Effective Rent
(Third
Quarter 1993)
Since rent concessions first became prevalent
in the mid-1980s, there have been many
attempts to measure the "real rent"
payable according to a lease. These attempts
center on calculating effective rent.
Unfortunately, there is no adequate
definition of effective rent, and the two
methods used to calculate effective rent are
considered interchangeable. In fact, however,
they do not produce the same effective rent. The methods,
each with several possible refinements, are
(1) calculation of the mathematical average
(mean) annual rent, net of free rent, and (2)
calculation of the annual rent (graduated or
constant) whose present value equals the
present value of the actual rent, net of free
rent. The present value method is more
reliable and produces a more realistic
interpretation of the market because it
reflects differences in leases that relate to
the timing of cash flow. These are not
reflected by an averaging method.
For the
averaging method, effective rent might be
defined as the average annual rent to be
collected over a lease term after deducting
free rent or other cash incentives. For the
present value method, we offer the following
definition of effective rent: The initial
annual rent, assuming (1) market periodic
increases (if any) and (2) market tenant
improvement costs, that results in the same
present value, using a market discount rate,
as the actual lease provisions.
"Market
periodic increases" are customary
periodic increases in base rent in leases of
a certain length. For example, three-year
leases might typically be written with a
constant base rent, while leases of five or
more years might typically provide for annual
increases in base rent (e.g., increases based
on a dollar amount, a percentage, or the
CPI). Therefore, to calculate effective rent
the common practice in the particular market
must be ascertained. Because rental rates are
generally quoted for the initial lease year
and periodic increases, if any, may vary, the
initial rent is most useful for the analysis
of market rent. In markets where constant
rents are the rule, initial rent and constant
rent are synonymous.
"Market
tenant improvement cost" is the typical
cost for tenant improvements (TIs) in an
area. In some markets TIs may vary by tenant
classification so it may be necessary to
distinguish between new tenants and renewal
tenants or between tenants for new (never
built-out) space and used (previously
built-out) space.
Rent
may be adjusted for TIs either by adjusting
the present value of the rent for the total
TIs or by adjusting the present value of the
rent for the difference between the actual
TIs specified in the lease and the market
level of TIs for comparable space. The
advantage of the first method is its
simplicity; it requires no judgments. It
does, however, produce somewhat lower
effective rent indications which are not
comparable to face rents. The second method
produces effective rent indications which can
be compared with face rates. The disadvantage
is that it requires a judgement about market
TIs.
The
"market discount rate" is an
average free and clear equity discount rate
used to estimate market value of the leased
fee estate of properties of similar quality
and location. The analyzed rents are derived
from these properties. The discount rate is
not intended to be property and tenant
specific. It is intended to be representative
of similar properties and similar tenancies,
which are represented by the data being
analyzed.
"Actual
lease provisions" include rent, free
rent, expense recovery provisions, tenant
improvement allowances, moving costs, lease
buy-outs, and any other cash incentives
provided in a lease.
The
following examples illustrate the calculation
of effective rent using an averaging method
and a present value method. The following
assumptions apply to all the examples:
- All
leases are for a term of five years.
- The
market discount rate is 12.00%.
- All
leases contain similar expense
recovery provisions.
- None
of the leases provide for other cash
incentives.
In the
first example, there are two leases. The
first has graduated rentals while the second
does not. Both provide for five months of
free rent in the first lease year. Exhibit 1
contains the calculations for both leases. As
is evident, both leases provide for a total
face rent of $90.00 per square foot over the
lease term. The first provides the landlord
with a total cash flow of $85.00 while the
second produces only $82.50, and the average
annual rents for the leases are $17.00 and
$16.50, respectively. Thus, the averaging
method indicates that Lease 1 has the higher
effective rent. Analysis on a present value
basis indicates that Lease 2 has the higher
present value due to the timing of the cash
flows. Thus, Lease 2 has the higher effective
rent.
Exhibit
1
| |
1 |
2 |
| Face
Rental |
Year 1
Year 2
Year 3
Year 4
Year 5 |
$12.00
15.00
18.00
21.00
24.00 |
$18.00
18.00
18.00
18.00
18.00 |
| Total |
$90.00 |
$90.00 |
| Average |
$18.00 |
$18.00 |
| Actual
Rent |
Year 1
Year 2
Year 3
Year 4
Year 5 |
$7.00
15.00
18.00
21.00
24.00 |
$10.50
18.00
18.00
18.00
18.00 |
| Total |
$85.00 |
$82.50 |
| Average |
$17.00 |
$16.50 |
| Present
Value at 12.00% |
| Total |
$57.98 |
$58.19 |
In the second example,
shown in Exhibit 2, three leases are
presented. Each has the same provisions
except for free rent. While each lease
provides for 10 months of free rent, Lease 3
has its free rent in the first lease year,
Lease 4 has its free rent spread over the
lease term (2 months per lease year), and
Lease 5 has its free rent in the last lease
year. Analysis by averaging indicates that
Lease 3 has the highest effective rent; the
present value method indicates that Lease 5
has the highest effective rent.
Exhibit
2
| |
3 |
4 |
5 |
| Face
Rent |
Year 1
Year 2
Year 3
Year 4
Year 5 |
$15.00
16.00
17.00
18.00
19.00 |
$15.00
16.00
17.00
18.00
19.00 |
$15.00
16.00
17.00
18.00
19.00 |
| Total |
$85.00 |
$85.00 |
$85.00 |
| Average |
$17.00 |
$17.00 |
$17.00 |
| Actual
Rent |
Year 1
Year 2
Year 3
Year 4
Year 5 |
$2.50
16.00
17.00
18.00
19.00 |
$12.50
13.33
14.17
15.00
15.83 |
$15.00
16.00
17.00
18.00
3.17 |
| Total |
$72.50 |
$70.83 |
$69.17 |
| Average |
$14.50 |
$14.17 |
$13.83 |
| Present
Value at 12.00% |
| Total |
$49.31 |
$50.39 |
$51.48 |
Clearly, the preceding
examples illustrate the benefit of using the
present value method. The following two
examples illustrate the adjustment of the
present value indication for TIs and the
conversion of the present value indication
into an initial rent indication. These
procedures are necessary if effective rent
conclusions are to be useful in market rent
analysis.
Exhibit
3 illustrates the adjustment for differences
in TIs. For example, say the leases in
Exhibit 2 had TIs of $20.00, $25.00, and
$30.00 per square foot, respectively, and
that the market TI cost is $25.00 per square
foot. Each present value indication is
adjusted only for the difference between the
actual TIs and the market TIs. The difference
in TIs can be subtracted directly from the
present value indication since TIs are
usually incurred at, or prior to, lease
commencement and therefore should not be
discounted.
Exhibit
3
| |
3 |
4 |
5 |
Total present
value
Actual Tls
Market Tls
Tl Adjustment |
$49.31
20.00
25.00
5.00 |
$50.39
25.00
25.00
0.00 |
$51.48
30.00
25.00
(5.00) |
| Adjusted present
value |
$54.31 |
$50.39 |
$46.48 |
In Exhibit 4, the present
value indication is converted to an
indication of initial annual rent. In this
example it is assumed that annual base rent
increases of $1.00 per square foot are
customary for five-year leases. Thus, the
typical increase provides for an additional
rent of $1.00 per square foot in the second
lease year, $2.00 per square foot in the
third lease year, $3.00 per square foot in
the fourth lease year, and $4.00 per square
foot in the fifth lease year. The present
value (at 12.00%) of receiving the additional
rent is $6.40. If constant rents were
typical, the present value of the additional
rent would be zero. To make the conversion to
initial annual rent, the present value of
receiving the typical increases is subtracted
from the adjusted total present value. The
remainder (subtotal in Exhibit 4) is the
total present value of receiving the initial
rent (or constant rent) for five years.
Dividing this amount by the present value
factor for receiving $1.00 per year for five
years (3.60) results in the initial annual
rent.
Exhibit
4
| |
3 |
4 |
5 |
Adjusted
PV
Less PV of additional rental |
$54.31
6.40 |
$50.39
6.40 |
$46.48
6.40 |
| Subtotal |
$47.91 |
$43.99 |
$40.09 |
| Divided by PV
factor |
3.60 |
3.60 |
3.60 |
| Indicated
initial annual rent |
$13.29 |
$12.20 |
$11.12 |
An example of the entire
adjustment process using leases with
differing graduated rent and free rent
provisions and differing TIs is illustrated
in Exhibit 5.
Exhibit
5
| |
6 |
7 |
8 |
| Face
Rent |
Year 1
Year 2
Year 3
Year 4
Year 5 |
$12.00
15.00
18.00
21.00
24.00 |
$16.00
17.00
18.00
19.00
20.00 |
$18.00
18.00
18.00
18.00
18.00 |
| Total face rent |
$90.00 |
$90.00 |
$90.00 |
| Free rent (mos.) |
9 |
6 |
3 |
| Actual
Rent |
Year 1
Year 2
Year 3
Year 4
Year 5 |
$3.00
15.00
18.00
21.00
24.00 |
$8.00
17.00
18.00
19.00
20.00 |
$13.50
18.00
18.00
18.00
18.00 |
| Total actual rent |
$81.00 |
$82.00 |
$85.50 |
| Average actual
rent |
$16.20 |
$16.40 |
$17.10 |
| PV at 12.00% |
$54.41 |
$56.93 |
$60.87 |
Actual Tls
Market Tls |
22.00
25.00 |
25.00
25.00 |
29.00
25.00 |
| Tl Adjustment |
3.00 |
0.00 |
(4.00) |
| Adjusted
Actual Rent |
$84.00 |
$82.00 |
$81.50 |
| Avg. Adj. actual
rent |
$16.80 |
$16.40 |
$16.30 |
| Adjusted PV |
$57.41 |
$56.93 |
$56.87 |
| Less PV of addtl
rent |
6.40 |
6.40 |
6.40 |
| Subtotal |
$51.02 |
$50.53 |
$50.47 |
| Divided by PV
factor |
3.60 |
3.60 |
3.60 |
| Indicated initial
annual rent |
$14.15 |
$14.02 |
$14.00 |
Examination reveals that
the range of initial rent indications is
narrowed significantly, thus providing a
benchmark by which market rent conclusions
may be tested for reasonableness. In the
example in Exhibit 5, the initial-year face
rents are widely divergent and range from
$12.00 to $18.00 per square foot per year, a
variance of $6.00. The average actual rents
range from $16.20 to $17.10 and have a much
smaller variance of $0.90. After adjusting
for the difference in TIs (from market TIs),
the variance is decreased to $0.50 with a
range of $16.30 to $16.80. On a present value
basis, the variance in initial rent (assuming
increases of $1.00 annually) is reduced to
$0.15 with a range of $14.00 to $14.15. With
this much smaller variance, proposed lease
provisions may be analyzed objectively to
determine competitiveness with the market.
The
proliferation of leasing incentives in the
marketplace has complicated the analysis of
comparable rentals. It is no longer
sufficient to examine face rates and make
subjective adjustments for other lease
provisions such as free rent, tenant
improvements, graduated rents, moving
allowances, and other cash incentives. The
great variety of differences in specific
lease provisions requires a common
denominator for measurement. The anticipated
IRR is the common denominator for measuring
prospective earnings on real property
investments. Effective rent can be the common
denominator for measuring "real
rent".
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