Valuing Tenant Reimbursement (TI) Income When Selling/Acquiring Investment Property. NPV vs. XNPV.
Case Study: Understanding Net Present Value, Discount Rates, and Risk
A large fitness franchisee signed a 15-year lease as junior anchor in a shopping center. Most of the company’s outlets are franchises, though there are also company-owned stores. As part of the lease negotiation, the landlord agreed to build the space out to franchisee’s specifications and tenant would pay landlord back over the first eight years of the 15-year lease at the rate of $4,000/month. This amount was in addition to tenant’s other rent and NNN obligations.
Two years into the lease, the owner decides to put the shopping center on the market, and includes the $4,000/month tenant reimbursement as part of NOI for purposes of capitalization to support its selling price.
During due diligence, Buyer reviewed the lease, saw only 66 months of TI reimbursement remaining, and recalculated the NOI without the TI reimbursement. Without the $48,000/year in NOI, buyer reduced its offer by $685,000 (6.5% cap rate) and sought to renegotiate the value of the TI reimbursements separate from the center’s NOI.
The parties agreed that the best way to value the tenant’s reimbursement of TI is to use a present value calculation of the income stream of the $264,000 remaining to be reimbursed.
They also agreed that the discount rate (hurdle rate), which is also known as minimum acceptable rate of return (MARR) was 8%, even though the cap rate for the shopping center at-large was 6.5%, because of the additional risk of the franchisee default. There was no franchisor guarantee and no right of the franchisor to replace the operator in the event of a default. Also, because the franchisee had each of its fitness centers operating under different LLCs, there was little recourse in the event of a default. And Seller had already subordinated its lien rights to the franchisee’s finance company. The 6.5% cap rate was derived based on the strength of the other tenants, including the prime anchor.
Seller presented his calculation as an Excel spreadsheet utilizing Excel’s NPV function. With sixty-six payments remaining (estimated based on the closing date), Seller’s NPV calculation was $199,676.
The parties agreed to value the TI reimbursement at $200,00, with an adjustment up or down for an early closing or a late closing, depending on how many actual payments remained at the date of closing.
When working on the buyer’s due diligence, I introduced buyer to a different function in Excel called XNPV. XNPV recognizes that the tenant was going to be making monthly payments, not yearly ones and that using an 8% discount rate on monthly payments valued the same income stream at $215,151.68.
The true value of the income stream was more than $15,000 greater than the seller calculated. Seller essentially left more than $15,000 on the table. Buyer would have paid $215,000 for the stream of income from TI reimbursement from the fitness center.
What are the take-aways?
Reimbursements for TI should not be included in the NOI if a cap rate is used for valuation, as it artificially inflates the income that the property can earn.
Reimbursements for TI should be valued at the present value of the income stream from the closing until they expire.
Different methods of calculating net present value yield different valuations. To maximize the value of monthly payments, use XNPV — not NPV.
The discount rate on the TI income stream is likely different than the cap rate for the shopping center at-large as the risks involved in a single-tenant default vary from the risks involved across the larger tenant mix at the rest of the center.
Do not confuse cap rates with discount rates.
The competence of the broker and the individuals conducting due diligence are essential. Recognizing the issues is only half the task. Knowing how to analyze and present the issues separates the experienced professional from the amateur. After all, there is much truth to the adage that: “You make your money when you buy, not when you sell.” The purchase price is the main factor that determines profitability later on.