Recently we were presented a unique challenge in one of our appraisal assignments. We were asked to value the leased fee estate of a medical office property. Nothing unusual there, we do this all the time. However, this time, there was a new 10 year lease that had a lease rate we determined was well above market rents for similar properties in similar locations. Typically appraisers and market participants can reconcile various reasons for a slightly higher rental rate. The property could be new with high end updated features, include the amortization of tenant improvements, is in a superior location to all other similar types of properties, etc. After all, one property has to be the best with the highest rental rate in the market and one has to be the worst with the lowest rental rate in the market. Typically adequate adjustments can be made to reconcile comparable rents into a market rent for the subject property that would be somewhat in line with the contract rent. However, that was not the case in this situation. The property was an above average property in a typical location for medical office. The contract rent was not just a little bit higher than market, it was excessively higher than market (85% higher). This was the crux of the appraisal problem.
The property had “Excess Rent.” Excess rent as defined by “The Appraisal of Real Estate” thirteenth edition is “The amount by which contract rent exceeds market rent at the time of the appraisal.” It is “created by a lease favorable to the landlord and may reflect unusual management, unknowledgeable parties, or a lease execution in an earlier, stronger rental market.”
As appraisers, we are charged with defining the problem to be solved and then determining the scope of services necessary to solve the problem. The valuation problem was easily identifiable. The difficulty came in in determining how we were going to solve the problem. In the past we have had situations where the amount of excess rent was not nearly as substantial, was for a shorter period of time and was primarily caused by a change in market conditions after the lease was executed. In these cases we determined that there were slightly greater risk factors at work than for a similar property leased at market rates. In these scenarios we could simply adjust for the risk by either using a higher vacancy rate or capitalization rate or some combination of the two. This time it was not going to be that straight forward.
To solve the valuation problem, we immediately turned to “The Appraisal of Real Estate” thirteenth edition and to articles published in “The Appraisal Journal” to research the issue. We also conducted research in the market to see if we could identify sales of properties in similar situations. We soon learned what had already been suspected, there is a lack of empirical evidence in the market. Each situation with “Excess Rent” is different and difficult to isolate the various risk factors, market conditions and other variables to determine the amount of excess rent and how it was accounted for in the sale.
The only way to solve the problem was to analyze the income stream in its component parts (market rent and excess rent). The first step was to determine the appropriate market rental rate for the subject, the appropriate vacancy rate and capitalization rate. Basically we analyzed the property with the Hypothetical Condition that the property was leased for 10 years at a market rental rate to the current tenant. Then we conducted a discounted cash flow analysis on the excess rent (the difference in the contract rent and market rent). This is where we ran into the next issue. We knew how much excess rent the landlord would be receiving each year and for how long he was contracted to receive it. However, what we didn’t know for sure was how long and how much rent would actually be paid and we needed to properly account for the risk associated with not knowing if the doctor could or would continue paying the excess rent. We needed to figure out what the actual risks were and the best way to account for them.
With the lack of empirical evidence from the market place, we determined the best way to develop the appropriate discount rate premium was to survey brokers, appraisers and market participants. We developed a survey which included the details (in generic terms and form) of the property and the contract rent. We identified the details we felt were pertinent to the situation to help the survey participants quantify the risks. We also established a base line for the property and its market in order to help protect the confidential nature of the assignment. We established the market rent and appropriate capitalization and discount rates for the property as if it were leased at market. This way the confidential nature of the assignment could be preserved and the risks associated with the tenant, market, property, and market lease rate were all taken into consideration. With this baseline established, we ask the respondents to identify the appropriate risks for the excess rent only and gave them several discount rate premium ranges to select as appropriate for this scenario. The survey and comments we received are included at the end of this article.
Interpretation of the results
We surveyed 20 market participants who were primarily commercial real estate brokers or commercial real estate appraisers. We received 10 responses. The responses range from no premium to the discount rate to a premium of 21.5%. The average of the low end of the premium was 3.05% and the average high end of the premium was 8.55% with an average calculated premium of 5.82%. Based on the baseline and parameters given in the survey, the appropriate discount rate for the excess rent in this scenario would likely be between 14.5% and 20%.
Conclusion
The preferable method of valuing the leased fee interest of a property when there is excess rent is discounted cash flow analysis. The cash flow must be bifurcated into two income streams and analyzed individually for their own inherent risk factors. When and if available empirical evidence from the market should be used or considered. In the absence of that empirical evidence, surveys of market participants can be very useful in determining the appropriate discount rate. The final selection of the appropriate premium to apply to the discount rate is influenced by many factors. The more we can identify and quantify specific risks, the more accurate the risk premium we select will be. The comments made by the respondents from our survey highlight some of the factors that should be considered in the final selection of the discount rate premium.
Steve Weis, MBA is President of Logix Real Estate Solutions Inc., a full service commercial real estate appraisal firm serving Cincinnati, Dayton and all of Southwest Ohio and Northern Kentucky. Steve is a highly qualified Commercial Appraiser specializing complex valuation issues, litigation appraisal and consulting, and valuation issues for the real estate tax appeal process. Should you need further information regarding this article or if you need assistance in any valuation issue, please contact Steve Weis in our Dayton Ohio office at (937) 886-5068, or via e-mail at steve.weis@logix-realestate.com.