Lease due dilligence requires careful attention

Posted On Wednesday, 23 September 2009 02:00 Published by eProp Commercial Property News
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As certain as death and taxes, there is another inevitable fact of property life - the assessment of property expenses (operating costs) identified by buyers and sellers, which by exception and rare circumstance, will be the same

Property-Housing-ResidentialThe seller will minimise costs to enhance net income whereas the buyer will attempt to strengthen his negotiating position by maximizing costs.

A properly prepared and motivated expense schedule detailing proven or actual costs will normally allow both parties to agree and overcome a potential hurdle.

When assessing the value of an investment property there are other non recurring expenses that can have considerable impact on net income and aside from the normal monthly operating expenses, buyers need to clearly identify these factors during the initial stages of determining value. Other matters as important as arriving at expense costs are capitalization rates which should be properly investigated in the initial stage of any valuation.
By way of illustration, when valuing a multi-tenanted property, the tenant schedule provided by the seller may reflect a monthly rental income of R 86 818 giving a net figure of R 833 454 per annum after deducting expected expenses of 20% from the gross annual income.  This net income if capitalised at 10% will give a value of R 8 334 528.

A full lease analysis, explained below, reduces the rental to R 83 270 per month, expenses remain at R 208 363 pa, and at 10% the property value reduces to R 7 908 815. The lower rental arises as a result of 4 leases expiring in the 12 month reporting period. The seller advises that as far as he is aware all the leases will be renewed but he has no agreement that confirms the lessee’s intentions. (If there is no agreement the savvy buyer will not view this as a vacancy if the building is under rented, but an opportunity to add value. If the building is over-rented, he may resile from the deal or negotiate the price significantly downwards). The professional valuer would do a discounted cash flow (DCF) analysis, where rental will revert to market rent at termination of the lease and analyse the likelihood of filling the vacant space and thereby calculate a vacancy factor. Any under or over statement of rental should be sorted out in the DCF.

The majority of property management contracts include an agreed monthly management fee of between 3% and 5% calculated on monies collected (this should be included in the existing expense schedule as should the following):
• Commission/fees for negotiating renewal leases with existing tenants;
• Commission for finding a new tenant;
• Tenant installation costs for new and renewing tenants.
We understand that SARS allow Commission and painting to be written off in the tax year, while:
• Carpeting - if a total floor, cost depreciated over carpet’s life. If only a portion replaced, the leaning appears to allow a write off in full.
• Partitioning must be depreciated over 6 years.

As these additional expenses can have a significant impact on cash flow and value, possible/probable costs should be properly investigated. We know the experienced buyer will in any event factor these issues into their offer price.

In assessing value a “vacancy factor”, percentage, provision is sometimes deducted from gross income (the principle is ideally to have different priority ratings for different property types: vitally important for a regional shopping mall where prudence demands a vacancy factor estimate in assessing the income stream, less important in a multi tenanted industrial where barring liquidations the vacancy factor and provision is lease expiry driven. The alert asset manager will be pro-active in securing new tenants months before expiry to minimize the costs of the vacancy but the reality is that all premises are vacant at some time as it is very rare for an incoming tenant to be able to take over premises “as is”). Vacancies can be easily assessed and the cost properly calculated.
In the above example, if an arbitrary 5% was applied to the annual rental as a vacancy factor this would be R 52 091, but if a major tenant did not renew, in this case a tenant occupying 10.57% of the space and paying 17.73% of the rental, with possible loss of rental for at least a month, plus new tenant commission, plus tenant installation, estimated costs would be at least R 80 000.

A practical way to partially solve this possible problem is to make sure that the lease clause allowing for renewal specifies that it should be negotiated at least six months prior to expiry of the lease (in larger industrial premises this could be longer and property owners often include some form of re-instatement).  This will allow sufficient time for the owner to find out what the lessee intends to do.   A shorter notice period of say, three months, is not enough time.

Wall & Smith use a lease agreement that looks after the needs of both lessee and lessor.  It is fair to both, easy to understand and is being used by more and more of our clients. We will draw up the lease, after consultation with both parties, ensuring that both parties comply with FICA requirements.  Fees are negotiable depending on time taken. If you are considering selling, we suggest you get your leases in order, ensure that all contracts are in place, up to date and with an accurate schedule of rent and recoveries.

Last modified on Wednesday, 21 May 2014 22:07

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