The Value of Your Lease

People sometimes (mistakenly) think office building values are based on location and architectural design (appearance).? These are contributing factors, however, in most urban centers, investors use the income capitalization approach to valuation.? Here, the building is valued on current and projected net operating income.? To be sure, location and design will translate to differing levels of net operating income.? But other variables play a key role, as well.? For example, the landlord’s cost basis which impacts its ability to lease space at market pricing.? Where a landlord has paid too much for the asset, the underlying rental economics of the market may result in net negative leasing outcomes, causing the landlord to lose deals to other assets which have a lower cost basis and can productively transact at market.

How does the income capitalization approach work?? It’s a very simple method.? Net operating income ("NOI"), the income generated through leasing space less the costs to operate the building, taxes, and vacancy is “capitalized” to generate a valuation.? Capitalization is a function of the expected rate of return an investor seeks and/or the market supports – the “cap rate”.? Cap rates vary based on the risk of the underlying market and the quality of the NOI at the asset level.? A higher cap rate means the asset will sell for less, giving the buyer the potential for a higher return due to the increased risk of acquiring the asset.? Similarly, lower cap rates imply a more stable NOI and less risk (both at the asset and market level).? By way of example, let’s say a building is generating a stabilized NOI of $20/sf and the market cap rate is currently 6%.? To determine capitalized valuation, divide the NOI by the cap rate 20/.06, yielding a valuation of $333/sf.?

In 2019, the San Francisco office market was among the most highly valued global office markets.? To acquire assets, office investors often had to compete to win the bid.? This had the effect of compressing cap rates, or reducing the going-in yield for investors, while increasing sale pricing.? It would not be uncommon to see going-in cap rates of 3%-4%.? The quality of the tenancy (credit) and the weighted average lease term (“WALT”) also impact cap rates.? An asset which is leased to AAA credit tenants with long WALT is more valuable.

Each tenant’s lease is valuable.? It’s important for occupiers to understand how their lease impacts value.? In some cases, a lease will create enough value to warrant greater concessions and/or equity participation.? For example, let’s say a very strong credit tenant is leasing a 100,000-sf office building on a long-term (15 year) lease.? The lease generates $30/sf in NOI.? The market cap rate is 6%.? However, the quality of this tenant’s credit “compresses” the cap rate by 20%, making the post-lease cap rate for this property 4.8% vs. the market rate of 6%.? How much value does this generate for the owner?? At a 6% cap rate, the building is valued at $500/sf.? At a 4.8% cap rate, it is valued at $625/sf.? This is a $12,500,000 difference in value.? Given the right market conditions, this tenant should be able to participate in some portion of the increased value creating by its tenancy.? This could take the form of equity participation, or some percentage of the increased value being translated through other concessions, things like free rent or additional tenant improvement funding from the landlord.

It's important for office tenants to understand how their tenancy impacts building value.? The best leasing solutions are those which fully realize the tenant’s key leasing objectives, while maximizing leverage to access the full value spectrum.? Value is about more than just basic rental economics.

Ask TenantSee Weekly

This week’s question:? We’re completing construction of tenant improvements for our new space.? Recently, we received notice that we have to pay additional costs to upgrade certain aspects of the common areas of the building which are not compliant with the latest codes.? How can the landlord charge us for these expenses??

Sorry to hear this.? It all depends on what was negotiated in your lease.? A good lease negotiation will protect you from these costs.? It sounds like your landlord may have negotiated to deliver the space to you in its AS-IS condition, passing on full responsibility for compliance with laws/codes (both within and outside the Premises).? Tenants often don’t realize that codes are constantly changing and building common areas (lobbies, elevators, restrooms, etc.) are often in a state of non-compliance with the latest codes.? When a permit is pulled with the city, it triggers inspections which can result in the need for expensive upgrades.? Unless the lease explicitly calls out compliance with such codes as a landlord cost, the expense falls on the tenant. ?????