Valuation of excess rent from AAA credit tenant in commercial multi-family property?
I'm looking at a 21 unit apartment property in an incredible location.  I already have a AAA credit tenant ready to sign a 5 year lease on the entire property with an option for another 5 years at rent that is 60% higher than market.

On one hand, I can understand a lender underwriting this property at market rents. However, I have also read that when valuing lease holds that contract rent that is greater than the market rent, the portion that can be considered “excess rent”, may be thought to have more risk than the market portion and it could be capitalized separately at a higher rate.

Also, if the higher contract rent is well-supported by a financially secure AAA tenant, it may be considered that the contract rent in excess of the market rent presents no real extra risk.

**Would you underwrite this property solely based on market rents?**

**Would you underwrite this property based on all rents since the tenant is AAA rated?**

**Would you underwrite this property based on some combination of market and excess rents?**

Edit: My definition of AAA rated tenant: I have confirmed that all of their debt programs bear credit ratings from Moody’s, Standard &amp; Poor’s and Fitch for both long-term and short-term debt.

● The current long-term debt ratings are:

Moody’s: Aaa

S&amp;P: AAA

Fitch: AAA

● The current short-term debt ratings are:

Moody’s: P-1/VMIG1

S&amp;P: A-1+/A-1+

Fitch: F-1+/F1+
[{"id": "g77rh3l", "text": "AAA credit tenant in multifamily? \n\nAre you talking about a multiple property commercial building?", "replies": [{"id": "g77rz7g", "text": "It's a commercial multi-family property. That's the trick.  I understand the lease valuation discussion around a AAA tenant in a retail or office building setting but I'm trying to wrap my head around how an underwriter would look at an entire apartment building leased to a AAA credit tenant.\n\nWhat type of valuation could I expect in the form of a cash our re-fi or even a sale in this case?", "replies": [], "depth": 2}], "depth": 1}, {"id": "g77s1f7", "text": "You say its 21 multi family units, but then say there will be one tenant leasing the whole property. Confused to what the building actually is.", "replies": [{"id": "g77s6zw", "text": "Yes, that's correct. It is a 21 unit multi-family residential building. The tenant wants to lease the entire property at 60% above market for a period of 5 years.", "replies": [{"id": "g77swez", "text": "Ahh ok interesting situation. They will be master leasing the property? Is it a construction company or something for their workers? \n\nWhy are they willing to pay above market rent is my only question. \n\nYou should be able to get the valuation up some if you have a signed lease and deposit with this entity.", "replies": [{"id": "g782h88", "text": "Yes, they are master leasing the entire property.  I do see answers sort of all over the place in this thread. I would hope that you're right in that I'd be able to get the valuation up with this type of master lease.\n\nThey are willing to pay more than market because we would be delivering them a  completely turn key product for their use.", "replies": [{"id": "g783gwf", "text": "You will probably only get the financing though for the term of their lease, that will be the challenge. \n\nYou wont be able to get rents like that forever, and the bank will know that.", "replies": [{"id": "g784qo1", "text": "I guess this is where this scenario differs from the office or retail environment. Should this tenant go away then finding another tenant to pay the same rent would be much more difficult and they will calculate that risk in their underwriting.", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "g77synm", "text": "&gt;AAA credit tenant ready to sign a 5 year lease on the entire [apartment building]\n\nHUH? There are only a handful of triple-A rated corporations out there. Johnson &amp; Johnson and Microsoft and maybe another one or two. \n\nSo are you saying that one of these companies want to rent an entire apartment building from you for 5 years for 160% of market rent? I'd give a fat loan for that based on the over market rent. I'd only do a 5 year term though.", "replies": [{"id": "g78258e", "text": "It is the equivalent of an Apple or one of the companies you mentioned wanting to take the entire building. The difference here being that this is a residential building and not your typical office or retail space. \n\nI know it's atypical but that's why I came here was to get a variety of answers from a number of current (and former) appraisers and lenders.", "replies": [], "depth": 2}], "depth": 1}, {"id": "g77tqg5", "text": "It is uncommon to have a AAA tenant for a whole residential multifamily complex. There bank will do an appraisal on the 3 conditions and at the end of the day what they would want is to be safe in case you default. They might give you a 5 year balloon mortgage with 30 years of amortization base on the current NOI and debt yield. \n\nWhat the bank might do, since it is a AAA tenant, is a non-recourse.", "replies": [{"id": "g782uwa", "text": "5 year balloon works with 30 year amortization would work great for me. Even better with non-recourse. I do know how uncommon it is and that's why I wanted to come here to get a variety of opinions on it.\n\nDo you have any thoughts on what the sale value would be? Is this something that is investor class with this type of tenant and lease term?", "replies": [{"id": "g787m6k", "text": "It depends on the investor. Most funds I have work with would buy something as long as it is 20mm and higher. Residential is usually well liked by banks and investors because it is very safe with an average occupancy rate of 95%. Retail, if you have a brand new deal and you got an amazing tenant it should be very easy, as long as the tenant is part of the industries that they like. Some might even split it and have a partnership with someone taking ownership of the retail and other taking the residential. Depending on the market, noi, lease terms and occupation, you should be in a cap of around 5. The sale price would depend on when you plan to do the disposition. If your plan is right away, then you can get the 5, if you wait 3 ot 4 years, it might go up to 6 since you NPV NOI will have tanked and they would assume the risk of the company renewing in 3 years. If you get the renewal you would be back in the 5 if the market continues as it is today. The beauty of your business is that residential is very strong.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "g77usvj", "text": "Lots of room for difference of opinion among appraisers here.   I don't think they will ignore your excess rent.  Seems likely they will land on one of the other two scenarios you describe.  (background: former appraiser)", "replies": [{"id": "g7831p8", "text": "I'm okay with a blended valuation with different cap rates applied to each. At least that way I do get some credit for excess rent. I can't help but feel that if it were an office space or retail space it'd be a no brainer for a lender to come in and underwrite it for us.\n\nI know it's an atypical scenario so wanted to get a lot of opinions on it.", "replies": [{"id": "g783yes", "text": "It won\u2019t be cap rates. It would be appropriate to use market rent and a market cap rate, and then take the amount of rent over market and discount it to present value.", "replies": [{"id": "g784tbh", "text": "This is the most likely answer. Commercial appraiser in the Midwest, and i've dealt with excess rent multiple times-just not on multi-family. The two ways i've dealt with it: Use market rent and then discount the excess rent back to a present value as suggested. A few times, if the tenant is credit and there is a long term lease in place (often 10 years+), we'll analyze the leased fee estate and consider the entire lease rate even if over market.", "replies": [{"id": "g7869el", "text": "Ahhhhh....very interesting. You think if I can get them to commit to 10 years that the bank will consider all excess rent in their valuation? Five years is considered too short? Our client has also mentioned a purchase option so at the end of their lease term they possibly buy the property from us. I don't know how that would impact underwriting.", "replies": [{"id": "g787htf", "text": "Longer term the better. Unfortunately, in the end it will depend on the appraiser. Especially since this is even more uncommon, as it is a multi-family property where it is often typical to use market rent for the units due to their short-term nature. Since you have at least 5 years, or possibly more, I don't necessarily see why it wouldn't be treated with the in place rents. My advice is to give the bank the most complete information you can. The lease, negotiated as long as you can will be a big start to quelling any bank worries, income and expenses, along with pro forma if possible. Create the most doubt for the bank, and you'll make them and the appraiser happy.", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "g782nmv", "text": "As others have chimed in, there are only a small\nHandful of AAA corporations in the world. Why is one of them willing to lease this so far above market? Corporations are not stupid, usually.\n\nIf they are leasing the entire building at well above market, the bank will hesitate on that because once the lease is up, the property will likely revert to market rates.\n\nAre there escalations in the lease as well? Is this property near one of their primary locations? Like union for amazon?", "replies": [{"id": "g783cw1", "text": "I don't want to give out too much identifying information but you're not far off. We are not far from their headquarters and we are delivering a completely turn key product for their use so they are willing to pay a premium.\n\nI know it sounds like an odd scenario and I wanted others thoughts on valuation for any purchase, refinance, sale or other liquidation event.  A lot of food for thought here when thinking about the exit.", "replies": [{"id": "g78590a", "text": "The sellers are likely asking value with the lease, correct?", "replies": [{"id": "g785s63", "text": "No, the property is currently 100% vacant but we found this tenant and we would be placing them in the property. The seller's ask is extremely high so I wanted to see if this deal made sense if we had this solid tenant in place for at least 5 years.\n\nIt's been tough to do a pro-forma and make accurate calculations for our equity partners since I have no idea how a bank or appraiser would look at it.", "replies": [{"id": "g787yw6", "text": "If you have private equity appraisal doesn\u2019t really matter, or are they LPs with small contributions?\n\nI would do a proforma at market, and a second proforma at proposed lease. The building as vacant should be valued fairly low, I would assume, compared to the value you can bring your investors.\n\nThe bold assumption here is that MS signs the lease.", "replies": [{"id": "g7athb0", "text": "We don't have a PE appraisal on it but are trying to put together a pro forma to send to our PE partners and are having difficulty on the valuation side and determining other IRR metrics. It looks like the valuation could be all over the place based on the comments in this thread. To be as conservative as possible, it looks like we should underwrite at market rents which would mean this wouldn't pencil for us.", "replies": [{"id": "g7au0bb", "text": "I am not surprised it wouldn\u2019t work at market rents given the costs of materials right now.\n\nIs there enough VE your GC can do to make it work?\n\nYour proforma will give you a hard cost number that makes the deal work. Give that target to your gc and see if they can get there.", "replies": [], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "g78irki", "text": "Unless the lease is signed, there is no excess rent. Also, like others have said, there is no replacement tenant willing to pay 60% above market if this tenant walks, so you\u2019ll have to lease it up from zero. There\u2019s plenty of market risk in this deal. I think a DCF analysis might be a decent way to handle the valuation.", "replies": [], "depth": 1}, {"id": "g79bgei", "text": "I'm going to say that the property will be valued with market rents with little consideration given to the tenant willing to overpay.  If you have a AAA office tenant that signed a 20 year lease 5 years ago at top rents and now market rents are 60% less then the NOI as is would be recognized for valuation.  If somebody was buying a house that was their childhood home and was willing to pay twice the value but they needed financing then the bank would still value it at market value and the AAA buyer would have to come up with the difference.  Same thing here.  You will not get value based on over market rents.", "replies": [], "depth": 1}, {"id": "g79hkqu", "text": "I\u2019ll be in a similar situation next month with a new industrial development for an a-rated company paying 30% above market for 15 years. I plan on getting credit for the full economic value and not just the market rent or the replacement cost.", "replies": [{"id": "g7aug9p", "text": "That's fantastic :) How are you able to get credit for all excess rent? Do you have fantastic relationships with banks and lenders that will do this just for you or are you going with another strategy?\n\nI wonder since your lease is longer term if that factors into being able to convince underwriters of the risk levels.", "replies": [], "depth": 2}], "depth": 1}, {"id": "g79s2po", "text": "Check if the higher contract rent is well supported by a financially secure AAA tenant. Analysis over assumption leads to false conclusions. If the contract rent data exceeding the market rent is correct, it should be considered regarding the risk.", "replies": [{"id": "g7aupal", "text": "We've been in this market (and sub-market) for 20 years so we are very tuned into the current market rents.  We have been in business and providing our services for the past 10 years but have only worked with single family homes and never before with a multi-family property. I know valuations work completely different in the commercial world but yes I can confirm the rate our client would pay is definitely 60% above market.", "replies": [], "depth": 2}], "depth": 1}]