Valuing a Deal with Dramatic Tenant Improvement Income Disappearing in Option Periods
How would you guys value a property that has a significant amount of TI that a tenant is repaying in the base term (over $11,000/ month) that is paid off by the options period? Essentially, the option periods, starting in 8 years, go back to a base amount and the difference is substantial. Do you discount that additional income or wipe it out completely? Do you apply a softer CAP rate and include that TI as rent, knowing that there is- at best- $11,000 less per month coming in if the tenant exercises their options?


This is the largest tenant in a multi-tenant strip center.  

I’d love to hear what you think from a broker/ investor/ banker’s perspective. Thanks!
[{"id": "ihx0cv5", "text": "I\u2019d say you have to underwrite it at what the base rent is after repayment of the TI.  Questions I\u2019d have is how many more years left of the elevated rent vs how many years in the option period.", "replies": [{"id": "ihx0y9u", "text": "Great question. There are 8 years remaining with that TI included, then four 5-year options with moderate rent bumps. The initial \u201crent loss\u201d in 8 years is around $145,000 annually.", "replies": [{"id": "ihx3qtg", "text": "Ah ok I misread I didn\u2019t realize there were 8 years left.  This is interesting\u2026 if they didn\u2019t exercise their option would the market rate be closer to the base rate after TI?  I assume so.  If that\u2019s the case then yeah I think you have to underwrite it on the base rate and maybe give some to the cap because that\u2019s a nice amount of gravy.  I\u2019m sure the institutional guys would have a way to blend the cap based on their anticipated hold time frames but I\u2019m not personally sure.", "replies": [{"id": "ihx40u2", "text": "This is almost exactly my line of thinking because the rent with the TI included (assuming they don\u2019t exercise their options) is nearly 3x\u2019s market for a space that size. There\u2019s no way I can imagine a new tenant coming along wanting that much space at that high of a rent.", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ihx3b0u", "text": "As a former appraiser I could tell you how I handled something like this. It would be valued by standard ways of market rent and market cap rate. Then any excess/deficit rent (compared to market) would be discounted at an appropriate rate and added back below the line on valuation. \n\nThat is likely what you would see in an appraisal but we all know different CRE professionals or investors might look at it differently.", "replies": [{"id": "ihx3rid", "text": "That is how I was leaning at this point- aggressive CAP on the rent, not including TI, then add the TI income- over $1mm- below the line. That doesn\u2019t get me to where seller wants to be, but I think it\u2019s marketable/ defendable this way and likely not the other ways I am weighing.", "replies": [{"id": "ihx6p0x", "text": "If you go this route just make sure you discount the TI amount over the years its being paid to account for time value of money.", "replies": [], "depth": 3}, {"id": "ihzzzsc", "text": "This is correct. You need to stabilize any rent you're going to capitalize, and discount any unstable income to account for the time and risk.", "replies": [], "depth": 3}], "depth": 2}, {"id": "ihx3ryy", "text": "Thank you", "replies": [], "depth": 2}, {"id": "ihxboh4", "text": "Yep, current appraiser here, that\u2019s how we\u2019d do it as well. You can\u2019t capitalize above market rent into perpetuity, so you have to capitalize a market rent then take a below the line deduction for the excess rent (after discounting). Unless you\u2019re buying the property in cash, this is probably how it will be appraised for your loan. Do you think your seller is basing his value on the full rent plus TIs?", "replies": [{"id": "iikxi69", "text": "I didn\u2019t get back to you, I\u2019m sorry. Yes. Seller was taking rent plus TI and capitalizing, but they are a smart outfit. I told them pretty bluntly that we either have such a huge discount on the CAP rate under those terms that it wipes out the gain, or we go the below the line deduction route and I try to compress the CAP rate (based on base rents and NNNs) aggressively to try to recoup some of the \u201clost value\u201d they were banking on.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ihx6qnq", "text": "I wouldn't allocate anything to the T/I repayment as it is a reimbursement for expense incurred by the current owner. I would suggest making sure that if the property were to sell that the Tenant (and current owner) don't have some type of agreement on how this reimbursement would continue to be paid \\[are there terms in the lease stating the tenant would need to keep paying this amount to a \"new\" owner\\]? I bring this up as I have had some dealings with some pretty shady sellers in the past....ones who believe they may still be entitled to this amount since they were the ones who incurred the original costs.", "replies": [{"id": "ihxgakk", "text": "Oh, that\u2019s a great point. I\u2019ve read the lease a few times, but didn\u2019t pay special attention to any language about that TI being passed on to a future owner.", "replies": [], "depth": 2}], "depth": 1}, {"id": "ihy23mh", "text": "Assuming this recovery is transferrable at sale, you can value the property net of that income then stub the seller for the NPV of that additional cash flow on top of the value.", "replies": [], "depth": 1}, {"id": "ihznlux", "text": "By offering the tenant above market TI's for above market rent, the landlord is basically lending money to the tenant. \n\nValue the building off the base rent and then add the PV of the additional rent using a discount rate appropriate for the credit worthiness of the tenant. This is how an institutional investor would do it.", "replies": [{"id": "ihzpzyp", "text": "That\u2019s perfect. This is helpful. Thank you!", "replies": [], "depth": 2}], "depth": 1}]