By Marc Wieder, Partner,
Anchin, Block and Anchin LLP
Owners of commercial real estate often find themselves in a dilemma: Do they accept what they perceive to be below-market rent today, or do they allow space to sit vacant while they hold out for a higher price?
The answer depends on several assumptions regarding the owner’s future plans for the property, the real estate market, and the time value of money.
Once these assumptions are made, it’s simply a question of doing the math to determine which strategy will provide the greatest value.
Example 1: Owner Plans to Hold the Property
Bill owns a 20,000 square-foot retail space. A prospective tenant offers him $75 per square foot, but Bill believes the market rent is $90 per square foot. If he holds out for higher rent, however, it may take as long as two years to find a suitable tenant. Is Bill better off taking $75 now or $90 in two years?
Let’s assume that under either scenario, the tenant would sign a 10-year lease with built-in rent increases of 3 percent per year and that an appropriate discount rate for determining the present value of future rental payments is 5 percent. If Bill accepts $75 per square foot now, he’ll receive $1,500,000 per year for 10 years, with 3 percent annual increases, which has a present value of approximately $13,347,000.
If he waits two years to sign a lease for $90 per square foot, then during the same 10-year period he’ll have no income during the first two years, followed by $1,800,000 per year, with 3 percent annual increases, for eight years. Under this scenario, the present value of the rental payments is about $13,069,000 million.
In this example, Bill is better off accepting below-market rent today than holding out for higher rent.
Example 2: Owner Plans to Sell the Property
Assume the same facts as Example 1, except that Bill plans to sell the property. Typically, commercial rental property is valued based on a multiple of net operating income (NOI). For purposes of this example, let’s assume that an appropriate multiple is 20 times NOI (a 5% cap rate).
If Bill rents the property today for $75 per square foot, its value (assuming no additional costs that reduce NOI) will be 20 times $1,500,000, or $30 million. If, instead, Bill holds out for $90 per square foot, the property will be valued at $36 million (20 x $1,800,000) in two years.
The present value of $36 million in two years (again, assuming a 5 percent discount rate) is approximately $32,581,000. If Bill was to lease the property for $75 per square foot and then sell the property after 2 years, Bill would sell the property for approximately $30.9 million. The present value of $30.9 million would be approximately $27,965,000.
In addition Bill would have received rent for the 2 years which equates to $2,891,000 on a present value basis. Therefore accepting a lower rent and selling in 2 years would have netted Bill approximately $30,856,000 million on a present value basis. So, in this example, Bill would be better off by approximately $1,725,000, by waiting 2 years and selling when the market rent is $90 per square foot.
The above examples do not take into account any tax considerations and market risk in waiting 2 years.
Many Factors to Consider
When faced with the question of whether to accept below-market rent now or higher rent later, there’s no one right answer. It depends on several factors, including the amounts and time frames involved, the appropriate discount rate for computing present value, whether or not you plan to sell or hold the property. Even small changes in these assumptions can change the outcome of the examples discussed above.
To determine the right strategy for you, work with your financial advisors to do the math and evaluate the results under various potential scenarios.