What Is Your Value

What is the value of your lease to the landlord?

This is a fundamental question central to most real estate negotiations; however, the answer is not always easy to determine. The value of a tenant’s lease can vary depending on internal factors like the company’s credit and growth trajectory, and external market factors such as vacancy, absorption, asking rental rates and demographic trends – to name a few.

While each of these shifting components should be properly weighed and considered on a case-by-case basis, below we share two fundamental valuation methodologies that can be applied in order to gain a better understanding of your company’s position in a building.

Generally Accepted Methods of Value

In general, investors and lenders alike value a property using one of two methodologies – the capitalization approach or the discounted cash flow analysis. The capitalization approach entails applying a cap rate to the building’s net operating income (NOI). The cap rate in simple terms is the rate of return you would expect in the first year of ownership. So, if you buy a building for $10 million at an 8% cap rate your return or NOI in year one would be $800,000. The other approach, a discounted cash flow analysis, considers current and future cap rates, sale prices and rental income among other inputs, and adjusts the cash flows for the time value of money. This second approach is more complex and generally relied on by sophisticated real estate investors.

The common denominator in both valuation methodologies is understanding the property’s net operating income which is the cash flow of the property after operating expenses, capital improvements, real estate taxes and debt service. As a tenant, to understand the value you generate for the property, you want to get a sense of your occupancy share in the building and contribution to NOI. As a rule of thumb, the greater your contribution to NOI the more value you bring to the property on a cash basis. Take, for example, a building that is 250,000 square feet and has three tenants of varying sizes and NOI contributions as outlined below:

Because tenant’s rental rates vary, their contribution to NOI is not proportionate to their occupancy share in the building. To develop a quick understanding of the value of your tenancy you can apply a market cap rate to the annual rental revenue generated by your lease – your NOI contribution. In order to determine a market cap rate, it is important to consider your remaining lease term, existing landlord concessions, recent sale comps and cap rates, as well as your tenant credit profile.

For example, let’s assume a market cap rate is 8%. If Tenant A applied an 8% cap rate to the NOI they generate, they will find that they bring at least $8.75 million in value to the building ($700,000 NOI / 8% Cap Rate = $8,750,000 Value). After calculating your value based on the capitalization approach, it would be important to run a Net Present Value analysis of your remaining rent. This can serve as a system of checks and balances, because if there is a large disparity between the capitalized NOI and the NPV analysis, you may have inaccurate assumptions for cap rate or discount rate.

Why does this matter?

Leverage, leverage, leverage! If you are near a lease expiration, need capital improvements to optimize your space, or are considering re-sizing, it is important to understand the value your lease brings to the building. In addition to having a thorough understand of your company’s position in the building, it’s critical that tenants understand larger market dynamics (leasing, absorption, occupancy trends, etc..) to establish a strong basis before engaging with a landlord.

By understanding these factors and how they are interrelated, you can develop a differential cash flow model and quantify the value of your lease and tenancy to a landlord. It is imperative as a tenant that you are equipped with the proper information to ensure an optimal transaction outcome.