Above/Below Market Leases
This article is part of a series covering basic components of a real estate purchase price allocation (PPA) study. All leases existing at the time of a real estate acquisition must be evaluated to determine if the contract rate is either above market (favorable to landlord) or below market (unfavorable to landlord). Any leases concluded to be significantly different than market require an asset or liability on the balance sheet to capture the net present value of the above or below market condition.
Significance of Difference
To avoid unnecessary entries on small differences, the industry generally applies a few tests to determine if an asset or liability should be reported for a particular lease:
Difference between contract and market: consider a percentage difference threshold to weed out small variations. A threshold of 5% to 10% is typical. The theory is that the accuracy of estimating the appropriate market rent for any specific space is only accurate to within 5 to 10%, so it would be presumptive to definitively conclude a reportable difference.
Recently signed leases: if the lease was just executed within the past six months, it is hard to argue that it is out of sync with the market. Perhaps this recently signed lease is your best data point and your market rent conclusion is suspect in general or in relation to this tenant space in particular.
Materiality: Some companies also apply a materiality test either in absolute dollar amount or based on remaining lease term length.
Assessing market rent
Some thoughts to consider when determining the current market rent for each of the space types in your property include:
Obtain rent comps (from Costar, real estate brokerage relationship, or your internal staff)
Research recent leases at the subject property
Read brokerage reports on the submarket for high-level averages and trends
Make adjustments for expense structure (NNN, Gross, MG)
Adjust for specific suite differences (upper vs. lower floors, obstructed views, superior buildout)
Calculating Above/Below Intangible
Once the market rent is determined, you can calculate the net present value (NPV) of the difference between contract and market lease payments over the remaining life of the lease. For this analysis, consider only the contractual lease term unless an option period is clearly below market and at a defined rate. Discount the NPV calculation by a discount rate consistent with rates that would be used at the property level. The property-level discount rate can also be further adjusted up or down slightly based on specific tenant credit ratings. Some leases have contractual payments that vary based on percentage rent or CPI adjustments, requiring a certain level of judgement within the analysis to adjust for such uncertainties when calculating the expected difference between contract and market payments.
Amortization
The resulting asset or liability for each lease is amortized over the remaining life of the lease. As such, the accounting entires will all be done on a lease-by-lease basis. If a below-market option period was taken into account, be sure to adjust the lease expiration date in your calculations to have the liability depreciate over the longer term.
This was a brief overview of the steps involved in calculating an above- or below-market lease intangible and I hope it is helpful in your situation. Feel free to reach out to the team at Allocation Advisors if you require assistance working through these and other purchase price allocation considerations.