Mixed-Use Building with Below-Market Retail Leases and a Street Reconstruction Project
Subject: a three-story mixed-use building in a transitioning riverfront district. Ground floor: two retail units, 1,800 sq ft each, leased at $28/sq ft through 2029; market rent is $42/sq ft. Floors 2-3: eight apartments, 900 sq ft each, month-to-month at $1,650/month; market rent is $2,100/month. The building is 24,000 sq ft gross and 18,000 rentable. Zoning permits up to five stories; a nearby parcel sold for $2.1 million and was redeveloped into condos. The city has begun a two-year street reconstruction project that has reduced foot traffic by 40%. Operating expenses, including taxes and reserves, run 36% of effective gross income. The owner provides a pro forma using 100% market rent, 5% vacancy, and a 6.0% cap rate, concluding $8.9 million. Recent sales of older mixed-use buildings in the submarket traded at 7.25%-7.75% cap rates on in-place income. Cost new is $310/sq ft; land value is $1.3 million; depreciation is estimated at 55%.
1. Analyze highest and best use as improved versus as vacant. Explain how the street reconstruction affects the conclusion.
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Highest and best use must be legally permissible, physically possible, financially feasible and maximally productive. As vacant, zoning permits a five-story building, and the nearby $2.1 million parcel sale suggests redevelopment demand. As improved, the existing building produces income, but the retail leases are below market and the street project has cut foot traffic. The street reconstruction is likely temporary, so it should not by itself drive a demolition conclusion; it affects market rent, vacancy and risk during the construction period. The appraiser should test whether the land value plus demolition cost exceeds the value of the existing improvements. The cost approach gives $7.44 million for the building plus $1.3 million land, less 55% depreciation, or about $3.93 million. That supports continued use rather than immediate redevelopment, unless a condo feasibility study shows a higher residual land value.
2. Explain how the below-market retail leases should be treated in the income approach. Should the appraiser use contract rent or market rent?
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For a leased-fee valuation, use contract rent for the remaining lease term and market rent thereafter. The two retail leases run through 2029 at $28/sq ft while market rent is $42/sq ft. That difference is a below-market leasehold benefit benefiting the tenant, not the owner. The owner's use of 100% market rent overstates the leased fee. Alternatively, value the property as if leased at market and then deduct the present value of the leasehold interests, or value the fee simple subject to the leases using contract rent. The apartments are month-to-month and below market, so it is reasonable to use market rent for them after allowing for vacancy, turnover and leasing costs. The appraiser must state the interest being valued and avoid mixing contract and market rent without reconciliation.
3. Critique the owner's $8.9 million conclusion and calculate a corrected income-approach value range using the given data.
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The owner's pro forma is internally inconsistent and unsupported. Using market rent for all space, 5% vacancy and 36% expenses gives potential rent of $352,800, effective gross income of $335,160 and net operating income of about $214,500; at a 6.0% cap rate that is about $3.58 million, not $8.9 million. The 6.0% cap rate is also too low for older mixed-use property in this submarket; recent sales indicate 7.25%-7.75%. Using in-place retail rent and market apartment rent: retail is 3,600 sq ft times $28, or $100,800; apartments are eight units times $2,100 times 12, or $201,600; potential rent is $302,400. At 5% vacancy, effective gross income is $287,280; at 36% expenses, NOI is about $183,900. At 7.50%, value is about $2.45 million. Using contract rent for the apartments instead gives NOI of about $157,600 and a value near $2.10 million. A reasonable range is roughly $2.1-$2.5 million, subject to leasing and market support, far below $8.9 million.