Leases — the lifeblood of real estate investments
There are reasons leases are so important to a property’s value
Let’s take a look at why leases are so important to the value of investment real estate. It really doesn’t matter whether we’re talking about one or many tenants — the same principles apply.
Investors want to know the bottom line, and they look at net operating income (NOI), which is what’s left of the gross rental income after deducting all of the operating expenses of the property (but not debt service or taxes). Investors will generally apply a capitalization, or cap, rate — a measure of the ratio between the cash flow produced and its capital cost — to the NOI in order to arrive at a quick assessment of the value of the property.
Expenses do vary, but they are generally predictable from year to year (energy costs and taxes notwithstanding). The real variable in the calculation is the gross rental income, because the quality of the leases and the tenants can have a dramatic impact on the regularity of the gross income.
Let’s look at the key aspects of leases that affect the value of investment properties:
• Tenant credit quality: The most important factor in analyzing leases is the credit quality of the tenant. For publicly-traded companies, this information is readily available, but for private companies, financial, banking and credit information needs to be obtained and reviewed. It’s fairly common for landlords to ask for personal guarantees from smaller firms, and similar information must be obtained from the persons who will be providing the guarantees.
Investors (and lenders) will carefully look at tenant quality in determining the value of a property. Generally, the better the tenant quality, the lower the cap rate, which means a higher value for the property. In some cases, investors will sort tenants according to quality, and apply different cap rates to different groups in arriving at a value.
• Term of lease: Some tenants want short-term leases for flexibility in the event of growth or business contraction, but others want long-term leases for stability and predictability. Landlords, too, may have reasons for one or the other. As a general matter, the longer the lease term, the better for the investor and lender. They want to be able to count on an income stream for some period of time, in order to avoid turnover fees (commissions and fit-up costs) and to support debt service.
• Rent structure: Investors want to make sure that all operating expenses are paid for by the tenants, and generally prefer triple net (or NNN) leases, which have an agreed-upon base rent and obligate tenants to pay their proportionate share of all operating expenses.
Investors also want to make sure that there are regular rent increases in order to keep up with inflation and to support appreciation in the value of the property. So when negotiating lease terms, it’s very important that a landlord always keep in mind that at some point the property will be sold and the buyer will be looking closely at the rent structure when determining value.
• Renewal options: Tenants like to have renewal options every few years, so that they can make judgments from time to time as to their space needs. They also like to have prearranged terms, especially for the base rent, so that it is not necessary to renegotiate those items. Investors are somewhat wary of renewal options. While it’s true that most good tenants stay where they are for some time, and generally renew options, these provisions can make it difficult for owners to reposition their property with new tenants, to adjust their tenant mix, or to collect market-rate rents.
In some cases, these options also can thwart a sale of property. We’ve seen situations where owners have wanted to sell multi-tenant buildings, and all but one of the tenants is agreeable to moving out, and it’s usually the tenant who has the option to renew the lease for an even further time period.
It makes good sense to audit leases on some regular basis in order to fully understand all of the issues mentioned above and how they affect the current and future value of an investment property. A qualified investment real estate professional can assist in conducting such an audit.
Dan Scanlon, a senior associate with Colliers International in Manchester, focuses on business tenant representation and investment sales. He can be reached at 603-206-9605 or email@example.com.