The Income Approach With a Lease That Does Not Match the Market
You are reviewing an appraisal of a small retail building, 4,800 square feet, leased to a single tenant. The lease has 3 years remaining at $19.50 per square foot, triple net. Market rent for comparable space is $23.00 per square foot. The appraiser used contract rent, deducted a 5% vacancy and collection allowance, $1.85 per square foot in operating expenses (even though the lease is triple net), and capitalized at 7.25%, arriving at roughly $1,020,000. The subject sold 18 months ago for $890,000 when market rent was $21.50. Cap rates for comparable retail have compressed from about 7.75% to 7.25% over that period. The tenant is a regional chain with two years of reported losses.
1. Identify the income approach errors and explain how each affects the indicated value.
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Several errors compound.
1. Using contract rent instead of market rent. For fee simple value, the income approach uses market rent, not the below-market contract rent. Market rent is $23.00 versus $19.50 contract - a 15% understatement of potential gross income. The gap is a leasehold interest belonging to the tenant, not a deduction from the fee.
2. Deducting operating expenses on a triple-net lease. In a NNN lease the tenant pays taxes, insurance, and maintenance. Deducting $1.85/sf of operating expenses double-counts costs the owner does not bear and understates net income.
3. Applying a 5% vacancy allowance to a leased property with 3 years remaining. Vacancy should reflect market vacancy over the remaining term and the probability of renewal, not a blanket allowance. With a single tenant and a firm lease, a full 5% is unsupported unless market data show it.
4. The tenant's credit is ignored. A regional chain with two years of losses is a real risk. The cap rate should reflect tenant credit, lease term, and re-leasing risk. A 7.25% rate derived from comparables with stronger tenants may be too low, which inflates value.
The combined effect of the rent and expense errors is a large understatement of net income; the cap rate error pushes the other way.
2. Reconstruct the income approach using market rent and a NNN structure, and assess whether $1,020,000 is defensible.
Read the worked answer
Reconstructed, market-rent, NNN basis:
- Potential gross income: 4,800 sf × $23.00 = $110,400
- Vacancy and collection: at a supportable market allowance, say 3% = $3,312
- Effective gross income: $107,088
- Operating expenses: $0 (tenant pays under NNN)
- Net operating income: $107,088
At the appraiser's 7.25% cap rate: $107,088 ÷ 0.0725 ≈ $1,477,000. That is far above the $1,020,000 conclusion and above the $890,000 prior sale - a signal that something in the inputs is off, not that the property tripled in value.
The likely culprit is the cap rate. A single-tenant building with a weak-credit tenant and three years of lease term carries more risk than stabilized multi-tenant retail. A rate reflecting that risk, say 8.5% to 9.0%, gives $1,190,000 to $1,260,000. The prior sale at $890,000 with market rent of $21.50 implies a much higher cap rate or a different income base and must be reconciled, not ignored.
So $1,020,000 is not defensible as presented: it rests on contract rent, an inappropriate expense deduction, an unsupported vacancy allowance, and a cap rate that ignores tenant credit. The reviewer should require corrected income, a market-supported vacancy allowance, and cap rate evidence tied to comparable tenant quality and lease term.