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Leasing Expenses: Above the Line or Below the Line Expenses and Does It Matter - Part 2

(This archived article was published in 2014. More recent data is found in the articles section of our web site). As noted in Part 1, no single universally recognized standard exists for how leasing expenses—commissions, tenant improvements (TIs)—are recognized in direct capitalization. The Appraisal of Real Estate states:
In certain real estate markets, space is rented to a new tenant only after substantial interior improvements are made. If this work is performed at the landlord's expense and is required to achieve the estimated rent, the expense of these improvements may be included in the reconstructed operating statement as part of the replacement allowance, in a separate "tenant improvements" or "capital expenditure" category, depending on local practice.[1]
…The appraiser must know whether or not a replacement allowance is included in any operating statement used to derive a market capitalization rate for use in the income capitalization approach. It is essential that the income statements of the comparable properties be consistent. Otherwise adjustments will be required.[2]
…leasing commissions are either treated as a normalized annual expense or not included as an expense in the reconstructed operating statement depending on local practice…Initial leasing commissions, which may be extensive in a new development, are usually treated as part of the capital expenditure for developing the project. These initial leasing commissions are not included as ongoing periodic expenses.[3]
Rather than to get caught up with semantics in terms of what does and does not constitute an above the line or below the line expense in the definition of NOI, commercial appraisers need to focus on the appraisal problem at hand— the real estate valuation of property based on the demonstrable behavior of actual participants in the market place. Key considerations include: local market practices; to what extent tenant improvement allowances or extensive tenant improvements are reflected in the concluded market rent; whether or not the capital expenses are made by the tenant or the lessor; the property rights appraised; and even the age of the property and stage of development. In a yield capitalization analysis, leasing expenses and reserves items can be specified explicitly and recorded in the cash flow statement in the projection period in which they are forecast to occur. Depending on the specific circumstances of the property and the assignment, there are four main avenues available for a commercial appraiser to address commissions, tenant improvement allowances and other extraordinary non-recurring expenses in a direct capitalization analysis:
  • Commissions, tenant improvement and reserves can be factored implicitly into the development of a capitalization rate derived from market data; 
  • If the expenses are projected to occur in the near-term, such as for capital items for a new building that has not yet reached stabilized operations, they may be deducted after income has been capitalized into value similar to the technique used for deferred maintenance; 
  • Tenant improvement allowances and leasing commissions also may be treated in the income statement in a manner similar to a replacement allowance over the life of the lease or the life of the tenant improvements. 
  • In markets characterized by above-market tenant improvements or atypical allowances adjustments may be required to determine the true effective rent or actual occupancy costs. 
1)Incorporate into the Capitalization Rate Selected  Regardless of how specific expense items are treated in the reconstructed operating statement it is important for the capitalization rate derived from market sources be applied to the subject property on the same basis as the income is estimated or that it is adjusted to reflect the differences. If an expense is implicit in the capitalization rate, the commercial appraiser need not deduct it in estimating the net operating income for a subject. But the capitalization rate selected must be consistent with the NOI it is applied to. As discussed in Part 1, one size does not fit all for cap rates, and a single property transaction may produce multiple cap rate indices depending on what level of income is used by the commercial property appraiser to calculate the rate. Writing in January 23, 2001 with respect to appraisals performed for ad valorem purposes, Jeffrey D. Fisher, Ph.D. and A. Scruggs Love, Jr., MAI, CRE, make several pertinent observations in their paper, "Issues in Comparing Capitalization Rates for Leased Fee and Fee Simple Estates."
Differences in the nature of fee simple NOI versus leased fee NOI must be considered when selecting an appropriate capitalization rate for a fee simple estate. For example, as noted above, there is likely to be a much lower amount of TIs and leasing commissions for a leased fee estate where there are existing tenants likely to renew their leases. When valuing a fee simple estate under the assumption that market rents for new tenants are used, the additional amount of TIs and leasing commissions must be taken into consideration. This can be done by either subtracting more TIs and leasing commissions from the NOI when valuing a fee simple estate OR using a higher capitalization rate than that used for a leased fee estate.…It is important to recognize that the amount of tenant finish out and/or leasing commissions included when estimating the value of a fee simple estate is not likely to be the same as that used when estimating the value of a leased fee estate. A leased fee estate is based on an existing rent roll and typically makes an assumption as to the probability that existing tenants will renew their leases. Leasing commissions and tenant finish out will be minimal for tenants that renew their lease. Thus, even though the owner may not receive as high a rent on a lease renewal, he or she can also expect to incur less expenses for tenant finish out and/or leasing commissions. In contrast, fee simple valuation makes the hypothetical assumption that all rents are at the current market rate and that the property is not encumbered by existing leases. To be consistent with this assumption, it would also have to be assumed that the expenses incurred for initial tenant finish out and/or leasing commissions would be the amount typical for new leases. That is, we cannot assume that many tenants will renew their lease and we will not have to incur these expenses because we have assumed that the space is unencumbered by existing leases.
Regarding use of investor surveys, the authors go on to note:
Surveys like the Korpacz Investor Survey [now PwC Real Estate Investor Survey], reports capitalization rates based on surveys of "equity real estate market participants" who are investing in properties subject to leases. As such, their perception of a property capitalization rate is from the perspective of the owner of a leased fee estate in the real estate. Because the survey is from the perspective of investors in leased fee estates in the property, the treatment of tenant finish out, leasing commissions, and replacement allowances would be from the perspective of a leased fee estate. Thus, we would expect that the amount of tenant finish out, leasing commissions, and replacement allowances reflected in the calculation of capitalization rates for these properties would be the typical amount for a property subject to leases of varying maturities and renewal probabilities.
2)Deduct After Income is Capitalized the Same as Other Capital Items  In the direct capitalization method, a single year's income is capitalized by the commercial real estate appraiser assuming that the property is operating at a stabilized or equilibrium levels. For a commercial property that is new and not tenanted, is vacant, or below stabilized occupancy adjustments may be made for the additional cost to ownership to achieve optimal performance. The adjustment may be quantified by calculating the present value of the rent loss during the period required to achieve stabilized occupancy and for the present value of tenant improvements, commissions and legal fees over and above normal expenses. Bear in mind that to prospective buyers these are actual costs which may not be discounted, or if they are discounted, would be discounted at a safe rate equivalent to a sinking fund set aside to pay for the costs when needed. 3)Handle Similarly to Replacement Reserves For apartment buildings, repair and redecorating expenses in between tenants are routinely treated as operating expenses bycommercial appraisers, so why would this not be the same for an office building or shopping center? It is not a matter related to the magnitude of the expense since even significant repairs that do not extend an asset's life are properly treated as routine operating expenses. Accordingly, as described in the first quotation from The Appraisal of Real Estate cited above, anticipated TIs for an existing space being retenanted may properly be treated as an element of (or subset) of the replacement allowance. The labels tenant improvement or leasing commissions are not the determining factor about whether or not these are expenses to be reflected in NOI, but whether or not such expenditures extend the life of the asset making it a capital expenditure or do they merely return the asset back to its previous condition by making improvements necessary to maintain the property in its current condition and, for commercial properties, the cost of re‐tenanting space upon lease expiration, in which case they are properly considered to be operating expenses by the commercial appraiser. 4)Effective Rent Adjustment  Situations may occur when extraordinary tenant improvement allowances are better reflected as an adjustment to rental income based on concessions in effect at the time of the appraisal that are used to induce a tenant to enter a lease.
In markets where concessions take the form of free rent, above-market tenant improvements, or atypical allowances, the true effective rent must be quantified…. Effective rent may be defined as the total of base rent, or minimum rent stipulated in a lease, over the specified lease term minus rent concessions— e.g., free rent, excessive tenant improvements, moving allowances, lease buyouts, cash allowances, and other leasing incentives…. Effective rent can be calculated as the average, annual rent net of rent concessions or as an annual rent that produces the same present value as the actual annual rents net of concessions…. There are options for the treatment of tenant improvement costs. The appraisal problem will dictate whether it is appropriate to deduct all tenant improvements or only deduct the additional actual tenant improvement costs over a market standard.[4]
In the end, the most critical consideration is that in direct capitalization, the capitalization rate selected by the commercial appraiser must be consistent with the method used to compute NOI. Regardless of the method used, the impact on value of so called below the line expenses including tenant improvements and commissions must be reflected either directly or implicitly in the valuation. They cannot be ignored as they factor into the purchaser's decision and into underwriting standards. The appraisal problem, property characteristics, and local market practices dictate the appropriate approach or approaches applicable. A commercial appraiser's reconstructed operating statement should not be construed as a pro forma income statement as would be prepared by an accountant. Its function is unique to this appraisal process. It is not intended to resemble a financial statement such as a balance sheet used by a business. The commercial real estate appraiser's reconstructed operating statement will differ from a pro forma income statement prepared by an accountant. Endnotes: [1]Appraisal Institute, The Appraisal of Real Estate 13th ed. Chicago:2008, p.491 [2]Idem, p. 492 [3]Idem, p. 489 [4]Idem, p. 454-5 Also: "Analyzing Operating Statements" Presented by: Arthur A. Linfante, MAl, CRE, August 29, 2012. Jeffrey D. Fisher, Ph.D. and A. Scruggs Love, Jr., MAI, CRE, "Issues in Comparing Capitalization Rates for Leased Fee and Fee Simple Estates."