Commercial Real Estate Finance Principles

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There are several factors that should be considered in the new lease agreement between the lessor and the lessee. As the lessee is seeking for a longer lease period than provided for by the lessor, the lessor should factor in various issues before signing the new deal. One of the most important valuation variables in long-term lease pricing is reversion. This is a lump sum benefit that the lessor receives at the end of the agreement. Reversion is discounted using the reversion factor, which is influenced by factors like; the physical and functional attributes, market and locational externalities and life expectancy of the property. The reversion value of a lease property is directly proportional to the reversion factor; and the longer the lease period, the lower the expected reversion value and vice versa (Gaddy, Hart and Wolk 94).

The lessor should consider the market variables – interest rates and inflation – prevalent at the time and any anticipated changes likely to happen in the future in the lease prices. As the lease is bound for a longer period a lot of factors are bound to change both for the tenant and the landlord. The landlord should first of all check the value and trends of the real estate market, and going by current analysis they are growing steadily. Therefore the rent of the ten year period should be calculated to reflect this trend.

The current trend in real estate market projects an appreciation in value by 6.25 percent, therefore this factor should be well included in the lease price. Thus the total ten year rent should be adjusted to reflect the net present value of the total rent payable. After that he should increase the value by 6.25 percent and divide the amount by the square foot of the building to get what the tenant should be paying. After that the value should be divided by the total number if months that the tenant will be leasing the building in this case, one hundred and twenty months. Therefore the payment should be $22.51 per square feet.

Since it is a commercial building percentage lease is considered by the lessor when filing annual tax returns, whereby a percentage of the lessee’s gross lease rental income is calculated and allowed in his or her total rent income payable. Therefore apart from the minimum rent calculated above, 2 percent of the gross sales of excess of $ 200,000 per year should be added. There should also be a recapture clause that allows the lessor to reclaim the property if the minimum sales agreed are not met (Cortesi 23).

Another variable to be considered is the gross up for realty taxes, in a number of states, the taxation on realty increases due to vacancy levels in building since the tax is calculated based on full vacancy. It will be wise therefore for the lessor to increase the lease rentals by the percentage increase of the tax rate. In addition he should factor in the changes after the fifth year of tenancy whereby should he fail to get new tenants; the existing tenants will have to share the cost of rentable area gross-ups which will be calculated per square feet. Thus he will be able to receive rent as if the whole building was rented (Gaddy, Hart and Wolk 94).

The lessor should put into consideration the expected rate of return to the property. This is calculated by summing up the required rate of return and the risk premium. In this situation the risk premium will include default risk that the lessor could be exposed to when they enter into a contract with the lessee. Default risk is a probability that the lessee will not be able to pay the rent on due time or for the whole period. High risk clients will be charged a higher rate to cover the uncertainty to the lessee in case the tenant is unable to honor his or her obligation promptly. Default rate is usually in percentage and is added to the cost of the property to get the expected rate of return to the lessor. To insulate against default risk the lessor can demand lease rentals to be paid in advance for the preceding periods.

Also the landlord should be able to predict the stability of the tenant and whether she might forfeit her tenancy subjecting him to extra expenses in the long run. The terms and conditions should have a clause that explains the remedies that the lessor can take if the lessee forfeits’ the tenancy. The clause should not be open but has a stipulated framework on how the lessor will be compensated , therefore after the agreed initial five years on the lease the tenant will be subjected to pay 55 percent of the remaining value of rent if they forfeit the lease for the remain years.

Terms and conditions can allow for lease and leaseback transactions, whereby the lessor can lease the property back from the lessee who he had earlier leased the property to. This can happen in case the lessor is disgruntled with the lessee or the lessor wants to put the property into other proper use. The landlord should also consider the possibility of potential, better tenants to his establishment, therefore there should be a clause that can allow the landlord to re-occupy the establishment at his will and forfeit the lease if faced with better offers of tenancy in the market. He should also put into consideration the flexibility of the contract, that is, if the lease is a gross lease or a net lease. If it is a net lease then he does not need to worry as the tenant will cater for the building expenses.

However if it is a gross lease he should consider the possibility of gross-ups for operating costs of running the building such as land rates and insurance. Therefore the appreciation in expenses should be reflected in the amount of rent that the tenant pays. Therefore an additional clause should be added, which will cater for any increase or decrease in expenses. Thus if there is a variation, the lease rentals will increase by a certain percentage or decrease if there is a decrease. This cost should be allocated on a proportionate basis shared between the lessor and lessee.

Thus after consideration of all the variables the new lease should clearly show all the expected cost the tenant is expected to pay and the pattern of the expected payment schedule for the ten years. Also the new clauses added should be clear and precise to the tenant and the landlord (Floyd and Allen 51).

Present value of lease = Annuities*PVAF r% nyrs + 2% projected tenant income
+ 55 % No. Of years forfeited rent
Projected annual rent increase is 6.25%
Present value $ 20
PV = 20 * 6.25% $ 21.25 /sq. F.
2% Projected tenancy income = 122500/100.000 sq. F. $ 1.225 / sq. F
$22.50 /sq. F.
Forfeited rent NPV = (22.50*0.55)*No. Of years forfeited x
Total lease rental per sq. F xxxxx

Works cited

Cortesi, Gerald. Mastering Real Estate Principles. Dearbon, MI: Dearborn Trade Publishing, 2000. Print.

Floyd, Charles, and Allen Marcus. Real Estate Principles. Dearbon, MI: Dearborn Real Estate, 2002. Print.

Gaddy, Hart, and Wolk Judy. Real Estate Fundamentals. Dearbon, MI; Dearborn Real Estate, 2003. Print.

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