How Developers Create Increased Profit By Offering More Tenant Improvement Dollars
The issue is creating overvalued shopping centers with over-inflated rent structures.
Steve Doran and Mark Ladd

Steve Doran

Consider the following case study. Suppose an owner has a 7,500-square-foot retail center with market rents at $25 per square foot. If the rent roll consists of five 1,500-square-foot users who all command an additional $75,000 at lease signing, the developer or owner has to ante up an additional $375,000. The norm for most developers/owners is to amortize this over the first 10 years of a lease period at a 10 percent interest rate. This translates into an additional $7.93 per square foot per tenant.

Mark Ladd

As cap rates compress in the coastal markets, this gap widens even more. The same scenario above at a 6 percent cap rate would create a gap of $991,250 in sale price equating to additional profits of $616,250 ($991,250 minus $375,000).

Who Pays For This? 

As stated above, investors will get hurt the most. As leases expire and tenants vacate, investors will have to either ante up additional TI dollars to command the same rents or lower the leasing rates to market rents. Over-leveraged investors may find it hard to meet debt service in these situations. Smart investors will stray from these shopping centers and diligently research market rents. However, developers or owners shouldn’t worry — the investment market is still booming. As product continues to be scarce, over-valued shopping centers will still be marketable.

In order to finalize the analysis, interest rates at historical lows and resurgence to all things real estate among conservative and aggressive investors is a key player in the establishment of a purchase price. Interest rates at their current position provide developers and investors with sufficient return gaps from financing to rental income as the capital cost is underwritten at low rates for national credit tenants. In addition, the first generation retail space is considered among many investors and financiers as the safest overall investment in commercial real estate. This is due to the fact that typical tenants have national or regional presence and personal guarantees are commonplace for use in underwriting purposes to secure the best internal rate of return. Other investment product does not carry the same security on a nationwide basis of analysis. Finally, conservative and aggressive growth investors alike all have a niche within retail real estate. Their interests can often converge within the same product mix and that is usually the meeting of developer to purchaser on first generation retail space.

An investment analyzed on a holistic approach requires that the tax advantages be understood on an individual purchase to illustrate that the cap rate for purchase price is only one factor in the overall investment’s internal rate of return weighed against initial tax advantages, capital cost and future cash flows.

Will This Last?

Don’t expect this trend to continue forever. Retail real estate executives and managers are getting smarter. Since most retail executives renovate their stores at least every 10 years, expect them to start asking developers for more tenant improvement dollars after the expiration of the primary lease term or an adjustment in rent.

For example, in order for rents to stay at the above market rate of $32.93 per square foot (plus increases), retailers are beginning to ask for that additional $75,000 tenant improvement contribution after the initial lease term or an adjustment to their base rent down to market rate ($25 plus increases). After all, in the example above, the tenant improvement dollars will have been fully amortized by the end of 10 years.

How Will This Affect Valuation?

Underwriters will take notice. As more and more leases begin incorporating tenant improvement contributions in option periods, expect underwriters and analysts to monitor market rates. Shopping centers valued before at $32.93 per square foot may be downgraded to a blended rate in between $25 and $32.93. Or, worse yet for developers, lenders may begin pulling the tenant improvement portion out of the rental stream all together and treat it as a 10-year annuity. In the scenario above, the annual NOI difference between the two shopping centers was $59,475 ($246,975 minus $187,500). The present value of this difference discounted at 7 percent is $417,727. This is still a $42,727 surplus profit for the developer ($417,727 minus $375,000 tenant improvement contribution). However, it is more reflective of the value created and far less than the almost $850,000 increase in purchase price by valuing the center on inflated rents of $32.93 per square foot versus the market rate of $25 per square foot.

Looking To The Future

Again, over the long term, as interest rates climb, the investment rates of return will begin to move in a similar direction at equivalent analysis points. Within an increasing interest rate comes a greater risk that also has historic relevance to the credit of national tenants with sophisticated financing portfolios, especially those experiencing high growth rates. A savvy underwriter will appropriately analyze the credit of tenancy, competitive position of the purchased property and the cash flow analysis while not forgetting that lease concessions are standard practice but also provide personal and cross corporate guarantees.

Steve Doran is a principal in the Madison, Wisconsin, office of Lee & Associates and Mark Ladd is a principal in the St. Louis office of Lee & Associates. Both specialize in the sale and leasing of retail properties. They can be reached by e-mail at sdoran@lee-associates.com and mladd@lee-associates.com.