Tenant improvement allowance
I've got a client who, instead of spending $300,000 or offering an equivalent $300,000 TI concession, loaned the tenant $300,000 that the tenant is paying back at 2% interest over the 10-year lease term. Got the appraisal back this morning and the appraiser is applying the $31,000 in loan (principal and interest) payment toward the net operating income, which is adding over $500,000 in value to the property's appraised value.
I've never seen an appraiser do this before. Is this a legitimate way of looking at TI allowance loan?
Depends on hwo the note is structured. If a default of the note is a default of the lease then it seems legit. But really depends on how much a stickler the lender is. From the appraisers POV its no different than amortizing the construction cost over the lease term. From the LL perspective its even better because the tenant is probably recourse for that note.
EDIT: I want to stress it really depends on the structure of the note. Also obviously only if its transferable in the event of the sale of a property.
Well first thing, I hope the principal portion isn't a part of the NOI. It should only be adding back interest if anything. I think its perfectly reasonable to do this. My two cents would be to see what the credit quality of the tenant is in this case since its a 10 yr term, which seems long. The other piece is I would break the NOI value, one for actual NOI, use the direct cap approach to get a value. Then on the interest take a much more modest value on that. Add those two values together.
Yeah, the appraiser is adding in principal and interest. I can kind of understand adding interest (even though I personally wouldn't since it's really more of a quark in the lease agreement than it is demonstrative of typical property income), but the appraiser is using the principal as well. The tenant is of average quality--we don't have his financials and his restaurant is brand new, although he has 18 years of experience owning a well known restaurant in that area.
Whats important is that an income capitalization valuation is not the only method in an appraisal.
From a LL's POV it has to be shown somehow though because you can't show 300K in TI without the amortization of it in the rent (which is what they essentially did just with a seperate instrument). There are few hard and fast rules and at the end of the day if they did it how they should have and just amortized the TI over the term in the lease it wouldn't even be an issue. Right now they are just seperated into two instruments and as long as they are cross-defaulted and transferable to a new landlord I'm fairly confident you can convince a lender to leave it in an appraisal, shoot most lenders will underwrite it if you assign it to them.
This should really be a below line cash flow that shouldn't alter value if you arrive at value by capitalizing income. If you think about it, the true addition of value is the sum of the improvements completed, not the marginal value of capitalizing financing activities.
If were actually classified as it should be, a TI, would the TI be added back to NOI before capping it?
The guidance I got from my boss was that the appraiser should have valued it separately as a discounted cash flow and that underwriting should ignore the cash flow when determining debt coverage.
I guess - but what is the point of DCF'ing the cash flow? The value of the financing cash flow could almost be considered a non-property level cash flow. You are underwriting the ability for the real estate to cover, not financing cash flow to cover.
You can make an argument that the I&P receivable is an asset of the guarantor, not the real estate. Correct me if I am wrong, but this may play a larger role in analyzing liquidity of the guarantor, and not the stabilized real estates ability to cover.
I agree with you. I don't see the logic in valuing it at all. I could make a qualitative argument that there is value in $300,000 of tenant improvements that you, the land lord, didn't pay for. But really I don't see the quantitative argument in valuing it at all--instead of negotiating $70/sqft less $2 for tenant improvements he negotiated $68/sqft and no concession for tenant improvements (instead issuing a loan).
What I did was create a 120-month amortization schedule, added up the interest cash flow and discounted it by 7% per year. It added something like $20,000 in value onto an $8.5 million value. I felt like this was so immaterial as to not impact the analysis of the transaction, especially compared to the $500,000+ the appraiser was adding on to the property's value by adding the cash flow into the NOI.
Haha sounds like bs
There's some pretty stupid appraisers out there
I'm not an underwriter*, but I don't have to ask the head of my underwriting department to confirm that we wouldn't underwrite that income. I think you're spot on in throwing it out.
*Though I was briefly.
Should definitely NPV it and then add it onto the overall value. It is not an NOI item, as this implies perpetuity. If you were doing a DCF, then it should definitely be included in the cash flow.
The lease rate is also probably artificially low because of this TI. Think about it.
Wait - NOI implies perpetuity?
Edit- I understand what you're saying, but disagree on some level.
While many underwriters would have no problem at all including this as 'other income,' I definitely do not believe that is the case. This is not property level income, it is P&I payments from a regional type tenant. Even if the note was guaranteed by a corporation or an individual (definitely not a remote entiry) and fully assignable, I still would not underwrite it as it should not increase property value. Upon lease maturity, the space will likely have to be built out again. I understand the interest argument, but being conservative I would stay away from that as well.
From a lender's POV, this would not be included in ds coverage income as it is not reliable. Would the LL truly exercise his or her rights as provided in the loan documents, and risk having an anchor space vacant for a significant period of time, as well as incur additional TI/LC expenses?
We had loan committee the other day on this file. Everyone agreed that the P&I on the loan payment shouldn't be used to evaluate value or cash flow. However, one person did make an interesting point about possibly giving credit for the cash flow that made me think--he said that if the tenant doesn't default on its lease then it's not going to default on the loan, so the land lord is no less likely to receive debt repayment than he is to receive regular rent payment; therefore, if giving credit for the lease cash flow we should give credit to the loan repayment cash flow. Thought that was an interesting point. Nevertheless, the argument was rejected.
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