Contract Rent vs. Market Rent in Appraisals

Contract Rent versus Market Rent in "Real Estate Appraisals"

The short version of this discussion is that contract rent is what is agreed to in a lease - " the contractual lease agreement" and market rent rent is what is the most likely rental rate based on market evidence/comparable rentals/leases. This is a very similar concept to the price vs. value discussion/blog. In relation to the prior price vs. value discussion, contract rent is the price an owner of property agrees to lease and the price a tenant agrees to pay as stipulated in the lease agreement. This could be based on market rent levels/market evidence or any number of factors not related to market rent. Where as, market rent is the opinion of what a property should or would lease for based on other comparable properties that have leased or are available for lease. Market rent is the most likely lease rate for a property based on the specifics of that property and how those property specifics relate to the market/other comparable rental properties.

The Appraisal of Real Estate published by the Appraisal Institute defines Contract Rent and Market Rent, as follows:

"Contract Rent is the actual rental income specified in a lease."

"Market Rent is the rental income that a property would probably command in the open market; indicated by the current rents that are either paid or asked for comparable space as of the date of the appraisal." 
 

How is this applied in the appraisal process.

The income/rent the property generates and/or can generate is analyzed in the Income Approach to value. In a standard "commercial real estate appraisal" (non-single family property) the Income Approach is one of three approaches to derive value of real estate and the analysis of market rent is only one step in the Income Approach in deriving a value for a property.

Depending on the type of assignment and the specifics of the property, both the contract rent and market rent can be analyzed, or just one may be analyzed. If market value is sought then market rent should typically be determined and analyzed and if the property is leased then market rent should be compared to the contract rent as the market value can be impacted by a difference in the terms of market rent vs. contract rent. If interested, see the previous discussion/blog on fee simple interest for how contract rent and market rent can impact the fee simple and/or leased fee values of property.

Beyond a typical appraisal, a "market rent study" or "market rent appraisal" can be conducted if only the appropriate rent is in question or sought. In this case an "independent, third party - appraiser" is brought in to estimate/derive fair market rent only and the value of the property is not needed.

There are many reasons why a market rent study is requested, such as in a business partnership situation where one partner owns the real estate and the fair market rent is needed to confirm that the appropriate amount is being paid. A tenant in a property may request to have a rent study done to help in negotiations with the landlord when nearing a lease renewal or when signing a new lease for a property to make sure they are not paying more than typical or to provide to shareholders in the business that the lease rate being paid by the business is appropriate. An owner/landlord may want to confirm that they are charging appropriate rents to their tenants based on comparable properties in order to minimize the risk of vacancies or to know their potential income exposure if a lease renewal is approaching. An investor may want to know what the most probable rents for a potential investment are in order to utilize in their investment calculations as part of their due diligence prior to closing on an investment property. There are a multitude of reasons for having an "independent, unbiased, third party - appraiser" determine the appropriate market rent for a property. If the fair market rent is in question, then a market rent study may be in order.

If you have questions regarding market rent and/or contract rent or if you think that you might need a market rent study and/or appraisal we are available to assist.

Please feel free to contact us.

Mike Cliggitt, MAI, MRICS

Cliggitt Valuation, Inc.
Real Estate Analysts and Advisors
Based in Central Florida (Lakeland, FL)
863-661-1165
www.cliggitt.com

    

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Real Estate Appraisal - The Fee Simple Interest

"Real Estate Appraisal" - The Fee Simple Interest
The term fee simple in an appraisal is describing a group/bundle of rights associated with the ownership of the property.

Fee Simple is defined as "absolute ownerhsip unencumbered by any other interest or estate, subject only to the limitations imposed by governmental powers of taxation, eminent domain, police power, and escheat." definition from The Appraisal of Real Estate, Appraisal Institute

In essence, fee simple interest ownership in property is a complete form of ownership, subject only to standard goverment power. It is the most wholistic form of legal ownership there is.

So in an appraisal, when the appraiser states that he/she is appraising the fee simple interest in the property, they are stating that they are appraising the property unencumbered, except regarding the 4 governmental powers described above. The complete group of rights or many times referred to as a bundle of rights included with fee simple ownership are:

• The right to sell or sell an interest in the property
• The right to lease or lease an interest in the property
• The right to mortgage the property
• The right to give away/gift the property or an interest in the property
• The right to do none or all of these things

Doing any of the above, except of course for the last bullet of doing none of the above, will create a fractional ownership interest in the property that will typically need to be analyzed or discussed in an appraisal. For instance - when a property owner leases a property to a tenant for say a 5 year period, the property owner has given up the right of use/occupancy of the property and the tenant has gained that right for the 5 year lease period. However, the owner - now landlord - has given up that right for the right to receive income/rent from that tenant over the 5 year term of the lease. The leasing of the property to a tenant for 5 years has created a leased fee interest in the property for the owner and a leasehold interest in the property for the tenant.

Leased Fee Interest is defined as - "An ownership interest held by a landlord with the rights of use and occupancy transferred by the lease to others. The rights of the lessor (leased fee owner) and the leased fee are specified by contract terms contained within the lease" - Appraisal of Real Estate, Appraisal Institute

Leasehold Interest is defined as - "The interest held by the lessee (the tenant or renter) through a lease transferring the rights of  use and occupancy for a stated term under certain conditions as specified in the lease" - also from the Appraisal of Real Estate, Appraisal Institute

Leasing a property does create a form of fractional interest in real property. This is one example of how a partial interest in a property is granted/conveyed by an owner of property.

So does leasing a property change the value of the property, since some of the fee simple interest - bundle of rights - have been granted to a tenant? This is a very good question and one that is encountered often when appraising a property, however the answer is not yes or no but, it depends. It depends on the difference between contract rent and market rent, as well as the value of the fee simple interest (unencumbered), the length of the lease, the amount of lease (lease rate), and how that compares to market lease rates and terms. It also depends on investor perceptions, and a range of other issues.

If you have questions regarding how a lease could impact the value of your real estate or any other questions regarding a whole or fractional interest in real property, we are available to assist.

Please feel free to contact us.

Mike Cliggitt, MAI, MRICS

Cliggitt Valuation, Inc.
Real Estate Analysts & Advisors
Based in Central Florida (Lakeland, FL)
863-661-1165
www.cliggitt.com

What is a Triple Net Lease?

When leasing a property, the rental rate and expense sharing/responsibilities shared between a tenant and landlord are important items that should be considered in the leasing decision process and negotiations. Some rental rates may appear to be lower than others but the tenant is responsible for a larger amount of the property expenses, where as other properties have a higher quoted rental rate but that rental rate includes all property expenses with nothing passed through to the tenant. Below, is a discussion of the triple net lease, where property expenses are passed through to a tenant.

A triple net lease is a lease arrangement where the landlord passes through property expenses to the tenant. The term pass-through is regularly used in the real estate leasing environment and just means an expense item that is being passed on from the owner/landlord to the tenant. It can be passed through in a yearly annual fee or the actual specific bills for each pass through item can be handed over to the tenant to pay directly to the billing entity (i.e. property taxes, insurance, etc.). If the building is a multi-tenant property than the pass-through should/will be based on a pro-rata share of the tenant’s percentage of occupied space in relation to the entire building/property. Example – If a tenant occupies 10% of a building then their pro-rata share of the expenses will be 10% of the total expenses being passed through. The term “Tripe Net”, also known as “Net Net Net” or “NNN” are all used interchangeably and typically mean that certain/specific property related expenses are passed through to the tenant. Under this type of lease the tenant will be responsible for the agreed rental rate, as well as additional property related expenses. The primary expenses typically passed through in a Triple Net lease are property taxes, building replacement insurance, and property maintenance. So the term Triple Net or NNN, means the rental rate is net of (or does not include) three expense items, hence Net Net Net. So Triple Net means the rental rate is net of property expenses, net of property insurance, and net of maintenance and repairs – Net Net Net.
 

Example:

NNN Lease Includes:

Negotiated/Agreed Base Rent
+ Property Taxes (Pro-Rata Share)
+ Property Insurance (Pro-Rata Share)
+ Maintenance & Repairs (Pro-Rata Share)
= Total Lease Costs/Responsibility of Tenant

Triple Net Lease (with real $) Example:

$15.00/SF – Base Rent
+$2.00/SF – Property Taxes
+$0.60/SF – Property Insurance
+$1.00/SF – Maintenance & Repairs
= $18.60/SF - Total Lease Costs/Responsibility of Tenant

So a triple net lease passes through the cost of certain property expenses, as well as the possible risk of future increases or decreases of those expenses over the term of the lease to the tenant. Landlords typically prefer this lease structure as it helps limit uncertainty/risks related to property expense increases and many large property owners (REIT’s, institutional investors, etc.) lease property to tenants on a triple net basis or similar terms.

Just as the triple net lease typically refers to exclusions of three property expense categories, the term double net or single net refers to the exclusion or pass-through of two property expense items (Double Net or Net Net or NN) or a single property expense item (Single Net or Net or N). There are also other ways to refer to leases/lease expense sharing such as a Net Lease, Modified Net Lease, Gross Lease, Modified Gross Lease, Full Service Lease, etc. Each of these various categories refers to how expenses are classified/paid for/shared between the landlord and tenant. Some are utilized interchangeably and may vary from region to region based on local terminology and expectations within various markets around the county. When contemplating entering into a lease, understanding how the property expenses are being paid for/shared is an important item and hiring an attorney to draft a lease or provide clarification and interpretation of a lease is highly recommended.

As a business owner/tenant or prospective tenant understanding the structure of the lease agreement and total cost (base rent and expenses) of a lease is important business decision. Some leases on the surface may look cheaper but when factoring the various pass through expenses end up costing more than other leases.

Our firm performs comparable rent analysis and studies, comparable expense analysis, total lease cost analysis for a single year or multi-year lease contracts, leasing versus owning cost analysis. We also provide negotiation services for tenants and/or landlords with market based evidence/support of our recommendation used as a basis for negotiation or renegotiation of a lease. For all non-legal lease related questions, we are available to assist so please feel free to contact us. We can also recommend an attorney to help with drafting and/or legal interpretation of a lease.

 

Mike Cliggitt, MAI, MRICS

Cliggitt Valuation, Inc.
Real Estate Analysts & Advisors
Based in Central Florida
Lakeland, Winter Haven, Bartow Commercial Property Specialists
863-661-1165
www.cliggitt.com