A Professional Courtesy of:
Mark T. Kenney, MAI, SRPA, MBA
American Valuation Group, Inc.
207 Abbey Lane
Lansdale, Pennsylvania 19446
5201 Ocean Avenue #2007
Wildwood, New Jersey 08260
Specializing in Real Estate Appraisal and Property Tax Consulting


In This Issue:

  • Build-to-suit Retail
  • Net Leases: Understanding The Differences
  • Low Income Tax Credit Apartments
  • The Impact of Entitlements on Value

  • Build-to-suit Retail

    A significant change in retail real estate has been the preference of certain retailers for free-standing buildings rather than strip retail structures. The reasons for this change include

    • Better visibility, access and egress;
    • Brand reinforcement; and
    • Brand differentiation.
    Examples of such retailers are drugstores, banks, emergency clinics and fast food restaurants. Such entities prefer to lease rather than own the real estate in order to preserve capital and because lease obligations need not be reflected on such firms' balance sheets. In the typical situation, an investor acquires a site and enters into a lease with the retailer. The lease commences upon the completion of construction and the attainment of a certificate of occupancy. In relatively rare instances, the investor simply leases the vacant site to the retailer who then constructs the improvements.

    Generally, such tenants have distinctive design criteria that reinforce brand identity. The idea is that the consumer can immediately identify such a retailer because all of its stores have the same appearance.

    From the investor's perspective, such distinctive design equates to increased risk in the event of lease default and/or termination. Simply put, free-standing structures designed for one national retailer are unlikely to be suitable for other national retailers. Future users of these improvements are likely to be local retailers.

    Given the limited marketability of such structures to other than the original users, investors require long-term leases as the quid pro quo for the assumption of such risk. Leases are likely to be for 25 years or more, often with several options to renew at the choice of the tenant.

    National retailers requiring free-standing structures are willing to agree to lease rates reflective of costs of site acquisition and construction, as well as entrepreneurial profit. Market rent to future users is likely to be sharply lower in current dollars. Thus, the need for long-term leases for the investor is obvious.

    It is also most important to determine whether the lessee is the parent retailer or a single asset entity owned by the parent. Clearly, risk in the case of the former is likely to be far less than for the latter. In any event, the creditworthiness of the parent retailer is of prime importance in terms of risk assessment.

    Net Leases: Understanding the Differences

    In real estate parlance, the term "net lease" is tossed about frequently, often in an imprecise manner. The Dictionary of Real Estate Appraisal (Fourth Edition) includes three definitions.

    Net lease: "Generally a lease in which the tenant pays for utilities, janitorial services, and either property taxes or insurance, and the landlord pays for maintenance, repairs, and the property taxes or insurance not paid by the tenant. Also called single net lease, modified gross lease, and semi-gross lease; sometimes used synonymously with single net lease but better stated as a partial net lease to eliminate confusion." Adding to the confusion, this same source offers further terms, specifically:

    Net net lease: "Generally a lease in which the tenant pays for utilities, janitorial services, property taxes, and insurance in addition to the rent, and the landlord pays for maintenance and repairs. Also called double net lease, NN, modified gross lease and semi-gross lease."

    Net net net lease: "A net lease under which the lessee assumes all expenses of operating a property, including both fixed and variable expenses and any common area maintenance that might apply, but the landlord is responsible for structural repairs. Also called triple net lease, or NNN but better stated as a fully net lease."

    It is obvious that the term net lease begs clarification from the user. The accuracy of analyses of operating statements and forecasts of revenue and expenses depends on the correct allocation of expenses to the responsible party (i.e., tenant or landlord). Careful review of existing leases is the most reliable means of understanding such responsibilities.

    Tenant-paid expenses are termed "expense recoveries" or "expense reimbursements." They are accounted for as revenue sources, offset by corresponding expenses. By so doing, vacancy and credit loss is taken on recoveries as well as on other sources of revenue. This is appropriate since the lessor must bear such expenses during periods of vacancy. If recoveries are not handled in this manner, net operating income may be overstated.

    It is also important that differences between tenant expenses paid and tenant expense responsibilities be reconciled. In periods of "soft" market conditions, landlords may elect to forgo recovery of certain tenant expenses in order to sustain occupancy. The assumed receipt of tenant reimbursements in such cases will lead to overvaluation of the real estate in question.

    Tenant responsibility for expenses varies by property type. For apartments, tenants' obligations are often limited to utility charges. Industrial and retail tenants typically pay all expenses except structural maintenance. In regional malls, tenants are also usually responsible for marketing expenses. Office tenants may pay for electricity (particularly that for after-hours usage) as well as increases over the base year. There is sometimes disagreement between tenant and landlord over the distinction between repairs and capital improvements. For example, a landlord may seek reimbursement for replacing the security system in a high-rise office building. Tenants may argue that such expenditure is a capital improvement (enhancement) and not an expense, and that reimbursement is not appropriate. The appraiser should he guided by precedent, both for the subject and competing properties.

    In summary, the term net lease is ambiguous. One must fully understand the division of expense responsibilities in order to reliably estimate income and value. The failure to recognize differences in expense burdens between comparable data and those assumed for the property being appraised will likely lead to inaccurate conclusions. The likelihood of collecting expense recoveries is also an important aspect of the analysis.

    Low Income Tax Credit Apartments

    The Low Income Housing Tax Credit (LIHTC) program is intended to facilitate the creation of affordable apartments. More than 1.52 million units have been created throughout the United States since 1987. LIHTC properties are found in urban, suburban and rural market areas. The size of LIHTC complexes ranges from 10 units to several hundred units.

    Maximum rental rates are based on median incomes established by the U.S. Department of Housing and Urban Development. At least 20% of units in an LIHTC complex must be leased to those whose income is 50% or less of the area's median income (AMI). The alternative is to lease at least 40% of the units to those whose income is 60% or less of the AMI. These thresholds are required in order to receive the tax credits. The foregoing percentages are merely the first thresholds; there are additional considerations including assumed household size for each type of unit.

    Annual tax credits are approximately 4% of the cost of acquisition and 9% of the costs of new construction or substantial rehabilitation. If federal subsidies or tax-exempt financing is used, the tax credit is no more than 4% of all project components. Since the credits are taken over a 10-year period, tax credits of roughly 40-90% can be sold to investors. In recent years, tax credits have been approximately 85% of maximum levels.

    Tax credits are allocated by the IRS to state housing agencies. State agencies then develop a qualified allocation plan and solicit proposals from LIHTC developers. Such developers locate sites, obtain approvals, arrange for financing and address other requirements prior to submission of proposals. State agencies then select the projects to be awarded the credits, based on their allocation plans.

    Conventional apartment development typically utilizes debt-to-asset ratio of 75%/25% to 80%/20%. In LIHTC developments, debt is likely to be only 20-25%, with equity being 75-80%. Equity in such deals includes the value of tax credits that are sold to investors.

    The motivation of Investors is clearly driven by tax credits. Indeed, the cash flow-to-equity from LIHTC properties is extremely modest. Furthermore, the requirement of restricted rental rates far exceeds the period over which the tax credits may be used (10 years).

    It is apparent that a significant portion of the value of LIHTC properties is intangible rather than real property. This is significant from the standpoint of ad valorem taxation. In most states, intangibles are not subject to property taxation. A May 9, 2003, ruling by the Tax Court of Arizona held that the tax credits constitute intangible property and consequently should not be added to the value of stream of income (Cottonwood v. Yavapai County).

    The analysis and valuation of LIHTC properties involve a company's numerous considerations, many of which are beyond the scope of this article. It is important that participants rely on experts with significant experience in this specialized niche of the real estate sector.

    The Impact of Entitlements on Value

    The development of real estate requires that various local governmental requirements and conditions be satisfied prior to commencement. But success in obtaining such approvals should not be considered a fait accompli.

    The definition of "entitlement" in The Dictionary of Real Estate Appraisal (Fourth Edition) includes the following: "In the context of ownership, use, and/or development of real property, the right to receive governmental approvals for annexation, zoning, utility extensions, construction permits, and occupancy/use permits."

    Although entitlements may be a matter of right, their attainment typically involves considerable expenditures of time, effort and money. The process varies widely among cities and towns across the United States. Some communities actively seek development while others have adopted slow growth or no growth policies. Furthermore, some types of development are more welcome than others, often highly correlated with related needs for supporting public services and infrastructure. In any event, the attainment of all necessary agreements, approvals and permits should not be regarded as a certainty.

    Greater involvement of government in dealing with increased traffic congestion, noise, wetlands preservation, endangered species/environments and growth policy has resulted in greater expenditures of time and money in the permitting process. This in turn has increased the initial risk in many developments. It is of great importance that the dynamics of the permitting process in a particular area be carefully considered, especially the time required to secure all needed approvals.

    Viewed in this manner, it follows that the successful attainment of all approvals and permits for a proposed development results in an incremental increase in value of the land, assuming of course that the proposed development is economically feasible. Similarly, a cogent argument can be made that the appropriate discount rate used in the subdivision analysis method should be higher if done prior to the attainment of entitlements in order to reflect increased risk. Indeed, risk in such a development tends to diminish as demonstrable success is achieved in completing infrastructure and in selling/leasing the property.

    It is not at all unusual for governmental entities to require specified dedications without compensation from developers applying for necessary approvals. Such donations are often termed "extractions." Extractions may include the dedication of land for parks, green space and public improvements (e.g., schools, firehouses, etc.). In short, governments may negotiate extractions in exchange for the granting of needed approval for development.

    The valuation professional is trained to properly reflect the impact of entitlements on value. It is in the client's interest to provide the appraiser with as much information regarding the status of the entitlement process as possible. This will save time and expense and increase the reliability of the valuation results.

    Next Issue:

  • Conservation easements
  • Subdivision valuation
  • Billboard valuation
  • Partial interests in real estate

  • Home | Newsletters | About Us | Contact Us