Lease pricing

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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. - PowerPoint PPT Presentation

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<ul><li><p>Lease pricing</p></li><li><p>Lease PricingDistinction between owner-occupied and tenanted commercial propertyOur focus is on the latter, characterised by the landlord / tenant relationshipTenants commercial property requirementsRent is the cost of occupation</p></li><li><p>LeasesInterests in land and contractsLaw provides backdrop to negotiations and resultant structuresWherever hallmarks of a lease are present (i.e. exclusive possession for a fixed or ascertainable period) the arrangement is a leaseApprox. 40% leases contracted out LTA54Less able to sublet / assign short leasesRecommended reading:RICS (2006) Valuation Information Paper 8: Analysis of Commercial Lease Transactions, RICS, LondonCrosby, N., Hughes, C. and Murdoch, S. (2005) Monitoring the 2002 Code of Practice for Commercial Leases, Office of the Deputy Prime Minister, London</p></li><li><p>Lease Terms Lease IncentivesAlternative lease arrangementsLengthRent review typeRent review frequencyUse clauseImprovementsRepairsAssignmentSub-lettingBreaks(rent caps / floors)Rent-free periodsCapital contributions, including: fitting-out costs take-back of existing premisesPremiumsStepped rentsTurnover rents</p></li><li><p>Lease Terms (1)Unlike resi leases, no legal requirement terms be fair and reasonable, but there are statutory limits on some lease provisions&lt; 1996 there was a statutory requirement that landlords couldnt unreasonably withhold consent to assignment or sublettingDifficult for L to prevent T carrying out improvementsOn 1/1/96 LT(C)A95 amended S19(1) of LTA27 so Ls can draft leases that pre-specify conditions / circumstances that must be satisfied before T can assign and, where this is done, there is no longer a requirement that these conditions and circumstances be reasonableLeases &gt; 7 years are affected by Leasehold Property (Repairs) Act 1938 which confers protection on tenants during leaseRestricts Ls right to recover damages for breach of a repair obligation if the lease is 7 years or more and there are at least 3 years unexpired</p></li><li><p>Lease TermsRepairFRI is norm but standalone second-hand property may modify strict FRI terms by reference to a schedule of conditionBreak clausesFixed points in time (rolling breaks are rare) whereas other means of flexibility (assignment or subletting) can be undertaken at any time6 months is a typical notice periodPenalties for exercising breaks are occasionalUsually exercised for operational rather than affordability reasonsAssignmentUsually preferable to subletting as it avoids taking on L responsibilitiesCondition about parity of financial standingSub-lettingNormal 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 acceptableUsually sublease is required to be contracted out of LTA54 to prevent ST having right to renew sublease against HL should head-lease fall awayCan offer reverse premium on assignment if market dropped</p></li><li><p>Impact on valueDownside volatility has a floor based on covenant strengthEquity element is market-driven, via rent reviews and reversionary / residual values, RPI or turnover rent provisionsDifferent 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 optionsPricing 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 modelSome 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)</p></li><li><p>Landlords lease incentives1. rent-free periodsValuer needs to determine the effective rent assuming no rent-free periodMethods and assumptions vary depending on length of leaseBenefit 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</p></li><li><p>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)?</p><p>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</p><p>Headline rent 50,000x 4 yrs 4CV of headline rent200,000 5 yrs 5Annual equivalent of headline rent40,000</p></li><li><p>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</p><p>Headline rent 50,000x 9 yrs 9 CV of headline rent 450,000 10 yrs 10Annual equivalent of headline rent 45,000</p><p>The first approach favours the T and the second the LChoice depends on rental growth rate assumption...</p></li><li><p>Rent-free periods(time value method)Now introduce the time value of money...</p><p>Headline rent 50,000YP 4 yrs @ 8%* 3.3121PV 1 1 yr @ 8% 0.9259CV of headline rent153,334 YP 5 yrs @ 8% 3.9927Annual equivalent of headline rentdiscounted up to rent review (ER)38,404</p><p>* Money discount rate</p></li><li><p>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/rs) </p><p>Headline rent 50,000YP 9 yrs @ 8% 6.25PV 1 1 yr @ 8% 0.926CV of headline rent289,375 YP 10 yrs @ 8% 6.71Annual equivalent of headline rentdiscounted over whole lease (ER)43,125</p><p>Choice depends on rental growth rate assumption...</p></li><li><p>Rent-free periods(time value method)Growth rate for 5 year write-off:38,404 x (1+g)^5 = 50,000g = 0.0542</p><p>Growth rate for 10 year write-off:43,125 x (1+g)^10 = 50,000(1+g)^10 = 1.1594g = 0.0149</p><p>...can also be done on Excel</p></li><li><p>Rent-free periods(straight-line method)Now lets introduce a fitting-out period...</p><p>Two ways of handling thisAssume fitting-period already taken place before lease startAssume fitting-out period begins at lease start</p><p>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.</p><p>What is the effective rent?</p></li><li><p>Rent-free periods(straight-line method)1. Assuming fitting-out period already taken place:</p><p>Amortising the incentive over 5 yrsHeadline rent 50,000x 4 yrs (5 yrs less 1 yr rent-free) 4CV of headline rent200,000 5 yrs (spread over 5 yrs assuming no fit-out) 5Annual equivalent of headline rent40,000</p><p>Amortising the incentive over 10 yrsHeadline rent 50,000x 9 yrs 9CV of headline rent 450,000 10 yrs 10Annual equivalent of headline rent 45,000</p></li><li><p>Rent-free periods(straight-line method)2. Assuming fitting-out period starts at lease commencement:</p><p>Spreading the incentive over 5 yrsHeadline rent 50,000x 3.75 yrs (5 yrs less 1.25 yrs rent-free) 3.75CV of headline rent187,500 4.75 yrs (spread over 4.75 yrs) 4.75Annual equivalent of headline rent39,473</p><p>Spreading the incentive over 10 yrsHeadline rent 50,000x 8.75 yrs 8.75CV of headline rent 437,500 9.75 yrs 9.75Annual equivalent of headline rent 44,871</p></li><li><p>Rent-free periods(time value method)Amortising the incentive over 5 yrs and assuming the fitting out period starts at lease commencement:</p><p>Headline rent 50,000x YP 3.25 yrs @ 8% 3.1336PV 1 1.25 yrs @ 8% 0.9083CV of headline rent142,311 YP 4.75 yrs @ 8% 3.8274x PV 0.25 yrs @ 8% 0.9809Deferred YP 3.7545Annual equivalent of headline rentdiscounted over whole lease (ER) 37,904</p></li><li><p>Rent-free periods(time value method)Amortising the incentive over 10 yrs and assuming the fitting out period starts at commencement of lease:</p><p>Headline rent 50,000x YP 8.75 yrs @ 8% 6.1254PV 1 1.25 yrs @ 8% 0.9083CV of headline rent278,180 YP 9.75 yrs @ 8% 6.5976x PV 0.25 yrs @ 8% 0.9809Deferred YP 6.4719Annual equivalent of headline rentdiscounted over whole lease (ER)42,983</p><p>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)</p></li><li><p>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%</p><p>Over first five years, no rental growthHeadline rent 50,000YP 4 yrs @ 10% 3.1699 PV 1 1 yr @ 10% 0.9091CV of headline rent144,085 YP 5 yrs @ 10% 3.7908Annual equivalent of headline rentdiscounted over whole lease (ER) 38,009</p><p>NB. This is the same answer as with growth implicit approach as there is no growth</p></li><li><p>Rent-free periods(growth explicit DCF method)Over lease term</p><p>Headline rent 50,000YP 9 yrs @ 10% 5.7590PV 1 1 yrs @ 10% 0.9091CV of 10 yrs of headline rent261,774--------------------------------------------------Effective rentxYP 5 yrs @ 10%3.7908CV of first 5 yrs of ER3.7908x</p><p>Growth in ER @ 3.5% p.a. at review, (1.035)^51.1877xYP 5 yrs @ 10%3.7908PV 5 yrs @ 10%0.62092.7955xCV of 10 yrs of effective rent6.5863x</p></li><li><p>Rent-free periods(growth explicit DCF method)If deals are financially equal</p><p>261,774 = 6.5863x</p><p>So x (effective rent) = 39,745 p.a.</p><p>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 yearsWhen will ER &gt; HR?Apply growth rate to check...</p></li><li><p>Landlords lease incentives2. capital contributionsUsually a financial payment but may also be for fitting out, taking financial responsibility for an existing lease or some other non-pecuniary contributionL would expect to a rent in excess of market rentCalculation 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)</p></li><li><p>Capital contributionsA 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</p><p>Calculations can also be done using Excel...</p><p>Headline rent ()300,000Capital contribution ()-100,000 YP 5 years @ 10%3.7908Annual equivalent of capital contribution -26,380Effective rent ()273,620</p></li><li><p>Tenants lease incentives:PremiumsA 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-clauseBenefit to a L is a cash-flow where a capital sum is received early, benefit to the T will be an immediate profit rentKey money may be paid by tenant (usually retail) to secure premisesPayment should be amortised and added to rent to estimate effective rentImportant to determine whether a capital payment is for FFE, a trading position (key money) or in lieu of a rent saving (premium)</p></li><li><p>Rent estimate given a premiumTo calculate market rent when a premium has been agreed, amortise the premium over the period of the benefit and add it to the rentE.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. Whats the effective rent?</p><p>Contract Rent ()10,000Premium ()11,750 YP 5 yrs @ 10% 3.7908Annual equivalent of premium () 3,100Effective rent ()13,100</p></li><li><p>Premiums on assignmentAssignee may pay a premium if contract rent is below market rentAssignee may pay a premium even if the property is already let at MR because ofa perceived difference between rent at a new letting and rent at a reviewthe acquisition of a right to renewA 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</p><p>Profit Rent () 2,500YP 4 yrs @ 10%* 3.1699Premium ()7,925</p></li><li><p>Premiums for geared profit rentsA 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?</p></li><li><p>Premiums for geared profit rents</p><p>Effective rent for first 5 years ()xLess contract rent for first 5 years ()-5,000Profit rent ()x - 5,000YP 5 yrs @8%3.99273.9927x 19,964Effective rent for second 5 years ()xLess contract rent at review ()0.7xProfit rent ()0.3xYP 5 yrs @ 8%*3.9927PV 5 yrs @ 8%0.68060.8152xCapital value of profit rent4.8078x 19,964Premium to landlord should exactly compensate for the profit rent to tenant, therefore;10,000=4.8078x 19,964x (effective rent ())=6,232</p></li><li><p>Reverse premiumsA 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? </p></li><li><p>Reverse premiumsThis 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...</p></li></ul>