It's commonplace for real estate brokers to win awards for earning the greatest commissions for sales. Imagine the chagrin of a lot of the real estate board members a few years ago who discovered that the top producer was a fellow who'd signed up a commercial tenant to a 50 year Lease on a major building calling for $2,000,000 a year in rents. His Lease commission was 6%. His annual $120,000 income will extend for 50 years from his residual commission income from just this one deal alone. Management fees over the years will be in addition to this.
The value of a long term Lease is calculated in much the same way as the value of a mortgage Note. When interest rates drop, value is transferred from the borrower to the lender to the extent that existing Notes earn above-market yields. A buyer of these Notes would pay more for them under those circumstances. On the other hand, when interest rates rise to a point above fixed Note yields, value is thus transferred back to the borrower, and the market value of the Note drops.
If you watch the 30-year Bond market on CNBC, you can see this happen before your eyes as Bond buyers respond to short term interest rate fluctuations. Long term leases behave in precisely the same way. Safeway, the mammoth grocery company, discovered a few years ago that the value of their store and warehouse Leases was a major asset on their balance sheets. They had signed 50 year Leases in the early 40s and 50s. When interest rates rose into the double digits, these below market Leases could be sold at a profit and assigned to other users at prevailing market rates, enabling Safeway to build its own stores out of the profits.
There's another interesting feature regarding Leases that makes them quite different from Mortgages. The longer a Lease lasts, the more it is regarded as a form of equitable title in the leased real estate. Lease interests in property whose original term, including any extensions, last more than 30 years can be depreciated and exchanged for other real estate tax free, as if the property itself, rather than the Lease, were owned by the Lessee. This aspect of Leases can also be seen when a property is condemned through Eminent Domain proceedings.
Suppose the State highway were being widened and properties on both sides of the projected route were being acquired. In such instances, all the interests of the various parties who have an interest in a property are awarded compensation. With short term leases, this isn't a problem. The tenant is given notice that the property is being condemned, and he moves on to other lodgings. But with a long term Lease, particularly with larger properties, the interests of the parties are appraised. The condemnation award is shared according to these appraised interests.
If what you get is based upon the appraisal, how is this done? Appraisers evaluate Leases according to the relationship of economic rent to contract rent. Here's what this means. If one of Safeway's Leased stores were being condemned and the market (economic rents) were based upon a yield of 12%, Safeway's 30 year, 6% Lease (contract rent) being half of this would entitle it to half of the condemnation proceeds. Thus, by signing a long term Lease, the owner would have sacrificed his investment and appreciation in return for a strong, long term tenant.
It's extremely tempting to sign a long-term Lease with such a tenant, especially if a building has been vacant for a long time. On the other hand, because, for the most part, in this century Lease rates have risen over time, such a course is almost a prescription for disaster. Let's face it, the tenant can go out of business and file bankruptcy to avoid paying off the Lease. But it's a rare owner who can file bankruptcy simply because he could have increased his rents had he signed a shorter term Lease. The solution for landlords is to index Leases.
