NOTE: The following article is from the collection of articles in our Automobile Dealership Buy/Sell Newsletters. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because of changes in the law from the date shown at the end of the article. This article is not to be taken as legal, accounting, tax, or other advice. You should consult your own professionals for such advice and for any updating of the information provided.
The appraisal of a property under a “market value” premise assumes a consummation of a sale. Most of the time, the appraisal will be utilized to assist in obtaining financing for the real estate. The purchaser (or lender if the loan goes into default) is primarily interested in what they will receive from the property.
When selling a property that is leased under an “arms-length” transaction (no intra-company lease), the interest being sold is considered the “Leased Fee.” The definition of a “Leased Fee” is:
“An ownership interest held by a landlord with the rights of use and occupancy conveyed by lease to others. The rights of the lessor (the leased fee owner) and the leased fee are specified by contract terms contained within the lease.”(The Dictionary of Real Estate Appraisal, Third Edition, published by the Appraisal Institute).
An older, but more concise, definition would be:
“A LEASED FEE interest is defined as the right to receive periodic rental payments over the term of the lease and the ultimate right of repossession of the premises at the expiration of the lease.”
The above definitions mean that the owner of the property (landlord) will receive rental payments over the term of the lease (based upon the lease terms) and return of possession of the property at the end of the lease term.
When the contract rental rate is the same as the “market” rental rate, then the value of the property (leased fee value) is typically synonymous with “market value.” If the rental rate is “below market” and the remaining term of the lease (including options at the lower rate) is more than a couple years, then the leased fee value is less than the “market value.” Conversely, if the contract rental rate is higher than the “market” rental rate, then the leased fee value of the property is slightly higher than “market value.”
For example, assume a property is rented for $15,000 per month on a “market” rental basis. Using a typical vacancy rate of 5%, a typical expense ratio of 4%, and a typical overall capitalization rate of 10%, results in a property value of $1,640,000. If the “contract” rent on that same property is $10,000 per month and the remaining lease term is 20 years (including options), then the “leased fee” value of that property drops to approximately $1,190,000, an approximate 27% drop in value. Conversely, if the “contract” rent is $20,000 per month and the remaining lease term is 20 years (including options), then the “leased fee” value of the property increases to approximately $1,965,000, an approximate 20% increase in value. Considering a remaining lease term of 5 years under the above scenarios would indicate “leased fee” values of $1,415,000, or a 13.7% decrease for the “below market” lease and $1,835,000, or an 11.9% increase for the “above market” lease.[More consideration is given to the value of "below market" rents as they are considered to be assured.The strength of the tenant has to be taken into consideration in valuing "above market" rents.]
As you can see, the contract rental rate on a property can affect the sale value of that property. Because those rental rates may affect the sale price or financing capability of the property, the property owner needs to remember these factors when negotiating rental rates.
Note: Most auto dealership facilities are owner-occupied or contain intra-company leases. Even though these “intra-company” leases may be written at a market rate, they cannot be utilized by the appraiser in the valuation of the real estate as they could be canceled at any time. Most owner-occupied auto dealerships write leases to themselves for accounting/tax purposes and these leases are not utilized in the valuation.
Typically, rental rates on newer auto dealership facilities are based upon a percentage amount of the current value of the land and cost of improvements with returns at 10% on the land and 12% on the improvements (new). Some developers are utilizing an 11% rate on both the land and improvements as a composite and equal to [(10% + 12%) ÷ 2.] Rental rates are sometimes based upon a slight return above or commensurate return of the mortgage interest rate on the property, usually with a CPI adjustment annually or every 5 years (compounded).[Rental rates on older facilities can be calculated in a similar manner with the discount rate on the improvements adjusted slightly for the age of the improvements (generally not to the extent required for a residual analysis).]The rents are nearly always on a triple net basis with the tenant paying all expenses of operating the property including real estate taxes, insurance and maintenance. Typically, lease terms are for 10 to 20 years (seldom less than 5 years) with annual increases (usually CPI), or increases at least every 3 to 5 years.
Though auto makers generally set guidelines for how much rent a specific dealership can afford to pay (usually on a dollar amount per vehicle), market rental rates areseldombased upon the number of vehicles sold (either on a per-unit or dollar amount basis). The guidelines are more of a statement as to how much a particular dealership can afford to pay (similar to rental or mortgage qualification of a consumer based upon their income-i.e., 4 X, etc.). And, as you know, what the dealership can afford to pay is not necessarily reflective of the rental value of the property as different auto makes and dealership operations generate higher or lower sales volumes. [Note: In a slower market or when working with new market entrants, some auto dealership leases have been structured to include a lower minimum monthly rent (10% to 20% lower than "market") versus a percentage or dollar amount per vehicle sold. This lease type offers a lower minimum rental at the beginning of the lease while providing for potentially higher rental rates (above market) in the future when sales for the dealership increase. The dollar amount per vehicle sold (and/or percentage plus a percentage of service charges) would depend upon the sales history of the facility during the previous "normal" periods and the current time.]
The important thing to take into consideration when placing an “arms-length” lease on a property is that the terms of that lease will have a direct bearing on the market value of the property when sold or for financing. Some property owners will negotiate a “less than market rate” lease in order to sell the business only to find out later that the low rental rate has drastically affected the value of their property when they tried to sell it.
This article was written in 1998.