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Commercial Real Estate Appraisal Considerations: TI's & Leasing Commissions - Above the Line Expense?

When doing an income approach for an office, retail or industrial property tax appraisal in the Chicago Metropolitan area it is not uncommon for the appraiser to list expenses such as tenant improvement allowances or leasing commissions as an expense that is "above the line". Other commercial real estate appraisers, and many in the industry, consider these items as a "below the line" expense. Depending upon which way you go the Net Operating Income would be substantially different. What follows is an abbreviated example: 

                                                      Above the line                        Below the line

Gross Income                                $200,000                               $200,000
Vacancy 10%                                    $20,000                                 $20,000
Effective Gross Income                $180,000                               $180,000

Management 5%                               $9,000                                   $9,000
Repairs                                             $10,000                                 $10,000
Insurance                                            $2,000                                   $2,000
Reserves                                            $1,500                                   $1,500
Legal/Admin                                       $2,000                                   $2,000
Tenant Improvements (build-out)/
Leasing Concessions                   $10,000                                         NA
Total Expenses                                $34,500                               $24,500

Net Operating Income                  $145,500                            $155,500

Now in theory the appraiser that applies the Tenant Improvement allowances above the line should use a lower capitalization rate than the commercial real estate appraiser that uses a below the line expense so the value should be the same either way. The issue could come up in any tax appraisal but is more likely to occur in appraisals of multi-tenant industrial, office or retail properties. Our tax appraisal practice focuses on the Chicago metropolitan area and Cook County.

Where commercial real estate appraisers (and the tax representatives) can get in trouble is when they apply an above the line TI expense which gets challenged by an intervener that claims it should be a below the line expense, not an above the line expense. The intervener (or competing commercial real estate appraiser) could argue that in the majority of cases appraisers place TIs as a below the line expense. By convention then, the $10,000 expense was improperly applied and should be added back to the NOI. If our commercial real estate appraiser had capitalized his above the line NOI at 10% the value would have been ($145,500/.10=$1,455,000). If the $10,000 TI expense is then added back as in the below the line example with the same capitalization rate the value would be $100,000 higher ($155,500/.10=$1,555,000).

Our contention, which is well supported legally, by scholarship and by common sense is that in most cases they should be considered an above the line expense.

Leasing Commissions and Tenant Improvement allowances can be considered an above or below the line expense. According to The Appraisal of Real Estate (13th Edition, 2008, p. 480):

Extensive tenant improvements can influence contract rent or   they may be built into the asking rent as a tenant improvement allowance. Consideration of tenant improvements (TIs) is usually addressed in yield capitalization and discounted cash flow analysis because the costs accrued can be incorporated into the analysis at the appropriate points of the projection period. Ignoring the impact of TIs in direct capitalization may be a mistake. Stabilized net operating income should recognize the tenant improvements made to a property that are appropriate for the market. 

It must be clearly understood that there is no universally recognized standard for how tenant improvement allowances are incorporated into the commercial real estate appraiser's reconstructed operating statement. The key considerations are local market practices, to what extent tenant improvement allowances or extensive tenant improvements are reflected in the concluded market rent, whether or not the capital expenses are made by the tenant or the lessor, and even the age of the property. For example, in The Appraisal of Real Estate, 12th ed. Chicago: 2001 pages 508-9 it noted that:

Furthermore, tenant improvements on a new building are usually capital expenditures while TIs in an existing space being re-tenanted are usually an expense. When TIs occur during the economic lifespan of a building dictates how they are tread and impact NOI – i.e., if they directly impact NOI and are recorded above the NOI line item in a reconstructed operating statement, they are considered above-the-line expenses, while at other times they are below the line.

A 2004 New York Supreme Court decision in the Matter of Reckson Operating Partnership v Assessor of Town of Greenburgh (2004 NY Slip Op 50153(U) Decided on March 19, 2004 Supreme Court, Westchester County Published by New York State Law Reporting Bureau pursuant to Judiciary Law 431) found that:

Tenant improvement costs are a recognized expense for space being re-tenanted in a building that, like the subject property, is well into its economic life span. On a stabilized basis over the course of an investment an owner would recognize the need to fund tenant work and meet these expenditures when they arise…

And goes on to note that:

In the context of ordinary turnover in a multi-tenant office building such as 555 White Plains Road, courts have recognized tenant-installation costs as an ongoing expense to be deducted from income as part of the capitalization process.

Regardless of how specific expense items are treated by the commercial real estate tax appraiser in the reconstructed operating statement it is important for the capitalization rate derived from market sources be applied to the subject property on the same basis as the income is estimated or that it is adjusted to reflect the differences. Furthermore, it is noted that the function of the reconstructed statement as prepared by a commercial real estate tax appraiser is unique to this appraisal process. It is not intended to resemble a financial statement such as a balance sheet used by a business. A reconstructed operating statement as prepared by the commercial real estate tax appraiser will probably differ from a pro forma income statement prepared by an accountant.

To bring theory back to our example, either approach is acceptable but the above the line appraiser should be utilizing a .0935 capitalization rate ($145,500/.0935= $1,556,150) versus a .10 capitalization rate for the below the line commercial real estate tax appraiser ($155,500/.10= $1,550,000) for the same value to be achieved. So when our above the line commercial real estate tax appraiser is selecting a capitalization rate he needs to be sure to comment that he is assuming the expenses are above the line.

At Cook County Tax Appraisals we try to anticipate and pre-empt these potential arguments in our commercial and industrial real estate tax appraisals. We now include some of the aforementioned analysis in our reports. Even if the argument is lost about whether it should be an above or below the line expense, the capitalization rate would by definition need to go up to reflect this difference. It is important, however, to mention in the commercial real estate tax appraisal report that the capitalization rate was selected with the assumption of above the line expenses. If your commercial real estate tax appraiser isn't thinking about these issues perhaps you should be thinking about a different appraiser. Cook County Tax Appraisals focuses on commercial and industrial real estate tax appraisals in Chicago and its suburban area and Cook County.

Gary T. Peterson, MAI, MBA