The revenue stream from income-producing real estate is determined by the terms of the lease agreement between the lessee and the lessor. It is that revenue minus the operating expenses that creates the net operating income (NOI) used to calculate the capitalization rate. It is this capitalization rate that ultimately becomes the key factor deciding the value of the real estate. But what if the revenue stream generated from the lease’s terms is not the same as that of the current marketplace? Which income stream should you use to compute the capitalization rate?

Traditionally, there are only two times when a lease represents the value of the real estate: When it is negotiated and when it is renegotiated. There is another pragmatic consideration: The length of time between those two periods. Longer term leases (ten years plus) are usually considered credit arrangements. The fiscal strength of the lessee(s) and interest rates become the keys to finding property value. The values of properties with leases that expire in less than ten years are more impacted by changes in the rental market. Following is a value analysis of income property when leases expire in less than ten years and market rents are lower than lease rents.

Most leases use one of two techniques for deciding what the annual increases will be. (1) Some lessors and lessees use an inflation index and increase the revenue annually by the index’s published rate of inflation. (2) Some lessees and lessors base the annual revenue increase on a fixed predetermined dollar amount or percentage.

Regardless of which of these techniques is used to decide the revenue increase, one serious consideration is omitted. The result is a real problem in determining the value of the real estate.

Neither technique considers the changing economic conditions in the immediate area of the real estate, nor do they consider changes that have taken place in the supply/demand relationship of similar real estate. In recent years, excesses of real estate and general poor-to-average local economies have caused the difference between lease revenues and market revenues to widen. The size of the gap depends on when the lease was written. In many cases, the older the lease, the wider the gap.

In past markets, disparities in the revenue stream between lease revenue and market revenue converged as the markets caught up with contractual lease increases. But because each real estate cycle now lasts longer, the separation of the two revenue streams is becoming wider. In many areas of the country, market revenue streams are not catching up with the lease rates.

Now let’s get back to the original question. Which revenue stream should you use to compute the capitalization rate – the lease rate or the market rate? From the buyer’s perspective, let’s assume you’re considering the purchase of a commercial building whose lessees have two years remaining on their leases. According to the lease terms of this building, the lessor is currently collecting $1/square foot per month from the lessees. Since these leases were executed three years ago, the largest local employer has moved away; unemployment has increased from 5% to 9%; two similar projects have been developed, which caused local vacancy rates to go from 8% to 15%; and rents have gone down from $1/square foot to 65¢/ square foot.

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