Calculating PP with changes in State regulations

7 Replies

I have an interesting question for everyone! I am looking at a mixed use deal right now. The rents in the apartments are a good amount below market. The building has the ability to produce 140000+ in rental income with 72000K if that coming from one tenant (Aarons furniture rental) . This tenant rents about 7500SF. My questions/concern is my state has just put big restrictions on the way companies like Aaron's and Rent-A-Center do business. They felt these companies were taking advantage of the low income population. My fear is that these new restrictions will make it so Aarons does not renew their lease in the future and then I am left with 7500SF of commercial space empty and 72K less in income. 

My questions is how would you go about factoring this possibility into your analysis? and does this change the way I calculate my purchase price? 

Yes, it does have a bearing on what you do and how you calculate price. What is the term of the lease? How many years left? if it is short term, say under five years then you need to factor in the possibility of losing the tenant. If it is more than five years you factor that in as well and determine what the relative risks are worth to you. Sorry I cannot add more as there are no formulas for deciding on this risk and values. Much has to do with location, quality of growth in the area, etc.

7,500 is a junior box size mini-anchor. Representing over 50% of the income stream you have a right to be concerned. When it goes vacant that size space will take awhile to release generally unless it is a very high median income area which might accelerate lease up.

Breaking the large space into smaller spaces might make sense when they vacate. Generally the 1,000 sq ft to 2,000 sq ft spaces rent for a lot more per sq ft retail. You also spread out more risk with more tenants among various business sectors. Your breakeven occupancy is at a better percentage as well.

If the town you are in is a ( one economy ) town I would not desire such a location. Any shift in Aaron's  and just  a few other businesses could take the town down. In a an area with positive growth and multiple strong business anchors then many companies will want to be there.

I would want to see Aaron's on a 7 to 10 year primary term of the lease. If it is a 3 year type thing I would not be interested. Mixed use a lender likely will only go to 65% ltv or less as they are harder to manage and dispose of. Less lenders want to lend on them and less buyers want to purchase mixed use. 

Thanks for the input! The term of the lease is 5yrs with an option to renew for another five years at the end of the term. I believe they are about 3 yrs into their lease term. Form the questions I have asked the owner they have no plans on going anywhere. The owner is an older gent who is just looking to relocate to Florida and not have to worry about anything up here. As far as it being a (one economy town), Aarons is definitely not holding the town together. If Aarons left there are still plenty of job opportunities and the town would remain strong. The town has been doing ALOT of improvement to its main roads and investors have been buying up large commercial buildings and restoring them to their former glory.\

I am trying to put some kind of owner financing package together with this one but am having a hard time arriving at a fair purchase price. Here are some numbers to go along with it according to the last 3 yrs of tax returns: 


Income-138K

Expenses-83K

NOI- 55K

If the whole building was rented and the apartments rents were brought up to market rents the income levels would be somewhere in the ballpark of 185-190K and then of course we have vacancy in there somewhere, but you can see the potential. But again this is assuming that Aarons doesnt leave.....pretty scary thought!  

"From the questions I have asked the owner they have no plans on going anywhere."

Lenders do not count the option periods as it is not a given they will renew. You need to review the leases and see if Aaron's for that location has to disclose annual audited sales numbers. You are looking for if stores sales are at the national average, above it, or below it to get a sense of how that store location is doing. If they do not disclose sales another key metric is to see if they recently spent a lot of money re-imaging the store. If they have 2 years left on primary and have not spent money to re-image then it is telling usually they are moving to another location. You can't count on the option period to renew either as the tenant might use it to renegotiate even if they want to stay.

Look at the lease for Aaron's now and what rate per sq ft they are paying. You need to know what the current market rent is. For example if Aaron's signed on at 19 sq ft with a rent increase in the option period to 22 and market rent is 15 now that is not a good sign. You generally know in that case Aaron's is renegotiating or leaving. Also you need to know in addition to current market rent per sq ft rates if the rates are rising, falling, or staying flat.

If you know the cap rate is 8 on your purchase but the rent rolls are over market averages then  a lender will discount the cash down to market. The reason is they know if a space goes dark that is all you will get in a best case scenario. The option period can't be counted so if I was looking at it I want Aaron's to go ahead and sign the 5 year extension giving me a 7 year guaranteed lease. How you generally do this to offer the tenant in exchange for renewing early that you will discount their coming rent increase if it is large or if it is smaller than not give an increase all together. You could also offer in place of keeping rent the same to do upgrades to the building and exterior for their business. Pharmacies sometimes request this for extending early.

You can't buy on POTENTIAL. Remember the sellers numbers might not be yours when you take over the asset. You have to predict how the asset will perform for you and not what it did in the past. The past is important to analyze but is not a guarantee of the future.      

Joel, 

Thanks for the input! I was thinking the same thing. I dont think it is a very smart risk to take. Just the sheer fact that Aarons makes up more than 50% of this properties income make me uneasy. I think I will have to keep looking ! 

Thanks for the input! 

I wouldn't just count it out because it's 'risky.' Quantify the risk and see if you should buy it. 

I would run your at least one set of numbers assuming Aaron's vacates. If you need to, talk to a local leasing rep to see how long the space would take to lease up and what sort of TI/commissions would be involved, and what rents you could command. 

Once you have that info, just price your vacate scenario based on a stabilized  return on cost instead if a cap rate. (i.e. Stabilized noi/your cap rate = stabilized purch price - stabilization costs = what you should pay for the deal.)

The issue is lenders will look into the future at a "liquidity event" if Aaron vacates with just 2 years left.

They will likely place heavy reserves demands to be held in escrow upfront which will suck down heavily the cash flow returns. You still have the money but the lender is holding it as security.

They do this more with non-recourse loans as they want to protect the property with a bunch of safeguards because your individual bet worth is useless to them when they cannot attach to it.