KENNEY PLAZA: LEASING DECISIONS IN COMMERCIAL REAL ESTATE
“This isn’t as easy as I thought it would be,” Ben Cross murmured to himself. It had been only three years since Cross had purchased a thriving retail shopping center outside of Denver, Colorado. Now in January 2019, his anchor tenant had declared bankruptcy, and vacancies in his inline spaces had been more difficult to fill than he had anticipated, given the rise in online shopping. Denver, Colorado is known as the mile-high city, sitting at 5,280 feet above sea level. The city has a spectacular view of the mountains and has 6 professional sports teams for football, baseball, basketball, hockey, soccer, and lacrosse. In 2019, Denver had a population of approximately 730,000, which had increased from about 600,000 in 2010. With a population of 400,000 people per square mile, the median household income was approximately $68,000.
The Property
Kenney Plaza was a 59,100-square-foot gross leasable area (GLA) neighborhood shopping center located in the West Denver Submarket. The property contained two buildings with 8,650 and 50,450 square feet of leasable space, respectively. Located nearby, but not part of the property were two freestanding buildings currently occupied by banks. The property was located across the street from a local grocery store. Cross’s initial years of ownership had been rather uneventful, but the property’s anchor tenant, a nationwide electronics retailer, had recently vacated its space and ceased paying rent. Looking over the property’s site plan and rent roll (Exhibit 4), Cross realized that he would have to address the shopping center’s vacancies. He also considered that the lease of some of his existing tenants would soon expire. Wishing or an existing tenant to vacate might have seemed counterintuitive, given the changes that were undoubtedly facing the shopping center. Nevertheless, Cross wondered whether upcoming lease expirations were an opportunity to change the overall tenant mix. Of course, his experience suggested that every vacated space typically took six months to fill and required potentially significant tenant-specific improvement expenditures (TIs).
Leasing Opportunities and Costs
With significant vacancy and lease renewals, Cross realized that leasing commissions (LCs) and TIs were major costs to be considered in an operation of Kenney Plaza over the near term. His leasing broker, Alice Smith, charged a commission of 3% of total lease revenue (total rental payments less TIs) for new tenants, and 1.5% for renewing existing tenants. These commissions were due immediately upon signing of a new lease. TIs varied widely according to the type of tenant, so Cross carefully reviewed a list of prospective anchor tenants, which Alice had put together for him, that outlined each tenant’s specific lease terms, including their TI needs (Exhibit 5). Cross noticed immediately that the lease terms offered by the potential anchor tenants differed not only in terms of required TIs but also in terms of base rent and term. Alice had also provided similar information for potential inline tenants (Exhibit 6).
Cross understood from Alice that the most important decision he needed to make was how to fill the anchor space in the shopping center. An anchor tenant tends to drive traffic to other stores in a plaza, and as a result, is typically offered lower rent on a per-square-foot basis. An anchor’s ability to drive traffic to inline stores depends crucially on the similarity of the anchor’s typical customer and the demographics of the local population. Thus, Cross had to give serious thought to which tenants would be best for Kenney Plaza.
The Decision
Cross understood that he needed to act quickly. Because his tenants had triple net leases, Cross didn’t personally incur any operating expenses. However, he was responsible for any capital expenditures on the property, which historically averaged around $85,000/year. He also had annual mortgage payments on the property of $750,000/year. He certainly didn’t want to think about what might happen if he didn’t make every mortgage payment on time. As he sat down at his desk to start crunching some numbers, the words “Skilled financial analysts can make a spreadsheet to justify anything—so think carefully about your assumptions,” echoed through his head. If only he could recall where he had first heard them.
Questions
- Assuming that the appropriate discount rate for rental cash flow is 10%, what is the NPV of each anchor tenant’s lease? Be sure to incorporate tenant-specific improvement expenditures (TIs) and leasing commissions (LCs).
- Calculate the effective rent (including TIs and LCs) that each anchor would pay. You may assume that TIs, LCs, and the first year’s rent are paid together (time 1) and that the anchor tenant fills spaces A16-19. For Walgreens, calculate these values under two different assumptions: that it vacates after the initial lease term, and that it vacates after using all five extension options. No leasing commissions will be paid after Year 25 if Walgreens exercises all its options.
- What are the qualitative pros and cons of each potential anchor tenant? Does applying the same discount rate in Question 1 seem appropriate for each potential anchor, in light of these pros and cons?
- Rank your preferences for the anchor tenant, from the first choice to the last choice. Provide justification for your ranking.
- Suppose Cross’s only source of income comes from Kenney Plaza. Estimate his first year-out-of-pocket expense (if any) to sign each anchor tenant, assuming the vacant inline space remains vacant.
- Describe your overall leasing strategy for Kenney Plaza. Given that strategy, are there any inline tenants that you would not wish to renew? What new inline tenants would you sign? Be sure to explain how your choices are consistent with your strategy.
KENNEY PLAZA: LEASING DECISIONS IN COMMERCIAL REAL ESTATE
“This isn’t as easy as I thought it would be,” Ben Cross murmured to himself. It had been only three years since Cross had purchased a thriving retail shopping center outside of Denver, Colorado. Now in January 2019, his anchor tenant had declared bankruptcy, and vacancies in his inline spaces had been more difficult to fill than he had anticipated, given the rise in online shopping. Denver, Colorado is known as the mile-high city, sitting at 5,280 feet above sea level. The city has a spectacular view of the mountains and has 6 professional sports teams for football, baseball, basketball, hockey, soccer, and lacrosse. In 2019, Denver had a population of approximately 730,000, which had increased from about 600,000 in 2010. With a population of 400,000 people per square mile, the median household income was approximately $68,000.
The Property
Kenney Plaza was a 59,100-square-foot gross leasable area (GLA) neighborhood shopping center located in the West Denver Submarket. The property contained two buildings with 8,650 and 50,450 square feet of leasable space, respectively. Located nearby, but not part of the property were two freestanding buildings currently occupied by banks. The property was located across the street from a local grocery store. Cross’s initial years of ownership had been rather uneventful, but the property’s anchor tenant, a nationwide electronics retailer, had recently vacated its space and ceased paying rent. Looking over the property’s site plan and rent roll (Exhibit 4), Cross realized that he would have to address the shopping center’s vacancies. He also considered that the lease of some of his existing tenants would soon expire. Wishing or an existing tenant to vacate might have seemed counterintuitive, given the changes that were undoubtedly facing the shopping center. Nevertheless, Cross wondered whether upcoming lease expirations were an opportunity to change the overall tenant mix. Of course, his experience suggested that every vacated space typically took six months to fill and required potentially significant tenant-specific improvement expenditures (TIs).
Leasing Opportunities and Costs
With significant vacancy and lease renewals, Cross realized that leasing commissions (LCs) and TIs were major costs to be considered in an operation of Kenney Plaza over the near term. His leasing broker, Alice Smith, charged a commission of 3% of total lease revenue (total rental payments less TIs) for new tenants, and 1.5% for renewing existing tenants. These commissions were due immediately upon signing of a new lease. TIs varied widely according to the type of tenant, so Cross carefully reviewed a list of prospective anchor tenants, which Alice had put together for him, that outlined each tenant’s specific lease terms, including their TI needs (Exhibit 5). Cross noticed immediately that the lease terms offered by the potential anchor tenants differed not only in terms of required TIs but also in terms of base rent and term. Alice had also provided similar information for potential inline tenants (Exhibit 6).
Cross understood from Alice that the most important decision he needed to make was how to fill the anchor space in the shopping center. An anchor tenant tends to drive traffic to other stores in a plaza, and as a result, is typically offered lower rent on a per-square-foot basis. An anchor’s ability to drive traffic to inline stores depends crucially on the similarity of the anchor’s typical customer and the demographics of the local population. Thus, Cross had to give serious thought to which tenants would be best for Kenney Plaza.
The Decision
Cross understood that he needed to act quickly. Because his tenants had triple net leases, Cross didn’t personally incur any operating expenses. However, he was responsible for any capital expenditures on the property, which historically averaged around $85,000/year. He also had annual mortgage payments on the property of $750,000/year. He certainly didn’t want to think about what might happen if he didn’t make every mortgage payment on time. As he sat down at his desk to start crunching some numbers, the words “Skilled financial analysts can make a spreadsheet to justify anything—so think carefully about your assumptions,” echoed through his head. If only he could recall where he had first heard them.
Questions
- Assuming that the appropriate discount rate for rental cash flow is 10%, what is the NPV of each anchor tenant’s lease? Be sure to incorporate tenant-specific improvement expenditures (TIs) and leasing commissions (LCs).
- Calculate the effective rent (including TIs and LCs) that each anchor would pay. You may assume that TIs, LCs, and the first year’s rent are paid together (time 1) and that the anchor tenant fills spaces A16-19. For Walgreens, calculate these values under two different assumptions: that it vacates after the initial lease term, and that it vacates after using all five extension options. No leasing commissions will be paid after Year 25 if Walgreens exercises all its options.
- What are the qualitative pros and cons of each potential anchor tenant? Does applying the same discount rate in Question 1 seem appropriate for each potential anchor, in light of these pros and cons?
- Rank your preferences for the anchor tenant, from the first choice to the last choice. Provide justification for your ranking.
- Suppose Cross’s only source of income comes from Kenney Plaza. Estimate his first year-out-of-pocket expense (if any) to sign each anchor tenant, assuming the vacant inline space remains vacant.
- Describe your overall leasing strategy for Kenney Plaza. Given that strategy, are there any inline tenants that you would not wish to renew? What new inline tenants would you sign? Be sure to explain how your choices are consistent with your strategy.
