square footage (range), building age (range), location, etc. should be as narrow as possible. The resulting (short) list of properties should produce an accurate market rent (range) for the property. Rents quoted in triple net terms allow for a quick and easy calculation of net operating income (rental rate x square footage = NOI). Full-service gross leases present more of a challenge and require all costs of ownership (real estate taxes, operating expenses, utilities, cleaning, & insurance) be added together and subtracted from the rental rate on a per square foot basis. The resulting number is the triple net equivalent rent which can then be multiplied by the square footage to calculate the property’s net operating income.

After calculating the subject property’s potential net operating income, more market research and analysis is required to determine the appropriate market cap rate to apply to the income stream. There are a number of sources which provide cap rate information based on submarket, property type, etc.; however, as before, the narrower the focus the more accurate the resulting valuation. Assessors will add basis points to cap rates based on age, vacancy, etc. thereby lowering the value relative to NOI. For example, if the market cap rate for industrial properties in a particular submarket is 7% with average vacancy rate at the time of sale of 50%, a property that is 0% vacant may justify a 0.5% reduction in the cap rate while a property that is 100% vacant may require a 0.5% increase to account for risk. For a property with an NOI of $100,000 the resulting difference in value would be $205,128.21 = ($100,000 ÷ 6.5%) – ($100,000 ÷ 7.5%). Relevant/current data coupled with market knowledge and experience will produce the best, most accurate estimates of value.

Case Study

Ryan Rauner is interested in purchasing 123 Industrial Ave and plans to occupy and use the 25,000 SF property for his storage and distribution business. Due to a lack of comparable sales in the surrounding area, Ryan is having trouble determining how much he should pay for the property. After researching leasing rates for comparable properties within the same submarket, he determines that the market rent is about $10.00-$11.00/NNN; resulting in a potential net operating income of $250,000-$275,000. The current market cap rate for industrial properties in the subject submarket is 7%; however, the submarket’s vacancy rate is slightly about the market average. Ryan knows that investors would likely require a higher rate of return to account for the risk associated with the property’s vacancy and thus adds 1 basis point to the cap rate as a risk premium. He then capitalizes the potential NOI by 8% for a resulting valuation of $3,125,000-$3,437,500.

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Fairfax County Town & City Submarkets Q4 2019

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Fairfax City

  • RBA: 5,054,602 SF
  • Vacancy Rate: 10.9%
  • 12 Month Net Absorption: 24,000 SF
  • Average Asking Rent: $24.72
  • 12 Month Rent Growth: (0.2%)

At slightly over 5,000,000 SF, Fairfax City is 1.78, 2.55, and 2.96 times larger than the McLean, Vienna, and Falls Church submarkets respectively. The vast majority of the submarket is comprised of 3-Star and 1 & 2-Star properties (98%) and the average market rate of $24.72/SF reflects as much. The submarket’s vacancy rate of 10.9% is well below the metro average but this is the result of zero supply side pressure. There have been no significant deliveries since 2007, before the Great Recession, and there are no projects under construction and none proposed in the next 12 months. Low demand is the biggest threat to Fairfax City’s fundamentals. The office inventory is old with an average and median age of 1978 and 1982 respectively and small with an average and median size of 22,872 SF and 13,096 SF respectively). Combined with a lack of metro access the submarket will continue to struggle to attract large tenants. This risk is reflected in the recent sales of WillowWood Plaza I & II (10300 & 10306 Eaton Pl) and WillowWood Plaza III & IV (10302-10304 Eaton Pl), arguably the submarket’s nicest and best located buildings. Buildings I & II sold in June 2018 for $22,300,000 ($91/SF) and were about 50% vacant at the time of sale. Buildings III & IV sold in December 2018 for $32,000,000 ($115/SF) and were 0% and 50.1% vacant at the time of sale respectively. The submarket’s largest tenant, Zeta Associates, occupies the entire building at 10302 Eaton Pl (Building III). Despite having an occupancy level approximately 25% higher, this portfolio sale was only able to achieve a $24/SF higher sales price.

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City of Falls Church

  • RBA: 2,831,871 SF
  • Vacancy Rate: 12.4%
  • 12 Month Net Absorption: (25,400 SF)
  • Average Asking Rent: $25.46
  • 12 Month Rent Growth: 1.4%

Negative net absorption of 25,400 SF led to a 0.9% increase in the submarket’s vacancy rate over the past 12 months. Oddly, this was accompanied by a 1.4% increase in market rents. Even more strange was that this increase came largely from 4 & 5-Star properties ($30.10/SF average rent), which have a vacancy rate of 21.5%. Despite only comprising 17.5% of total office inventory, 4 & 5-Star metrics are heavily influencing the submarket’s fundamentals. Combined, 3-Star and 1 & 2-Star properties have an average market rent of $24.48/SF and vacancy rate of 10.5% versus the submarket’s $25.46/SF and 12.4%. Vacancy rates should remain low due to zero supply side pressure. There are no properties under construction or proposed in the next 12 months. The average & median age of the office inventory is 1962 & 1965 and the average & median size is 14,749 SF & 5,560 SF respectively. As a result of demand trends, Falls Church would benefit from new product, particularly in proximity to the submarket’s lone metro station (East Falls Church). The most significant recent sale was of 6400 & 6402 Arlington Blvd in February 2019. The 410,197 SF project was 26.76% vacant at the time of sale and sold for $38,119,000 ($92.93/SF); reflecting the value-add nature of the sale.

mclean

McLean

  • RBA: 1,708,579 SF
  • Vacancy Rate: 11.2%
  • 12 Month Net Absorption: (40,800 SF)
  • Average Asking Rent: $31.18
  • 12 Month Rent Growth: (0.5%)

McLean was once the central business district of Fairfax County; however, this title was usurped by neighboring Tysons Corner. The submarket’s fundamentals provide a telling picture of the state of office demand in McLean and the greater DC metro, as a whole. Negative net absorption of 40,800 SF led to a 2.4% increase in the submarket’s vacancy rate and a 0.5% drop in market rents, which despite having no 4 & 5-Star properties average $31.18/SF. At $32.82/SF and $28.93/SF, McLean has the highest 3-Star and 1 & 2-Star rents in Fairfax County. With an aging inventory (average/median age of 1977/1980) and no access to metro, McLean’s fundamentals should continue to suffer. The submarket’s one saving grace, zero supply-side pressure, is also the main contributing factor to its lack of demand.  There are no properties under construction or proposed in the next 12 months and with high rents relative to asset quality and demand trends favoring newer product with proximity to metro, tenants will likely look to Tysons Corner for their office needs. Despite this Fairfax County’s Department of Tax Administration considers McLean to be one of the County’s premier submarkets, along with Tysons Corner and Reston. As a result, commercial properties received a 0.5% reduction in their market cap rate; leading to an increase in assessed values even if a property’s net operating income remained the same. The recent sale of 1420 Beverly Rd may cause assessors to reevaluate the submarket’s status. The 46,000 SF building, built in 1985, sold in November 2018 for $12,700,000 ($276/SF) at a 7% cap rate and was fully leased at the time of sale. Another significant sale occurred in December of 2018 when 1313 Dolley Madison Blvd (53,051 SF) sold for $13,000,000 ($245/SF). The property was 13.8% vacant at the time of sale with the most recent lease signed in September 2018 at $32.00/SF full-service.

town of vienna

Town of Vienna

  • RBA: 1,984,657 SF
  • Vacancy Rate: 7.3%
  • 12 Month Net Absorption: (8,200 SF)
  • Average Asking Rent: $28.86
  • 12 Month Rent Growth: 2.0%

Vienna’s total office inventory is fairly, evenly divided between 4 & 5-Star, 3-Star, and 1 & 2-Star properties (634,390 SF, 595,033 SF, and 755,234 SF respectively) as are the rents for each property class with an average of $4.46/SF between them. Despite a 7.3% vacancy rate which decreased by 0.5% over the past 12 months and is nearly half the metro average along with 2% rent growth over the same period, Vienna’s fundamentals are misleading. The true Vienna submarket is located within 2 blocks of Maple Ave (Rt-123) and is comprised solely of 3-Star and 1 & 2-Star properties with an average rent and vacancy rate of $26.64/SF and 10.4% versus the submarket’s $28.86/SF and 7.3%. Vienna’s inventory is old and small, with an average and median age of 43 years (built in 1976) and average and median size of 18,901 SF and 7,200 SF respectively. A total of 3 buildings comprise the submarket’s 634,390 SF of 4 & 5-Star office inventory. One of the three is 1007 Electric Ave, a build-to-suit, headquarters expansion for Navy Federal Credit Union that delivered in 2017 and increased the submarket’s 4 & 5-Star inventory by 37%. This property borders Tysons Corner. The other two, 9300 & 9302 Lee Hwy, are located by the Dunn Loring Metro and I-66’s Nutley St exit and border the Fairfax City submarket. Full building leases for both properties expire in 2022, which could have a tremendous impact on the submarket’s vacancy rate if they remain unleased. That being said, the properties’ proximity to metro coupled with the submarket’s most significant, recent sale may alleviate such concerns. In December 2018, the 41,224 SF 2-Star office building located at 9401 Lee Hwy sold for $9,300,000 ($226/SF) despite its age (built in 1973). This property is even closer to the Fairfax City submarket, notably the new mixed-use development, Scout on the Circle, which will have 83,200 SF of retail space and 400 apartments and was likely purchased as a redevelopment play.

Regular Business Hours

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“Regular Business Hours” is a term used in full-service gross (primarily office) leases and refer to the days and times that a property is open/accessible to the public and during which building services are provided at maximum levels. They are based on and consistent with how and when most office users/businesses operate. In most commercial leases, regular business hours are 8:00am-6:00pm, Monday through Friday, and 9:00am-1:00pm on Saturdays with federally recognized holidays exempted. Office tenants still have access to the property 24 hours a day, 7 days a week, 365 days out of the year; however, some building services may be unavailable or reduced to minimum levels outside regular business hours in order to reduce expenses. Examples of services that may be unavailable at such times can include but are not limited to property management, mail service, access to fitness or conferencing facilities, etc. Elevator service will always be available but may be reduced to one lift during off-hours.

Regular business hours are generally not subject to negotiation, particularly in multi-tenant office buildings where provisions that govern management of the entire property require consistency. For tenants that consistently operate outside regular business hours, there may be the option to have the leased premises separately submetered; however, this may be inefficient, ineffective, or prohibitive from a cost standpoint. Full-building tenants might request changes/extensions to the building’s regular business hours based on their hours of operation; however, this must be done during the proposal/letter of intent stage of negotiations because of the potential impact on operating expenses. Any resulting increase or decrease would need to be factored into the other economic terms of the deal. For the landlord this means increasing the base rent, lowering the amount of rental abatement (if any), and/or lowering the improvement allowance (if any). For tenants it means extracting additional economic concessions equivalent to the landlord’s savings.

The primary purpose of regular business hours is to provide the landlord with a framework to accurately estimate operating expenses and thus their projected rate of return. The primary building service affected by regular business hours is HVAC (heating, ventilation, and air conditioning). Lease language may vary, but landlords are required to maintain comfortable temperature levels during regular business hours (comparable to other office buildings) as part of a tenant’s right to quiet enjoyment. Utilities such as electricity and water are always fully available, but heating and cooling levels are modified during off-hours to lower energy consumption. Landlords do not turn off the heat in the winter or air conditioning in the summer outside regular business hours, but rather lower the minimum temperature and increase the maximum temperature respectively. For example, the HVAC system in an office building may have the temperature/heat set at 70° during regular business hours and at 65° after hours.  Tenants may request the landlord to extend HVAC service beyond regular business hours by providing advance notice and paying the landlord’s hourly rate for such service, which is subject to change. Depending on the tenant’s square footage, this may not be a viable or cost-effective long-term solution.

Most office leases are full-service gross and include all costs of ownership within the base rental rate. Real estate taxes are based on the assessed value of the property and determined by the applicable municipality’s tax rate and are thus outside the landlord’s control. Operating expenses, on the other hand, which include utilities and HVAC present the opportunity for cost savings through efficient management and/or investment in capital improvements such as energy efficient systems. Because the difference between the base rental rate and the costs of ownership equals the landlord’s net profit and landlords are constrained by market rents, they have an interest in minimizing their controllable expenses in order to maximize their profit. Landlords are able to charge tenants for increases in expenses after the first lease year (base year), but acquisitions are based on a property’s projected net operating income and without a consistent, set schedule acting as a control against which to measure expenses (energy consumption), landlord proformas would be unreliable and their rates of returns unpredictable. Furthermore, the predictability of energy consumption and the associated costs provide landlords with a benchmark against which to measure and identify usage that exceeds normal office use on a per square foot basis. Most leases contain provisions that allow landlords to submeter a tenant’s space, at the tenant’s expense, and require them to make payments directly to the utility provider in cases of excessive use.

Finally, regular business hours also provide the landlord with means to predict and limit wear and tear on a building’s common areas. Tenants may have 24/7, 365-access to their building and space, but visitors and guests do not. Regular business hours restrict access for non-tenants and discourage excessive usage by building tenants by limiting building services and decreasing energy consumption, particularly with regards to HVAC levels; thereby prolonging the life of building systems and finishes and reducing the frequency of and need for repairs, replacements, and capital improvements.

not even supposed to be here

HVAC Maintenance, Repair, and Replacement: Who’s Responsible?

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HVAC stands for heating, ventilation and air conditioning (HVAC) and refers to the different systems, machines and technologies used to provide heating and cooling in and for commercial properties. The party responsible for a property’s HVAC system (tenant vs. landlord) is intrinsically linked to the tenant’s use, and the lease structure, full-service gross vs. triple net, which defines those responsibilities is a byproduct of that use. The vast majority of office leases, especially multi-floor office buildings with internal common areas/amenities, are structured as full-service gross leases where all costs of ownership (NNNs – real estate taxes, operating expenses/CAM, insurance) and occupancy (utilities and cleaning) are included in the base rent. Landlords are responsible for HVAC maintenance, repairs, and replacement along with maintaining a comfortable temperature levels. Landlords are willing to assume this responsibility because office tenants, regardless of their business, have little difference in their consumption of building resources/utilities. Therefore, landlords can estimate and include these costs in their proforma and accurately calculate their net revenue. In addition, landlords can “pass through” any increases in those costs over the initial year of tenancy to the tenant and most leases also contain provisions allowing the landlord to submeter a tenant’s space and charge them directly for utilities if it is determined that their use exceeds normal office use.

Retail, flex, and industrial properties, on the other hand, are structured as triple net leases. In addition to the base rent, tenants must pay their proportionate share of real estate taxes, operating expenses/CAM, and insurance along with utilities and cleaning for the leased premises. Particularly with respect to utilities, this is because of the uniqueness of each tenant’s use and their consumption needs to support their business operations. The same industrial project may have as tenants both a granite fabricator and a storage & distribution center. The granite fabricator will use significantly more water and power than the storage & distribution center; making an accurate allocation of utility charges an administrative nightmare. Of all commercial property types, retail projects contain the most diverse mix of tenants and uses, which presents the same challenge. Flex properties are a mix of office and warehouse; however, the proportion of office and warehouse can differ from project to project and even within spaces within the same project. Even for tenants within the same industry, the amount of office versus warehouse (conditioned vs. unconditioned space) will directly impact their consumption of utilities. For this reason, landlords treat each space/tenant as a self-contained unit and as such each will have their own HVAC unit(s)/system of which they are at least partially responsible.

In a typical (landlord-sided) lease, the tenant is responsible for maintenance, repair, AND replacement of the HVAC unit(s)/system. The HVAC system is and remains the property of the landlord even after the tenant’s occupancy/lease has ended. As a result, tenants may inherit an HVAC system along with any preexisting issues and/or deferred maintenance. Tenants should always inspect and/or request information on the existing HVAC unit(s) prior to signing the lease agreement. While HVAC responsibilities in triple net leases generally fall on the tenant, like most things in life and commercial real estate, they are subject to negotiation.

Maintenance

In nearly all cases, tenants are responsible for maintenance of the HVAC unit(s) servicing the leased premises. Lease agreements generally require tenants to contract with a licensed HVAC contractor to perform regular system maintenance (quarterly or biannually). The landlord may require the tenant to provide copies of the maintenance reports detailing the condition of unit. HVAC maintenance contracts include:

  • Inspecting and Changing Filters
  • Visual Inspection of the Entire System
  • Cleaning and Removing Debris
  • Checking the Condensate Drain
  • Checking the Thermostat Settings
  • Checking the Electrical Connections and Voltage
  • Lubricating Moving Parts
  • Inspecting Exhaust Outlets
  • Checking Fuel Lines and Connections
  • Checking the Refrigerant Levels

Repair

Despite regular maintenance, the HVAC unit(s) servicing the leased premises may require repairs over the term of the lease. Depending on the issue and/or age of the unit, repairs can be costly. As a result, tenants may request the landlord be responsible for repairs, especially if the unit is old and nearing the end of its useful life thus increasing the likelihood repairs will be needed. At the very least, tenants can negotiate a cap on repairs with the amount tied to the age/condition of the unit along with the tenant’s negotiating leverage. Tenants can also request that any existing warranties be transferred to tenant or request the landlord warranty the unit(s), themselves. Regardless, any damage caused by tenant or required repairs resulting from tenant’s negligence or actions will be the sole responsibility of the tenant.

Replacement

Due to the cost associated with replacing an HVAC unit/system, landlords want to place the responsibility on the tenant and vice versa with the age and condition of the existing unit(s) playing the primary role in the negotiations. The fact that the HVAC system is/remains the property of the landlord, the issue of replacement is a particularly contentious one for tenants. If a tenant is inheriting a unit at the end or nearing the end of its useful life, they should either request the landlord install new units prior to occupancy or require the landlord be responsible for replacements during the initial lease term. If the landlord is unwilling to agree to such terms and the tenant is responsible for replacement of the existing HVAC system, the tenant should request any warranties be transferred and that the landlord covenant that the system servicing the leased premises is in good, working order at the time of lease commencement. A case can be made that with regular maintenance and repairs as needed, a system in good, working order should not require replacement over the initial lease term or other agreed upon time period (for longer lease terms, i.e. 10 years). Landlords may be willing to warrant the unit for a reasonable period, i.e. 5 years, after which the tenant would be responsible for replacing the unit as required. Another solution to mitigate the tenant’s cost to replace the HVAC system (especially towards the end of the lease term) is to negotiate a proration of the cost of the new unit over its useful life. For example, if the cost of a new, $6,000 unit has a useful life of 15 years the tenant’s costs would be limited to $400/year of term remaining.

The Tax Cuts and Jobs Act of 2018 will likely have a huge impact on how both landlords and tenants approach the issue of HVAC replacement. Prior to its passage, HVAC replacement was viewed as a capital expense and thus subject to depreciation over a 39-year period. The new/current tax law treats replacement of an HVAC system (up to $2,500,000) as a business expense that may be deducted that same year (capped at $1,000,000/year). The value and timeliness of this change cannot be understated, as R22 (Freon), the industry standard refrigerant for many years, will be completely phased out by January 1, 2020.

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Freon Phaseout: Chilling News for Owners/Tenants

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On August 26, 1987, the United States signed the Montreal Protocol (on Substances that Deplete the Ozone Layer), an international treaty whose purpose was to protect the ozone layer by creating a timeline to “phaseout” the production of numerous substances responsible for ozone depletion. In response, the Clean Air Act of 1963 was amended in 1990; establishing new EPA regulations to phase out both the production and import of ozone-depleting substances (ODS) based on the schedule set forth by the Montreal Protocol. Ozone-depleting substances are divided into Class I and Class II categories with Class I substances, primarily comprised of chlorofluorocarbons (CFCs) which have higher ozone-depletion potential, already being 100% phased out in 2005. Class II substances, known as hydrochlorofluorocarbons (HCFCs) and originally used as transitional substitutes for Class I substances, are now being phased out.

Why it Matters

R22, otherwise known as Freon, is classified as a HCFC, HCFC-22 to be exact. For years this was the industry standard for air conditioning units; however, as of January 1, 2020 R22 will no longer be produced or imported in the United States. Therefore, starting in 2020 it will be increasingly difficult and expensive to obtain R22. Manufacturers have been switching over to the replacement coolant, R410a, for years; however, the older the unit the greater likelihood that it uses R22. Property owners and tenants responsible for HVAC maintenance, repair, and/or replacement as part of their lease should inspect their units to determine the type of coolant used. If it is determined that R22 is the coolant used, owners/tenants have 3 options:

Keep the Existing Unit/System

Depending on the age of the unit, owners/tenants may elect to keep the existing system. If well maintained it may continue to run for months or years. This does present a significant risk, as system failures during a heatwave coupled with the declining supply of R22 could result in extended downtime while units are being serviced or replaced. This is particularly relevant for commercial owners/tenants whose revenue is dependent on the habitability of their space and then again based on the property type, use, etc. Owners of multi-tenant office buildings must maintain comfortable temperature levels as part of their tenants’ right to quiet enjoyment. Failure to replace outdated HVAC units that results in untenantable conditions in the building could result in rent losses for the landlord. The impact of a system failure could be even more catastrophic for retailers, particularly restaurants, whose income is directly tied to being open for business and who have certain days/times in which the majority of their revenue is generated, i.e. weekends/evenings.

R22 can still be used to service existing HVAC units and technicians/contractors should recover and reclaim R22 from existing units to maintain adequate supply.

Retrofit the Existing Unit/System

Some units may be able to be converted to use approved refrigerants such as R410a; the operative word being “may.” Some units cannot be retrofitted, and in other cases, the process may be cost prohibitive. Additionally, depending on the condition of the unit, it may be difficult to find a technician that is willing and able to perform the work. Owners/tenants should confirm with their equipment supplier can be retrofitted to use an ozone-friendly, SNAP-approved (Significant New Alternatives Policy) refrigerant, that all system components are compatible with the new refrigerant, and that it will not void their warranty.

Replace the Existing Unit

While the cost of replacing an HVAC unit/system with a new one can be costly, there are tax credits for some residential HVAC systems and deductions for energy savings for commercial buildings. For principal residences and secondary homes, geothermal heat pumps are eligible for a 30% credit if placed in service by December 31, 2019 (26% if by December 31, 2020 and 22% by December 31, 2021). The Tax Cuts and Jobs Act of 2018 (26 U.S. Code § Section 179) provides a major tax break to commercial property owners/tenants that replace/invest in commercial HVAC equipment. Previously viewed as a capital improvement and therefore depreciable over 39 years, the new law allows owners/tenants to deduct up to $1,000,000 per year for purchases of new and used HVAC equipment. The Section 179 deduction is reduced, dollar for dollar, for investments exceeding $2,500,000. Owners/tenants should always consult a licensed tax accountant to ensure compliance with current tax laws.

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National Landing Submarkets Q4 2019

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On November 13, 2018, a date which will live in infamy, Amazon announced that it would locate its HQ2 in Crystal City. There are a number of analogies that one could use to describe Amazon’s announcement to locate its HQ2 in Crystal City: white knight, life preserver to a drowning man, etc. but on that date the submarket’s fundamentals did a complete 180; turning it into one of the hottest submarket in the DC metro area, if not the entire country. I always “knew” Amazon would choose somewhere in the DC metro area, specifically Loudoun County due to its reputation as Data Center Alley; however, the choice of National Landing (Crystal & Pentagon City) is not surprising for a number of reasons.

Arlington is the most educated county in the nation with neighboring Alexandria, Fairfax, Loudoun, and Montgomery Counties coming in at #2, 5, 7, and 8 respectively. In terms of wealth (median income), Arlington ranks 5th [again] with neighboring Loudoun County, Fairfax County, City of Falls Church, and City of Fairfax coming in at #1, 2, 4, and 10 respectively. Reagan National Airport is located within the Crystal City submarket and both Crystal City and Pentagon City have metro stations; connecting National Landing to both the nation and region. Recent development at the Wharf and Navy Yard have shifted demand in DC to the Southwest and Capitol Riverfront submarkets, which are across the river from National Landing. Previously mentioned, neighboring Loudoun County, is home to the largest concentration of data centers in the world with over 70% of the world’s internet traffic flowing through its Data Center Alley. Amazon’s subsidiary Amazon Web Services currently leases hundreds of thousands of square feet of data center space with no end in sight to its expansion plans/needs.

Another compelling, but relatively unknown, factor in Amazon’s decision was the fact that JBG Smith owns 5,9920,88 SF of the submarket’s 11,195,025 SF (53.5%). This allowed the company to negotiate with one lease with one landlord to fulfill its space needs. Consistent with Amazon’s service offering, this efficient approach lowered costs and streamlined the expansion process.

Finally, Jeff Bezos has a home in Washington, DC and owns the Washington Post. Amazon’s disruption of the retail market has been met significant backlash with talks of breaking up the company under anti-trust laws. As a result, Amazon and Bezos have a vested interest in establishing close ties with lawmakers and engaging in vigorous lobbying efforts to protect the company’s position, rights, and legal status.

Amazon’s announcement combined with increases in defense spending and the submarket cluster’s proximity to the Pentagon, has led to one of, if not, the greatest reversals in fundamentals in the history of the DC metro area. Vacancy in Crystal City has dropped by an astonishing 7.5% in the past 12 months driven by Amazon leasing 585,000 SF in 4 deals and, despite 100,000 SF delivering in the same time net absorption was approximately 700,000 SF. The plummeting vacancy rate has led to strong rent growth. Interestingly, the 4 & 5-Star properties that were responsible for rent losses from 2014-2017 are now leading the resurgence. This trend should continue as both Amazon and JBG deliver new supply of both office and multi-family properties to meet growing demand.

Fundamentals in Pentagon City are deceptively positive. Its 2.7% vacancy rate is more a factor of zero supply side pressure for over 10 years. The only sale in that time was when Boeing bought its 2 build-to-suit buildings constructed in 2013. There has been no leasing and no deliveries in the past 12 months and there are no projects planned in the next 12 months. The submarket was the definition of stagnant and despite extremely low vacancy rates landlords were unable to increase rents due to lack of demand. That has all changed and the future is bright for Pentagon City. Rents increased by 4.4% over the past 12 months and its proximity to both Amazon and the Pentagon coupled with an increase in defense spending should spark a flurry of new development in the years to come as demand continues to shift from the Rosslyn-Ballston corridor to National Landing.

Crystal City

  • RBA: 11,686,539 SF
  • Vacancy Rate: 15.7% (2.7% reduction in one quarter)
  • 12 Month Net Absorption: 700,000 SF
  • Average Asking Rent: $38.65 ($0.61/SF increase in one quarter)
  • 12 Month Rent Growth: 1.9%

Pentagon City

  • RBA: 1,588,349 SF
  • Vacancy Rate: 2.7%
  • 12 Month Net Absorption: (42,500 SF)
  • Average Asking Rent: $39.43
  • 12 Month Rent Growth: 4.4%

Leverage in Rental Rate Negotiations

 

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Clients/tenants are always asking “how negotiable” asking rents are. The answer is more nuanced than the question may suggest. In general, negotiations are based on leverage and the party with greater leverage controls the terms. There are both macroeconomic and microeconomic factors at play when establishing leverage. For the most part, landlords and tenants cannot control market cycles, fiscal/monetary policy, etc. that shape the state of the commercial space market and economy, as a whole, and they are instead forced to adapt and operate under existing market conditions. At the micro level though, there are factors that are within either party’s control that can improve or weaken their negotiating position. From the tenant’s position, leverage is directly related to their desirability (how bad the landlord wants them as a tenant). A landlord’s leverage is based on the status and performance of the subject property. In this article, I will discuss the macroeconomic and microeconomic factors that influence commercial real estate rental rate negotiations.

Macro

When it comes to factors that influence market conditions and thus, rent negotiations, it doesn’t get much more “macro” then the overall state of the economy. Generally speaking, a good economy will be characterized by decreased unemployment/increased hiring; resulting in the need for more commercial space. The increased demand and relatively static supply will lead to decreased vacancy rates with a corresponding increase in market rents. In a landlord’s market, where the demand for space exceeds the available supply, tenants must compete with one another just to satisfy their space needs. In such a market, there may be little to no room to negotiate a reduction in the rental rate. In a tenant’s market, landlords must compete for tenants; resulting in lower asking rates along with other concessions to attract tenants.

Property type and class also play a significant role in determining the negotiability of market rents. An interesting phenomenon in the DC metro office market over the past few years has been an increase in market rents despite historically high vacancy rates. While this may seem to violate the law of supply and demand, it can be understood and explained when analyzing absorption rates by asset class. In many DC office submarkets, new, 4 & 5-Star properties are driving demand and have vacancy rates below and rent growth above the submarket average. This flight to quality has led to stark differences between Class A, B, and C buildings within the same submarket; resulting in a demand vs. supply microcosm. Amazon’s influence has led to the strongest industrial market in years. In addition to it being a landlord’s market, even small incremental reductions in the asking rate, i.e. $0.25-$0.50/SF/yr, are amplified due to the relatively low base rates for industrial properties. For example, a $1.00/SF reduction in the asking rate for an office property whose asking rate is $30.00/SF equates to a 3.3% decrease while a $1.00/SF reduction for an industrial property with an asking rate of $10.00/SF is 10%. Retail is, by far, the most unique commercial property type. Rental rate negotiations and other economic concessions for retail spaces are more heavily influenced by the tenant’s profile (desirability) than in any other asset type. Finally, there is flex space, which is a combination of office and warehouse. The proportion of office to warehouse can vary from project to project and from space to space within each project; resulting in corresponding variations in asking rents. Flex rates are a blend of office and industrial rates as is their negotiability.

Micro

Within the space market paradigm, there are microeconomic factors that can either increase or decrease a tenant or landlord’s negotiating leverage. For tenants, the goal is to maximize their appeal to prospective landlords. For landlords, it is successful property and asset management.

Tenants

As stated previously, a business’/company’s desirability as a tenant plays the strong role in being able to negotiate the maximum amount of concessions from the landlord. Of the many factors that contribute to a tenant’s desirability and thus their leverage, square footage, financial strength, and lease term play the most significant roles. The larger a tenant’s square footage requirement the greater their leverage. While not a direct (proportional) relationship, landlords are generally willing to accept less rent on a per square foot basis the larger the space being leased. This is particularly true for retail space.

Landlords must analyze a tenant’s risk of default when determining the amount of any economic concessions. The more economically viable the tenant, the more desirable. Tenants’ financial strength is extremely important in landlord markets because they can be the deciding factor in which tenant the landlord chooses to lease to. Even in tenant markets, a tenant’s financial strength provides substantial leverage by reducing the likelihood of default and the associated costs, i.e. vacancy, commissions, improvement allowances, etc.; allowing the landlord the opportunity to share those savings with the tenant in the form of a reduced rental rate.

Lease term can also play a role in lease rate negotiations. In most cases, the longer the lease term the greater the tenant’s leverage. This is particularly relevant when coupled with a tenant’s financial strength because landlords’ main goal is to have their property leased for as long as possible (at or above the prevailing market rent). Landlords may be willing to reduce the base rental rate for a long-term lease with the expectation that annual escalations will bring the rate up to market over the term. Also, the longer the lease term the longer the period in which the landlord does not incur lease up costs. In rare cases, landlords may be willing to reduce their rental rate for short-term leases, i.e. 3 years, in order to secure a tenant in a competitive market. In this situation, the landlord can provide the tenant with a renewal option at the expiration of the term at the then market rate.

Finally, rental rate negotiations are influenced by the amount of any other economic concessions/considerations related to the deal, i.e. free rent, improvement allowances, etc. Free rent is foregone income while tenant improvement allowances are cash out-of-pocket. Landlords recoup these losses through rental payments. The more months of rental abatement and the larger the improvement allowance the longer the time required for the landlord to recover their costs and thus the less room for negotiation off the asking rate.

Landlords

Landlords are able to maximize the strength of the negotiating position through effective and efficient property and asset management. This begins from the point of acquisition and the price at and assumptions under which the subject property was purchased. When determining whether to purchase an investment property (and at what price), investors must make projections based on their analysis of current and future market conditions. They create proformas that guide deal structuring based on asking rates, lease terms, square footage, etc. Landlords that purchases assets based on conservative assumptions or at below market prices, i.e. bankruptcy/foreclosure sales, have room to negotiate on their rental rate while still maintaining an acceptable internal rate of return. During the holding period, landlords can position their property to be competitive within its asset type/class and submarket by investing in capital improvements to reduce operating costs and/or, in the case of amenities or renovations, increase asking rents. By making wise acquisition and management decisions, landlords strengthen their financial position, thereby increasing their leverage. They are able to negotiate on their asking rate, but not required to do so, and the lower the subject property’s vacancy the less inclined a landlord is to come off their asking rent.

On the flip side, landlords that overpay or do not effectively manage their property may have little to no control over their leasing rate. Landlords with high vacancy properties have little leverage and may be forced to agree to significant rate reductions simply to cover the costs of ownership and/or “stop the bleeding.” Landlords that do not maintain their property relative to their competitors risk functional obsolescence and the potential situation in which they cannot reduce their asking rate enough to attract tenants while generating an acceptable rate of return or, in dire circumstances, a positive net operating income.

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Loaded Cap Rates

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Every year, municipalities assess the market value of all real property within their jurisdiction for the purpose of collecting real estate taxes. Due to the vast number of properties, assessors conduct mass appraisals. Real property is divided into classes based on property type and further stratified based on its unique characteristics. Assessors then use the most appropriate valuation model and apply collected market value indicators to calculate value. Most commercial properties are income-producing and, therefore, the income capitalization approach is primarily used because it provides the most accurate and pertinent approximation of market value.

Because the purpose of the assessment process is to determine value for the purposes of taxation, assessors are left with a Catch-22 dilemma. The direct capitalization approach calculates value by dividing a property’s net operating income by the market cap rate. Net operating income is calculated by subtracting all costs of ownership from the property’s gross revenue; including real estate taxes. Real estate taxes are ad valorem taxes; meaning their amount is based on the value of a transaction or, for the purposes of this article, a property. This means that if assessors were to use the traditional direct capitalization approach they would have to subtract real estate taxes from the gross revenue to establish the net operating income in order to calculate the value which would determine the real estate taxes that would need to be subtracted from the gross revenue to calculate the net operating income to calculate value which would determine the real estate taxes… You get the point.

So, how do assessors escape this circular logic? Simple, by loading the cap rate used to establish value.

Loading the cap rate involves adding the municipality’s ad valorem tax rate to the market cap rate for a particular property (class, type, etc.). Assessors then remove real estate taxes from the property’s net operating income and divide that amount by the loaded cap rate to calculate the property’s market value. I’ve provided examples below (with actual real estate tax rates) to show how calculations using loaded cap rates arrive at the same valuation as when real estate taxes are included in a property’s net operating income and the “unloaded,” market cap rate is used.

Loaded Cap Rate Example