CCIM NEW DESIGNATION CURRICULUM

Enhance your career, deepen your knowledge, and be better equipped for todays
market with CCIMs 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 Analysis

for 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.

CCIM DESIGNATION AND INSTITUTE MEMBERSHIP

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

CCIM Institute Member Benefits

Commercial Investment Real Estate (CIRE) Magazine
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mapping and demographic data, aerial viewing of properties, flood zone determinations,
financial analysis tools, customized reports, and a broad spectrum of other business services.
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.

User Decision Analysis for Commercial Investment Real Estate

CI 103

Introduction

In This Section
Welcome Letter ....................................................... i
Course Material ...................................................... ii
Table of Icons ......................................................... ii

Table of Contents.TOC i

 Copyright 2011 by the CCIM Institute

All rights reserved Revision date 05/11

Contents

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 financial
analysis tools, concepts, and calculations. It provides you with the foundation
you will need to take subsequent CCIM courses. The course material consists
of three componentsa 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 states
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 Institutes on-site
administrator. Enjoy the course.

CCIM Institute

User Decision for Commercial Investment Real Estate i

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 closedbook 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

ii User Decision Analysis for Commercial Investment Real Estate

Summary

Case Study

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

User Decision Analysis for Commercial Investment Real Estate TOC i

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

Module 2: Self-Assessment Review ...................................................2.21

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 Process

Module Snapshot ...............................................................................3.1
Module Goal ......................................................................................................... 3.1
Objectives .............................................................................................................. 3.2

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

Owners Leased-Fee Interest ................................................................................ 3.3
Tenants 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
TOC ii User Decision Analysis for Commercial Investment Real Estate

Table of Contents

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

User Decision Analysis for Commercial Investment Real Estate TOC iii

Module 3: Self-Assessment Review ...................................................3.38

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 ...............................................................4.7

Sample 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

TOC iv User Decision Analysis for Commercial Investment Real Estate

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 or
More 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

Table of Contents

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

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

Module 4: Self-Assessment Review ...................................................4.47

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
User Decision Analysis for Commercial Investment Real Estate TOC v

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 ........................................................................................... 5.22
Sales 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

Module 5: Self-Assessment Review ...................................................5.37
Answer Section ................................................................................5.41
Activity 5-1: Methods of Comparing Costs ....................................................... 5.42
Activity 5-2: Calculating Costs............................................................................ 5.43
Module 5: Self-Assessment Review ................................................................... 5.44

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

TOC vi User Decision Analysis for Commercial Investment Real Estate

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

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

Table of Contents

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

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 and Relocate ................................. 6.25
Module 6: Self-Assessment Review................................................................... 6.29

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

User Decision Analysis for Commercial Investment Real Estate TOC vii

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

Module 7: Self-Assessment Review ...................................................7.38
Answer Section ................................................................................7.39
Module 7: Self-Assessment Review ................................................................... 7.40

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
Step 2: What Actions Can Be Taken to Satisfy Everyones Needs?
Develop Action Steps and Evaluate Them against Interests ............................. 8.19
TOC viii User Decision Analysis for Commercial Investment Real Estate

Table of Contents

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 Analysis

Case 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 Comparison of the Leases ........................ 9.10

Answer Section ................................................................................9.11

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

Case Study 2: Lease versus Purchase Analysis

Case Study Overview .......................................................................................... 10.1
Case Objectives ................................................................................................... 10.1

Lease versus Purchase Analysis ........................................................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 a Recommendation ........................ 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 3: Lease Buyout

Case Study Overview .......................................................................................... 11.1
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 Owners Current Position ..... 11.5
Task 3-3: Determine the Present Value of the Worst-Case Scenario ............. 11.6
Task 3-4: Establish the Owners Minimum Buyout Price ............................... 11.7
User Decision Analysis for Commercial Investment Real Estate TOC ix

Task 3-5: Determine the Present Value of the Tenants 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:
Task 3-2:
Task 3-3:
Task 3-4:
Task 3-5:
Task 3-6:
Task 3-7:
Task 3-8:
Task 3-9:

Review Interests Analysis ................................................................ 11.20

Determine the Present Value of the Owners Current Position .... 11.20
Determine the Present Value of the Worst-Case Scenario ........... 11.20
Establish the Owners Minimum Buyout Price.............................. 11.21
Determine the Present Value of the Tenants Current Position ... 11.21
Determine the Negotiation Range .................................................. 11.21
Develop a List of Possible Actions ................................................. 11.21
Identify Fighting Alternatives .......................................................... 11.21
Negotiate .......................................................................................... 11.21

Case Study 4: Sale Leaseback

Case Study Overview .......................................................................................... 12.1
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

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

TOC x User Decision Analysis for Commercial Investment Real Estate

User Decision Analysis for Commercial Investment Real Estate

In This Module
Module Snapshot ...................................... 1.1

Introduction to
User Decision
Analysis

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

Introduction to User Decision

Analysis
Module Snapshot
Module Goal
The material contained in this course addresses occupancy costs from the
users perspective. Users of real estate are organizations that use property such
as office and warehouse space, retail stores, or industrial plants for a business
purpose. 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.

User Decision Analysis for Commercial Investment Real Estate 1.1

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.

1.2 User Decision Analysis for Commercial Investment Real Estate

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.

1 Introduction

User Decisions

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:

Acquisition 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?

User Decision Analysis for Commercial Investment Real Estate 1.3

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?

1.4 User Decision Analysis for Commercial Investment Real Estate

1 Introduction

Space (User/Tenant) Markets versus Capital

(Investment) Markets
The 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

Space Market
Market Net Rent
NOI

Current Market
Net Rent

Vacant
Space
D
Current
Occupied
Space

Total
Space

Quantity
Of 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
User Decision Analysis for Commercial Investment Real Estate 1.5

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 are
deciding 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 demandthat 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 owneroccupied 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 property
is 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
1.6 User Decision Analysis for Commercial Investment Real Estate

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.

1 Introduction

purchase price compared to current NOI) if they expect the NOI and/or value
to increase over time.

Figure 1.2 Relationship between NOI and Cap Rate

Capital Market
Market Net Rent
NOI

Cap
Rate

Current Market
Net Rent

Current
Value

Value
Of Space

Correlating space market (Figure 1.1) with capital market (Figure 1.2) we can
see 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
netwherein 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.

User Decision Analysis for Commercial Investment Real Estate 1.7

Figure 1.3 Relationship between Space and Capital Markets

Space Market

Capital Market
Market
Net Rent
(NOI)

Market
Net Rent
(NOI)
S

Market
Cap
Rate

Current
Market
Net Rent

D
Current
Occupied
Space

Quantity
Of
Space

Current
Value

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 because
of 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.
1.8 User Decision Analysis for Commercial Investment Real Estate

Value
Of
Space

1 Introduction

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 developers 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 developers 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 developers 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

Cost versus Value-Rent Setting

Net Rent
NOI

Cost
Cap Rate
Market
Cap Rate

Current
NOI

Profit

Total
Project Cost

Current
Value

Value
Of Space

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.

User Decision Analysis for Commercial Investment Real Estate 1.9

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

Developers 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 developers 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

1.10 User Decision Analysis for Commercial Investment Real Estate

NOI market cap rate = market value

Market value total project cost = developer profit

1 Introduction

5. Calculate the developers profit, assuming the market will support the rent
calculated in Task 4.

End of activity
User Decision Analysis for Commercial Investment Real Estate 1.11

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 decision
process. 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.

1.12 User Decision Analysis for Commercial Investment Real Estate

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.

1 Introduction

Pension Funds

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.

User Decision Analysis for Commercial Investment Real Estate 1.13

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 with
the 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 longterm 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 investingthe potential money to be made
is too great for them not to.

1.14 User Decision Analysis for Commercial Investment Real Estate

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.

1 Introduction

Commercial Mortgage-backed Securities and Commercial Real Estate

Collateralized Debt Obligations

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 any
principal) 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
User Decision Analysis for Commercial Investment Real Estate 1.15

regulatory requirements on risk-based capital and the companies liability

structures.

Savings Institutions
Originally thought of as home mortgage lenders, savings institutions held longterm 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 and
Freddie 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.

1.16 User Decision Analysis for Commercial Investment Real Estate

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.

1 Introduction

Summary

In subsequent modules and case studies, we will explore various user decisionmaking tools and their practical applications.

User Decision Analysis for Commercial Investment Real Estate 1.17

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

1.18 User Decision Analysis for Commercial Investment Real Estate

a. Vacancy
b. Rent

1 Introduction

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

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)
Market cap rate: 7.25 percent
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
User Decision Analysis for Commercial Investment Real Estate 1.19

1.20 User Decision Analysis for Commercial Investment Real Estate

1 Introduction

Answer Section

User Decision Analysis for Commercial Investment Real Estate 1.21

Activity 1-1: Rent Setting Using Cap Rate

1. Calculate the developers cost cap rate.
Market cap rate + cap rate spread = cost cap rate
7.5% + 1.5% = 9.0%

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

acceptable profit.
Cost cap rate total project cost = minimum NOI needed
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

NOI (1 operating expense ratio) NOI = operating expenses

$270,000 (1 40%) $270,000 = $180,000
NOI + operating expenses = GOI
$270,000 + $180,000 = $450,000
GOI (1 vacancy rate) GOI = vacancy and credit losses
$450,000 (1 9%) $450,000 = $44,505
GOI + vacancy and credit losses = PRI
$450,000 + $44,505 = $494,505

4. Calculate the minimum rent per square foot (psf) needed to achieve the
acceptable profit.
PRI building rsf = rent per rsf
$494,505 20,000 = $24.73

5. Calculate the developers profit, assuming the market will support the rent
calculated in Task 4.
NOI market cap rate = market value
$270,000 0.075 = $3,600,000
Market value total project cost = developer profit
$3,600,000 $3,000,000 = $600,000

1.22 User Decision Analysis for Commercial Investment Real Estate

1. Which of the following is not considered one of the basic phases in user
decisions?

1 Introduction

Module 1: Self-Assessment Review

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)
Market cap rate: 7.25 percent
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

User Decision Analysis for Commercial Investment Real Estate 1.23

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

Market cap rate + cap rate spread = 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.
Cost cap rate total project cost = minimum NOI needed
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 (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

NOI + operating expense = GOI

NOI:

$350,625

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

$350,625 + $112,500 = $463,125

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

$463,125 0 .92 = $503,397 - $463,125 = $40,272

GOI + vacancy and credit losses = PRI

$463,125 + $40,272 = $503,397

1.24 User Decision Analysis for Commercial Investment Real Estate

1 Introduction

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

achieve the acceptable profit.
PRI building rsf = rent per rsf
$503,397 15,000 = $33.56

7. What is the Investment Group's projected profit, assuming the market will
support the rent calculated in question 6.
NOI market cap rate = market value
$350,625 7.25% = $4,836,207
Market value total project cost = Investment Group profit
$4,836,207 $4,125,000 = $711,207

User Decision Analysis for Commercial Investment Real Estate 1.25

User Decision Analysis for Commercial Investment Real Estate

Special
Considerations
for Cost of
Occupancy

In This Module
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

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

Module 2: Self-Assessment Review .......... 2.21

Answer Section ....................................... 2.25
Activity 2-1: After-Tax Weighted Average Cost
of Capital ............................................................ 2.26
Module 2: Self-Assessment Review .................. 2.29

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 covers
the 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 companys 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 capital
for a corporation.
User Decision Analysis for Commercial Investment Real Estate 2.1

Concepts of Financial Reporting

The reporting of an organizations 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 organizations
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 organizationsbasically
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 and
laws 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 companys overall health.
It should be noted that the drive to consistency and transparency in financial
reporting 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 productionthe 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
2.2 User Decision Analysis for Commercial Investment Real Estate

2 Special Considerations

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 companys 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 practitionersthose who represent
companies or businessesand 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 and
large everyone understands exactly what each metric means. This is the
information investors, lenders, regulators and others use to determine a
companys 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 a
consultant) 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 companys
financial report, yet real estate practitioners frequently misunderstand its impact.

User Decision Analysis for Commercial Investment Real Estate 2.3

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 clients
overall financial goals.

Understanding and communicating the impact of common real estate

transactions on an organizations 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 companys size, these
stakeholders dislike surprises, good or bad.
Typically, a public company issues its quarterly earnings about 1545 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 projectionsin either a positive
or negative wayquestions 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 companys 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 offbalance-sheet transactions. (Balance sheets are covered in depth in the next
section.) How does this relate to real estate transactions? Negotiating lease
agreementsone of the most common real estate transactionsgenerally
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

2.4 User Decision Analysis for Commercial Investment Real Estate

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 clients 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.

2 Special Considerations

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

whether the transaction is on or off balance sheet.

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 saleleaseback 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
companys 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 financialsa 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
User Decision Analysis for Commercial Investment Real Estate 2.5

prosecutions for those who attest to a companys 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 organization
might 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 it
and good news when you benefit from it.

2.6 User Decision Analysis for Commercial Investment Real Estate

Financial reporting consists of various reports detailing different aspects of a

companys financial performance. Collectively, these should reflect the overall
financial position of the organization. This section addresses the reports most
relevant to real estate and its impact on a companys reporting.

2 Special Considerations

The Basics of Financial Reporting for Real

Estate

Income Statement
This document presents the results of an organizations operations for a specific
period. It details the revenue, expenses, and net income. The income
statement can be compared to an individual tax returnhow 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 companys assets, liabilities, and net equity. It can be compared to a
personal statement of net worthwhat 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
statements 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
User Decision Analysis for Commercial Investment Real Estate 2.7

Footnotes to the financials: The notes where disclosure items are outlined,
and where many real estate lease transactions appear in the financials

Managements discussion and analysis: A narrative provided by senior

management to explain their business activities

Auditors opinion letters: The letters from a companys 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 standardsthose common financial practices and principles across
businesslargely 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, some
governing 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
2.8 User Decision Analysis for Commercial Investment Real Estate

2 Special Considerations

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.

User Decision Analysis for Commercial Investment Real Estate 2.9

Income Statement
The 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 estate
or 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 costsrent payments when leasing or

interest and depreciation costs for owningall appear as expenses on the
income 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.
2.10 User Decision Analysis for Commercial Investment Real Estate

The Importance of Quarterly Earnings

Given the rules governing when real estate transaction expenses and revenue
are recorded, a companys quarterly earnings can drive when a transaction
occurs. 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.

2 Special Considerations

Application to Corporate Real Estate

Free Rent Periods (Early Occupancy) Arent 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 rent
period (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.

User Decision Analysis for Commercial Investment Real Estate 2.11

Balance Sheet
The 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 are
recorded 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 years 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
2.12 User Decision Analysis for Commercial Investment Real Estate

Conservatism Principle
Reporting rules require gains to be recorded when they are earned, while losses
must 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.

2 Special Considerations

a cost of doing business on financial statementslisting 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.

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.

User Decision Analysis for Commercial Investment Real Estate 2.13

Selection of Discount Rate for the User

Users 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 the
user 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 occupancy
costs for users. Users usually fall into two categoriescorporate and noncorporate (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 users
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 dont have any capital
of their own. All of a corporations capital is raised from two sourcesdebt and
equityand 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

2.14 User Decision Analysis for Commercial Investment Real Estate

Commercial banks provide the short-term debt portion of the capital structure,
typically in unsecured short-term notes, and bond investors provide the longterm 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 corporations 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.

2 Special Considerations

by the debt and equity sources. This also may be the after-tax cost of any
capital used for occupancy costs.

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 corporations capital structure and the
opportunity cost of the equity investors who provided the equity portion of the
corporations 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 users 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 users 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
User Decision Analysis for Commercial Investment Real Estate 2.15

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.

Summary
The 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.

2.16 User Decision Analysis for Commercial Investment Real Estate

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

2 Special Considerations

Activity 2-1: After-Tax Weighted Average Cost of Capital

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

User Decision Analysis for Commercial Investment Real Estate 2.17

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.
Gilberts 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.

2.18 User Decision Analysis for Commercial Investment Real Estate

Marginal tax bracket: 33 percent

Real estate purchase price: $1,255,000

Conventional loan terms:

o 75 percent LTV ratio

2 Special Considerations

Assumptions

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. Pam
and 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.

User Decision Analysis for Commercial Investment Real Estate 2.19

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
ALTA Survey
Document Preparation
Appraisal
Escrow Fees
Title Insurance, Endorsements

$2,250
$2,500
$ 500
$2,000
$1,390
$3,700

What is the effective cost of capital (cost of borrowed funds)?

End of activity
2.20 User Decision Analysis for Commercial Investment Real Estate

To test your understanding of the key concepts in this module, answer the
following questions.
1. Which of the following is not considered a valid rationale for financial
reporting?

2 Special Considerations

Module 2: Self-Assessment Review

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 to
misrepresentation
2. An organization using Generally Accepted Accounting Principles (GAAP) is
considering 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?

User Decision Analysis for Commercial Investment Real Estate 2.21

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
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 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:
a. $8,375,000
b. $4,125,000
c.

$412,500

d.

($262,500)

2.22 User Decision Analysis for Commercial Investment Real Estate

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

2 Special Considerations

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:

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

User Decision Analysis for Commercial Investment Real Estate 2.23

2.24 User Decision Analysis for Commercial Investment Real Estate

2 Special Considerations

Answer Section

User Decision Analysis for Commercial Investment Real Estate 2.25

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

Before Tax
Cost of
Capital

Percent of
Total

Capital Category

Before Tax
Weighted 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 Cost

of Capital

Tax Rate
Complement

After Tax Weighted

Cost of Capital

4.69%

67.00%

3.14%

3.25%

67.00%

2.18%

After Tax Weighted Average Cost of Capital

2.26 User Decision Analysis for Commercial Investment Real Estate

5.32%

6.77 percent

How to Solve:

2 Special Considerations

3. What is the effective cost of capital (effective cost of borrowed funds)?

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).

User Decision Analysis for Commercial Investment Real Estate 2.27

Total loan costs:

Loan Points:
Loan Amount
$1,100,000

Loan Point %
1.0%

Loan Point $
$11,000

Other loan costs:

Phase I Environmental Study
ALTA Survey
Document Preparation
Appraisal
Escrow Fees

$ 2,250.00
$ 2,500.00
$ 500.00
$ 2,000.00
$ 1,390.00

Title Insurance, Endorsements

$ 3,700.00

TOTAL

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

2.28 User Decision Analysis for Commercial Investment Real Estate

$12,340.00

1. Which of the following is not considered a valid rationale for financial

reporting?

c. Income opportunity for accounting and audit firms

2 Special Considerations

Module 2: Self-Assessment Review

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

User Decision Analysis for Commercial Investment Real Estate 2.29

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 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, defensible
derivation for a corporate user (corporations, public companies) would be

a. Their after tax weighted average cost of capital

2.30 User Decision Analysis for Commercial Investment Real Estate

User Decision Analysis for Commercial Investment Real Estate

Space
Acquisition
Process

In This Module
Module Snapshot ...................................... 3.1
Module Goal ........................................................ 3.1
Objectives ............................................................. 3.2

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

Owners Leased-Fee Interest ............................... 3.3
Tenants 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

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, and
Indemnity ........................................................... 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 the
Causes of Risk .................................................... 3.33

Module 3: Self-Assessment Review .......... 3.38

Answer Section ....................................... 3.41
Activity 3-1: Calculating Percentage Rent.......... 3.42
Module 3: Self-Assessment Review .................. 3.43

Space Acquisition Process

Module Snapshot
Module Goal
Acquiring space whether via a lease or purchase often can be a prolonged
balancing act, with a users needs and goals on one side and the landlord/sellers
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 partieslandlord/seller and user/tenant/purchaserengage in requests
for proposals, proposals, and counterproposals and eventually come to an
agreement that theoretically best meets everyones 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 users 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 processfrom the search for space to final
occupancyhas 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 users goals and objectives
for acquiring space.

User Decision Analysis for Commercial Investment Real Estate 3.1

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 tenants 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.

3.2 User Decision Analysis for Commercial Investment 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.

3 Space Acquisition

Interests in Real Estate

The owners group of rights and obligations is called the leased-fee interest, and
the tenants group is called the leasehold interest. The owners interest in a
property, without consideration of leases, is called the fee-simple interest.

Owners 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 owners rights to tenant(s) affects the propertys
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, LeasedFee Interest has the same meaning as Leased-Fee Estate).

Tenants 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 the
lease 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

User Decision Analysis for Commercial Investment Real Estate 3.3

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 belowmarket 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.

3.4 User Decision Analysis for Commercial Investment Real Estate

Many participants are involved in the space acquisition process, and all of them
ultimately support either the tenant/purchaser or the landlord/seller. The
number 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 landlords resources to help them define and construct what they need.

3 Space Acquisition

The Potential Parties in the Space

Acquisition Process

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 specificoffice, industrial, or retail spacefor their
business. To make a sound user decision, the tenant/purchaser and those
representing the tenant/purchasers interest should

Understand the budget set by the user prior to looking for space.

Know the geographic area that best serves the users needs.

Understand how the proposed space integrates with the users business
objectives.

Be able to clearly articulate the users needs for the space.

Be knowledgeable about the necessary infrastructure any building must

have in order to be considered.

Negotiate terms that meet the users 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
User Decision Analysis for Commercial Investment Real Estate 3.5

the amount of time the space acquisition process takes, the specific market
dynamics, and how to achieve the most favorable terms for the company.

Tenant/Purchaser Representative
The tenant/purchaser representative (tenant rep or buyer rep) is the real
estate professional engaged by a tenant/purchaser to facilitate the space
acquisition process and consult with the user throughout the entire process.
Tenant/purchaser reps should have good market knowledge, extensive
experience with the space acquisition process, and strong negotiation skills in
order to help the tenant/purchaser obtain the best space possible and avoid
costly mistakes and negotiating mishaps during the space acquisition process.

Landlord/Seller
Just as the tenant wants to negotiate optimum rates and flexibility, the landlord
wants to lease their space for the maximum amount the market will bear and
ensure maximum occupancy. Successful landlords understand the decisionmaking process and the proposed tenants capability. For example, is the local
user part of a corporation within which leasing and other real estate decisions
are made at a corporate headquarters? Can the user make decisions
autonomously? Once the initial tenant outreach is made, the landlord would
be well served to learn as much as possible about the potential tenant. From
the landlords perspective, a company with a stellar credit rating and/or a
proven track record of business success is the optimum choice of a tenant. The
landlord will be more amenable to making concessions when a proposed tenant
closely meets the landlords desired criteria.
Similarly, just as the purchaser wants to negotiate an optimum price and terms,
the seller wants to ensure that they receive a price that is in line with current
market values of similar properties.

Landlord/Seller Representative
The landlord/seller representative plays a similar role for the landlord/seller as
the tenant/purchaser representative does for the tenant/purchaser. The
landlord engages this agent to market and promote their product. This requires
the landlords rep to have an in-depth knowledge of the buildingfrom items
such as the load (or add-on) factor and operating expense stop in an office
building or power capacity to an industrial building, parking ratios, or how the
buildings tenant improvement (TI) allowance compares to the competitionin
order to determine if the property will match a prospective users needs. In
3.6 User Decision Analysis for Commercial Investment Real Estate

The sellers representative is engaged by the seller to market the sellers

building. This also requires an in-depth knowledge of the product to know if it
will match a prospective purchasers needs. In addition, this real estate
professional 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.

3 Space Acquisition

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 buildings competition.

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 users square footage needs and help identify which
prospective buildings 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 users
interests. The tenant rep should work with tenants 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 usually
commences during the purchase agreement negotiation phase. The attorney
usually stays involved through the closing and transfer of title.

User Decision Analysis for Commercial Investment Real Estate 3.7

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

3.8 User Decision Analysis for Commercial Investment Real Estate

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 users physical,
geographic, budget, timing and various subjective requirements. The needs
analysis represents the users 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.

3 Space Acquisition

User Needs Analysis

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 indepth 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 space
that 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 tenants/purchasers 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?

User Decision Analysis for Commercial Investment Real Estate 3.9

 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 for
certain 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 companys 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)?

3.10 User Decision Analysis for Commercial Investment Real Estate

Budget/cost imperatives
Does the user have to stay within any specific budget parameters?
Who has final say over the budgetthe 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?

3 Space Acquisition

Deal breakers
Is a major competitor located in the same building or area?

Miscellaneous employee and space information

What is the companys male-to-female ratio?
What are the common area needs?
Does the company have aging or disabled employees?

Market Research and Survey

Once the users 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 reps 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 to
understand 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
tenants/purchasers needs. During research and verification, the
tenant/purchaser rep can enlighten the prospective landlords/sellers agent
about the space requirements and some of the specific nuances of the users
requirements. Sample floor plans, if available, should be included in the
building survey presentation. Buildings or spaces that meet the
tenants/purchasers 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
doesnt replace a site visit. Site visits allows the user the opportunity to
understand aspects such as the buildings ingress and egress, the views from the
proposed floors, the image projected by the buildings lobby and common
User Decision Analysis for Commercial Investment Real Estate 3.11

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 tenants 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 buildings 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 landlords position and what

concessions they may or may not be willing to make.

Articulate issues that are critical from the tenants 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.
3.12 User Decision Analysis for Commercial Investment Real Estate

Space Requirement. This section sets forth the estimated space that the tenant
needs. Additionally, it could include a breakout of the interior workings of the
space 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

3 Space Acquisition

Client Description. This brief description of the tenants business establishes

credibility and gives potential landlords an understanding of the potential use
for the space. This is a good place to reference the companys website, so the
landlords can do further research.

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
businesss hours of operation probably wont match the buildings 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 tenants smaller square footage requirement. The
landlords reluctance to give the tenant the desired floor can become a
negotiation point.
Primary Lease Term. This section details the tenants 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
User Decision Analysis for Commercial Investment Real Estate 3.13

may ask for a breakdown of operating expenses for the last three years and the
buildings occupancy during each of those years.
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 users 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 the
tenant 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 tenants
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 install
systems, 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 users 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 tenants space planner or those employed by the landlord. The space
planner will design the space to the tenants specifications, and the sketches
then may be sent for preliminary construction bids to contractors of the
landlords and/or tenants 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 landlords proposals, the tenant must determine which
landlord is offering the best overall TI allowance. A simple comparison
3.14 User Decision Analysis for Commercial Investment Real Estate

Options to Renew. This section of the RFP lays out the users 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 notice
that the landlord requires.

3 Space Acquisition

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.

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
tenants future expansion, or, if space becomes available, an option might
provide 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 what
current 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.

User Decision Analysis for Commercial Investment Real Estate 3.15

Technology Requirements. This section describes the users 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 to
ensure that the work is being done to a quality and price thats 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 tenants 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 cant 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.
3.16 User Decision Analysis for Commercial Investment Real Estate

Building Security. The section requests information about security measures,

to both the building itself and the tenants space. Tenants running highly
sensitive operations could require a level of security that certain buildings cant
offer, which may eliminate buildings from the search.

3 Space Acquisition

Signage. Some properties have very specific clauses about their tenants signs.
This section should determine if the building can satisfy the tenants signage
requirements, or if any restrictions conflict with the tenants identity and
branding standards.

After-hours Access. If the tenant is operating an entity such as a call center,

access to the building after it has closed is a concern. This section determines
the business hours of operation for the property, and what the cost is for non
business hours, sometimes referred to as building overtime.
Right to Sublease or Assign. This section would define the landlords position
on subleasing and assignment. Sublease and assignment typically is negotiated
in the lease itself, but if it is an important consideration to the tenant, it is
beneficial to determine the landlords policy regarding the tenants right to
sublease or assign.
Non-compete. If important to the tenant, the RFP should state that a
competing business cannot lease space in the building or in other buildings
owned or controlled by the landlord within a certain geographic area. If the
landlord is unwilling to agree, this can eliminate the building.
Ownership Considerations. Information about the ownership structure is
crucial. What other entities, if any, have to approve the lease? In weak
economic times (and even in strong economic times), the financial capacity of
the landlord/owner is an important concern.
Building Considerations. The RFP should state if the tenant has any specific
requirements regarding utilities, communications, floor loading, etc.
Municipal Incentives. This section would inquire about available bonds or
other municipal or economic development incentives for locating in a specific
area.
Heating, Ventilating, and Air-conditioning (HVAC) Costs. This section defines
which energy costs the tenant will be responsible for paying and the timeframe
for payment. A building energy management system can save on operating
expenses, so the RFP should inquire about any such systems as well.
Environmental Issues. The RFP also should state if the tenant has any
environmental standards that must be met, or if there are any concerns about a
specific building due to its age, condition or location.

User Decision Analysis for Commercial Investment Real Estate 3.17

ADA (Americans with Disabilities Act). The RFP should request

representation of the buildings 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 tenants 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 landlords response to the tenants 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 key
points 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

3.18 User Decision Analysis for Commercial Investment Real Estate

Lease Document Negotiation and Execution

3 Space Acquisition

non-binding letter. If used, the LOI articulates the business points agreed to by
both parties.

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.

User Decision Analysis for Commercial Investment Real Estate 3.19

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 tenants promise to

pay rent in exchange for the right to occupy the premises, and the owners
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.

3.20 User Decision Analysis for Commercial Investment Real Estate

Most commercial leases contain the following sections.

Parties to the Lease

3 Space Acquisition

Lease Clauses

This 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 to
occupy 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 of
late 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.

User Decision Analysis for Commercial Investment Real Estate 3.21

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 landlords position regarding acceptable and excessive
utility use. The lease should be very clear on the normal, or base, utility use
included 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.

Signage
This section discloses the Landlords 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 landlords 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. In
some 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.

3.22 User Decision Analysis for Commercial Investment Real Estate

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,
landlords approval of plans, and the disposition of the improvements at the
end of the term.

3 Space Acquisition

Alterations and Improvements

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 tenants visitors.

Condemnation
Condemnation is an order allowing private property to be taken and used for
the publicfor 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.

User Decision Analysis for Commercial Investment Real Estate 3.23

Right to Relocate the Premises

This clause defines under what conditions (if any) that allows the landlord to
relocate the tenants premises. Large tenants sometimes can strike the clause,
but small tenants generally dont 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, but
more 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
tenants space, or it could involve a sublease of the entire property for a portion
of the original tenants 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.

3.24 User Decision Analysis for Commercial Investment Real Estate

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 the
building. 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.

3 Space Acquisition

Expansion and Contraction Options

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 landlords rights in the event of any default on the part
of the tenant, and further, defines the tenants rights in the event of any default
on the part of the landlord.

User Decision Analysis for Commercial Investment Real Estate 3.25

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.

3.26 User Decision Analysis for Commercial Investment Real Estate

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 at

given 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 tenants

gross sales receipts (percentage leases)

Periodic changes in contract rent based on pre-negotiation

3 Space Acquisition

Rent Terminology in Leases

Fixed Rent
Contract rents are fixed (dont 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 tenants lease payments and more likely is
included in long-term leases. If all else is the same, owners would prefer to
include this protection against inflation in their commercial leases because, in
effect, indexation passes any inflation risk from the owner to the tenant.

User Decision Analysis for Commercial Investment Real Estate 3.27

Percentage (Overage) Rent

Percentage rent is additional rent (over a base rent amount) that tenants pay to
the owner based on the tenants 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 tenants 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
Breakpoint
= Excess sales

$3,500,000
$3,000,000
$500,000

Excess sales
Overage percentage
= Overage rent

$ 500,000
0.04
$ 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 tenants 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.

3.28 User Decision Analysis for Commercial Investment Real Estate

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
following assumptions:

Base rent: $15 psf

Base lease term: 20 years

Percentage rent: 3 percent of sales above the natural breakpoint

3 Space Acquisition

Activity 3-1: Calculating Percentage Rent

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

User Decision Analysis for Commercial Investment Real Estate 3.29

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

3.30 User Decision Analysis for Commercial Investment Real Estate

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 fullservice) leases are used primarily in multitenant office buildings.

3 Space Acquisition

Operating Expenses

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 passthroughs); 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.
User Decision Analysis for Commercial Investment Real Estate 3.31

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 propertyso 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 the
percentage of the buildings rentable area or the sf that the tenant occupies.
This clause effectively limitsor stopsthe owners 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, owners 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 tenants expense cap is combined with the landlords
expense stop. In this application, the tenants expense cap may be expressed as
a limit to the amount a landlords 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 tenants share of these
expense pass-throughs is based on the gross leasable area (GLA) of the tenants
store as a proportion of the GLA of the entire shopping center. In office
properties, the pass-through is based on the tenants rentable area as a
percentage of the buildings 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.

3.32 User Decision Analysis for Commercial Investment Real Estate

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 net
lease, 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.

3 Space Acquisition

Common Area Maintenance

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 95100 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 timeeven on
a large propertyfor the completion of due diligence.
User Decision Analysis for Commercial Investment Real Estate 3.33

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 to
confirm 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

3.34 User Decision Analysis for Commercial Investment Real Estate

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.

3 Space Acquisition

Parking access in the subject property area

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

User Decision Analysis for Commercial Investment Real Estate 3.35

Tenant mix and the impact of that mix, if any, on the propertys 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 dont 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?

3.36 User Decision Analysis for Commercial Investment Real Estate

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 on
the 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.

3 Space Acquisition

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.

User Decision Analysis for Commercial Investment Real Estate 3.37

Module 3: Self-Assessment Review

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

1. An owners 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. Office
b. Industrial
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.
b. The costs to maintain the exterior of a property.
c. Those expenses and charges in operating a property that are considered
normal, 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

3.38 User Decision Analysis for Commercial Investment Real Estate

a. True
b. False

3 Space Acquisition

6. The term expense stop refers to a predetermined maximum amount that

an owner will pay annually or per square foot toward operating expense.

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 tenants 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 tenants
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

User Decision Analysis for Commercial Investment Real Estate 3.39

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 tenants 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

3.40 User Decision Analysis for Commercial Investment Real Estate

3 Space Acquisition

Answer Section

User Decision Analysis for Commercial Investment Real Estate 3.41

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

Amount of sales subject to percentage rent percent amount = percentage rent

$630,758 3% = $18,923

3.42 User Decision Analysis for Commercial Investment Real Estate

1. An owners interest in a property that is leased is called:

c. Leased fee interest

3 Space Acquisition

Module 3: Self-Assessment Review

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 or
maximum 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 tenants 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

User Decision Analysis for Commercial Investment Real Estate 3.43

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 tenants
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
5%

= $2,000,000

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
Total sales natural breakpoint = amount of sales subject to percentage rent
$2,500,000 $2,000,000 = $500,000
Amount of sales subject to percentage rent percent amount = percentage rent
$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 tenants percentage rent (excluding its base rent)?

d.

$18,771

Total sales natural breakpoint = amount of sales subject to percentage rent

$2,375,420 $2,000,000 = $375,420
Amount of sales subject to percentage rent percent amount = percentage rent
$375,420 5% = $18,771

3.44 User Decision Analysis for Commercial Investment Real Estate

a. $15.75
Year One:

$15.00

Year Two:

$15.00

Year Three: $15.75

3 Space Acquisition

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?

(No increase)
($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)

User Decision Analysis for Commercial Investment Real Estate 3.45

User Decision Analysis for Commercial Investment Real Estate

4
Comparative Lease
Analysis
and Valuing
Leasehold
Interests

In This Module
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 ....................... 4.7

Sample 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

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 or More 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 FAS13 ........................................................................ 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

Module 4: Self-Assessment Review .......... 4.47

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

Comparative Lease Analysis

and Valuing Leasehold
Interests
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 users 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 users

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.

User Decision Analysis for Commercial Real Estate 4.1

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.

Rate
This 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 operating
expense 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

4.2 User Decision Analysis for Commercial Investment Real Estate

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.

4 Lease Analysis, Leasehold Interests

Average Annual Effective Rent

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 users 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.

User Decision Analysis for Commercial Investment Real Estate 4.3

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 capabilitiesessentially 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 users
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 users financial
situation may not be able to accommodate that upfront cost, or it may be more
prudent 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 users 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 businesss lifecycle. The user also might decide to enter the
more expensive alternative if that choice better meets the users 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 which
operating expenses are included in the base rentin 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 triplenet or absolute-net leases), in which the user pays all operating expenses in
addition to the base rent.

4.4 User Decision Analysis for Commercial Investment Real Estate

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 ceiling
on expenses paid by the landlord.

Modified Gross Lease

4 Lease Analysis, Leasehold Interests

Full Service 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 property
taxes but not insurance, or vice versa. Its 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.

User Decision Analysis for Commercial Investment Real Estate 4.5

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.

4.6 User Decision Analysis for Commercial Investment Real Estate

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 users 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.

4 Lease Analysis, Leasehold Interests

Objective Leasing Decisions

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 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.)
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 B

Lease A
EOP

EOP

($0)

($0)

$61,250

$39,667

$63,088

$61,250

$64,980

$63,000

$66,930

$64,750

$68,937

$66,500

Total:

$325,185

$295,167

User Decision Analysis for Commercial Investment Real Estate 4.7

2. Derive total effective rents and rates from lease cash flows for each
alternative.
a. Annual effective rate = each years cash flow rsf
A
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

Total effective rent

$325,185

$295,167

c. Total effective rate = total effective rent total rsf

Total effective rate

$92.91 psf

$84.33 psf

d. Average annual effective rent = total effective rent number of lease

term years

Average annual effective rent

$65,037 per year

$59,033 per year

e. Average annual effective rate = average annual effective rent total rsf

Average annual effective rate

4.8 User Decision Analysis for Commercial Investment Real Estate

$18.58 psf per year

$16.87 psf per year

So far, the lease comparison analysis has failed to take into account the time
value of money (TVM). The value of a stream of cash flows depends on
the magnitude and timing of the cash flows. Using a discount rate of 10
percent, (provided by the client in this case) calculate the PV of the annual
effective rents. The result is the discounted effective rent, or the PV (cost)
of occupancy, or the present cost of occupancy.
The choice of a discount rate may affect the clients decision, especially if
the pattern of the cash flows varies significantly across leases. In particular,
although higher discount rates will reduce the PV of the cash flows on all
lease options, the effect will be more significant on leases that have a large
proportion of cash flows in the later years of the lease. (Refer to Module 2
for more information on selection of a discount rate for a user.) As such, it
may be advisable to provide a range of discounted effective rents based on a
range of discount rates.
A

4 Lease Analysis, Leasehold Interests

3. Calculate the PV of the lease cash flows.

PV at 9%

$251,688

$225,683

PV at 10%

$245,159

$219,530

PV at 11%

$238,896

$213,630

4. Using the output in the above calculations, advise the client.

By every measure (average annual effective rent, average annual effective
rate, present cost of occupancy), Lease B is less expensive than Lease A.
Other considerations (subjective and utility factors) being equal, the client
should, therefore, choose Lease B.
This example illustrates several important elements in the process of evaluating
and comparing leases and points out some difficulties as well. The following
steps will aid the participant in the analysis of leases.

In analyzing a lease, convert all economic items of the lease into actual cash
flows.

When using the PV method of comparing leases, derive and establish a

discount rate with the user or use a range of discount rates. Discount rates
may not necessarily be the same if the cash flows associated with one lease
are more risky (or less certain) than the cash flows associated with another
lease.

User Decision Analysis for Commercial Investment Real Estate 4.9

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) is
the 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 common
area (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.

4.10 User Decision Analysis for Commercial Investment Real Estate

1. The term effective rent includes downward adjustments for concessions

and allowances and upward adjustments for tenant-paid costs and expenses.
a. True
b. 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

4 Lease Analysis, Leasehold Interests

Activity 4-1: Economic Lease Comparison

3. The term total effective rate refers to the total effective rent divided by the
total 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
User Decision Analysis for Commercial Investment Real Estate 4.11

Analyzing Lease Cost

In the previous example, no consideration was given to additional leasing costs
or allowancesbase 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.

4.12 User Decision Analysis for Commercial Investment Real Estate

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

4 Lease Analysis, Leasehold Interests

The analysis must be adapted for the circumstances of each lease, as follows:

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.

User Decision Analysis for Commercial Investment Real Estate 4.13

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 the
first 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 landlords 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.

4.14 User Decision Analysis for Commercial Investment Real Estate

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 users 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.

4 Lease Analysis, Leasehold Interests

User Decision Analysis for Commercial Investment Real Estate 4.15

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

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

TI allowance

$12 psf

Free rent (four months)

$19,833

Owners contribution to users lease termination fee

$12,000

Owners contribution to users moving expenses

$7,000

Tenant Expenses

Landlord Allowances

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

Users 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).

4.16 User Decision Analysis for Commercial Investment Real Estate

Year

Base rent

$59,500

$61,250

$63,000

$64,750

$66,500

Operating expenses

24,500

25,235

25,992

26,772

27,575

Landlords 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

Landlords property tax expense stop

7,000

7,000

7,000

7,000

7,000

Net TPTI*

Parking

5,250

5,250

5,250

5,250

5,250

Net Existing Lease Buyout

Net Moving Expenses

Free rent

Total Effective Rent

$67,445

$70,168

$72,921

$75,704

$21,000
15,000

4 Lease Analysis, Leasehold Interests

Lease B: Annual Cash Flows Users Perspective

8,000
19,833
$44,000

$44,917

*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

Total effective rent

$375,155

Premises square feet

Total effective rate

$107.19 psf

Total effective rent

Lease term
Average annual effective rent

3,500

$375,155

5 years
$75,031

User Decision Analysis for Commercial Investment Real Estate 4.17

Average annual effective rent

Premises square feet

$75,031

Average effective rate

3,500
$21.44 psf

Present Value: Discounted Effective Rent Analysis

EOY

$44,000

$44,917

$67,445

$70,168

$72,921

$75,704

PV @ 10% = $290,104

Discounted effective rent or present cost of occupancy

4.18 User Decision Analysis for Commercial Investment Real Estate

4 Lease Analysis, Leasehold Interests

Activity 4-2: Analyzing Multi-Period Leases

The landlord and user have entered into additional negotiations over the multiperiod 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 has agreed to the users 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 users:

Total effective rent

Total effective rate

Average annual effective rent

Average annual effective rate

Discounted effective rent at the users 10 percent discount rate

Lease B: Counter Offer Annual Cash Flows:
Year

Base rent
+

Operating expenses

Landlords operating expense stop

Property taxes

Landlords property tax expense stop

Net TPTI

Parking

Net existing lease buyout

Net moving expenses

Free rent

Total effective rent

User Decision Analysis for Commercial Investment Real Estate 4.19

Part Two
Furthermore, the user has just been notified that their current landlord has
leased the space that the user is vacating. Consequently, the current landlord
has agreed to eliminate the buyout cost if the user can vacate within 45 days,
which the user has agreed to do. As a result, the new landlord has agreed to
provide six months of free rent since the landlords existing lease buyout
allowance is now eliminated. Based on these new developments, using the
worksheet below, recalculate the users:

Total effective rent

Total effective rate

Average annual effective rent

Average annual effective rate

Discounted effective rent at the users 10 percent discount rate

Lease B: Revised Counter Offer Annual Cash Flows:

Year

Base rent
+

Operating expenses

Landlords operating
expense stop

Property taxes

Landlords property
tax expense stop

Net TPTI

Parking

Net existing lease

buyout

Net moving expenses

Free rent

= Total effective rent

End of activity
4.20 User Decision Analysis for Commercial Investment Real Estate

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 users 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

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 expense

growth

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

TI allowance

$12 psf

$12 psf

Free rent at beginning of

term

0 months

6 months

Tenant expenses

Landlord allowances

Landlords contribution to
users moving expenses

$12,000

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

4 Lease Analysis, Leasehold Interests

Comparing Two Leases of Equal Terms

$7,000

User Decision Analysis for Commercial Investment Real Estate 4.21

Lease A: Annual Cash Flows

Year

Base rent

$61,250

$63,394

$65,613

$67,909

$70,286

Operating expenses

26,250

27,038

27,849

28,684

29,545

Landlords operating
expense stop

26,250

26,250

26,250

26,250

26,250

Property taxes

7,875

8,111

8,355

8,605

8,863

Landlords property tax

expense stop

7,875

7,875

7,875

7,875

7,875

Net TPTI

Parking

6,000

6,000

6,000

6,000

6,000

Net existing lease buyout

Net moving expenses

$70,418

$73,691

$77,073

$80,569

= Total effective rent

$0
3,000
0
$3,000

$67,250

Lease B: Annual Cash Flows

Year

Base rent

$59,500

$60,375

$61,250

$62,125

$63,000

Operating expenses

24,500

25,235

25,992

26,772

27,575

Owners 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

Owners property tax

expense stop

7,000

7,000

7,000

7,000

7,000

Net TPTI

Parking

5,250

5,250

5,250

5,250

5,250

Net moving expenses

Free rent

$66,570

$68,418

$70,296

$72,204

= Total effective rent

$21,000
8,000
29,750
$29,000

$35,000

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.

4.22 User Decision Analysis for Commercial Investment Real Estate

Year

Lease B

$3,000

$29,000

67,250

35,000

70,418

66,570

73,691

68,418

77,073

70,296

80,569

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

4 Lease Analysis, Leasehold Interests

Lease A

PV Analysis
Lease A
EOP

Lease B
$

EOP

$3,000

$29,000

$67,250

$35,000

$70,418

$66,570

$73,691

$68,418

$77,073

$70,296

$80,569

$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

$21.26

$19.51

$280,367

$260,084

Average annual effective rate (psf)

Discounted effective rent

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 users interests in mind, including the subjective
and functional differences between the alternative spaces.
User Decision Analysis for Commercial Investment Real Estate 4.23

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 lease
proposal 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

4.24 User Decision Analysis for Commercial Investment Real Estate

As introduced in Module 2, there are financial accounting, reporting rules, and

standards specific to leases. These rules and standards must be taken into
account 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

4 Lease Analysis, Leasehold Interests

Principles of Financial Accounting and

Reporting for Leases

If an organization uses generally accepted accounting principles (GAAP), the

companys 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 companys 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 balance
statement. 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 companys best interests.
The determination of whether a lease is a capital lease versus an operating lease
lies in the proposed leases 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 comprise
the vast majority of leases, do not pass any of the GAAP FAS-13 tests for a
capital lease.

User Decision Analysis for Commercial Investment Real Estate 4.25

Operating Lease Reporting

Under GAAP, operating leases require the following accounting and reporting:

Rent is entered as an expense on the users income statement.

Rent expense is straight lined over the full term of the lease, including free
rent, build-out periods, or rent vacationsvirtually 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 tenants balance statement as an
asset, less accumulated depreciation.

Tenant improvement depreciation is included as an expense on the users

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 users balance statement. The net rent cash flows,
including free rent periods, are discounted at the users 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 users 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 users incremental borrowing rate. The principal amortization
portion reduces the outstanding balance of the capital lease liability on the
users balance statement.

The interest and cost recovery expense appear on the users income
statement.

4.26 User Decision Analysis for Commercial Investment Real Estate

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.

Although 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 users financial statementsincluding recording the lease
liability and asset on the users balance statementbecause the lease terms pass
certain FAS-13 tests.

4 Lease Analysis, Leasehold Interests

User Decision Analysis for Commercial Investment Real Estate 4.27

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 users 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 users
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 users incremental
borrowing rate.
Each of the four tests is covered in more detail below.

Ownership of the Premises Transfers to the User at the

End 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

4.28 User Decision Analysis for Commercial Investment Real Estate

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.

4 Lease Analysis, Leasehold Interests

tankers.) A bargain purchase option may come into play if the property is a
special-purpose asset.

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 performing
building, 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. FAS13 includes the following guidelines when calculating the PV of the users
proposed 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.

User Decision Analysis for Commercial Investment Real Estate 4.29

Include rent only to the earliest termination option date.

Include any early termination fees.

Discount the cash flows at the users 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 users 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 users 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 premises 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 upon
mutual 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 users lease cash flows
against 90 percent of the fair market value of the premises at inception of the
lease. If the PV of the users 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 a
capital 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 propertys 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 were
in 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.
4.30 User Decision Analysis for Commercial Investment Real Estate

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 users ability to
borrow additional funds, which are greatly needed for the users growing
business operations.

4 Lease Analysis, Leasehold Interests

Sample Problem 4-3: FAS-13 Lease AnalysisCapital

Lease Tests

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

User Decision Analysis for Commercial Investment Real Estate 4.31

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 at
the 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

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,000,000

$1,100,000

$1,100,000

$1,100,000

$1,100,000

$3,100,000

$1,100,000

$1,100,000

$1,100,000

$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
18
19
20

$1,331,000
$1,331,000
$1,331,000
$1,331,000

Note: Highlighted rows are the years in which the 10 percent rent escalation
begins.

4.32 User Decision Analysis for Commercial Investment Real Estate

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 to
resolves 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?

4 Lease Analysis, Leasehold Interests

Practical Applications and Facts about FAS-13

Prior to signing, many leases still can be structured (or restructured) to achieve
the desired accounting impact. However, it is difficult to change the structure
and 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 users 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 effective
rent 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

Lease term (years)

= Average annual effective net rent

User Decision Analysis for Commercial Investment Real Estate 4.33

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. Its perfect.
Were all set up. Weve been here going on 10 years. Its the right size and the
right location, and the employees like it here.
He goes on, Its well maintained, and nothing needs to be done to the place.
Besides, moving would be a royal pain. Ill e-mail you the landlords proposal.
He kept the rent flat for the first five years like we requested. Buddy, Im
having lunch with my three other shareholders in a couple hours. Were
working on some financing for the company right now. Sorry, but can you get
me something to share with them at lunch? Ill owe you big time.
Before hanging up, at your request, he transfers you to Michelle Landing, the
companys chief financial officer, who promises to e-mail you the answers to
your information requests. She adds, Were trying to finalize a new credit
facility for the company, so make sure the lease isnt 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 Landings e-mail gives you the answers to your information requests:

The companys banker says that if they were to buy the building with a 10to 15-year loan, the borrowing rate would be 7 percent.

4.34 User Decision Analysis for Commercial Investment Real Estate

Given the corporate structure, the companys 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.

4 Lease Analysis, Leasehold Interests

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?

User Decision Analysis for Commercial Investment Real Estate 4.35

4. What is the total effective net rent for the extension proposal?
Year

Gross (Full Service) Rent

Expense Stop

Net Rent

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Total effective rent

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 companys objectives?

End of activity
4.36 User Decision Analysis for Commercial Investment Real Estate

Depending on the types of spaces under consideration, as well as the users

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 users 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.

4 Lease Analysis, Leasehold Interests

Comparing Dissimilar Leases

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.

User Decision Analysis for Commercial Investment Real Estate 4.37

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 companys 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 its 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 an
entrance/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): In
the 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 RCSs needs with only minor modification. The
space has an additional 2,000 sf of non-air-conditioned space that RCS
doesnt 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
4.38 User Decision Analysis for Commercial Investment Real Estate

4 Lease Analysis, Leasehold Interests

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

Users discount rate: 9 percent

Lease Term is 5 years

Proposed Terms
InfoTech Building A

Chambers
Building

InfoTech Building G

12,000 sf

11,500 sf

14,000 sf

$12 psf

$16 psf

$6 psf

$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

Size
Base rental rate year one
Operating expense base year one

User Decision Analysis for Commercial Investment Real Estate 4.39

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

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

4.40 User Decision Analysis for Commercial Investment Real Estate

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

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

4 Lease Analysis, Leasehold Interests

Chambers

User Decision Analysis for Commercial Investment Real Estate 4.41

InfoTech Building G

Year 0

Year 1

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

4.42 User Decision Analysis for Commercial Investment Real Estate

Year 2

Year 3

Year 4

Year 5

InfoTech A

Chambers

Total effective rent

Total effective rate
Average annual effective rent
Average annual effective rate
Discounted effective rent
(present cost of occupancy)

InfoTech G

4 Lease Analysis, Leasehold Interests

1. Complete the following comparison table of occupancy cost measures.

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
User Decision Analysis for Commercial Investment Real Estate 4.43

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 the
user) 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)

4.44 User Decision Analysis for Commercial Investment Real Estate

4 Lease Analysis, Leasehold Interests

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 rate

Annual Lease Cash Flows
Year

Rent

Free rent
Totals

$80,000

$83,200

$86,528

40,000

-----

-----

$40,000

$83,200

$86,528

$89,989

5
$93,589
-----

$89,989

$93,589

PV (Present Cost of Occupancy) Using Annual Discounting

EOP

($0)

$40,000

$83,200

$86,528

$89,989

$93,589

PV = $289,709

User Decision Analysis for Commercial Investment Real Estate 4.45

PV Using Monthly Discounting10 Percent Annual Rate (0.8333

percent monthly)
EOP

($0)

Year 1, Months 1-6

$0

Year 1, Months 7-12

$6,666.67

Year 2, Months 13-24

$6,933.33

Year 3, Months 25-36

$7,210.67

Year 4, Months 37-48

$7,499.08

Year 5, Months 49-60

$7,799.08

PV = $298,398

Summary:
Annual discounting PV:

$289,709

Monthly discounting PV: $298,398

Arguably, it is better to discount on a monthly basis because rents typically are

paid monthly. Although this is a simple example, the same approach can be
used for operating expenses, property tax adjustments, or any monthly or
annual adjustments. The fact that lease payments typically are made at the
beginning of the month also can be incorporated into a refined analysis.
Whatever time period is used, annual or monthly, remember the application is
a comparative analysis. In other words, the utilization of the PV (present cost of
occupancy) is for comparing various leasing alternatives for the user. Therefore,
it is important to use the same number of periods per year (annual or monthly)
for each of the leases being compared.

4.46 User Decision Analysis for Commercial Investment Real Estate

To test your understanding of the key concepts in this module, answer the
following 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 users
moving costs are estimated at $2,500. What is the users total effective
rent?

4 Lease Analysis, Leasehold Interests

Module 4: Self-Assessment Review

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

User Decision Analysis for Commercial Investment Real Estate 4.47

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 owners 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 year
two?
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

4.48 User Decision Analysis for Commercial Investment Real Estate

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.

4 Lease Analysis, Leasehold Interests

6. From the information in questions 3 through 5, how could you handle the
user-paid costs in year zero?

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 users 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
1
2
3
4
5

($4,700)
(87,387)
(89,407)
(92,536)
(95,542)
($99,365)

a. ($326,412)
b. ($375,323)
c. ($354,511)
d. ($368,633)

User Decision Analysis for Commercial Investment Real Estate 4.49

9. From the information in question 8, and assuming 7,282 rsf, what is the
users 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 users 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 users average
annual effective rent?
a. $96,732
b. $93,787
c. $87,340
d. $101,843

12. From the information in questions 8 through 11, what is the users average
annual effective rate?
a. $12.26
b. $11.48
c. $13.64
d. $12.88

End of assessment

4.50 User Decision Analysis for Commercial Investment Real Estate

4 Lease Analysis, Leasehold Interests

Answer Section

User Decision Analysis for Commercial Investment Real Estate 4.51

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. True
2. The term total effective rent refers to the total rent paid by a user over
only the first year of a multiyear lease.

b. False
3. The term total effective rate refers to the total effective rent divided by the
total rentable square feet occupied by a user.

a. True
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
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.

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

4.52 User Decision Analysis for Commercial Investment Real Estate

4 Lease Analysis, Leasehold Interests

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

Base rent

$59,500

$60,375

$61,250

$62,125

$63,000

Operating
expenses

24,500

25,235

25,992

26,772

27,575

Landlords
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

Landlords
property tax
expense stop

7,000

7,000

7,000

7,000

7,000

Net TPTI

Parking

5,250

5,250

5,250

5,250

5,250

Net existing lease

buyout

Net moving
expenses

Free rent

= Total effective rent

$21,000

15,000
8,000
9,917
$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

User Decision Analysis for Commercial Investment Real Estate 4.53

Lease B: Revised Counter Offer Annual Cash Flows

Year

Base rent

$59,500

$60,375

$61,250

$62,125

$63,000

Operating expenses

24,500

25,235

25,992

26,772

27,575

Landlords 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

Landlords property tax

expense stop

7,000

7,000

7,000

7,000

7,000

Net TPTI

Parking

5,250

5,250

5,250

5,250

5,250

Net existing lease buyout

Net moving expenses

Free rent

$66,570

$68,418

$70,296

$72,204

$21,000
0
8,000
29,750

= Total effective rent

$29,000

$35,000

Activity 4-3: Analyzing Occupancy Cost Measures

1. Which occupancy cost measure do you feel is most credible for the user?
Why?

Answers may 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.

4.54 User Decision Analysis for Commercial Investment Real Estate

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)?

4 Lease Analysis, Leasehold Interests

Activity 4-4: Analyzing Operating Versus Capital Leases

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 premises 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

$584,400

$584,400

$584,400

$584,400

$584,400

$654,528

$674,164

$694,389

$715,220

10

$736,677

11

$758,777

12

$781,541

13

$804,987

14

$829,136

15

$854,011

Total effective rent

$10,425,430

User Decision Analysis for Commercial Investment Real Estate 4.55

4. What is the total effective net rent for the extension proposal?

$7,704,317
Year

Gross (Full
Service) Rent

Expense Stop

Net Rent

$ 584,400

$181,408

$402,992.50

$584,400

$181,408

$402,992.50

$584,400

$181,408

$402,992.50

$ 584,400

$181,408

$402,992.50

$584,400

$181,408

$402,992.50

$654,528

$181,408

$473,120.50

$674,164

$181,408

$492,756.34

$694,389

$181,408

$512,981.26

$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 users 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.

4.56 User Decision Analysis for Commercial Investment Real Estate

4 Lease Analysis, Leasehold Interests

7. What recommendations would you make to your friend/client to modify

the proposal to better meet the companys 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
Base rent

Year 0

Parking
+

Year 1
$144,000

Year 2
$144,000

Year 3
$144,000

Year 4
$144,000

54,000

55,620

57,289

59,007

60,777

Year 5
$144,000
-

Operating expense
Operating expense
stop

(54,000)

(54,000)

(54,000)

(54,000)

(54,000)

Property tax

Property tax stop

CAM expense

CAM expense stop

Insurance
Insurance expense
stop

Janitorial
Janitorial expense
stop

14,400

14,832

26,400

Electricity expense
Electricity expense
stop

Total TI cost

$84,000

TI allowance

(72,000)

Moving cost
Moving cost
allowance

Lease buyout cost

Lease buyout
allowance

Free rent

Total effective rent

15,277

15,735

16,207

27,456

28,554

29,696

30,884

$184,800

$187,908

$191,120

$194,439

$197,869

$12,000

User Decision Analysis for Commercial Investment Real Estate 4.57

Chambers Building

Year 0

Base rent

Year 1

Year 2

Year 3

Year 4

Year 5

$184,000

$184,000

$184,000

$184,000

$184,000

92,000

94,760

97,603

100,531

103,547

(92,000)

(92,000)

(92,000)

(92,000)

(92,000)

Parking
+

Operating expense
Operating expense
stop

Property tax

Property tax stop

CAM expense

CAM expense stop

Insurance
Insurance expense
stop

Janitorial
Janitorial expense
stop

Electricity expense
Electricity expense
stop

Total TI cost

$ 161,000

TI allowance

(138,000)

Moving cost
Moving cost
allowance

40,250

$184,000

$186,760

$189,603

$192,531

$195,547

Lease buyout cost

Lease buyout
allowance

Free rent

Total effective rent

(23,000)
$40,250

4.58 User Decision Analysis for Commercial Investment Real Estate

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

$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

Property tax stop

CAM expense

39,393

Base rent
+

35,000

36,050

37,132

38,245

CAM expense stop

Insurance
Insurance expense
stop

11,900

12,257

12,625

13,003

13,394

Janitorial
Janitorial expense
stop

15,400

15,862

23,800

24,752

25,742

Electricity expense
Electricity expense
stop

Total TI cost

$84,000

TI allowance

(56,000)

Moving cost
Moving cost
allowance

42,000

$200,900

$204,337

$207,880

Lease buyout cost

Lease buyout
allowance

Free rent

Total effective rent

16,338

16,828

17,333

26,772
-

4 Lease Analysis, Leasehold Interests

Infotech Building G

27,843
-

(21,000)
$49,000

$211,534

$215,301

User Decision Analysis for Commercial Investment Real Estate 4.59

1. Complete the following comparison table of occupancy cost measures.

InfoTech A

Chambers

InfoTech G

Total effective rent

$968,136

$988,691

$1,088,952

Total effective rate

$80.68 psf

$85.97 psf

$77.78 psf

Average annual effective rent

$193,627

$197,738

$217,790

Average annual effective rate

$16.14 psf

$17.19 psf

$15.56 psf

Discounted effective rent

$753,626

$776,144

$855,607

2. If the discount rate was increased, would the resulting discounted effective
rent make InfoTech A more or less preferable?

It would make it more preferable; primarily due to the lower time period
zero costs.

3. In this situation, why is the analysis of rate (total effective or average annual)
not as important or reliable?

Each alternative has a different square footage, so comparing rents is a more

relevant comparison as it takes into consideration differences in size, rates,
etc.

4.60 User Decision Analysis for Commercial Investment Real Estate

4 Lease Analysis, Leasehold Interests

Module 4: Self-Assessment Review

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 users
moving costs are estimated at $2,500. What is the users total effective
rent?

b. $1,081,250
Year 0
Base rent

Year 1
$150,000

Parking
+

Year 3
$150,000

Year 4
$150,000

Year 5
$150,000

Operating expense
Operating expense
stop

Property tax

Property tax stop

CAM expense

CAM expense stop

Insurance
Insurance expense
stop

Janitorial
Janitorial expense
stop

Electricity expense
Electricity expense
stop

Total TI cost

$7,500

TI allowance

($5,000)

Moving cost
Moving cost
allowance

$2,500

$215,250

$215,250

$215,250

$215,250

$215,250

Year 2
$150,000

Lease buyout cost

Lease buyout
allowance

Free rent
Total effective rent

$65,250

$65,250

$65,250

$65,250

$65,250

$5,000

User Decision Analysis for Commercial Investment Real Estate 4.61

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 owners 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 year
two?

a. $2,032
Year 1 operating expense psf

$4.00

Year 2 operating expense psf

Difference psf:
Monthly difference

$4.16
$0.16
$2,032.00

(Increase of 4%)

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

4.62 User Decision Analysis for Commercial Investment Real Estate

$38,100

(12,700 $3.00)

a. $43,100
Net TPTI
Moving expense
Total period zero cost

$38,100
$5,000
$43,100

6. From the information in questions 3 through 5, how could you handle the
user-paid costs in year zero?

4 Lease Analysis, Leasehold Interests

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?

d. Any of the above

7. Comparative lease analysis is useful to

d. All of the above

8. As seen from the users 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

c.

0
1
2
3
4
5

($4,700)
(87,387)
(89,407)
(92,536)
(95,542)
($99,365)

($354,511)

User Decision Analysis for Commercial Investment Real Estate 4.63

9. From the information in question 8, and assuming 7,282 rsf, what is the
users total effective rent?

a. $468,937
Year 0
Year 1

($4,700)
(87,387)

Year 2
Year 3

(89,407)
(92,536)

Year 4

(95,542)
(99,365)

Year 5
Total effective rent

($468,937)

10. From the information in questions 8 and 9, what is the users total effective
rate?

c. $64.40
Total effective rent premises sf = total effective rate
$468,937 7,282 = $64.40

11. From the information in questions 8 through 10, what is the users average
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 users average
annual effective rate?

d. $12.88
Average annual effective rent premises sf = average annual effective rate
$98,787 7,282 = $12.88

4.64 User Decision Analysis for Commercial Investment Real Estate

User Decision Analysis for Commercial Investment Real Estate

Lease
Versus Own

In This Module
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
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
Future Sales 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

Module 5: Self-Assessment Review .......... 5.37
Answer Section ....................................... 5.41
Activity 5-1: Methods of Comparing Costs ..... 5.42
Activity 5-2: Calculating Costs Answers ............ 5.43
Module 5: Self-Assessment Review ................... 5.44

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 users financial statements.

User Decision Analysis for Commercial Investment Real Estate 5.1

NOTES

5.2 User Decision Analysis for Commercial Investment Real Estate

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.

5 Lease versus Own

Leasing

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 lessors risk in the event of the firms failure. If the
lessee 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.

User Decision Analysis for Commercial Investment Real Estate 5.3

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 lessees 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 Assets 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 improvements
importantsuch as technological changes necessary to the business, physical
changes to accommodate staff, or cosmetic changes to impress customersthe
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

5.4 User Decision Analysis for Commercial Investment Real Estate

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.

5 Lease versus Own

obligated to keep paying the lease and may not cancel it without paying a
penalty.

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 lessees 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.

User Decision Analysis for Commercial Investment Real Estate 5.5

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, fund the owners 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 be
important 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 companys operations or other investments.
Financing. Often a companys ability to obtain a loan not only depends on its
financial 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.
5.6 User Decision Analysis for Commercial Investment Real Estate

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.

5 Lease versus Own

Risks. Risks to ownership include potential damage, obsolescence, and the

inability to sell at preferred prices at the right time.

User Decision Analysis for Commercial Investment Real Estate 5.7

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 users 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

Val ue Line Char t

$50,000

$40,000

$30,000

$20,000

$10,000

$0

Positive NPV/PV

($10,000)

($20,000)

($30,000)

($40,000)

Lesser
NPV/PV

($50,000)

(Negative NPV/PV)

Greater
NPV/PV

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

5.8 User Decision Analysis for Commercial Investment Real Estate

5 Lease versus Own

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 each
alternative. 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 an
NPV 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 alternatives periodic cash flows after tax
from the own alternatives periodic cash flows after tax and calculates an IRR of
this differential. This IRR is after tax and is compared to the users 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 makers opportunity cost is higher than this equilibrium rate, it will be
cheaper to lease.

User Decision Analysis for Commercial Investment Real Estate 5.9

The IRR of the differential cash flows also indicates the after-tax yield on the
capital invested in the ownership alternative if the user chooses to own.
This yield can be compared to the yield on alternative investment opportunities
that may be available, such as investing in the core business.
The following steps are used in the IRR of the differential cash flows method:
1. Determine the after-tax cash flows for both the lease and the own
alternative.
2. Subtract the lease alternatives periodic cash flows from those of the own
alternative to determine a differential cash flow for each period. Calculate
the IRR on the differential cash flows for the holding period.
3. Compare the resulting IRR with the decision makers opportunity costs.

If the IRR is greater than the appropriate discount rate, the best
decision is to buy.

If the IRR is less than the appropriate discount rate, the best decision is
to lease.

If the IRR equals the appropriate discount rate, revert to non-cost

factors to make the decision.

5.10 User Decision Analysis for Commercial Investment Real Estate

1. The two methods of comparing leasing and owning costs are the net present
value method and the future value (method.
a. True

5 Lease versus Own

Activity 5-1: Methods of Comparing Costs

b. False
2. The net present value method compares the net present values of the aftertax 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 users appropriate
discount rate.
a. True
b. False
6. If the internal rate of return of the differential cash flows is greater than the
users appropriate discount rate, then the user should buy (own) instead of
lease.
a. True
b. False

User Decision Analysis for Commercial Investment Real Estate 5.11

7. If the internal rate of return of the differential cash flows is less than the
users 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
users opportunity cost, then the user should evaluate the subjective aspects
of buying (owning) or leasing.
a. True
b. False

End of activity
5.12 User Decision Analysis for Commercial Investment Real Estate

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 retrofitting
to 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.

5 Lease versus Own

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

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 to
including an early termination clause in the lease to avoid it being categorized as
a capital lease. A termination clause at the tenants 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 years 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

User Decision Analysis for Commercial Investment Real Estate 5.13

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

5.14 User Decision Analysis for Commercial Investment Real Estate

The two analytical approaches to comparing the costs of owning and leasing are
the NPV method and the IRR of the differential method.

5 Lease versus Own

Determining the Impact of Different

Alternatives
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 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:
Annual leasing cost (pre-tax)

Tax bracket
Annual tax savings

Annual leasing cost (pre-tax)

Annual tax savings

Annual leasing cost (after tax)

User Decision Analysis for Commercial Investment Real Estate 5.15

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.

(1)
Annual Lease
Payments

(2)
Tax Savings
(1) 34%

Cash Flow
After Tax
(1) (2)

$0

$0

$0

($120,000)

($40,800)

($79,200)

($120,000)

($40,800)

($79,200)

($120,000)

($40,800)

($79,200)

($120,000)

($40,800)

($79,200)

($120,000)

($40,800)

($79,200)

($120,000)

($40,800)

($79,200)

($120,000)

($40,800)

($79,200)

($120,000)

($40,800)

($79,200)

($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 years 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.

5.16 User Decision Analysis for Commercial Investment Real Estate

5 Lease versus Own

Following is the cash flow analysis worksheet (CFAW) for years one through
five.

User Decision Analysis for Commercial Investment Real Estate 5.17

Following is the CFAW for years six through ten.

5.18 User Decision Analysis for Commercial Investment Real Estate

5 Lease versus Own

Following is the CFAW for years 1115.

User Decision Analysis for Commercial Investment Real Estate 5.19

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

Principal Balance - 1st Mortgage

Principal Balance - 2nd Mortgage
TOTAL UNPAID BALANCE

Calculation of Sale Proceeds

$1,884,000

PROJECTED SALES PRICE

CALCULATION OF ADJUSTED BASIS:

1

Basis at Acquisition

2
3

+Capital Additions
-Cost Recovery (Depreciation) Taken

-Basis in Partial Sales

=Adjusted Basis at Sale

$1,450,000
$415,925
$1,034,075

CALCULATION OF CAPITAL GAIN ON SALE:

6

Sale Price

7
8

-Costs of Sale
-Adjusted Basis at Sale (Line 5)

-Participation Payment on Sale

$1,884,000
$56,520
$1,034,075

10 =Gain or (Loss)
11 -Straight Line Cost Recovery (limited to gain)

$793,405
$415,925

12 -Suspended Losses

$377,480

13 =Capital Gain from Appreciation

ITEMS TAXED AS ORDINARY INCOME:
14 Unamortized Loan Fees/Costs (negative)
15 +
16 =Ordinary Taxable Income
CALCULATION OF SALES PROCEEDS AFTER TAX:
17

$1,884,000
$56,520

Sale Price

18 -Cost of Sale
19 -Participation Payment on Sale
20 -Mortgage Balance(s)
21 +Balance of Funded Reserves

$1,827,480

22 =Sale Proceeds Before Tax

23 -Tax (Savings): Ordinary Income at 34% of Line 16
24 -Tax: Straight Line Recapture at 34% of Line 11
25 -Tax on Capital Gains at 34% of Line 13
26 =SALE PROCEEDS AFTER TAX

$141,415
$128,343
$1,557,722

Copyright 2009 by the CCIM Institute

The statements and figures herein, while not guaranteed, are secured from sources we believe authoritative.

5.20 User Decision Analysis for Commercial Investment Real Estate

15

b) Calculate the NPV of the sale proceeds after tax using the 9 percent aftertax discount rate applied to the ownership sale proceeds after tax.

5 Lease versus Own

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.

c) Add the two NPVs to quantify the total NPV of the ownership alternative.
n

Annual Cash
Flows

Sale Proceeds
After Tax

($1,450,000)

$0

$9,085

$0

$9,480

$0

$9,480

$0

$9,480

$0

$9,480

$0

$9,480

$0

$9,480

$0

$9,480

$0

$9,480

$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

Net Present Value

of Ownership

($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.
User Decision Analysis for Commercial Investment Real Estate 5.21

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.
Annual leasing cost (pre-tax)

Tax bracket
Annual tax savings

Annual leasing cost (pre-tax)

Annual tax savings

Annual leasing cost (after tax)

5.22 User Decision Analysis for Commercial Investment Real Estate

(1)
Annual Lease
Payments

(2)
Tax Savings
(1) 34%

Cash Flow
After Tax
(1) (2)

$0

$0

$0

($120,000)

($40,800)

($79,200)

($120,000)

($40,800)

($79,200)

($120,000)

($40,800)

($79,200)

($120,000)

($40,800)

($79,200)

($120,000)

($40,800)

($79,200)

($120,000)

($40,800)

($79,200)

($120,000)

($40,800)

($79,200)

($120,000)

($40,800)

($79,200)

($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% =

5 Lease versus Own

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).

($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 cost
recovery deduction.
2. Calculate the SPAT at the end of the holding period.

User Decision Analysis for Commercial Investment Real Estate 5.23

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

($1,450,000)

$9,085

$9,480

$9,480

$9,480

$9,480

$9,480

$9,480

$9,480

$9,480

10

$9,480

11

$9,480

12

$9,480

13

$9,480

14

$9,480

15

$9,085

NPV @ 7.00%

($799,576)

Sale Proceeds
After Tax

$1,557,722

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.

5.24 User Decision Analysis for Commercial Investment Real Estate

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 assumptions
necessary 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.

5 Lease versus Own

Future Sales Price Sensitivity

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 or
down 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

User Decision Analysis for Commercial Investment Real Estate 5.25

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 and
adjusting 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:
5.26 User Decision Analysis for Commercial Investment Real Estate

SPAT adjustment

5 Lease versus Own

SPAT adjustment (Step 2)

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 forecast
sale 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%

User Decision Analysis for Commercial Investment Real Estate 5.27

+
+

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 clients
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 of
indifference, 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
$1,400,000

15 years

End of year 15 sale price

$2,221,000

Annual growth rate in value needed to equalize the NPVs: 3.12 percent

5.28 User Decision Analysis for Commercial Investment Real Estate

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.

5 Lease versus Own

Method 3: Internal Rate of Return of the Differential

Cash Flows Method

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

n
Period 0

$
Initial Investment

Lease

Differential

Period 0

Period 0 Costs

Period 0

Difference

Year 1

CFAT of Own

Year 1

CFAT of Lease

Year 1

Difference

Year 2

CFAT of Own

Year 2

CFAT of Lease

Year 2

Difference

Year 3

CFAT of Own

Year 3

CFAT of Lease

Year 3

Difference

Year 4

CFAT of Own

Year 4

CFAT of Lease

Year 4

Difference

Year 5

CFAT of Own

Year 5

CFAT of Lease

Year 5

Difference

SPAT

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 is
invested in the ownership alternative. This rate of return is then compared to
the user's opportunity cost:
If IRR > Opportunity cost, then buy
If 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 ownership
alternative 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

User Decision Analysis for Commercial Investment Real Estate 5.29

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

($1,450,000)

$0

($1,450,000)

$9,085

($79,200)

$88,285

$9,480

($79,200)

$88,680

$9,480

($79,200)

$88,680

$9,480

($79,200)

$88,680

$9,480

($79,200)

$88,680

$9,480

($79,200)

$88,680

$9,480

($79,200)

$88,680

$9,480

($79,200)

$88,680

$9,480

($79,200)

$88,680

10

$9,480

($79,200)

$88,680

11

$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

($79,200)

$1,646,007

$1,557,722

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 corporations 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 corporations 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
5.30 User Decision Analysis for Commercial Investment Real Estate

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)

5 Lease versus Own

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.

User Decision Analysis for Commercial Investment Real Estate 5.31

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

Period 0

(S2,280,000)

($2,280,000)

Period 0

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

($726,000)

Year 10

$3,479,544

($759,485)

3,513,029

PV = ____________

Period 0

Year 10

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?

5.32 User Decision Analysis for Commercial Investment Real Estate

5 Lease versus Own

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 the
ten-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
User Decision Analysis for Commercial Investment Real Estate 5.33

GAAP Accounting Impact on Financial

Statements for SAV-A-LOT
Purchase Alternative

There is no impact on the liability side of the balance sheet unless mortgage
financing is used to purchase the real estate. In that case, the mortgage amount
is added to the liability side of the balance sheet, but the cash used to purchase
reflected on the asset side is reduced by the amount of mortgage financing.
The bottom line result is no change in the stockholders equity. The only
5.34 User Decision Analysis for Commercial Investment Real Estate

Lease Alternative

5 Lease versus Own

impact that mortgage financing might have on the companys financial picture is
in the debt-to-equity ratio. If the loan to value ratio of the mortgage financing is
greater than the companys debt-to-equity ratio prior to the purchase of the real
estate, then the companys overall debt-to-equity ratio would be increased.

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 stockholders
equity is caused by the lease.

User Decision Analysis for Commercial Investment Real Estate 5.35

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 terms
base rent payments exceeds 90 percent of the fair market value. The discount
rate used to calculate this PV is the users 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.

5.36 User Decision Analysis for Commercial Investment Real Estate

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

5 Lease versus Own

Module 5: Self-Assessment Review

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 rapid
growth and expansion requirements.
b. When a users opportunity cost is higher than the internal rate of return
of the differential cash flows
c. When a user is considering a long-term lease
d. When the users available capital is limited
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 tax
cash flows for each alternative described below, which alternative is best for
the user?
n

Own

($100,000)

($10,000)

($90,000)

(37,864)

(35,000)

(2,864)

(39,766)

(36,750)

(3,016)

(41,569)

(38,588)

(2,981)

(43,871)

(40,517)

(3,354)

5
PV =

$147,653

Lease

($42,543)
PV =

Difference

$190,196
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 users opportunity cost

User Decision Analysis for Commercial Investment Real Estate 5.37

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
users 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 users tax bracket
b. Multiply the annual rent paid to the owner by the tenants opportunity
cost
c. Subtract cost recovery from original basis
d. Subtract the users tax rate from the annual rent paid to the owner
5. To calculate a users after-tax cost of leasing:
a. Subtract the users 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 operating
income
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
b. The security deposit, moving costs, parking charges, base rent, and
operating expenses
c. The down payment, pretax occupancy costs, and capital appreciation
d. The initial investment, tenant finish allowance, cost recovery, and sales
price

5.38 User Decision Analysis for Commercial Investment Real Estate

a. Subtracting all cost recovery taken from the original basis of the
property, less the loans
b. Subtracting the improvements from the original purchase price
c. Calculating the total cost recovery taken, less the straight-line
depreciation

5 Lease versus Own

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, 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 different
discount rates
b. The point of indifference, which is the same as the internal rate of
return 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) is

important because:
a. When the internal rate of return of the indifference is less than the
users opportunity cost, it should lease
b. When the internal rate of return of the indifference is greater than the
users 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

User Decision Analysis for Commercial Investment Real Estate 5.39

11. What is the significance in calculating the sales price point of indifference?
a. Determining the sales price required to make the leasing and owning
alternatives equal
b. To measure the average annual growth rate necessary to achieve the sale
price point of indifference against the historic inflation rate
c. To help determine whether the leasing or owning alternative is
preferred
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 deductions
taken over the life of the investment
c. Ignores whether the price paid for the property at acquisition is at
market, below market, or above market
d. Is the only important measure in lease-versus-own analysis

End of assessment
5.40 User Decision Analysis for Commercial Investment Real Estate

5 Lease versus Own

Answer Section

User Decision Analysis for Commercial Investment Real Estate 5.41

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 aftertax 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, the
alternative 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 users appropriate
discount rate.

a. True
6. If the internal rate of return of the differential cash flows is greater than the
users 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
users 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 the
users opportunity cost, then the user should evaluate the subjective aspects
of buying (owning) or leasing.

a. True

5.42 User Decision Analysis for Commercial Investment Real Estate

1. What is the internal rate of return of the differential cash flows?

3.58 percent

5 Lease versus Own

Activity 5-2: Calculating Costs Answers

2. Based solely on the internal rate of return of the differential, which

alternative should the user choose? Why?

The internal rate of return of the differential is 3.58 percent. Since the
users 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
User Decision Analysis for Commercial Investment Real Estate 5.43

9. What is the indifferent sale price?

$4,535,954 + $11,400,000 = $15,935,954

Module 5: Self-Assessment Review

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 tax
cash flows for each alternative described below, which alternative is best for
the user?
n

Own

Lease

Difference

($100,000)

($10,000)

($90,000)

(37,864)

(35,000)

(2,864)

(39,766)

(36,750)

(3,016)

(41,569)

(38,588)

(2,981)

(43,871)

(40,517)

(3,354)

5
PV =

$147,653

($136,801)

($42,543)
PV =

($155,271)

$190,196
IRR =

13.99%

d. Own, since the internal rate of return of the differential is greater than
the users opportunity cost
The internal rate of return of the differential cash flows is 13.99 percent,
greater than the users opportunity cost of 10 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 users tax bracket

5.44 User Decision Analysis for Commercial Investment Real Estate

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

5 Lease versus Own

5. To calculate a users after-tax cost of leasing:

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, the
preferred 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) is
important 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 market

User Decision Analysis for Commercial Investment Real Estate 5.45

User Decision Analysis for Commercial Investment Real Estate

Lease Exit
Strategies

In This Module
Module Snapshot ...................................... 6.1
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, 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

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

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 and
Relocate .............................................................. 6.25
Module 6: Self-Assessment Review ................... 6.29

Lease Exit Strategies

Module Snapshot
Module Goal
In the previous modules, leases were examined from the standpoint of the
users 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 users 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.

User Decision Analysis for Commercial Investment Real Estate 6.1

NOTES

6.2 User Decision Analysis for Commercial Investment Real Estate

When a user signs a lease, that leasehold interest has a value. From the users
perspective, the value is a cost, but it can be a positive value compared to other
alternatives. For example, if the user is leasing space that costs $50,000 per year
and the market cost for similar space is $60,000 per year, then the leasehold
interest has a $10,000 benefit with respect to the market. That gives the user a
slight competitive advantage. Conversely, if a user is paying $60,000 but could
get similar space for $50,000, then the value is negative $10,000.

6 Lease Exit Strategies

Valuing Considerations

An example of lease value is a football team owner who has a positive stadium
agreement with a city, where the team owner pays a minimal rent. That gives
the owner an economic advantage over those who have to pay full rent for their
stadiums.
In essence, lease value can be positive or negative.

User Decision Analysis for Commercial Investment Real Estate 6.3

Financial Reporting for Subleasing

Real estate subleases allow a tenant to offset some or all of a leases financial
obligations. The primary tenant offsets some or their entire financial obligation
through the rent paid by the subtenant. However, specific accounting rules
come into play and make it necessary for the primary tenant to record a loss in
the amount of the present value (PV) of the anticipated shortfall (if any) over
the remaining primary lease term. This can be a large and unexpected hit to
earnings at an inconvenient time for the company.
Current accounting rules require the projected loss to be recognized when the
company has made the decision to cease use of the leased property. In
practice, companies must certainly be careful to not make this decision unless
they are aware of the loss impact, and must be mindful of the timing of the exit
or sublease decision.
An alternative decision strategy is for the space to remain partially used with two
plans: one for future reuse by the company and another to vacate if an
acceptable sublease is obtained. Companies may have multiple options
available to them as they seek to consolidate their occupied space in a particular
area at a particular time.
Once a decision is made to vacate, or if a sublessee is found for all or a portion
of the space, then no reasonable uncertainty exists, and the loss must be
recognized on the financial reports.

Why Sublease?
A variety of factors are constantly changing and evolving in business and in real
estate, including such things as market dynamics, fluctuations in the users
business, external factors, or industry changes, all of which could cause a change
in the users space needs. Effectively valuing the lease and market options as
well as understanding the impact of decisions on the users financial statements
ensures that the user has the information to make decisions about occupancy
costs. Some common factors are

Growth or shrinkage of space needs

Declines in business

Economic recession

Business restructure

Technology changes

Centralized or decentralized business model

6.4 User Decision Analysis for Commercial Investment Real Estate

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.

6 Lease Exit Strategies

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:

User Decision Analysis for Commercial Investment Real Estate 6.5

Valuing Leasehold Interest and Subleases

The following section delineates an owners 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

$60,000

$50,000

$10,000

$60,000

$50,000

$10,000

$60,000

$50,000

$10,000

$60,000

$50,000

$10,000

$60,000

$50,000

$10,000

$60,000

$50,000

$10,000

$60,000

$50,000

$10,000

$60,000

$50,000

$10,000

$53,349

Present value @ 10.00%

The value of the leasehold interest is the value of the lessees interest if the
lessee entered into a sublease at the market rate. Even if the lessees 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.

6.6 User Decision Analysis for Commercial Investment Real Estate

Market Rent

Contract Rent

Difference

$40,000

$50,000

($10,000)

$40,000

$50,000

($10,000)

$40,000

$50,000

($10,000)

$40,000

$50,000

($10,000)

$40,000

$50,000

($10,000)

$40,000

$50,000

($10,000)

$40,000

$50,000

($10,000)

$40,000

$50,000

($10,000)

($53,349)

Present value @ 10.00%

6 Lease Exit Strategies

EOY

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 than

Market
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

$48,000

$45,000

$3,000

$48,000

$45,000

$3,000

$48,000

$45,000

$3,000

$48,000

$45,000

$3,000

$48,000

$45,000

$3,000

$48,000

$45,000

$3,000

$48,000

$45,000

$3,000

$48,000

$45,000

$3,000

$16,005

Present value @ 10.00%

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 sublessees interest is the differential between the
sublease rent and the market rent.

User Decision Analysis for Commercial Investment Real Estate 6.7

EOY

Market Rent

Sublease Rent

Difference

$50,000

$48,000

$2,000

$50,000

$48,000

$2,000

$50,000

$48,000

$2,000

$50,000

$48,000

$2,000

$50,000

$48,000

$2,000

$50,000

$48,000

$2,000

$50,000

$48,000

$2,000

$50,000

$48,000

$2,000

$10,670

Present Value @ 10.00%

Sublease Rent Is Lower than Contract Rent

Sometimes a user needs to sublease at a rate below the contract rent to move
out of a space. In this example, consider that the space is sublet at $45,000 per
year, and the contract rent is $50,000 per year.
EOY

Sublease Rent

Contract Rent

Difference

$45,000

$50,000

($5,000)

$45,000

$50,000

($5,000)

$45,000

$50,000

($5,000)

$45,000

$50,000

($5,000)

$45,000

$50,000

($5,000)

$45,000

$50,000

($5,000)

$45,000

$50,000

($5,000)

$45,000

$50,000

($5,000)

($26,675)

Present Value @ 10.00%

The differential between the contract rent and the sublease rent is the amount it
costs the primary lessee to get out of the lease. The PV of these cash flows
(discounted at 10 percent over eight years) represents the actual cost to the
primary lessee.

6.8 User Decision Analysis for Commercial Investment Real Estate

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 lessees leasehold interest with the users 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.)

6 Lease Exit Strategies

Activity 6-1: Leasehold Interests

End of activity
User Decision Analysis for Commercial Investment Real Estate 6.9

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 earlyassuming 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

$150,000

$200,000

($50,000)

$150,000

$200,000

($50,000)

$150,000

$200,000

($50,000)

$150,000

$200,000

($50,000)

$150,000

$200,000

($50,000)

($205,010)

Present value @ 7.00%

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.

6.10 User Decision Analysis for Commercial Investment Real Estate

EOY

Contract

$200,000

$200,000

$200,000

$200,000

$200,000

Present value @ 7.00%

6 Lease Exit Strategies

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:

$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 additional
costs 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 tenants 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.

User Decision Analysis for Commercial Investment Real Estate 6.11

The Buyout Pendulum

Its clear from the examples that in some cases the leasehold interest may or
may not be of value to the lessee and may be of value only to the owner. The
relative positions of contract and market rent create these situations, but in
other occasions, are created by the realities of the users business and the
owners investment objectives. For various reasons, either the owner or the
lessee might want to sell their interest in the leasehold.
Decisions about when and whether to sublease or whether to negotiate a lease
buyout and who should do the buying all are linked. Changing market
conditions, remaining lease life, and changes in needs and objectives cause the
position of strength between the user and owner to swing like a pendulum. For
instance, the motivations for the owner and the user regarding a buyout
resemble the following table.
Buyout Motivations
Contract Lower than Market

Contract Higher than Market

Wants new user

Wants better user

Likes user

Enjoys excess rent

Wants security

Will buy out

Wants better space

Wants lower rent

Wont buy out

Enjoys bargain rent

Enjoys space

Will buy out

Owner

User

Wont buy out

Wants higher rent

Can sublet at a profit

Doesnt want new user at

lower rent

Wants security

This table reveals that the relative economic value of the leasehold has various
effects on both the owner and the user. From an economic perspective, when
the leasehold value is positive (market rent is higher than contract rent), the
owner is motivated to buy out the user, but the user has an economic
motivation to maintain its leasehold position. Similarly, when the leasehold
value is negative (market rent is lower than contract rent), the user has a motive
to buy out the lease, while the owner has little financial motivation to remove
the user from the lease obligation.
The above table shows owner and user motivations that are not based on the
leasehold economic value alone. The owner fears vacancy, while the user fears
wasted space (which costs money) and the risks associated with subletting.

6.12 User Decision Analysis for Commercial Investment Real Estate

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

6 Lease Exit Strategies

Thus, the timing of the lease, the relationship of contract rent to market rent,
and the users business needs all contribute to pushing the pendulum to one
side or the other.

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 be
necessary 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.

User Decision Analysis for Commercial Investment Real Estate 6.13

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.

6.14 User Decision Analysis for Commercial Investment Real Estate

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 CMs 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.

6 Lease Exit Strategies

Activity 6-2: Do Nothing versus Sublease and Relocate

As a result of your superior marketing efforts, you have identified a potential

subtenant who would like to take all of CMs space for the remaining term at a
rental rate that is less than CMs 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 expensive
space, or if they should stay in place and pay out their current contract rent for
the remaining four years of lease term.
CMs Current Lease

Sublease Terms

CMs 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

4% of base rent

Paid by Landlord

Sublease commission
Relocation costs

$30,000
$2 psf paid by
Sublessor

Tenant improvements

None needed

Additional assumptions are as follows:

Operating expense growth rate: 3 percent

CMs 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

User Decision Analysis for Commercial Investment Real Estate 6.15

Sublease

Period 0

Year 1

Year 2

Year 3

Period 0

Year 1

Year 2

Year 3

Year 4

Base rent
Operating expense
Operating expense stop
Tenant improvements
Commission
Total

New Location
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?

6.16 User Decision Analysis for Commercial Investment Real Estate

Year 4

Which alternative is preferable from an economic perspective? By how

much?

Current Lease

PV @ 8.5% =

Sublease

PV @ 8.5% =

Net Cost

6 Lease Exit Strategies

3.

PV @ 8.5% =

New Lease

PV @ 8.5% =

End of activity

User Decision Analysis for Commercial Investment Real Estate 6.17

Module 6: Self-Assessment Review

To test your understanding of the key concepts in this module, answer the
following questions.
1.

When the contract rent of a sublease is higher than the contract rent of the
primary 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 be
motivated to accept a below-market sublease and pay the loss for the
following reason:
a. The user needs more or less square footage
b. The user prefers a buyout to relocate to higher quality space
c. The users alternative lease rate is substantially below its existing rate
d. All of the above

4.

An owner may elect to buy out a users 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

6.18 User Decision Analysis for Commercial Investment Real Estate

If a user indicates a desire to relocate when market rents are higher than
their contract rent, the owner may elect to negotiate a ____________ to release at a profit.
a. Renewal option
b. Buyout

6 Lease Exit Strategies

5.

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 market
rate for comparable space is $12 per square foot gross but is expected to
remain 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 the
differential 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 since
it 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 operating
expenses, what is the present value of the differential cash flows when
discounted at 10 percent?
a. ($10,779)
b. ($15,644)
c. ($8,629)
d. ($11,437)

User Decision Analysis for Commercial Investment Real Estate 6.19

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 rents
represents 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 flow
differential
d. All of the above

10.

A 3,000 square foot user with two years remaining on its lease has expressed
a 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 the
owners 15 percent cost of capital what is the discounted value of the users
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

6.20 User Decision Analysis for Commercial Investment Real Estate

From the information in Question 11 and using the owners 15 percent

opportunity cost, what is the present value of the new lease?
a. $43,652
b. $69,233

6 Lease Exit Strategies

12.

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 moving
allowance, is $7,500. What is the internal rate of return of the cash flow
differential between the revenue from the existing lease and the proposed
lease?
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 owners desired rate of return, should the owner elect to release the
existing 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
owners opportunity cost of capital
d. All of the above

End of assessment
User Decision Analysis for Commercial Investment Real Estate 6.21

6.22 User Decision Analysis for Commercial Investment Real Estate

6 Lease Exit Strategies

Answer Section

User Decision Analysis for Commercial Investment Real Estate 6.23

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 lessees leasehold interest with the users 9.5 percent cost of
capital as a discount rate? (Round to the nearest dollar.)

The present value of the primary lessees 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 lessees leasehold interest is $14,932.

6.24 User Decision Analysis for Commercial Investment Real Estate

6 Lease Exit Strategies

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

Current Lease

Period 0

Base rent
Operating expense
Operating expense stop
Total

Sublease

Period 0

Base rent
Operating expense
Operating expense stop
Tenant improvements

($20,000)

Commission

($28,800)

Total

($48,800)

Year 1

Year 2

Year 3

Year 4

($220,000)

($220,000)

($220,000)

($220,000)

($97,000)

($99,910)

($102,907)

($105,994)

$90,000

$90,000

$90,000

$90,000

($227,000)

($229,910)

($232,907)

($235,994)

Year 2

Year 3

Year 4

$180,000

$180,000

$180,000

$180,000

$97,000

$99,910

$102,907

$105,995

($97,000)

($97,000)

($97,000)

($97,000)

$180,000

$182,910

$185,907

$188,995

Year 1

User Decision Analysis for Commercial Investment Real Estate 6.25

New Location

Period 0

Year 1

Year 2

Year 3

Year 4

Base rent

($105,000)

($105,000)

($105,000)

($105,000)

Operating expense

($52,500)

($54,075)

($55,697)

($57,368)

$52,500

$52,500

$52,500

$52,500

($106,575)

($108,197)

($109,868)

Operating expense base

Relocation costs

($30,000)

Total

($30,000)

1.

($105,000)

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

6.26 User Decision Analysis for Commercial Investment Real Estate

Sublease

Net Cost

$0

($48,800)

($48,800)

(227,000)

180,000

(47,000)

(229,910)

182,910

(47,000)

(232,907)

185,907

(47,000)

(235,995)

188,995

(47,000)

PV @ 8.5% = ($757,147)

PV @ 8.5% = $554,394

6 Lease Exit Strategies

Current Lease

PV @ 8.5% = ($202,753)

New Lease
0

($30,000)

(105,000)

(106,575)

(108,197)

(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

Current Lease

Period 0

Base rent
Operating expense
Operating expense stop
Total

Year 1

Year 2

Year 3

Year 4

($220,000)

($220,000)

($220,000)

($220,000)

($97,000)

($99,910)

($102,907)

($105,994)

$90,000

$90,000

$90,000

$90,000

($227,000)

($229,910)

($232,907)

($235,994)

Net present value = ($757,147)

User Decision Analysis for Commercial Investment Real Estate 6.27

Sublease

Period 0

Base rent
Operating expense
Operating expense stop
Tenant improvements
Commission

($20,000)
($28,800)

Total

($48,800)

Net present value

Year 2

Year 3

$180,000

$180,000

$180,000

$180,000

$97,000

$99,910

$102,907

$105,995

($97,000)

($97,000)

($97,000)

($97,000)

$180,000

$182,910

$185,907

$188,995

Period 0

Year 1
($105,000)
($52,500)
$52,500

Year 2
($105,000)
($54,075)
$52,500

Year 3
($105,000)
($55,697)
$52,500

Year 4
($105,000)
($57,368)
$52,500

($30,000)
($30,000)

($108,197)

($109,868)

($105,000)

($106,575)

($381,291)
Current lease cost

Sublease cost
Net Sublease cost

New lease cost

Net cost/benefit of sublease and relocation

Current lease cost

Year 4

$554,394

New Location
Base rent
Operating expense
Operating expense base
Relocation costs
Total

Net present value

Year 1

Net cost of sublease and relocation

Net cost/benefit of sublease and relocation

6.28 User Decision Analysis for Commercial Investment Real Estate

($757,147)
(554,394)
($202,753)
(381,291)
($584,044)

($757,147)
(584,044)
($173,103)

1.

When the contract rent of a sublease is higher than the contract rent of the
primary user, the sublease has a positive value to the owner.
b. False

2.

6 Lease Exit Strategies

Module 6: Self-Assessment Review

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 be
motivated 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 users lease when:

c. The owner wants a better-quality user

5.

If a user indicates a desire to relocate when market rents are higher than
their contract rent, the owner may elect to negotiate a ____________ to release 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 is
expected to remain 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 the differential cash flows is discounted at 9 percent?
c. $19,251

User Decision Analysis for Commercial Investment Real Estate 6.29

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 since
it 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 operating
expenses, what is the present value of the differential cash flows when
discounted 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 rents
represents 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 expressed
a 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 the
owners 15 percent cost of capital what is the discounted value of the users
outstanding lease obligation?
c. ($59,887)

6.30 User Decision Analysis for Commercial Investment Real Estate

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?
c. $11,460
Current Lease

New Lease

Year 1

$36,000

$42,000

Year 2

$37,800

$43,260

Total

$73,800

$85,260

12.

New Lease Total:

$85,260

Current Lease:

$73,800

Additional Rent:

$11,460

6 Lease Exit Strategies

11.

From the information in Question 11 and using the owners 15 percent

opportunity cost, what is the present value of the new lease?
c. $69,233

User Decision Analysis for Commercial Investment Real Estate 6.31

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 moving
allowance, is $7,500. What is the internal rate of return of the cash flow
differential between the revenue from the existing lease and the proposed
lease?
a. 34.23 percent

14.

When comparing the internal rate of return of the differential cash flows to
the owners 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

6.32 User Decision Analysis for Commercial Investment Real Estate

User Decision Analysis for Commercial Investment Real Estate

Sale-Leaseback
Transactions

In This Module
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 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 Cash
Flows 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

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
Cost 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
Module 7: Self-Assessment Review ................... 7.40

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 up
capital 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 users continue-to-own versus the sale-leaseback decision.

User Decision Analysis for Commercial Investment Real Estate 7.1

Calculate and interpret the net present values (NPVs) of the users continueto-own and the sale-leaseback alternatives.

Calculate and interpret the yield (internal rate of return) of the differential
cash flows after tax from the users continue-to-own and the sale-leaseback
alternatives.

Calculate and explain the sales price point of indifference where the NPVs
of the users continue-to-own and the sale-leaseback alternatives are equal.

Measure the impact of generally accepted accounting principles (GAAP)

reporting on the users financial statements 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 to
finance or refinance the property the user owns and occupies.

From the investors 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.

7.2 User Decision Analysis for Commercial Investment Real Estate

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 stores 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.

7 Sale-Leaseback Transactions

Assessing the Opportunities

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 a
primary 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.

User Decision Analysis for Commercial Investment Real Estate 7.3

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 sale
of 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.

7.4 User Decision Analysis for Commercial Investment Real Estate

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.

7 Sale-Leaseback Transactions

User Decision Analysis for Commercial Investment Real Estate 7.5

User GAAP Accounting and Reporting For

Sale Leasebacks
One 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 propertys book value (adjusted basis).
+

Basis at acquisition
Capital additions

Cost recovery (depreciation taken)

Basis in partial sale

Adjusted basis at sale

Balance Sheet Impact

Real 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 companys
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 the
client doesnt 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
estates value over time, ultimately appearing as a gain on financials.

7.6 User Decision Analysis for Commercial Investment Real Estate

When planning the disposition of a piece of property, one of the real estate analysts
first questions should be: What is the book value? This will determine whether the
sale is a gain or loss.

7 Sale-Leaseback Transactions

As discussed, a lease appears on the balance sheet as a capital lease if certain

financial attributes are present. To companies, the difference between onbalance-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.

Cash Flow Statement Impact

The cash flow statement details the sources and uses of cash from operations,
investing, and financing activities. The cash flow statements 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
buildings 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.

User Decision Analysis for Commercial Investment Real Estate 7.7

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. Its 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

Net book value

Pre-tax gain on sale

$100,000,000
40,000,000
$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

7.8 User Decision Analysis for Commercial Investment Real Estate

Sale leasebacks generally fall into two categories for corporate users: strategic or
tactical.
Strategic sale leasebacks are used to raise cash. The company still has a longterm 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.

7 Sale-Leaseback Transactions

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 years earnings from the sale proceeds while creating a
burden on future years earnings with a higher lease expense.

Tactical sale leasebacks are done when a company plans to exit all or a portion
of 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.

User Decision Analysis for Commercial Investment Real Estate 7.9

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 users 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 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
Val ue Line Char t

$50,000

$40,000

$30,000

$20,000

$10,000

Positive NPV/PV

$0

($10,000)

($20,000)

($30,000)

($40,000)

Lesser
NPV/PV

($50,000)

(Negative NPV/PV)

Greater
NPV/PV

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 correct
choice 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
7.10 User Decision Analysis for Commercial Investment Real Estate

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 both
alternatives result in a positive NPV indicates a positive economic benefit
associated with both. The greater economic benefit of $20,000 is the better
choice.

7 Sale-Leaseback Transactions

of the cost associated with each alternative. A cost of $30,000 is a better choice
than a cost of $40,000.

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 alternative
the 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 valueor
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
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 users 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
User Decision Analysis for Commercial Investment Real Estate 7.11

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 users analysis is illustrated first, followed by the investors
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 stores superior location, the companys
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 Analysis Assumptions

Projected occupancy period: 10 years

Corporate tax rate for all sources of income including capital gains and costrecovery recapture: 34 percent

VSIs 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

7.12 User Decision Analysis for Commercial Investment Real Estate

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

7 Sale-Leaseback Transactions

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 years 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 isnt 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.

User Decision Analysis for Commercial Investment Real Estate 7.13

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
1st Mortgage

Cost Recovery Data

2nd Mortgage

Improvements

Amount

Value

Interest Rate

C. R. Method

Amortization Period

Useful Life

Loan Term
Payments/Year

In Service Date
Future Sale Date

Periodic Payment

Recapture

Annual Debt Service

Investment Tax

Loan Fees/Costs

Credit ($$ or %)

End of Year:
1

Vacancy & Credit Losses

3
4

= Effective Rental Income

+ Other Income (Collectable)

= Gross Operating Income

7
8

$2,458,003*
SL
39

Taxable Income
3

Jan. 2002
Dec. 2011

$72,202

$72,202

$72,202

$72,202

$72,202

(72,202)
(24,549)

(72,202)
(24,549)

(72,202)
(24,549)

(72,202)
(24,549)

(72,202)
(24,549)

Potential Rental Income

Personal Property

Operating Expenses
= NET OPERATING INCOME
Interest 1st Mortgage

Interest 2nd Mortgage

10

Participation Payments

11

Cost Recovery Improvements

12

Cost Recovery Personal Property

13

Amortization of Loan Fees/Costs

14

Leasing Commissions

15 = Real Estate Taxable Income

16 Tax Liability (Savings) at 34%

Cash Flow
17

NET OPERATING INCOME (Line 7)

18

Annual Debt Service

19

Participation Payments

20

Leasing Commissions

21

Funded Reserves

22 = CASH FLOW BEFORE TAXES

23

Tax Liability (Savings) (Line 16)

24 = CASH FLOW AFTER TAXES

(24,549)

(24,549)

(24,549)

(24,549)

(24,549)

$24,549

$24,549

$24,549

$24,549

$24,549

Copyright 2002 by the CCIM Institute

The statements and figures herein, while not guaranteed, are secured from sources we believe authoritative.

* The book value of improvements after five years of cost-recovery deductions

7.14 User Decision Analysis for Commercial Investment Real Estate

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
1st Mortgage

Cost Recovery Data

2nd Mortgage

Improvements

Amount

Value

Interest Rate

C. R. Method

Amortization Period
Loan Term

Useful Life
In Service Date

39
Jan. 2002

Payments/Year

Future Sale Date

Dec. 2011

Periodic Payment

Recapture

Annual Debt Service

Investment Tax

Loan Fees/Costs

Credit ($$ or %)

End of Year:
1

Potential Rental Income

Vacancy & Credit Losses

Personal
Property

7 Sale-Leaseback Transactions

Cash Flow Analysis Worksheet

$2,458,003
SL

Taxable Income
8
9

10

11

3 = Effective Rental Income

4 + Other Income (Collectable)
5 = Gross Operating Income
6

Operating Expenses

7 = NET OPERATING INCOME

8

Interest

1st Mortgage

Interest

2nd Mortgage

10

Participation Payments

11

Cost Recovery Improvements

12

Cost Recovery Personal Property

13

Amortization of Loan Fees/Costs

14

Leasing Commissions

15 = Real Estate Taxable Income

16

Tax Liability (Savings) at 34%

17

NET OPERATING INCOME (Line 7)

18

Annual Debt Service

19

Participation Payments

20

Leasing Commissions

21

Funded Reserves

$72,202

$72,202

$72,202

$72,202

$69,189

(72,202)

(72,202)

(72,202)

(72,202)

(69,189)

(24,549)

(24,549)

(24,549)

(24,549)

(23,524)

Cash Flow

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

Copyright 2002 by the CCIM Institute

The statements and figures herein, while not guaranteed, are secured from sources we believe authoritative.

User Decision Analysis for Commercial Investment Real Estate 7.15

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 doesnt affect the result since the analysis is
for a corporate entity. Thus, all gain is taxed at the corporate tax rate. In
the 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.

7.16 User Decision Analysis for Commercial Investment Real Estate

End of Year:
Principal Balance

Alternative Cash Sales Worksheet

1

Mortgage Balances
3
4

1st Mortgage

Principal Balance 2nd Mortgage

TOTAL UNPAID BALANCE
8

10

7 Sale-Leaseback Transactions

Continue-to-Own Alternative

Calculation of Sale Proceeds

$5,376,000

PROJECTED SALES PRICE

(At _________% cap)

CALCULATION OF ADJUSTED BASIS:
1
Basis at Acquisition
2 + Capital Additions
3
Cost Recovery (Depreciation) Taken
4

(At ________% cap)

$3,520,000
1,077,004*

Basis in Partial Sales

5 = Adjusted Basis at Sale

CALCULATION OF CAPITAL GAIN ON SALE:
6
Sale Price
7
Costs of Sale

2,442,996

Adjusted Basis at Sale (Line 5)

2,442,996

Participation Payment on Sale

5,376,000
215,040

10 = Gain or (Loss)
11
Straight Line Cost Recovery (Limited to Gain)
12

(At _________% cap)

2,717,964
1,077,004

Suspended Losses

13 = Capital Gain From Appreciation

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
18
Costs of Sale
19

Participation Payment on Sale

20

Mortgage Balance(s)

1,640,960

5,376,000
215,040

21 + Balance of Funded Reserves

22 = Sale Proceeds Before Tax
23
Tax (Savings): Ordinary Income
at 34% of Line 16
24
Tax: Straight Line Recapture
at 34% of Line 11
25
Tax on Capital Gains
at 34% of Line 13

5,160,960

366,181
557,926

26 = SALE PROCEEDS AFTER TAX:

$4,236,852

Copyright 2002 by the CCIM Institute

The statements and figures herein, while not guaranteed, are secured from sources we believe authoritative.

* This represents 15 years of cost recovery.

User Decision Analysis for Commercial Investment Real Estate 7.17

3. Calculate the NPV of the annual cash flows after tax from ownership and
the after-tax cash flows from disposition using the corporations after-tax
weighted average cost of capital as the discount rate.
NPV of the Continue-to-Own Alternative
EOY

$0

24,549

24,549

24,549

24,549

24,549

24,549

24,549

24,549

24,549

10

$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.

7.18 User Decision Analysis for Commercial Investment Real Estate

End of Year:
Principal Balance

Alternative Cash Sales Worksheet

1

Mortgage Balances
3
4

1st Mortgage

Principal Balance 2nd Mortgage

TOTAL UNPAID BALANCE
8

10

7 Sale-Leaseback Transactions

Sale-Leaseback
Alternative
2.

Calculation of Sale Proceeds

$4,000,000

PROJECTED SALES PRICE

(At _________% cap)

CALCULATION OF ADJUSTED BASIS:
1
Basis at Acquisition
2 + Capital Additions
3
Cost Recovery (Depreciation) Taken
4

(At ________% cap)

$3,520,000
354,984

Basis in Partial Sales

5 = Adjusted Basis at Sale

CALCULATION OF CAPITAL GAIN ON SALE:
6
Sale Price
7
Costs of Sale

3,165,016

Adjusted Basis at Sale (Line 5)

3,165,016

Participation Payment on Sale

10 = Gain or (Loss)
11
Straight Line Cost Recovery (Limited to Gain)
12

(At _________% cap)

4,000,000
160,000

674,984
354,984

Suspended Losses

13 = Capital Gain From Appreciation

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
18
Costs of Sale
19

Participation Payment on Sale

20

Mortgage Balance(s)

21 + Balance of Funded Reserves

22 = Sale Proceeds Before Tax
23
Tax (Savings): Ordinary Income
at 34% of Line 16
24
Tax: Straight Line Recapture
at 34% of Line 11
25
Tax on Capital Gains
at 34% of Line 13
26 = SALE PROCEEDS AFTER TAX:

320,000

4,000,000
160,000

3,840,000

120,695
108,800
$3,610,505

Copyright 2009 by the CCIM Institute

The statements and figures herein, while not guaranteed, are secured from sources we believe authoritative.

User Decision Analysis for Commercial Investment Real Estate 7.19

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
alternative using the corporations after-tax weighted average cost of capital
as the discount rate.
Sale-Leaseback Cash Flows and NPV
EOY

Sale Proceeds
After Tax Today

$3,610,505

Lease
Payment

(Tax Savings)

(Cash Flow
After Tax)

$0

$0

$3,610,505

(380,000)

(129,200)

(250,800)

(380,000)

(129,200)

(250,800)

(380,000)

(129,200)

(250,800)

(380,000)

(129,200)

(250,800)

(380,000)

(129,200)

(250,800)

(425,600)

(144,704)

(280,896)

(425,600)

(144,704)

(280,896)

(425,600)

(144,704)

(280,896)

(425,600)

(144,704)

(280,896)

10

($425,600)

($144,704)

($280,896)

NPV @ 12% = $2,131,870

7.20 User Decision Analysis for Commercial Investment Real Estate

After calculating the NPVs of the continue-to-own alternative and the saleleaseback 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.

7 Sale-Leaseback Transactions

Net Present Value Method Summary

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-own
alternative.
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.

User Decision Analysis for Commercial Investment Real Estate 7.21

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
equalize the two NPVs. Following is the model for making this calculation:
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
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 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

7.22 User Decision Analysis for Commercial Investment Real Estate

$1,502,529

NPV of the sale-leaseback alternative

2,131,870

Difference in NPVs

($629,341)

Compounded 10 years at 12%

SPAT adjustment to equalize the NPVs

$1,954,638

+ SPAT adjustment [$1,954,638 (1 34%) $1,954,638]

SPBT adjustment to equalize the NPVs

$1,006,935

7 Sale-Leaseback Transactions

NPV of the continue-to-own alternative

$2,961,572

+ Cost of sale on SPBT adjustment [$2,961,572 (1 4%) $2,961,572]

Sale price adjustment needed to equalize the NPVs
+ Original projected sale price

$123,399
$3,084,971
$5,376,000

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 the
continue-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 doesnt 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 IRR
of 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 aftertax weighted average cost of capital (or the marginal cost of capital from
User Decision Analysis for Commercial Investment Real Estate 7.23

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 doesnt 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 saleleaseback 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 continueto-own periodic cash flows after tax to determine the differential cash flows
after tax.

7.24 User Decision Analysis for Commercial Investment Real Estate

EOY

Ownership

Leaseback

Differential

$0

$3,610,505

($3,610,505)

24,459

(250,800)

275,349

24,459

(250,800)

275,349

24,459

(250,800)

275,349

24,459

(250,800)

275,349

24,459

(250,800)

275,349

24,459

(280,896)

305,445

24,459

(280,896)

305,445

24,459

(280,896)

305,445

24,459

(280,896)

305,445

10

$23,524 + $4,236,852

($280,896)

$4,541,273

7 Sale-Leaseback Transactions

3. Calculate the IRR of the differential cash flows.

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 corporations 12 percent aftertax 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-toequity 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 corporations after-tax cost of capital of
12 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.

User Decision Analysis for Commercial Investment Real Estate 7.25

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
GAAP straight-line annual rent expense (average annual effective net
rent)
+ GAAP future annual cost recovery avoided due to sale
Annual impact of sale leaseback on income statement

$67,498
402,800
72,202
($263,100)

Balance Sheet Impact (Asset Side)

Cash raised from sale leaseback
+ Deferred gain recognized over the term of the lease
Book value of property sold (adjusted bas is at the time of sale)
Net change in stockholders equity

7.26 User Decision Analysis for Commercial Investment Real Estate

$3,610,505
674,985
3,165,015
$1,120,475

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.

7 Sale-Leaseback Transactions

Conventional Financing

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 lenders loan-to-value
(LTV) ratio underwriting criteria. The value typically is determined by a
certified 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 borrowers 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 lenders LTV ratio
criteria is 70 percent for this type of property and VSIs credit strength.
The gross loan amount would be
Value

LTV ratio
Gross loan amount

$4,000,000
70%
$2,800,000

User Decision Analysis for Commercial Investment Real Estate 7.27

2. Determine the after-tax cost of the funds to be borrowed based on the

following assumptions:

Interest rate: 8.5 percent

Amortization period: 20 years

Loan term: 10 years

Payments per year: 12

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 users 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 borrowers effective cost.

7.28 User Decision Analysis for Commercial Investment Real Estate

1. Solve for payment with n based on the 20 year amortization.

7 Sale-Leaseback Transactions

Steps to solve:

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

User Decision Analysis for Commercial Investment Real Estate 7.29

5. Change the PV to reflect the discount points and solve for I/YR (before-tax
cost of the borrowed funds).

6. If the investors marginal tax rate is 34 percent, use the following model to
solve for the investors 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 users 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.

7.30 User Decision Analysis for Commercial Investment Real Estate

No matter how the transaction is structured to the users benefit, it also must
meet the investors 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

7 Sale-Leaseback Transactions

Investor Analysis

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

Acquisition costs: $30,000

Improvement allocation: 80 percent

Useful life of improvements: 39 years

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

User Decision Analysis for Commercial Investment Real Estate 7.31

Interest rate on loan: 8.5 percent

Amortization period: 20 years

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 lenders maximum LTV ratio criteria.
Value (purchase price)

Maximum LTV ratio

Loan amount

$4,000,000
75%
$3,000,000

Calculate the loan amount using the DSCR method. First, divide the firstyear NOI by the lenders 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
lenders required interest rate as i, and the lenders 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

(3,040,814)

26,388.89

240

26,388.89

7.32 User Decision Analysis for Commercial Investment Real Estate

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.

Cash Flow Analysis Worksheet

Property Name

VSI

Purchase Price

Prepared For

Investor Analysis

Plus Acquisition Costs

30,000

Plus Loan Fees/Costs

Less Mortgages

60,000
3,000,000

Prepared By
Date Prepared

$4,000,000

Equals Initial Investment

Mortgage Data
1st Mortgage
Amount

Payments/Year
Periodic Payment

Improvements
Value

8.50%

Amortization Period
Loan Term

SL

20
20

Useful Life
In Service Date

39
Jan. 2002

12

Future Sale Date

Dec. 2011

Recapture

Annual Debt Service

312,416

Investment Tax

Loan Fees/Costs

$60,000

Credit ($$ or %)

Potential Rental Income

Vacancy & Credit Losses

= Effective Rental Income

+ Other Income (Collectable)

= Gross Operating Income

6
7

Personal Property

$3,224,000

C. R. Method

$26,034.70

End of Year:

$1,090,000

Cost Recovery Data

2nd Mortgage

$3,000,000

Interest Rate

7 Sale-Leaseback Transactions

Taxable Income
3

$380,000

$380,000

$380,000

$380,000

$380,000

380,000

380,000

380,000

380,000

380,000

380,000

380,000

380,000

380,000

380,000

Operating Expenses
= NET OPERATING INCOME

Interest

1st Mortgage

Interest

2nd Mortgage

10

Participation Payments

11

Cost Recovery Improvements

12

Cost Recovery Personal Property

13

Amortization of Loan Fees/Costs

14

Leasing Commissions

15 = Real Estate Taxable Income

380,000

380,000

380,000

380,000

380,000

252,709

247,432

241,688

235,436

228,632

79,214

82,663

82,663

82,663

82,663

3,000

3,000

3,000

3,000

3,000

45,077

46,905

52,649

58,901

65,705

18,031

18,762

21,060

23,560

26,282

16

Tax Liability (Savings) at 40%

17

NET OPERATING INCOME (Line 7)

380,000

380,000

380,000

380,000

380,000

18

Annual Debt Service

312,416

312,416

312,416

312,416

312,416

19

Participation Payments

20

Leasing Commissions

21

Funded Reserves
67,584

67,584

67,584

67,584

67,584

18,031

18,762

21,060

23,560

26,282

$49,553

$48,822

$46,524

$44,023

$41,302

Cash Flow

22 = CASH FLOW BEFORE TAXES

23
Tax Liability (Savings) (Line 16)
24 = CASH FLOW AFTER TAXES

Copyright 2002 by the CCIM Institute

The statements and figures herein, while not guaranteed, are secured from sources we believe authoritative.

User Decision Analysis for Commercial Investment Real Estate 7.33

Cash Flow Analysis Worksheet

Property Name
Prepared For

VSI
Investor Analysis

Purchase Price
Plus Acquisition Costs

Prepared By

Plus Loan Fees/Costs

Date Prepared

Less Mortgages

$4,000,000
30,000
60,000
3,000,000

Equals Initial Investment

Mortgage Data

Cost Recovery Data

1st Mortgage
Amount
Interest Rate

$1,090,000

2nd Mortgage

$3,000,000
8.50%

Improvements
Value
C. R. Method

Personal Property

$3,224,000
SL

Amortization Period

20

Useful Life

Loan Term

20

In Service Date

Jan. 2002

12

Future Sale Date

Dec. 2011

Payments/Year
Periodic Payment
Annual Debt Service

$26,034.70
312,416

Recapture
Investment Tax

$60,000

Credit ($$ or %)

Loan Fees/Costs

End of Year:
1

Potential Rental Income

Vacancy & Credit Losses

39

Taxable Income
8
9

10

11

$425,600

$425,600

$425,600

$425,600

$425,600

$476,672

425,600

425,600

425,600

425,600

425,600

476,672

= Effective Rental Income

+ Other Income (Collectable)

5
6

= Gross Operating Income

Operating Expenses

425,600

425,600

425,600

425,600

425,600

476,672

= NET OPERATING INCOME

425,600

425,600

425,600

425,600

425,600

476,672

221,226

213,166

204,393

194,844

184,452

82,663

82,663

82,663

82,663

79,214

3,000

3,000

3,000

3,000

3,000

118,711

126,771

135,544

145,093

158,934

47,484

50,709

54,218

58,037

63,574

Interest

1st Mortgage

Interest

2nd Mortgage

10

Participation Payments

11

Cost Recovery Improvements

12

Cost Recovery Personal Property

13

Amortization of Loan Fees/Costs

14

Leasing Commissions

15 = Real Estate Taxable Income

16

Tax Liability (Savings) at 40%

17

NET OPERATING INCOME (Line 7)

425,600

425,600

425,600

425,600

425,600

18

Annual Debt Service

312,416

312,416

312,416

312,416

312,416

19

Participation Payments

20

Leasing Commissions

21

Funded Reserves
113,184

113,184

113,184

113,184

113,184

47,484
$65,699

50,709
$62,475

54,218
$58,966

58,037
$55,147

63,574
$49,610

Cash Flow

22 = CASH FLOW BEFORE TAXES

23
Tax Liability (Savings) (Line 16)
24 = CASH FLOW AFTER TAXES

Copyright 2002 by the CCIM Institute

The statements and figures herein, while not guaranteed, are secured from sources we believe authoritative.

7.34 User Decision Analysis for Commercial Investment Real Estate

VSI Investor Analysis

Alternative Cash Sales Worksheet

End of Year:
Principal Balance

1st Mortgage

Principal Balance 2nd Mortgage

TOTAL UNPAID BALANCE

Mortgage Balances
3
4

$2,940,293

$2,875,309

$2,804,580

$2,727,600

$2,643,815

$2,940,293

$2,875,309

$2,804,580

$2,727,600

$2,643,815

6
$2,552,625

7
$2,453,374

8
$2,345,351

9
$2,227,779

10
$2,099,815

$2,552,625

$2,453,374

$2,345,351

$2,227,779

$2,099,815

7 Sale-Leaseback Transactions

3. Calculate the before- and after-tax sale proceeds at the end of holding
period using the ACSW.

Calculation of Sale Proceeds

PROJECTED SALES PRICE

$5,018,000
(At 9.5% cap)

CALCULATION OF ADJUSTED BASIS:

1
Basis at Acquisition
2 + Capital Additions
3
Cost Recovery (Depreciation) Taken
4

(At ________% cap)

$4,030,000
819,732

Basis in Partial Sales

5 = Adjusted Basis at Sale

CALCULATION OF CAPITAL GAIN ON SALE:
6
Sale Price
7
Costs of Sale

3,210,268

Adjusted Basis at Sale (Line 5)

3,210,268

Participation Payment on Sale

5,018,000
200,720

10 = Gain or (Loss)
11
Straight Line Cost Recovery (Limited to Gain)
12

(At _________% cap)

1,607,012
819,732

Suspended Losses

13 = Capital Gain From Appreciation

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
18
Costs of Sale
19

Participation Payment on Sale

20

Mortgage Balance(s)

21 + Balance of Funded Reserves

22 = Sale Proceeds Before Tax
23
Tax (Savings): Ordinary Income
at 40% of Line 16
24
Tax: Straight Line Recapture
at 25% of Line 11
25
Tax on Capital Gains
at 15% of Line 13
26 = SALE PROCEEDS AFTER TAX:

787,280
(30,000)
(30,000)
5,018,000
200,720
2,099,815
2,717,465
(12,000)
204,933
118,092
$2,406,440

Copyright 2002 by the CCIM Institute

The statements and figures herein, while not guaranteed, are secured from sources we believe authoritative.

User Decision Analysis for Commercial Investment Real Estate 7.35

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%

Purchase price: $4,000,000

5. Calculate the before-tax cash on cash, which is the first-year cash flow before
tax 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

($1,090,000)

($1,090,000)

67,584

49,553

67,584

48,822

67,584

46,524

67,584

44,023

67,584

41,302

113,184

65,699

113,184

62,475

113,184

58,966

113,184

10

$113,184

$2,717,465

IRR = 14.96%

7.36 User Decision Analysis for Commercial Investment Real Estate

55,147

10

$49,610

IRR = 11.68%

$2,406,440

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

7 Sale-Leaseback Transactions

Sale-Leaseback Transaction Summary

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

User Decision Analysis for Commercial Investment Real Estate 7.37

Module 7: Self-Assessment Review

To test your understanding of the key concepts in this module, answer the
following questions.
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 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
11% interest
Cost to refinance: $35,500

20-year amortization
Monthly payments

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

7.38 User Decision Analysis for Commercial Investment Real Estate

7 Sale-Leaseback Transactions

Answer Section

User Decision Analysis for Commercial Investment Real Estate 7.39

Module 7: Self-Assessment Review

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 8
percent. If the user sells the property today, how much after-tax cash would
be generated?

b. $464,320
6

Sale Price

$1,250,000

Basis at Acquisition
- Cost Recovery
Taken

$1,000,000

= Adjusted Basis

$898,000

9
11

Recent appraised value

($102,000)

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 from

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)

32

= SPAT

$464,320

at 34%

2. The user in the previous problem can refinance the office building under
the following terms:
70% loan-to-value ratio
11% interest
Costs to refinance: $35,500

20-year amortization
Monthly payments

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

7.40 User Decision Analysis for Commercial Investment Real Estate

User Decision Analysis for Commercial Investment Real Estate

CCIM
Interest-Based
Negotiations
Review Model

In This Module
Module Snapshot ...................................... 8.1
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 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
Step 2: What Actions Can Be Taken to Satisfy
Everyones Needs? Develop Action Steps and
Evaluate 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

CCIM Interest-Based
Negotiations Review Model
Module Snapshot
Module Goal
In todays 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 successful
approach 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.

User Decision Analysis for Commercial Investment Real Estate 8.1

NOTES

8.2 User Decision Analysis for Commercial Investment Real Estate

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 and
agreements 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.

8 Negotiations Review

Negotiation Overview

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 peoplebrokers and clients,

buyers and sellers, and renters and landlordswho demand high-quality,
interpersonal interactions. Thus, effective negotiation skills (broadly defined)
are essential.

User Decision Analysis for Commercial Investment Real Estate 8.3

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 tradeoff between satisfying our own needs and satisfying the needs of others. As
depicted 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

The Key:
Find creative ways to satisfy their
needs in exchange for things that
satisfy your needs.

A more effective approach to negotiation follows a different path. As suggested

by the diagram, instead of seeking compromisewhere each party makes
sacrifices to achieve limited gainswe can use creativity to find imaginative ways
to simultaneously satisfy our own needs and the needs of others, leaving
compromise as a last resort.

8.4 User Decision Analysis for Commercial Investment Real Estate

8 Negotiations Review

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
stylerather than a confrontational, positional, or competitive approachbuilds
relationships and generates sustainable, long-term outcomes.

User Decision Analysis for Commercial Investment Real Estate 8.5

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 cant
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-based
negotiation 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 optionsor leverageand the
other side does not).

8.6 User Decision Analysis for Commercial Investment Real Estate

Step 1 is the foundation of sound decision-making in negotiations. Before

identifying stakeholder interests, its helpful to recall several important concepts
and their definitions:

People or organizations with an interest in a negotiations 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).

8 Negotiations Review

Step 1: Stakeholder Interests Analysis

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 deals 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

User Decision Analysis for Commercial Investment Real Estate 8.7

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, strong
negotiators 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 interests drive a stakeholders 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 partys 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 peoples
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

8.8 User Decision Analysis for Commercial Investment Real Estate

Active Listening Skills and Techniques

When trying to determine a stakeholders interests, it is important to remember
active listening skills and techniques. Effective negotiators listen as well as they
talk, but its not enough to just listenyou must prove that you are listening by
paraphrasing what the other person is saying, asking questions, and
acknowledging their interests when you hear them.

8 Negotiations Review

other people attach to specific interests. Finally, consider nonmonetary as well

as monetary interests.

The Importance of Nonmonetary Interests

Money isnt 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 deals 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

User Decision Analysis for Commercial Investment Real Estate 8.9

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

SHOWCASE

SHOWCASE

SHOWCASE

N/A

Timing of move

ASAP

ASAP

ASAP

LEVERAGE

Font Style

Relationship to Anchor

Font Effect

Importance

Bold

Same interest

CAPS + underline

CRITICAL

Italic

Opposite interest

CAPS, 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 companys current landlord. Two issues are listed: the appearance of the
new space and the timing of the move. The CEOs 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 peoples 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?

8.10 User Decision Analysis for Commercial Investment Real Estate

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 elses
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 interestsas they understand
their interests.

8 Negotiations Review

Step 1 Conclusion

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.

User Decision Analysis for Commercial Investment Real Estate 8.11

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.

Dont 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 actions effect

on stakeholder interests. Consider packages of actions, including actions
that may in isolation be unattractive.

After evaluating actions against each respective stakeholders interests, you will
create a best-case proposal using the optimal action steps for each partys
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.

8.12 User Decision Analysis for Commercial Investment Real Estate

Stakeholder objectives are derived directly from the critical stakeholders issues
and interests. Thus, the landlords objectives are:

High: Rent to landlord

Limited: Sublease approval

Tenant pay: Cost of modifications

8 Negotiations Review

Objectives

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 landlords 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 interestbased 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.

Cover the most important elements of the business relationship.

User Decision Analysis for Commercial Investment Real Estate 8.13

Objectives
In this example, the tenants 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 be
satisfied. 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.

8.14 User Decision Analysis for Commercial Investment Real Estate

Now 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 may
do if no agreement can be negotiated. Step 3 is the final piece of your analysis.

8 Negotiations Review

Step 3: Risk Analysis and Evaluating Fighting

Alternatives

Although most practitioners dont want to think about the possibility of not
closing a deal, it is important to consider each stakeholders fighting
alternatives. As shown in the next section on implementation, sometimes its
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 communicated
in a professional, nonthreatening manner. Its 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 No

Deal
In this step, you should define your bottom line and help all stakeholders fully
appreciate the costs of the fighting alternatives.

User Decision Analysis for Commercial Investment Real Estate 8.15

Implementation of the Three-Step Process:

Formulating and Presenting an Offer
Once 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 possible
actions (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 stakeholders 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 not
depend 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.

8.16 User Decision Analysis for Commercial Investment Real Estate

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.

8 Negotiations Review

Preparing for Counters and Objections

User Decision Analysis for Commercial Investment Real Estate 8.17

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 persons 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
stakeholders interests as they relate to each issue.
5. Determine each issues level of importance. Underline critical issues.

8.18 User Decision Analysis for Commercial Investment Real Estate

8 Negotiations Review

Step 2: What Actions Can Be Taken to Satisfy

Everyones Needs? Develop Action Steps and Evaluate
them Against Interests
The questions to answer in Step 2 are:

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
stakeholders 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)
The questions to answer in Step 3 are:

Have you considered what everyone may do to satisfy their own interests
unilaterally and potentially harm others interests if no deal is reached?

Have you evaluated the effects of those fighting alternatives on each

stakeholders interests?

Have you estimated how likely each party is to succeed if they pursue their
fighting alternatives?

User Decision Analysis for Commercial Investment Real Estate 8.19

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 peoples critical interests?

Have you considered how peoples 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?

8.20 User Decision Analysis for Commercial Investment Real Estate

User Decision Analysis for Commercial Investment Real Estate

9
Case Study 1:
Comparative Lease
Analysis

In This Module
Case 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 Comparison
of the Leases....................................................... 9.10

Answer Section ....................................... 9.11

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

Case Study 1: Comparative

Lease Analysis
Case Study Overview
This case study examines the process of evaluating and comparing lease
proposals from the users perspective. During this case study, you will analyze
and compare the costs of three proposals that meet a users 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 users
perspective.

Apply the CCIM Interest-based Negotiations Model to a case study

scenario.

User Decision Analysis for Commercial Investment Real Estate 9.1

NOTES

9.2 User Decision Analysis for Commercial Investment Real Estate

Case Setup

9 Case Study 1

Case Study 1: Comparative Lease Analysis

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 parents 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 RSCs needs and image, the building owner cannot
accommodate any future company growth. Other tenant leases in the building
are long term, and RSCs 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 companys 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:
User Decision Analysis for Commercial Investment Real Estate 9.3

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 leadership
morale. You just cant imagine how hard its been to make our current
space work, she said. I told Gino to not sign the last lease, but he
wouldnt 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 dont see why we need new space. We already
have a nice building, and were locked in for another two and a half years.
Barry elaborated that new office space is not a good use of the companys
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 rapid
growth 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 faade.
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 dont rush anything, Harry warned you. Make sure you
check for conflicts.

9.4 User Decision Analysis for Commercial Investment Real Estate

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 10
minutes before your update meeting, for which you have two objectives:

9 Case Study 1

Task 1-1: Interests Analysis

1. Confirm your analysis of the companys needs.

2. Obtain the committees 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 Analysis 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
User Decision Analysis for Commercial Investment Real Estate 9.5

In addition to confirming the stakeholders interests, during your interviews,

you conducted a Needs Assessment, and also discovered some important
information relating to RSCs 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

Tenants 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 local
MLS, 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 RSCs 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 RSCs 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 youve determined are suitable and reasonable
for your analysis.

9.6 User Decision Analysis for Commercial Investment Real Estate

9 Case Study 1

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%

Tenants 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

Marginal tax rate: 35 percent

Before-tax weighted average cost of capital: 7 percent

After-tax weighted average cost of capital: 6.25 percent

Tenants Generally Accepted Accounting Principles (GAAP) Accounting

Requirements

Tenants incremental borrowing rate: 6.75 percent

Reasonable cap rate to apply to initial base rent to determine fair market
value: 8 percent
User Decision Analysis for Commercial Investment Real Estate 9.7

Proposal B
Proposal from Owner

Lease term: 10 years

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%

Tenants Forecast Assumptions

Annual real estate tax increase: 2 percent

Annual operating expense increase: 3 percent

Total TIs required: $50 psf

Total moving costs: $10,000

Marginal tax rate: 35 percent

Before-tax weighted average cost of capital: 7 percent

After-tax weighted average cost of capital: 6.25 percent

Tenants GAAP Accounting Requirements

Tenants incremental borrowing rate: 6.75 percent

Reasonable cap rate to apply to initial base rent to determine fair market
value: 8 percent

9.8 User Decision Analysis for Commercial Investment Real Estate

9 Case Study 1

Proposal C
Proposal from Owner

Lease term: 10 years

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

Tenants 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

Marginal tax rate: 35 percent

Before-tax weighted average cost of capital: 7 percent

After-tax weighted average cost of capital: 6.25 percent

Tenants GAAP Accounting Requirements

Tenants incremental borrowing rate: 6.75 percent

Reasonable cap rate to apply to initial base rent to determine fair market
value: 8 percent

User Decision Analysis for Commercial Investment Real Estate 9.9

Task 1-2: Complete an Economic Comparison of the

Leases
1. Use the Comparative Lease Analysis workbook to compare the three
proposals.

2. Based solely on your economic analysis, which proposal would you

recommend? Why?

End of task

9.10 User Decision Analysis for Commercial Investment Real Estate

9 Case Study 1

Answer Section

User Decision Analysis for Commercial Investment Real Estate 9.11

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.

9.12 User Decision Analysis for Commercial Investment Real Estate

9 Case Study 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.

User Decision Analysis for Commercial Investment Real Estate 9.13

User Decision Analysis for Commercial Investment Real Estate

10
Case Study 2: Lease
Versus Purchase

In This Module
Case 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 a
Recommendation............................................. 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
Case 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
with 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 users 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.

User Decision Analysis for Commercial Investment Real Estate 10.1

NOTES

10.2 User Decision Analysis for Commercial Investment Real Estate

Case Setup

10 Case Study 2

Case Study 2: Lease versus Purchase

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. Bobs 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 and
interviewed 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 have
earned 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. Youve 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
User Decision Analysis for Commercial Investment Real Estate 10.3

whom you have met in the past, and the practices 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 firms
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 if
the 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

10.4 User Decision Analysis for Commercial Investment Real Estate

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 cant 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 dont end up paying too much down the road
when it is time for our lease renewal.

10 Case Study 2

financial information to the banks loan committee. You make a note to call
Bryce upon your return to your office.

You thank Will for his candid perspectives and advice and go to a meeting with
the developer. The developer provides additional details regarding their costplus construction/sale price proposal, as well as the simple methodology they
used to determine the starting lease rate. Jim Bridges, the developers lead
representative, indicates that they are totally ambivalent about whether the
doctors purchase or lease the facility. Either way, Jim says, wed love to
work with the doctors. Wed be happy to sell them the facility, or wed 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 themand 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 projects
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 Minnies input,
as well as his knowledge of the loan covenants of the partnerships 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 Minnies 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.

User Decision Analysis for Commercial Investment Real Estate 10.5

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 partnerships financial statements.
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 partnerships income statement and its balance sheet.
In addition, they are very curious how each alternative will impact the practices
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

Anticipated occupancy period: 20 years

Purchase Information

Acquisition price: $9,000,000

Acquisition costs: $180,000

Improvement allocation: 75 percent

Useful life of improvements: 39 years

10.6 User Decision Analysis for Commercial Investment Real Estate

Annual growth rate in value to calculate disposition price: 2 percent

Projected disposition cost of sale (percent of disposition price): 3 percent

Financing Information

Maximum loan amount (loan-to-purchase price): 75 percent

Interest rate: 6.5 percent

Amortization period: 20 years

Loan term: 20 years

Payments per year: 12

Loan costs (percent of loan amount): 2 percent

10 Case Study 2

(The financing information above is based on a loan commitment for a fullrecourse loan.)

Lease Information

Lease term: 20 years

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

User Decision Analysis for Commercial Investment Real Estate 10.7

Interests Chart for Best Practices LLC

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

LEVERAGE

PROTECT

N/A

protect

adequate

LONG

LONG

LONG

LONG

N/A

N/A

STATE OF THE ART

ADEQUATE

STATE OF THE ART

STATE OF THE ART

respectable

??

Ambivalent

PURCHASE

ambivalent

LEASE

ambivalent

N/A

Vision for medical

practice

ENHANCE

MAINTAIN

PROTECT

PROTECT

MAINTAIN

N/A

Partners income
taxes

MINIMIZE

protect

MINIMIZE

N/A

N/A

N/A

Length of occupancy
Facility design
Occupancy (lease v.
purchase)

Font Style

Relationship to Anchor

Font Effect

Importance

Bold

Same interest

CAPS + underline

CRITICAL

Italic

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 stakeholders 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?

10.8 User Decision Analysis for Commercial Investment Real Estate

i. What is the income statement impact?

10 Case Study 2

c. For the purchase alternative:

ii. What is the balance sheet impact?

3. How would each alternative (lease or purchase) impact the practices cash
flow?

End of task
User Decision Analysis for Commercial Investment Real Estate 10.9

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 best
interests of the business to enter into a capital lease. The potential impact on
the practices borrowing capacity could be devastating due to an ongoing
reliance on the banks 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 developers 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, which
includes 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 developers terms for the
15-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 Jims 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 following
page 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.

10.10 User Decision Analysis for Commercial Investment Real Estate

10 Case Study 2

Modified User Information

Incremental borrowing rate: 7 percent

Anticipated occupancy period: 15 years

Modified Purchase Information

No changes

Modified Financing Information

Maximum loan amount (loan-to-purchase price): 65 percent

Interest rate: 7 percent

Loan Amortization: Remains 20 Years

Loan term: 15 years

Modified Lease Information

Lease term: 15 years

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

LEVERAGE

PROTECT

N/A

protect

adequate

LONG

LONG

LONG

LONG

N/A

N/A

STATE OF THE ART

ADEQUATE

STATE OF THE ART

STATE OF THE ART

respectable

??

Occupancy (lease v.
purchase)

ambivalent

PURCHASE

ambivalent

LEASE

ambivalent

N/A

Vision for medical

practice

ENHANCE

MAINTAIN

PROTECT

PROTECT

MAINTAIN

N/A

Partners income
taxes

MINIMIZE

protect

MINIMIZE

N/A

N/A

N/A

Length of occupancy
Facility design

User Decision Analysis for Commercial Investment Real Estate 10.11

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 the
costs of leasing and purchasing equal?

End of task

10.12 User Decision Analysis for Commercial Investment Real Estate

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.

10 Case Study 2

Task 2-3: Determine Actions and Make a

Recommendation

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.

User Decision Analysis for Commercial Investment Real Estate 10.13

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.
10.14 User Decision Analysis for Commercial Investment Real Estate

Create talking points that link actions in your proposal to the interests of
other stakeholders that those actions will satisfy.

Make explicit how proposal components satisfy each stakeholders specific

needs.

10 Case Study 2

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:

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 21)? 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
User Decision Analysis for Commercial Investment Real Estate 10.15

10.16 User Decision Analysis for Commercial Investment Real Estate

10 Case Study 2

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 CDROM.

User Decision Analysis for Commercial Investment Real Estate 10.17

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 favorable 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 users 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.

10.18 User Decision Analysis for Commercial Investment Real Estate

a. Is the lease a capital lease or an operating lease?

10 Case Study 2

2. How will Best Practices GAAP financial statements be impacted?

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
percent of the fair market value, or $8,100,000.
The present value of the minimum net lease payments discounted at the
users 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
percent 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. What is the balance sheet impact?

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 users 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.

User Decision Analysis for Commercial Investment Real Estate 10.19

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 ownership, and $176,531 for
years two though 19; b) an interest expense for each year of
ownership, 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 make 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 unamortized 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 practices 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 acquire the property.

10.20 User Decision Analysis for Commercial Investment Real Estate

1. Compare the after tax present values of the leasing and purchasing
alternatives.

10 Case Study 2

Task 2-2: Update Your Interests and Financial Analyses

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.

User Decision Analysis for Commercial Investment Real Estate 10.21

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 users
borrowing rate (typically for individual users).
The internal rate of return of the differential is compared to the users
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

10.22 User Decision Analysis for Commercial Investment Real Estate

User Decision Analysis for Commercial Investment Real Estate

11
Case Study 3:
Lease Buyout

In This Module
Case Study Overview ......................................... 11.1
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
Owners Current Position .................................. 11.5
Task 3-3: Determine the Present Value of the
Owners Worst-Case Scenario .......................... 11.6
Task 3-4: Establish the Owners Minimum
Buyout Price....................................................... 11.7
Task 3-5: Determine the Present Value of the
Tenants 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 the
Owners Current Position ................................ 11.20

Task 3-3: Determine the Present Value of the

Worst-Case Scenario ....................................... 11.20
Task 3-4: Establish the Owners Minimum
Buyout Price..................................................... 11.20
Task 3-5: Determine the Present Value of the
Tenants 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

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 owners minimum and
the tenants maximum buyout price.
This case study uses present value (PV) techniques to evaluate the existing
leases worth as well as the estimated value of the best-, most-likely, and worstcase scenarios for the buyout. It looks at the situation from both the owners
and the tenants 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 tenants obligation under the existing lease.

Prepare for and complete a buyout negotiation.

User Decision Analysis for Commercial Investment Real Estate 11.1

NOTES

11.2 User Decision Analysis for Commercial Investment Real Estate

Case Setup

11 Case Study 3

Case Study 3: Lease Buyout

You are the trusted asset manager for an astute investor, George Lu, whose real
estate investment portfolio includes a 24,000 square foot (sf)
warehouse/showroom through his LLC, Lus 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 AMIs operations in Georges building would be
consolidated into one of the acquiring companys locations.
As subleasing is not allowed under the lease terms, AMIs only exit option is to
buy out of the lease. I dont 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
were going to get a comparable tenant, I dont want to wait. I dont 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 dont 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 leave Georges office, he says, One more thing. I cant stand some of
Bobs people at AMI. I wouldnt mind having a tenant whose senior people
dont whine about everything.
Based on your previous interactions with AMI, you understand Georges
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, AMIs chief operating officer (COO), to learn more about
AMIs motivations to get out of the lease. Will tells you that his company is
exploring acquisition and that its still hush-hush. Toward the end of your
conversation, Will offers whatever help AMI can provide to locate a new
tenant. I know we havent 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.

User Decision Analysis for Commercial Investment Real Estate 11.3

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
stakeholders interests as they relate to that issue.
5. Determine each issues level of importance. Underline critical issues.
George Lu

AMI

SUPERFICIAL

GOOD

ASAP

ASAP

Whether to do the buyout

DEPENDS

YES

Relationship with tenant

NO HEADACHES

N/A

Prospective tenant

STRONG CREDIT

N/A

AVOID

??

END

EXPLOIT

New tenant improvements

AMI PAYS

LU PAYS

Buyout price

MAXIMIZE

MINIMIZE

Georges relationship with Bob Jr.

Timing of buyout

Risk
Constant nibbling

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 influential
stakeholders, but at the onset of our analysis, we will focus on the two main
stakeholders.

End of task
11.4 User Decision Analysis for Commercial Investment Real Estate

Using the following worksheet, calculate the PV of the owners position with the
existing lease in place. Calculate it annually using the following assumptions:

11 Case Study 3

Task 3-2: Determine the Present Value of the Owners

Current Position

General Assumptions

Owners 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

Tenants portion of fixed expenses: $1,500 per month

Tenants variable expenses: $2,500 per month

Owners portion of fixed expenses: $1,000 per month

Fixed and variable expenses are expected to increase 3 percent annually.

Subleasing is not allowed.

Owners Position with Existing Lease Worksheet
EOY

Rent

Expenses

=
NPV @ 12%

NOI

End of task
User Decision Analysis for Commercial Investment Real Estate 11.5

Task 3-3: Determine the Present Value of the Owners

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
EOY

Rent

Expenses

=
NPV @ 12%

End of task
11.6 User Decision Analysis for Commercial Investment Real Estate

NOI

Calculate the minimum buyout price you will recommend to the owner.
PV of current position

11 Case Study 3

Task 3-4: Establish the Owners Minimum Buyout Price

PV of worst-case scenario
Recommended minimum buyout price

End of task
User Decision Analysis for Commercial Investment Real Estate 11.7

Task 3-5: Determine the Present Value of the Tenants

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 tenants cost of capital is 9 percent.
Calculate the PV cost of the tenants 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.
Worksheet for Task 3-5
EOY

Rent

Fixed Expenses

=
NPV @ 9%

End of task
11.8 User Decision Analysis for Commercial Investment Real Estate

Annual Cost

From your analysis, you have established the owners minimum and the
tenants maximum buyout prices. Quantify the negotiating range for the buyout
using the following model:

11 Case Study 3

Task 3-6: Determine the Negotiating Range

Tenants maximum price

Owners minimum price

Negotiating range

End of task
User Decision Analysis for Commercial Investment Real Estate 11.9

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.

11.10 User Decision Analysis for Commercial Investment Real Estate

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 partners situation.

11 Case Study 3

Talking Points

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
Georges objectives are

Avoid: Risk

Superficial: Georges 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 Georges 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.
User Decision Analysis for Commercial Investment Real Estate 11.11

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 Georges relationship with Bob, maintain the
relationship with AMI, and end constant nibbling.

Conclusion
The conclusion should reiterate how Georges 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
11.12 User Decision Analysis for Commercial Investment Real Estate

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 given
fighting alternative, if attempted, actually will occur.

11 Case Study 3

Task 3-8: Identify Fighting Alternatives

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
User Decision Analysis for Commercial Investment Real Estate 11.13

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

SUPERFICIAL

GOOD

Timing of buyout

ASAP

ASAP

Whether to do the
buyout

DEPENDS

YES

Relationship with
tenant

NO HEADACHES

N/A

Prospective tenant

STRONG CREDIT

N/A

AVOID

??

END

EXPLOIT

New tenant
improvements

AMI PAYS

LU PAYS

Buyout price

MAXIMIZE

MINIMIZE

Georges relationship
with Bob Jr.

Risk
Constant nibbling

11.14 User Decision Analysis for Commercial Investment Real Estate

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?

11 Case Study 3

Expand the List of Action Steps and Create Talking Points

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 emails
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 stakeholders interests to develop
key talking points for communicating with that stakeholder. Use the following
template to organize your talking points.
Talking Points for
User Decision Analysis for Commercial Investment Real Estate 11.15

<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.

Cover the most important elements of the business relationship.

Objectives
Stakeholder objectives are derived directly from the critical stakeholders issues
and interests. In this example, one of the issues is the buyout price. AMIs
interest (or objective) is to minimize the buyout price, whereas Georges is to
maximize buyout price.

Specific Actions
This list of actions results from evaluating the actions against each stakeholders
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 stakeholders 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.
11.16 User Decision Analysis for Commercial Investment Real Estate

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

11 Case Study 3

Update Fighting Alternatives

% Probability

Negotiate
Your initial objective for this meeting is to ask questions and identify or confirm
the other partys 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 partys
needs so you can satisfy your own or your clients needs.

End of task
User Decision Analysis for Commercial Investment Real Estate 11.17

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 stakeholders interests?

How did your solution meet the other partys interests?

What would you have done differently to achieve a more satisfactory

outcome?

End of task
11.18 User Decision Analysis for Commercial Investment Real Estate

11 Case Study 3

Answer Section

User Decision Analysis for Commercial Investment Real Estate 11.19

Task 3-1: Review Interests Analysis

Answers will vary.

Task 3-2: Determine the Present Value of the Owners

Current Position
Owners Position with Existing Lease Worksheet
EOY

Rent

Expenses

$240,000

$12,000

$228,000

$240,000

$12,360

$227,640

$240,000

$12,731

NOI

$227,269

$240,000

$13,113

$226,887

$240,000

$13,506

$226,494

$240,000

$13,911

$226,089

$240,000

$14,329

$225,671

$240,000

$14,758

$225,242

NPV @ 12%

$1,127,117

Task 3-3: Determine the Present Value of the WorstCase Scenario

Worksheet for Task 3-3
EOY

Rent

Expenses

NOI

$0

$30,000

($30,000)

$0

$30,900

($30,900)

$0

$31,827

($31,827)

$192,000

$13,113

$178,887

$192,000

$13,506

$178,494

$192,000

$13,912

$178,088

$192,000

$192,00
0

$14,329

=
=

$14,759
NPV @ 12%

$177,671
$177,241
$383,074

Task 3-4: Establish the Owners Minimum Buyout Price

PV of current position

PV of worst-case scenario
Recommended minimum buyout price

11.20 User Decision Analysis for Commercial Investment Real Estate

$1,127,117
383,074
$744,043

Worksheet for Task 3-5

EOY

Rent

Fixed Expenses

$240,000

$18,000

$258,000

$240,000

$18,540

$258,540

$240,000

$19,096

$259,096

$240,000

$19,669

$259,669

$240,000

$20,259

$260,259

$240,000

$20,867

$260,867

$240,000

$21,493

$261,493

$240,000

$22,138

$262,138

NPV @ 9%

11 Case Study 3

Task 3-5: Determine the Present Value of the Tenants

Current Position
Annual Cost

$1,437,632

Task 3-6: Determine the Negotiating Range

Tenants maximum price

Owners minimum price

Negotiating range

$1,437,632
744,043
$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

Dont allow buyout

Lu

Task 3-9: Negotiate

Talking Points for AMI
Objectives

Good: Georges relationship with Bob Jr.

User Decision Analysis for Commercial Investment Real Estate 11.21

ASAP: Timing of buyout

Minimize: Buyout price

Specific Actions

Close deal within 30 days, which satisfies the timing of buyout objective.

Keep George and Bob out of contentious negotiations that satisfy the
objective to maintain the relationship between the two.

Take less money 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: Georges 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 Georges 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.

Keep George and Bob out of contentious negotiations that satisfy the
objectives to maintain Georges relationship with Bob, maintain the
relationship with AMI, and end constant nibbling.

11.22 User Decision Analysis for Commercial Investment Real Estate

User Decision Analysis for Commercial Investment Real Estate

12
Case Study 4:
Sale Leaseback

In This Module
Case Study Overview ......................................... 12.1
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

Case Study Overview
This case study analyzes the sale-leaseback transaction from both the users and
the investors perspectives. Various measures from the users 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 investors perspective to determine if they meet the investors
minimum criteria.

Case Objectives

Determine the net present value (NPV) of the continue-to-own alternative

from a users perspective.

Determine the NPV of the sale-leaseback alternative from a users

perspective.

Determine the sale price at the end of the holding period of the continueto-own alternative that would make the two alternatives equal from a users
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 users perspective.

Determine the investment base for the continue-to own-alternative from the
users perspective.

Determine return on investment from the continue-to-own alternative by

calculating the IRR of the differential cash flows from a users perspective.

Integrate generally accepted accounting principles (GAAP) requirements

into the economic analysis from a users perspective.

Determine the acquisition capitalization rate from an investors perspective.

Determine the before-tax cash on cash from an investors perspective.

Determine the before-tax IRR from an investors perspective.

Determine the after-tax IRR from an investors perspective.

User Decision Analysis for Commercial Investment Real Estate 12.1

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 Moodys 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 the
conceptual 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.
AEIs corporate structure is closely held, with 80 percent of the shares
concentrated in the hands of five stockholders. These shareholders serve as the
board 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 boards
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, were 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
12.2 User Decision Analysis for Commercial Investment Real Estate

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.

12 Case Study 4

day of the tax year and used midmonth convention for the cost recovery
deduction for the first year of ownership.

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

AEIs after-tax weighted average cost of capital: 8 percent

AEIs 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

User Decision Analysis for Commercial Investment Real Estate 12.3

Tax rate for cost recovery recapture: 25 percent

Purchase price: $7,000,000

Acquisition costs: $75,000

Improvement allocation: 75 percent

Useful life of improvements: 39 years

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

Amortization period: 25 years

Loan term: 25 years

Loan payments per year: 12

Loan costs: 2 percent of the loan amount

12.4 User Decision Analysis for Commercial Investment Real Estate

Generate the solutions for this task using the Excel worksheet on your CDROM, and then answer the following questions:

12 Case Study 4

Task 4-1: User Analysis

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 users
incremental borrowing rate?

6. Is the proposed leaseback an operating lease or a capital lease?

7. What is the sale leasebacks annual impact on the income statement?

8. How much would the stockholders equity be improved by the sale

leaseback?

End of task
User Decision Analysis for Commercial Investment Real Estate 12.5

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
12.6 User Decision Analysis for Commercial Investment Real Estate

12 Case Study 4

Answer Section

User Decision Analysis for Commercial Investment Real Estate 12.7

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 saleleaseback 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 users
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 leasebacks annual impact on the income statement?

($361,905)

12.8 User Decision Analysis for Commercial Investment Real Estate

12 Case Study 4

8. How much would the stockholders 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)

Compounded 15 years at 8%

Sale proceeds after tax (SPAT) adjustment to equalize the NPVs

+

SPAT adjustment [$236,831 (1 34%) $236,831]

Sale proceeds before tax adjustment (SPBT) to equalize the NPVs

Costs of sale on SPBT adjustment [$358,835 (1 3%) $3,281,103]

Sale price adjustment needed to equalize the NPVs

$236,831
358,835
$358,835
369,933
$369,933

Original projected sale price

$9,421,000

Sale price needed to equalize the NPVs (rounded to the nearest $1,000)

$9,791,000

Value today
$7,000,000

15 years

EOY 10 sale price

$9,791,000

The annual growth rate in value needed to equalize the NPVs is 2.26 percent.

User Decision Analysis for Commercial Investment Real Estate 12.9

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

12.10 User Decision Analysis for Commercial Investment Real Estate

Index
A

Accrual, 2.10

Discount rate, 2.14

Analysis process, 7.32

Attorney, 3.7

Dissimilar lease, 4.37

Due diligence, 3.33

Acquisition, 3.5, 3.8

Assets, 2.12

Economic analysis, 4.2, 7.10

Effective rate, 4.2

Balance sheet, 2.12, 7.6

Effective rent, 4.2

Base rent, 4.2

Expense

Buyout Pendalum, 6.12

Pass-throughs, 3.28

Stops, 3.31

Capital lease, 4.25

Capital market, 1.6

Fighting alternatives, 8.15

Cash flow statement, 2.7, 7.7

Financial accounting/reporting, 2.4,

4.25, 6.4

CCIM Approach and Negotiation

Theory, 8.4
Common area maintenance, 3.33

Future sales price, 5.25

Comparison techniques, 5.8

Contact rent, 6.6

GAAP accounting, 5.34, 7.6, 7.26

Conventional mortgage financing,

7.27

Gross-up clause, 3.33

Corporate entities, 2.14

Cost of occupancy, 4.3

User Decision Analysis for Commercial Investment Real Estate 13.1

Income statement, 2.10, 7.6

Negotiations, 8.3

Indexed Leases, 3.26

Net present value method, 5.8,

5.15, 5.22, 7.10, 7.13

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

O
Occupancy, 3.22
Operating expenses, 3.31

Owners leased fee interest, 3.3

Owning, 5.6

Landlord, 3.6

Advantages, 5.6

Lease

Disadvantages, 5.6

Advantages, 5.3
Clause, 3.21

Cost, 4.12
Decisions, 4.7
Disadvantages, 5.4

Percentage (Overage) Rent, 3.27

Proposals, 3.18
Purchaser, 3.5

Multi-period, 4.24
Term, 3.21

Leasehold interests, 6.4

Leasing, 5.3

Quarterly earnings, 2.11

Maintenance, 3.23

Rate, 4.2

Market rent, 6.6

REIT, 1.12

Market research, 3.11

Market survey, 3.11
Matching principle, 2.10

13.2 User Decision Analysis for Commercial Investment Real Estate

Rent, 3.21
Request for proposals, 3.12
Risk analysis, 8.15

Tenant improvements, 3.22

Sale-leaseback, 7.1

Sale price sensitivity, 7.21

SEC, 2.7
Seller, 3.6
Signage, 3.22
Space market, 1.5

Tenants Leasehold Estate, 3.3

Unequal terms, 4.44

Use, 3.22
User needs analysis, 9
Utilities, 3.22

Space planner, 3.7

Stakeholder, 8.7

Step leases, 3.26

Subleases, 6.4

Valid lease, 3.20

T
Tenant, 3.5

User Decision Analysis for Commercial Investment Real Estate 13.3