Ch8. Rent Appraisal — Market Rent, Contract Rent, and Lease Analysis

The Rent-Appraisal Framework

Rent Appraisal: An opinion of the rental rate that a property would command in the open market — or the assessment of a specific lease’s terms relative to market conditions.

Rent terminology:
① Contract Rent:        The actual rent specified in a current lease
② Market Rent:          The rent the property would likely command if
                         leased today under current market conditions
③ Net Rent:             Rent paid to the landlord after tenant pays expenses
④ Gross Rent:           Rent that includes some or all operating expenses
⑤ Effective Gross Rent: Economic benefit to the landlord including concessions
                         (free rent, tenant improvement allowances, etc.)

Market Rent vs. Contract Rent — the key distinction:

When Contract Rent = Market Rent: the lease is “at market”
When Contract Rent < Market Rent: the tenant holds a below-market lease (advantageous to tenant)
When Contract Rent > Market Rent: the landlord holds an above-market lease (leased-fee benefit)

This distinction drives leased fee vs. leasehold valuations and directly affects the Income Approach.

Lease Structure Basics

Gross Lease:
  Tenant pays a flat rent; landlord pays most or all operating expenses
  → Common in residential and older office buildings

Net Lease (NNN):
  Tenant pays base rent plus property taxes, insurance, and maintenance
  → Dominant in retail and industrial commercial leases in the US

Modified Gross / Full-Service Lease:
  Hybrid — expenses are negotiated between landlord and tenant

Percentage Lease:
  Tenant pays a base rent plus a percentage of gross sales (retail)
  → Appraiser analyzes breakpoint rent and overage income

Effective Gross Rent with Concessions

In active leasing markets, landlords often grant rent concessions — free rent periods or tenant improvement (TI) allowances. Effective rent analysis amortizes those concessions over the lease term.

Effective Annual Rent (with free rent):
= [Total Rent Payments Over Lease Term] / Lease Term in Years

Example:
  5-year lease at $25/SF/year, but 6 months free rent:
  Total rent = $25 × 4.5 years of payments = $112.50/SF over 5 years
  Effective Annual Rent = $112.50 / 5 = $22.50/SF/year

Effective Rent including TI amortization:
= Annual Rent − (TI Allowance / Lease Term)
  Example: $25/SF rent, $15/SF TI allowance, 5-year term
  = $25 − ($15/5) = $25 − $3 = $22/SF effective net rent to landlord

Rent Appraisal Methods

Rental Comparison (Market Approach)

Market Rent = Comparable Lease Rate
            × Conditions of Lease Adjustment
            × Market Conditions (Time) Adjustment
            × Location Adjustment
            × Physical Characteristics Adjustment

Comparable selection:
- Similar use and building class
- Similar lease structure (gross vs. net vs. NNN)
- Recent execution date
- No atypical lease terms (below-market renewals, related-party leases)

Market applications:
- Office: adjust for floor, view, suite size, TI package
- Industrial: adjust for clear height, dock doors, office finish ratio
- Retail: adjust for trade area, co-tenancy, traffic counts, frontage

Yield Capitalization of Lease Cash Flows

When lease terms are known, the Income Approach can be structured
to reflect the actual lease-by-lease cash flow:

Step 1: Project NOI based on actual lease terms (contract rent)
Step 2: At lease expiration, revert to market rent
Step 3: Discount both streams to present value using appropriate rates:
        - Leased fee discount rate (lower risk from in-place leases)
        - Market rent discount rate (higher risk from re-leasing risk)

This approach distinguishes between:
- Leased Fee Value (ownership encumbered by existing leases)
- Fee Simple Value (ownership unencumbered — valued at market rent)

Cost Approach to Rent (Rental Build-Up)

Market Rent = (Property Value × Required Rate of Return)
            + Annual Operating Expenses Allocable to Landlord

Required expenses for landlord:
- Property taxes
- Insurance
- Structural maintenance and reserves
- Management fee
- Vacancy and credit loss allowance
- Return of capital (depreciation equivalent)

Example:
Property Value:      $1,000,000
Required Return:     4.5%
Annual landlord expenses: $18,000/year

Market Rent = ($1,000,000 × 4.5%) + $18,000
            = $45,000 + $18,000 = $63,000/year

Lease Impact on Property Value

Below-Market Lease (Contract < Market):
  - Leased Fee Value < Fee Simple Value
  - Tenant holds a leasehold interest with positive value
  - Discount rate for in-place below-market income should be higher
    (re-leasing risk or early termination risk)

Above-Market Lease (Contract > Market):
  - Leased Fee Value > Fee Simple Value
  - Landlord's above-market income stream carries credit risk
  - Must assess creditworthiness of the tenant

Long-Term Leases:
  - Reduce income volatility but limit upside capture
  - Value depends heavily on rent escalation clauses (fixed step-ups vs. CPI)

Key Concept Cards

Market Rent vs. Contract Rent ★★★★★ : Market rent is what the space would rent for today. Contract rent is what the current lease specifies. The spread between them determines whether the leased-fee or leasehold carries excess value. Memory trigger: Contract ≠ Market → someone holds an advantage

Effective Rent (with Concessions) ★★★★★ : Amortize free rent and TI allowances over the lease term to arrive at the true economic rent received by the landlord. Headline rent overstates the landlord’s position when concessions are high. Memory trigger: Effective Rent = Headline Rent minus amortized concessions

Cost Approach to Rent ★★★★☆ : Market rent must cover the property owner’s required return plus all operating costs the landlord bears. Useful as a check when comparable lease data are sparse. Memory trigger: Rent = (Value × Return Rate) + Landlord Expenses

Practice Quiz

Q. A 3-year retail lease is signed at $30/SF/year with 3 months free rent. What is the effective annual rent?

Total rent collected = $30 × 2.75 years =$ 82.50/SF over the 3-year term. Effective Annual Rent = $82.50 / 3 =$ 27.50/SF/year.

Q. Name four expenses a landlord must cover that the Cost Approach to rent would include.

Property taxes, property insurance, structural maintenance/reserves, management fee. (Debt service is excluded — it is a financing cost, not an operating expense.)

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