The Elusiveness of Market Rent

Oct. 21, 2009

I have been in the aviation industry for over 20 years, and much of that time has been spent evaluating aviation real estate. I have analyzed fixed base operations (FBOs), cargo facilities, airline maintenance operations, and just about every type of aeronautical real estate project and business one can imagine (and some that one probably can’t). One of the consistent issues I have faced over the years is the argument over the comparison between off-airport real estate and on-airport properties. More specifically, I have spent considerable time trying to educate airports, aviation businesses, and other appraisers as to why it is inappropriate to compare the two.

Let me start by discussing a basic real estate principle: property rights. Real estate is comprised of a bundle of rights, and the most common property ownership is fee simple estate. (This is likely what you own with your personal house.) The full bundle of rights in fee simple ownership relates to the fact that you own the property and have the ability to occupy it, lease it, modify it, tear it down and rebuild it, or any other number of things. With leased property, like what you find at airports, the full bundle of rights is broken down into two parts: leased fee and leasehold interest (also known as leased fee estate and leasehold estate).

If a property is leased, the airport sponsor has the leased fee interest, while the tenant maintains the leasehold interest. The airport’s leased fee interest is basically made up of the right to receive rent in accordance with the terms and conditions of the lease agreement, as well as the right to ownership of the property (with or without the leasehold improvements) at the termination of the lease, also known as reversion.

On the other side, the tenant’s leasehold interest is comprised of the right to occupy the property over the term of the lease, in accordance with the terms and conditions of the agreement. There are typically certain obligations on the tenant such as capital investment and/or operational requirements, but the primary obligation is to pay rent.

The significance of the initial discussion of fee simple, leased fee, and leasehold interests is that these basic real estate principles are the primary reason that comparing on-airport and off-airport are as different as comparing apples and oranges; in fact, I might argue that you are comparing oranges and candy orange slices. Yes, they are both orange in color and you can eat them, and the candy orange slices might even taste a little bit like an orange, but other than that they are very different. These differences are significantly more evident when evaluating aeronautical land on an airport, but are also prevalent with non-aviation real estate on airports.

Some basics
Okay, so what are the differences? Let’s start by addressing the basic difference: off-airport real estate is not generally subject to the same development restrictions as on-airport property. Limitations include restrictions on airport property being limited to aviation use, the impact of FAA regulations, an airport’s minimum standards and rules and regulations, lease terms and conditions, lease terms tied to a specific level of capital investment, and the impact of reversion clauses in a lease. (A reversion clause is a passage in a lease that requires that at the end of a lease, all leasehold improvements revert to the ownership of the airport, or the airport has the right to require that the tenant remove all improvements and bring the property back to a vacant state. As such, a reversion clause in a lease has an even greater impact when a lease term is limited to a period of time that does not provide an adequate term for the tenant to amortize the capital investment.)

In addition, another significant impact is typically the fact that most leases provide for a review and adjustment of rents at various intervals during the term of the lease. This provides a level of uncertainty as to the cost of occupying the property over time.

Off-airport real estate is typically bought and sold in the open market with numerous alternatives for a buyer (other properties offering similar utility). This usually provides a buyer with the ability to negotiate the best deal.

On the other side, the seller has to be aware of the fact that they do not usually have the only piece of real estate in that area and must negotiate accordingly. This is crucial to market value, which according to the Dictionary of Real Estate Appraisal is generally defined as: The most probable price, as of a specified date . . . for which specified property rights should sell after reasonable exposure in a competitive market . . . with the buyer and seller each acting prudently, knowledgeably, and for self-interest, and assuming that neither is under undue duress.

Similarly, market rent is defined as: The rental income that a property would most probably command in the open market; indicated by the current rents paid and asked for comparable space as of the date of appraisal.

Because of these definitions, it can be argued that any transaction on an airport cannot meet the true definition of market value (or market rent) because the “competitive market” is limited and difficult to define, and the market is really not “open”. In many cases, a prospective tenant does not have any viable alternatives if they are looking for somewhere to store an aircraft or operate an aviation business such as an FBO, flight school, or aircraft maintenance business.

Also, when you buy a piece of real estate, you own it. You do not have to pay rent (probably a mortgage, but there is usually a certain level of certainty about what your payments will be), but you will be responsible for paying property taxes. (Note: Many airport tenants also pay property taxes, at least on improvements.) If the value of that piece of real estate goes up, the mortgage stays the same. With on-airport property, the rent paid to the airport almost always goes up over the term of the lease, regardless of whether the property is actually worth more or able to generate more revenue.

Restrictions on the development and use of off-airport property are generally limited to uses prescribed by local zoning, which is usually fairly broad. Even if zoning is somewhat restrictive, an owner has the ability to request a zoning change or variance. On the airport, property along the flightline, or other property designated for aeronautical use is restricted to an aviation-related use. Furthermore, the height and setback restrictions on improvements are limited by FAA Part 77 regulations.

One of the most important things about owning real estate is the fact that over time, the value almost always goes up. Yes, there will be periods of decline (like in today’s economy), but over time the value of real estate will always increase. As such, real estate is typically bought and sold based upon the anticipation of those future increases in value. Buyers will pay more if they anticipate that the value will increase faster rather than slower, or they will pay less in a market like the one we are in now where there is a level of uncertainty as to when an upward trend will start again. Regardless, a buyer of off-airport real estate always has the option of holding onto a property forever, or at least until they decide it is time to sell it.

Supply and demand
Aeronautical tenants on an airport generally lease property for one of two reasons: 1) to construct and/or occupy a facility for their own private use or enjoyment; or 2) to construct and/or occupy a facility for the purpose of operating a for-profit business. Those leasing property for their own personal use have different motivations for entering into the agreement, and may be willing to pay more for a certain level of privacy and security.

Nevertheless, they still consider the fact that they will be building and/or occupying a facility for a fixed period of time, will likely have rent adjustments during that lease term, and either have to re-lease the property at lease termination at market rent, or can “enjoy” the opportunity to hand the keys to the airport at the end of the lease. If they do not re-lease the property and hand in the keys, they may also get the “opportunity” to pay to have the building demolished and hauled away. Those leasing aeronautical property for the purpose of operating a business must consider all of the above, as well as other factors that may impact the ability to generate a reasonable revenue stream to pay for the lease, improvements, equipment, personnel, and other expenses.

All of the above issues might lead one to believe that airport real estate is always worth less than its neighboring off-airport brethren. Fortunately for airport management, this is not always the case. The most significant issue impacting the value of any piece of real estate, whether on or off an airport, is supply and demand. If there are people lined up to buy something, then the seller can usually charge a premium.

With real estate, a property with several interested buyers is usually worth more than a property with only a single (or no) prospective buyer. This was a common phenomenon five years ago in many residential (and FBO) markets with many people paying well in excess of what a property or business was worth simply because they had to pay more just to be the successful bidder. (Unfortunately, this played a significant role in the current state of both the real estate and FBO industries.)

The supply and demand issue also has its limitations. There is an adage in the appraisal industry that “one sale does not make a market.” This is very applicable in the aviation world.

Paying a premium
If an airport is approached by an entity that needs a particular property because there are no other viable alternatives, and is willing to pay a premium as a result, then that does not necessarily set a new market. The motivation of this particular individual or company is not typical, as they have limited options and have to pay a premium as a result.

This was often the case with FBO sales, where a competitor was willing to pay a premium for market share, or a chain was willing to “overpay” because of the impact of a particular location on the network. Conversely, in today’s market there are businesses or leaseholders willing to sell at a level that is likely less than what a property or business is worth, out of financial necessity. This “fire sale” does not necessarily dictate that the value of other properties/businesses have declined at a similar rate.

Another factor that reduces the reliability of on/off-airport analysis is the fact that there is a completely different set of market participants. Real estate developers of office buildings, shopping centers, apartments, etc. do not typically “cross the fence” to do development projects on airports. Similarly, the few aviation facility developers that are active in the market do not typically focus on off-airport, or at least non-airport related, real estate projects. This is because developing and/or operating on an airport takes a special skill set that includes a detailed understanding of FAA regulations, airport operational restrictions, and relationships with an entirely different set of prospective tenants.

The comparison of on- and off-airport property reflects a complex issue that often results in an exercise in futility. If someone surmises that the value of the property on the airport is higher than what is found surrounding the airport, then they have the same potential of being correct as someone guessing that airport property is worth less or the same as off-airport. While hitting .333 will get a major league baseball player a substantial contract, it will not be very impressive if an NFL quarterback only completes one-third of the passes, an NBA player hits only 33 out of 100 free throws, or an NHL goalie only stops one-third of the shots on goal. In other words, making an assumption one way or the other will probably not yield a positive result. Carefully and objectively analyze the market, including supply and demand and other issues specific to the airport, before deciding what the true market rent should be.

About the Author
Michael A. Hodges, MAI is the president/CEO of Airport Business Solutions (ABS), a multi-discipline aviation valuation and consulting firm based in Tampa, with multiple offices throughout the U.S. ABS specializes in business, operational, and property-related issues for airports and aviation businesses worldwide. In addition, Hodges is the managing director of ABS Aviation, an organization providing short- and long-term contract management services for airports and FBOs worldwide.

FBOs - ‘It’s Been Very Challenging’
The headline comes from Lou Pepper, president of Atlantic Aviation; it might have come from any fixed base operator. It’s been a challenging year. AIRPORT BUSINESS recently spoke with executives from the two largest chains and two of the longest running family-owned FBOs to assess the economic damage and the prospects for the days ahead.

There is agreement that the boom years of 2006-2007 made the impact of the downturn more severe. Comments Kim Showalter, president of Showalter Flying Service at Orlando Executive Airport, “I don’t see aviation coming back to where it was. I sort of use 2007 as a benchmark; it was about our best year. I don’t see the volumes coming back for a very long time, and probably never in the same terms that it was then.”

Question: How would you characterize the past year?

• Showalter: “In the 36 years [husband] Bob and I have had the business, it’s probably the worst we’ve seen. We bought the business in the early ‘70s right before the Arab oil embargo; went through the stuff in the ‘80s. They were bad in their own way, but they were different. This one’s just been very deep; very long; pretty hard.
“We are perhaps more – and this sounds strange, I’m sure -- intimately involved with this one. We have worked harder and smarter for this one than any other. Perhaps that’s why it seems so deep and so hard. It’s an everyday thing for us. This one sucks.”

• Lou Pepper, Atlantic Aviation: “It’s the biggest downturn I’ve been in. After 2006 and 2007, our two best years, it made a bigger impact. We’ve had to adjust the way we do things, but we haven’t changed our philosophy — we’re the premium brand.
“We feel confident our business model is sound; it hasn’t altered our plans a bit. We’re still going to pursue opportunities. Now, you can’t have 68-plus locations and say they all fit the business model, but we are profitable.”

• Will Cutter, Jr., president of Cutter Aviation, based in Phoenix: “In a lot of cases it’s been devastating, but it’s also been a good eye opener that things aren’t always great all the time. It’s a time to keep your eye on the ball and make it be what it needs to be. Unfortunately, that means layoffs in people and services provided and the giveaways are much less.

“We’ve got to get back to running the business like a business instead of almost like a circus that we were under for awhile.

“We’ve kind of been running along at full throttle and reacting to all the good stuff that was happening and, I’ll say on my part, not a lot of great leadership going on — we were managing to the times but we really weren’t looking for the future other than let’s jump on that opportunity.”

• David Best, chief commercial officer for Signature Flight support: “Signature made the decision to be more competitve with pricing; a strategic shift. We are competing permanently on a price basis.

“The industry moves in cycles; we are in it for the long-term.

“We’re taking a cost-centric view of the market. Signature has positioned itself to be permanently competitive-priced.”

While the heads of the two chains say they expect to be profitable for the year, Showalter and Cutter say the challenge has been to break even.

Comments Cutter, “Last year we had one of our best years ever; we haven’t lost money in 20 years but we’re going to this year. The good news is I won’t be writing too many tax checks. I think it’s going to be worse for awhile.

“You sock money away in the good times and survive in the tough times, and we will. It’s not huge money we’re losing.”

Offers Showalter, “We’re absolutely going to lose money. I don’t think it’s going to be huge. Our goals this year were to break even and employ the same number of people; we’re going to be close on both. We have the potential to break even yet.

“The numbers that we have to achieve to break even are so much lower than a year ago because of changes and cuts we’ve made.”