How Underlying Leases Affect Building Value

One of the most fundamental aspects of a commercial building is how, when leased, its value is derived from its underlying lease(s).? This is because investors buy the leased building for its future NOI (Net Operating Income).? In other words, the investor (buyer of the building) is tying up a lump sum of money (i.e. its Value) in return for a future income stream.? The amount of that Value that the future annual income stream represents, is determined by the Cap Rate (Capitalization Rate).? The following basic equation shows the relationship of Value to NOI and Cap Rate.

?Value = NOI / Cap Rate

The NOI is the Gross Rent received less the Operating Expenses.? Therefore, given a fixed Operating Expense, the greater the lease rate, the greater the NOI and therefore the greater the Value.? Value is directly, proportionately related to NOI (ex. if NOI is increased by 10%, Value is increased by 10%).

The Cap Rate is basically the expected annual investment return from a building, given the risk exposure (of the tenant and building) to the investor.? The lower quality the building, the greater the risk.? Likewise, the lower quality tenant, the greater the risk.? For investors, the reward needs to justify the risk.? Therefore, the greater the risk, the greater the return (i.e. income stream) an investor will expect, to justify exposure to more risk.? As can be seen below, Value is indirectly, proportionately related to Cap Rate.? Meaning, the lower the expected Cap Rate, the greater?the Value (i.e. the more investors are willing to pay) and visa-versa.? If Cap Rate doubles, Value is halved or if Cap Rate is halved, Value doubles.

So, how does this relate to the underlying lease?? Firstly, as discussed above, the greater the Gross Rent, the greater the NOI.? Secondly, the better the terms of the lease?and the greater the financial strength and/or proven business concept of the tenant, the lower the risk and the lower the Cap Rate and investor will expect, meaning the more they're willing to pay.? Likewise, the worse the terms of the lease and/or the lower the financial strength and proven business concept of the tenant, the higher the risk and the higher the Cap Rate an investor will expect, meaning the less they're willing to pay.

Therefore, the market value of a leased?building will be heavily related to the underlying lease from the resulting NOI and the market Cap Rate.? These two factors alone are the reason it's so important to capture maximum market rates, a quality tenant and superior lease terms.? Typically, when selling a leased building, a buyer will want to see the previous 2-3 years of operating financial statements, as part of their due diligence.? This shows them the historical performance of the building and any unexpected risks in the form of vacancy loss, evictions and NOI?stability.

*I am neither a CPA nor an attorney, so please consult with your attorney or accountant for any legal or tax advice.

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