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Lease pricing

Lease pricing. Lease Pricing. Distinction between owner-occupied and tenanted commercial property Our focus is on the latter, characterised by the landlord / tenant relationship Tenants’ commercial property requirements… Rent is the cost of occupation. Leases.

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Lease pricing

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  1. Lease pricing

  2. Lease Pricing • Distinction between owner-occupied and tenanted commercial property • Our focus is on the latter, characterised by the landlord / tenant relationship • Tenants’ commercial property requirements… • Rent is the cost of occupation

  3. Leases • Interests in land and contracts • Law provides backdrop to negotiations and resultant structures • Wherever hallmarks of a lease are present (i.e. exclusive possession for a fixed or ascertainable period) the arrangement is a lease • Approx. 40% leases contracted out LTA54 • Less able to sublet / assign short leases • Recommended reading: • RICS (2006) Valuation Information Paper 8: Analysis of Commercial Lease Transactions, RICS, London • Crosby, N., Hughes, C. and Murdoch, S. (2005) Monitoring the 2002 Code of Practice for Commercial Leases, Office of the Deputy Prime Minister, London

  4. Lease Terms Lease Incentives Alternative lease arrangements Rent-free periods Capital contributions, including: fitting-out costs take-back of existing premises Premiums • Length • Rent review type • Rent review frequency • Use clause • Improvements • Repairs • Assignment • Sub-letting • Breaks • (rent caps / floors) Stepped rents Turnover rents

  5. Lease Terms • Repair • FRI is norm but standalone second-hand property may modify strict FRI terms by reference to a schedule of condition • Break clauses • Fixed points in time (rolling breaks are rare) whereas other means of flexibility (assignment or subletting) can be undertaken at any time • 6 months is a typical notice period • Penalties for exercising breaks are occasional • Usually exercised for operational rather than affordability reasons • Assignment • Usually preferable to subletting as it avoids taking on L responsibilities • Condition about parity of financial standing • Sub-letting • Normal for a lease to require sublease to contain same terms and at least the same rent or at MR. Allied Dunbar v Homebase Ltd (2002) held that an often-used side letter between T and ST for sidestepping head-lease conditions was not acceptable • Usually sublease is required to be contracted out of LTA54 to prevent ST having right to renew sublease against HL should head-lease fall away Can offer reverse premium on assignment if market dropped

  6. Impact on value • Downside volatility has a floor based on covenant strength • Equity element is market-driven, via rent reviews and reversionary / residual values, RPI or turnover rent provisions • Different lease terms should not impact on returns and therefore they should be priced for risk and return – need lease pricing models and data on inclusion and operation of lease options • Pricing of lease terms undertaken implicitly and without modelling – usually rent agreed first and then terms negotiated afterwards [what happens in other countries?] • Lease incentives are different from lease terms – rent is a product of lease terms while incentives induce T to take lease, but both affect rent so must be included in lease pricing model • Some incentives rely on lease terms to underpin them (e.g. UORR and lack of early break are needed for a long rent-free period or large capital contribution)

  7. Landlords’ lease incentives1. rent-free periods • Valuer needs to determine the effective rent assuming no rent-free period… • Methods and assumptions vary depending on length of lease • Benefit to tenant is a short-term cash bonus at expense of increased rent (known as the ‘headline rent’) later – there may be additional risk if rent reviews are upward-only

  8. Rent-free periods(straight line method) A ten year lease has been agreed at a ‘headline’ rent of £50,000 per annum with one year rent-free period and a rent review after five years. What is the effective rent (ER)? If it was felt that ER would overtake the headline rent by the rent review then the headline rent should only be capitalised and amortised up to this point Headline rent 50,000 x 4 yrs 4 CV of headline rent 200,000 ¸ 5 yrs 5 Annual equivalent of headline rent £40,000

  9. Rent-free periods(straight line method) If it was felt that MR would not overtake the headline rent by the rent review then the headline rent should only be capitalised and amortised up to the end of the lease Headline rent 50,000 x 9 yrs 9 CV of headline rent 450,000 ¸ 10 yrs 10 Annual equivalent of headline rent 45,000 • The first approach favours the T and the second the L • Choice depends on rental growth rate assumption...

  10. Rent-free periods(time value method) Now introduce the time value of money... Headline rent 50,000 YP 4 yrs @ 8%* 3.3121 PV £1 1 yr @ 8% 0.9259 CV of headline rent 153,334 ¸ YP 5 yrs @ 8% 3.9927 Annual equivalent of headline rent discounted up to rent review (ER) £38,404 * Money discount rate

  11. Rent-free periods(time value method) The headline rent may predominate past the rent review, i.e. rental growth is not enough to outstrip £50,000 p.a. (assuming up-only r/r’s) Headline rent 50,000 YP 9 yrs @ 8% 6.25 PV £1 1 yr @ 8% 0.926 CV of headline rent 289,375 ¸ YP 10 yrs @ 8% 6.71 Annual equivalent of headline rent discounted over whole lease (ER) £43,125 Choice depends on rental growth rate assumption...

  12. Rent-free periods(time value method) Growth rate for 5 year write-off: 38,404 x (1+g)^5 = 50,000 g = 0.0542 Growth rate for 10 year write-off: 43,125 x (1+g)^10 = 50,000 (1+g)^10 = 1.1594 g = 0.0149 ...can also be done on Excel

  13. Rent-free periods(straight-line method) Now let’s introduce a fitting-out period... Two ways of handling this • Assume fitting-period already taken place before lease start • Assume fitting-out period begins at lease start A ten year lease has been agreed at a ‘headline’ rent of £50,000 per annum with 1.25 year rent-free period (including three months for fitting out) and a rent review after five years. What is the effective rent?

  14. Rent-free periods(straight-line method) 1. Assuming fitting-out period already taken place: Amortising the incentive over 5 yrs Headline rent 50,000 x 4 yrs (5 yrs less 1 yr rent-free) 4 CV of headline rent 200,000 ¸ 5 yrs (spread over 5 yrs assuming no fit-out) 5 Annual equivalent of headline rent £40,000 Amortising the incentive over 10 yrs Headline rent 50,000 x 9 yrs 9 CV of headline rent 450,000 ¸ 10 yrs 10 Annual equivalent of headline rent £45,000

  15. Rent-free periods(straight-line method) 2. Assuming fitting-out period starts at lease commencement: Spreading the incentive over 5 yrs Headline rent 50,000 x 3.75 yrs (5 yrs less 1.25 yrs rent-free) 3.75 CV of headline rent 187,500 ¸ 4.75 yrs (spread over 4.75 yrs) 4.75 Annual equivalent of headline rent £39,473 Spreading the incentive over 10 yrs Headline rent 50,000 x 8.75 yrs 8.75 CV of headline rent 437,500 ¸ 9.75 yrs 9.75 Annual equivalent of headline rent £44,871

  16. Rent-free periods(time value method) Amortising the incentive over 5 yrs and assuming the fitting out period starts at lease commencement: Headline rent 50,000 x YP 3.25 yrs @ 8% 3.1336 PV £1 1.25 yrs @ 8% 0.9083 CV of headline rent 142,311 ¸ YP 4.75 yrs @ 8% 3.8274 x PV 0.25 yrs @ 8% 0.9809 Deferred YP 3.7545 Annual equivalent of headline rent discounted over whole lease (ER) £37,904

  17. Rent-free periods(time value method) Amortising the incentive over 10 yrs and assuming the fitting out period starts at commencement of lease: Headline rent 50,000 x YP 8.75 yrs @ 8% 6.1254 PV £1 1.25 yrs @ 8% 0.9083 CV of headline rent 278,180 ¸ YP 9.75 yrs @ 8% 6.5976 x PV 0.25 yrs @ 8% 0.9809 Deferred YP 6.4719 Annual equivalent of headline rent discounted over whole lease (ER) £42,983 Difficulties: • Choosing appropriate discount rate: borrowing rate, target rate? • Effective rent growing at ?% p.a. • Whether to include fitting-out period (likely to depend on whether tenant is in occupation / trading)

  18. Rent-free periods(growth explicit DCF method) A ten year lease has been agreed at a headline rent of £50,000 per annum with 1 year rent-free period (a three-month fitting-out period has already taken place) and a rent review after five years. What is the effective rent? Assume a 3.5% p.a. growth rate and a target rate of 10% Over first five years, no rental growth Headline rent 50,000 YP 4 yrs @ 10% 3.1699 PV £1 1 yr @ 10% 0.9091 CV of headline rent 144,085 ¸ YP 5 yrs @ 10% 3.7908 Annual equivalent of headline rent discounted over whole lease (ER) £38,009 NB. This is the same answer as with growth implicit approach as there is no growth

  19. Rent-free periods(growth explicit DCF method) Over lease term Headline rent 50,000 YP 9 yrs @ 10% 5.7590 PV £1 1 yrs @ 10% 0.9091 CV of 10 yrs of headline rent 261,774 -------------------------------------------------- Effective rent x YP 5 yrs @ 10% 3.7908 CV of first 5 yrs of ER 3.7908x Growth in ER @ 3.5% p.a. at review, (1.035)^5 1.1877x YP 5 yrs @ 10% 3.7908 PV 5 yrs @ 10% 0.6209 2.7955x CV of 10 yrs of effective rent 6.5863x

  20. Rent-free periods(growth explicit DCF method) If deals are financially equal £261,774 = 6.5863x So x (effective rent) = £39,745 p.a. • Should the circumstances be such that the incentives will have an effect on the rent beyond year ten, the calculation above will be extended to fifteen years • When will ER > HR? • Apply growth rate to check...

  21. Landlords’ lease incentives2. capital contributions • Usually a financial payment but may also be for fitting out, taking financial responsibility for an existing lease or some other non-pecuniary contribution • L would expect to a rent in excess of market rent • Calculation of effective rent where a capital contribution has been made and a headline rent is paid is same as for rent-free periods: determine the amount of the contribution and the length of the amortisation period (typically to a rent review or to the end of the lease)

  22. Capital contributions A landlord offers a tenant £100,000 to induce occupation under a new 15-year lease with five-year rent reviews at a rent of £300,000 per annum. Amortising the capital contribution over the period to the first rent review: Amortising the contribution over the whole lease produces a market rent of £286,853 per annum Calculations can also be done using Excel...

  23. Tenants’ lease incentives:Premiums • A premium is a consideration by a tenant to a landlord for the grant or renewal of a lease on favourable terms, e.g. • reduced rent, less frequent rent reviews, a percentage-based rent at review, landlord taking responsibility for repairs or insurance or a wider user-clause • Benefit to a L is a cash-flow where a capital sum is received early, benefit to the T will be an immediate profit rent • Key money may be paid by tenant (usually retail) to secure premises • Payment should be amortised and added to rent to estimate effective rent • Important to determine whether a capital payment is for FFE, a trading position (key money) or in lieu of a rent saving (premium)

  24. Rent estimate given a premium • To calculate market rent when a premium has been agreed, amortise the premium over the period of the benefit and add it to the rent • E.g. at the start of a new lease with 5 year rent reviews the tenant agrees to pay a rent of £10,000 per annum plus a premium of £11,750. What’s the effective rent?

  25. Premiums on assignment • Assignee may pay a premium if contract rent is below market rent • Assignee may pay a premium even if the property is already let at MR because of • a perceived difference between rent at a new letting and rent at a review • the acquisition of a right to renew • A property is let on a lease with 4 years remaining at a rent of £12,500 per annum. The current market rent is estimated to be £15,000 per annum. If the tenant assigns the lease what premium should be paid by the assignee to compensate for the profit rent? • Capitalising the profit rent over the four years: *Risk-free rate plus premium for risk, lack of growth and illiquidity

  26. Premiums for geared profit rents • A lease might specify that, at each rent review, the rent is reviewed to a proportion of market rent. A premium might be paid by the tenant to compensate the landlord for offering such an incentive. • E.g. a tenant pays a premium of £10,000 at the start of a ten-year lease where the rent is reviewed to 70% of market level in year five. The initial contract rent is £5,000 per annum but what is the effective rent of this property?

  27. Premiums for geared profit rents

  28. Reverse premiums • A reverse premium is a capital payment usually made by an assignor of a lease to induce the assignee to take occupation. This situation may arise in a depressed market where the supply of accommodation exceeds demand and the current rent exceeds the market rent; the property is thus over-rented. The assignor of a lease on a property that is over-rented will need to pay a reverse premium to the assignee equivalent to the capital value of the overage rent. • E.g. a property was let two years ago for £250,000 p.a. on a ten-year lease with an upward-only rent review in the year five. The tenant wishes to assign the lease but the current market rent is £235,000 p.a. What size of reverse premium should the assignor pay the assignee?

  29. Reverse premiums • This is calculated by determining the size of the overage rent (£15,000 per annum in this case) and then deciding over how long this overage rent would be paid for, bearing in mind that the rent review is upward-only and the future level of market rent will not be known. • If we assume that rental growth for this property will be negligible over the remaining term of the lease we can capitalise the overage for 8 years at a yield based on fixed income investments suitably adjusted for risk. A relatively high yield of 12% has been used here to reflect the over-rented nature of the interest.

  30. Reverse premiums • If a valuer is seeking to use a property on which a reverse premium has been paid as comparable evidence, the market rent of the property is calculated by deducting the annual equivalent of the reverse premium from the contract rent. • E.g. assume the tenant assigned the lease and paid a reverse premium of £75,000 to the assignee. Assuming the rent review is upward-only the market rent is...

  31. Lease pricing Valuing Alternative Lease Arrangements

  32. Introduction • Stepped rents • Turnover rents • Short leases and leases with break clauses

  33. Stepped Rents • Series of rent increases at intervals more frequent than 5 years • Normally but not necessarily to pre-agreed sums • Effective rent is determined by summing the PVs of each stepped rent payment and then calculating the annual equivalent of this sum over the period of the incentive • E.g. property let on 15-year lease with 5-year rent reviews at a rent of £200,000 in year 1, £225,000 in year 2, £250,000 in year 3, £275,000 in year 4 and £300,000 in year 5. After year 5 the rent reverts to market level • Assuming a 9% yield the sum of the PVs of the stepped rent is… Then amortise this sum over 5 years… *lower than £300,000 so tenant must take a view on rental growth…

  34. Turnover Rents • Popular with shop units in shopping centres, airports and other transport termini, sometimes found in high street retail and petrol stations • Favoured where comps difficult to obtain (e.g. units in a new development) or the landlord doesn’t wish to share rental information with tenants in a centre • Provide landlord with incentive to maintain and enhance rental growth • May also indicate the optimum time to refurbish • Landlord’s management costs likely to be higher • Common arrangement is base rent (say 75-80% of MR, and usually subject to 5-year rent reviews) plus rent based on % of the net turnover of the business • % of turnover is determined by the profit margins obtainable from different trades and by the level of base rent; the lower the base rent the higher the percentage applied to turnover

  35. Turnover Rents • Turnover lease terms can be complex, requiring a minimum trade performance level, notional turnover if closed for several days, restrictions that only allow assignments to similar trades • The tenant will normally try to cap the turnover rent at say 120% of market rent  • The most common type of turnover lease in the UK is where the tenant must pay either a market rent or a turnover rent, whichever is highest • Yield used on turnover component of rent usually higher than that used to capitalise the base rent • Current turnover usually capitalised

  36. Turnover Rents • An example of a capital valuation of a shop subject to a turnover rent • The base rent is 80% of the market rent for this type of property and the turnover rent is calculated as 5% of net turnover

  37. Short leases & leaseswith break clauses • Internationalisation of business and changing business practice led to shorter leases and more flexible terms • Shorter leases are not evident across all sectors though • Most break clauses now coincide with 5 and 10-year reviews and period of notice is typically 6-12 months • Some break within first 3 years (usually less valuable properties) • Because of diversity of break option terms, cash-flow uncertainty tends to be greater with a break clause than with a short lease • If a tenant vacates the landlord will incur a set of fixed and variable costs* • Short leases may lead to faster letting and reduce the need for rent-free periods. Indeed, a short lease granted at a headline rent, together with penalty payments, may easily compensate for the risk of incurring voids and re-letting costs *Fixed costs: fees for finding a new tenant. Variable costs: management & maintenance costs whilst property is empty, loss of rent until new tenant found and for the duration of any rent-free period offered to new tenant, and the cost of any other incentives that might be offered

  38. Short leases & leaseswith break clauses • When valuing short, breakable leases, the most popular financial adjustment was the inclusion of a rent void, but one which did not reflect the ‘true’ expected costs of the void. Instead it was moderated to reflect an estimated probability of the tenant breaking or not renewing. • For breaks, the notice period and penalty payment would be factored in (i.e. a long notice period and big rent penalty would neutralise void allowance). When valuing shopping centres in which units are let on short leases, the valuer would build in a running void assumption into the cash-flow based on the average void rate and expected average void period.

  39. Short leases & leaseswith break clauses • A higher rent* to compensate for the break option or short lease might be agreed but the level of the headline rent and the length of time over which it should be amortised will depend on views about rental growth over the lease term because, under a standard lease with upward-only rent reviews, the rent cannot fall whereas with a break the tenant could vacate • It will also depend on the size of the penalty payment • Impact will vary from sector to sector and is dependent on building and location quality *This higher rent might be calculated by first valuing the flexi-lease with a rent void and perhaps a higher all-risks yield too, then valuing the same property assuming standard lease terms and finally equating the capital values of each by adjusting the rent reserved for the first five years using the goal-seek function on a spreadsheet.

  40. Short leases & leaseswith break clauses | example Calculate the rent that should be paid for the first 5 years of a 10 year lease which has a break option and a rent review in year 5. It is assumed that there is a 6-month void at the break after which the rent reverts to the market rent (£300,000 p.a.)

  41. Short leases & leaseswith break clauses | example Now assume that the standard lease arrangement for this property is a 15 year lease with five year upward-only rent reviews let at a market rent of £300,000 per annum If we assume that the capital value of the property subject to the flexi-lease and the standard lease arrangement should be the same we can state that: £3,629,007 + 4.2124x = £5,000,000 x = £325,466 Can also use Excel...

  42. Lease pricing Valuations at lease end

  43. Lease end |Surrender & renewal of leases • T may wish to surrender current lease before its term has expired in order to negotiate a new lease. Why? • Preserve goodwill attached to a particular location • Remove future uncertainty surrounding the terms of a new lease • If L agrees, the capital value of any profit rent that the tenant was entitled to should be reflected in a rent reduction or some other financial benefit under the terms of the proposed lease • Valuations ensure neither L nor T jeopardise their existing financial positions by calculating the capital value of each party’s present and proposed interests in order to determine the rent that should be reserved under the proposed lease • In practice a negotiated settlement between L and T positions usually takes place and the impact of L&T legislation can strengthen T’s bargaining position

  44. Surrender & renewal of leases T wishes to surrender the remainder of an existing lease of a shop in Bath in return for the grant of a longer one The present lease has 3 years to run with no review and the rent passing is £20,000 p.a. The market rent is £27,000 p.a. and yield is 10%. L is willing to accept the surrender and grant a new 15-year lease with 5-year rent reviews

  45. Surrender & renewal of leases • Valuation of the landlord's present interest:

  46. Surrender & renewal of leases • Valuation of the landlord's proposed interest: If the landlord is to be in the same financial position under the proposed terms as under the present terms then: 167,643 + 3.8897x = 253,477 x (new rent) = £22,067

  47. Surrender & renewal of leases • Valuation of the tenant’s present interest: [a] This is the freehold all-risks yield adjusted upwards to reflect the additional risk and relative unattractiveness of a short leasehold investment

  48. Surrender & renewal of leases • Valuation of the tenant’s proposed interest: Assuming the value of the tenant’s present interest should equal the value of the proposed interest: 97,330 – 3.6048x = 16,813 x (new rent) = £22,336 A single figure is usually negotiated that lies somewhere between the two rental values. In fact, in nominal cash-flow terms, the rent forgone by the landlord is the same as the profit rent gained by the tenant; the only reason different rental values are calculated is because the yields are different.

  49. Lease end:Compensation payments Key legislation affecting business tenancies • Landlord and Tenant Act 1927 (amended by Landlord & Tenant Act 1954 Pt III) • compensation for improvements made by business tenants during lease • Landlord and Tenant Act 1954 (Part II) (amended by the Law of Property Act 1969) • security of tenure by continuing original term subject to certain grounds for possession • compensation for disturbance • Landlord and Tenant Act 1988 • L’s consent provisions regarding T’s improvements

  50. Lease end:Compensation payments A FH factory is held on a 21 year lease with five years left at a rent of £5,000 per annum. T carried out improvements (with L’s consent) four years ago which increased the MR by £1,000 per annum. The cost of these improvement today would be £7,500. The MR, including the value of improvements is £10,000 per annum and the Rateable Value is £12,000. Value the freehold interest in the property under each of the following scenarios: • T chooses to vacate at the end of the current lease • A new lease granted on expiry of current lease • L repossesses at end of current lease for own occupation • L repossesses at end of current lease for redevelopment (site value £100,000)

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