Why Some Commercial Real Estate Lease Structures are Better than Others-Lease Termination Options

In my previous post, I discussed how the length of a commercial real estate lease impacts the operational and financial considerations of a company or customer. This post is sort of an addendum to that post, since what I want to talk about is the lease termination option and its use in commercial real estate.

A lease termination option is a right held by the tenant, landlord, or both to end the lease prior to its scheduled expiration. Because they create uncertainty for the opposing party to a lease, lease termination options are one of the most challenging option rights to negotiate into leases.

Below I will discuss some of the reasons why options to terminate are desirable, their common types and structures, and analyze their use in commercial real estate transactions. Lease termination options can be negotiated into some lease agreements under certain conditions. Perhaps more than any other option right, in order to successfully negotiate a lease termination option to terminate the party desiring the right must have an awareness of the negative implications for the other party, and a willingness to provide reasonable solutions to address those implications if required.

Why Do You Need a Lease Termination Option?

Tenants and landlords usually have different stated reasons for desiring a lease termination option. However, at the most basic level they share the same reason, which is uncertainty regarding future events.

Why Tenants and Landlords Want the Right to Terminate

Tenants typically desire lease termination options to address uncertainty in their business, real estate portfolio, or environment. This could mean that the tenant is uncertain about the utility of a property for the entire length of the lease term, and wants the right to end its obligations after a certain period of time.

Landlords may also request termination rights to address uncertainty with the future of the property and current tenancy. For example, some landlords request a right to terminate if a neighboring tenant may expand into the Premises at some point during the lease term, usually when a much larger tenant needs to expand into a smaller space.

How unpredictability manifests itself in specific examples, such as property utility or property repositioning, usually determines the lease termination option’s type and structure.

Types and Structures

Regardless of which party holds a lease termination option, there are two main types. Each type depends on the conditions by which it can be exercised.

The most common type of lease termination option is exercised by notice to the other party. These would include ongoing options, where notice could be provided at any point during the term, and scheduled options, where notice can only be provided during a specific period during the term.

The second type of lease termination option can only be exercised when a specific event takes place during the lease term. These would include co-tenancy, where a retail tenant has the right to terminate if a neighboring tenant vacates; bailout, where a retail tenant has the right to terminate if its sales do not meet a certain threshold; and re-capture, where a landlord has the right to terminate a tenant’s lease obligations in the event of an assignment or sublease. These options are typically not automatic terminations of the lease and usually are subject to additional notice from the holder in order to be exercised.

Types of Lease Termination Options

There is no limit to the ways a lease termination option might be structured theoretically. However, lease termination rights are often constrained or unavailable in reality depending on a number of factors, not the least of which is the willingness of the party not holding the right to consider conferring such rights to the other party.

Practical Analysis of Lease Termination Options

Since lease termination options give a party the ability to end their lease obligations prior to the expiration of the lease, in order for one party to accept another party’s right to hold such an option, it can be assumed the party not holding the option has been sufficiently compensated. While monetary compensation, such as a termination fee, is common it is not the only consideration in most instances.

In fact, the inclusion of a lease termination option in a lease is arguably determined more by whether its inclusion is supported in the marketplace than the amount of monetary compensation provided if it is exercised. Landlords, for example, will be resistant to a tenant holding a lease termination option in a market where landlords would not need to provide one to obtain a market lease term. This is a very common situation in the top U.S. industrial markets when a tenant wants a 5 years lease term with an option to terminate after 3 years, and the market lease term is 5 years or more. The landlord has no market incentive to provide the lease termination option when they most likely can find another tenant who will not require one.

The notable exception to the market “exclusion” of lease termination options is when a tenant’s credit is substantial enough, and perhaps the tenant’s footprint large enough, to override market concerns. Some credit tenants reportedly are able to negotiate a lease termination option in almost all of their leases, regardless of market or landlord.

The table below lists some of the concerns tenants and landlords might have when they consider, negotiate, and exercise a termination right during the lease term.

A few concerns that are often missed in consideration of termination options are the impacts to budgeting and financial statements. For landlords and tenants, a lease termination option can frustrate their ability to properly budget for upcoming fiscal years. This is especially true for institutional landlords, whose asset managers are often responsible for creating projected fiscal budgets based upon anticipated cash flows within their portfolios. Such asset managers will try to avoid accepting option rights which create cash flow uncertainty inside of the contract lease term.

Notice in a Lease Termination Option held by the Tenant

Assuming the landlord is amenable to a tenant holding a lease termination option by notice, they typically would need to negotiate how the termination option can be exercised and the fee involved for doing so. Ongoing rights to terminate are exceedingly rare because of the uncertainty it creates for the other party. Therefore, most lease termination options by notice will have a specific period in which the tenant or landlord can exercise their right to terminate.

One of the landlord’s primary concerns is the amount of time it will take to re-lease a property to another tenant once the a lease has been terminated. The timeline below shows a simple lease termination and lease-up process where the tenant would provide notice by a certain date, the lease would terminate, and the subject space would be re-leased by another tenant. A landlord, in such a scenario, would try to mitigate vacancy or the period of time between the termination of the existing lease and the re-lease of the subject property.

Lease Termination with Equal Time Between Notice Expiration, Termination, and Re-Lease
Lease Termination with Greater Time Between Notice Expiration and Termination, and Less Time Between Termination and Re-Lease

In the context of the lease termination option negotiations, a landlord can mitigate vacancy by increasing the amount of time between the date the tenant must give notice of terminating the lease and the actual termination of the lease. However, increasing the time between the notice date and the termination can create uncertainty for the tenant. The earlier the notice date, the more likely the utility of the lease termination option is diminished because the tenant will be less certain about whether they should exercise it.

In my experience, lease termination options commonly have a structure where the tenant can exercise anywhere between 6 to 9 months prior to the termination date. This period is often small enough for a tenant to know whether it should terminate the lease and long enough for a landlord to have enough time to start marketing without significant concern about vacancy.

Termination Fees in a Lease Termination Option held by the Tenant

There are many methods to determining an appropriate termination fee for the tenant to pay in exchange for exercising its lease termination option. The most common method, in my experience, is equating the termination fee to the landlord’s costs to lease the property, prorated over the months remaining in the lease term following the termination, as the graphic below demonstrates.

Termination Fee Equal to Unamortized Landlord Costs to Lease

This method of determining the termination fee is compelling for both tenants and landlords. The landlord can reasonably amortize their costs over the entire lease term, not just up until the lease terminates, knowing any unamortized costs will be reimbursed if the tenant terminates the lease. Since the landlord can amortize their leasing costs over the entire lease term, the tenant can usually receive a greater amount of leasing incentives than they would without such a termination fee.

Although the above method is common, there are many other ways to structure a lease termination fee. Starting with no fee at all, possible lease termination fees include a nominal fee for legal and processing costs up to the present value of remaining obligations plus any initial costs. At a certain point, the termination fee becomes unattractive to the holder of the termination option because it is equal or greater than the remaining obligation or an alternative transaction such as a sublease or assignment becomes better financially.

Increasing Termination Fee Structures

Lease termination options are one way to address uncertainty from both the tenant or landlord perspective. Although they are not always possible to obtain in certain negotiations, if structured with reasonable notice periods and termination fees where required, they can help a tenant or landlord commit to a longer term lease while allowing for flexibility in the event one party needs to terminate before the scheduled lease expiration.

Why Some Commercial Real Estate Lease Structures are Better than Others-Length of Lease Term

In the previous post I reviewed why commercial real estate lease structures are important to our companies and customers, what measurements we can use to evaluate commercial real estate lease structures, and how we can best measure those lease structures in certain situations. In this post I will cover why lease terms matter to tenants and landlords and what a longer or shorter lease term does to the measurements we discussed in the previous post.

Why Lease Term is Important

At its most basic level, lease term is simply the time period during which one party grants property rights to another party in exchange for compensation, typically in the form of rent. While the amount of rent paid during the lease term partially depends on the length of term, there are other important considerations for both the tenant and landlord. The following table provides some other examples of reasons why lease term can be important to the tenant or landlord.

TenantLandlord
FlexibilityOccupancy
Project DurationProjected Hold Period
Financing of EquipmentFinancing of Property
Amount of Tenant InducementsAbility to Amortize Tenant Inducements
Market DirectionMarket Direction
Property TypeProperty Type
Reasons Why Lease Term is Important

For the tenant, there are several reasons why lease term matters. The majority of those reasons center around its anticipated utility of a property, retaining flexibility within its real estate portfolio, to assist in cash flow and other finance related objectives, and to maximize the amount of benefits they receive in a lease negotiation.

The landlord looks at lease term primarily as a commitment by the tenant to pay rent for a certain period of time. However, they also are concerned with secondary impacts of lease term on things like selling the property, financing or re-financing the property, and amortizing tenant improvement allowances or other tenant inducements.

For both tenants and landlord the market lease term likely has the most common impact on what each will be able to negotiate and accept. In markets where lease terms are always a minimum of five years, it can be difficult or impossible to secure a three year term unless there is an extraordinary benefit to the landlord. Extraordinary benefit can include higher rents, higher or more frequent rent adjustments, limited to no tenant inducements, and finally and especially a superior credit company or existing landlord customer. On the other hand, if three year terms are often done in a market and a landlord mandates a minimum of a five year term, their property can sit vacant until they find a tenant is willing to do a five year term or the landlord removes the mandate.

Lastly, property type can determine lease term length as well. Ground leases where the tenant will improve the property are typically long term leases, usually between 20 and 99 years in length, in order to amortize the cost of improvements over a longer period of time. Specialty property types such as cold storage, food processing, health/science, and data centers commonly have longer term leases for several reasons, including the amount of investment required to suit a tenant’s specific needs.

How Lease Term Affects Metrics

Variance in lease term does not impact all of the real estate metrics we discussed in the last post. Metrics impacted in leases regardless of the length of lease term include:

  • Total consideration
  • Discounted cash flows
  • Net present value
  • Net present value rate

Those metrics impacted by lease term in certain lease structures include:

  • Straight-line rent
  • Effective rate

The reason lease term impacts the first four metrics but not necessarily straight-line rent and effective rent is because straight-line rent and effective rents are averages, and averages will not change when lease term varies unless there are adjustments to the rent over the term.

For example, the graph below plots the effective and NPV rates (@6% discount rate) for a lease with a $1.00 per square foot start rate, no rent adjustments, and no free rent for 36, 60, 120, and 240 month lease terms. As the graph shows, the effective rate remains the same no matter what length of lease term while the NPV rate declines. Even though NPV rate is an average of the net present value per unit of size per unit of time, it is still derived from net present value which discounts future cash flows to the present.

Effective and NPV Rates (@6% discount rate) assuming $1.00/SF start rate, no rent escalations, no free rent, and no tenant improvement allowance

To show the changes to all the metrics mentioned above, we will assume in the following examples that there are changes in rent over the lease term.

Example 1-Lease of 100,000 SF Industrial Building in a Top Industrial Market

Let’s look at what an adjustment to lease term would do to the metrics for a recent renewal lease transaction for a Class A distribution building in the South Bay industrial submarket of the Greater Los Angeles Basin industrial marketplace:

  • 115,286 RSF
  • $1.02/SF Net start rate (monthly) / $12.24/SF Net start rate (annual)
  • 3% annual rent escalations
  • No rent abatement
  • No tenant improvement allowance
Graphic 1

Graphic 1 above shows the noted metrics when lease term is 36, 60, 84, 120, and 240 months for Example 1. You will likely notice a few trends right away:

  • Total consideration, effective rate and NPV all increase with the growth in lease term
  • NPV rate declines with the growth in lease term
  • The rate of increase in total consideration is greater than the rate of increase in NPV as the lease term grows
  • The effective rate and NPV rate appear to be diametrically opposed positive and negative rates of growth

These trends are due to the discounting of future cash flows in the NPV and NPV rate metrics, or the lack of discounting of future cash flows in total consideration and the effective rate metrics.

Given the variability in the direction and amount of each metric in Example 1, we need additional information in order to determine what lease term is better for the company or customer. Total consideration, NPV, and effective rates would show in isolation that the 36 month term has lower amounts for a tenant, while NPV rate would show leases longer than 36 months have lower amounts for a tenant. Since we need additional information in order to determine what metric is useful for comparison purposes, the metrics lose their effectiveness in Example 1.

So how can we identify when metrics are effective tools to compare leases and avoid the obscurity in Example 1? Real estate metrics are typically much more useful in isolation when:

  1. Comparing different properties with similar or equal lease terms;
  2. Comparing proposal histories for the same property with similar or equal lease terms

Example 2-Analyzing Different Properties with Similar Lease Terms

Let’s assume the tenant who renewed the lease in Example 1 considered two alternative available spaces. They sent a letter of intent to all three landlords proposing a five and seven year lease term summarized as follows:

  • Current Location
    • 115,286 SF
      • 61 Month Lease Term
        • $1.00/SF Net start rate
        • 3% annual rent escalations
        • 1 month of rent abatement
        • No tenant improvement allowance
      • 86 Month Lease Term
        • $0.98/SF Net start rate
        • 3% annual rent escalations
        • 2 months of rent abatement
        • $0.50/SF tenant improvement allowance
  • Alternative Location 1
    • 120,000 SF
      • 62 Month Lease Term
        • $1.00/SF Net start rate
        • 3% annual rent escalations
        • 2 months of rent abatement
        • $0.50/SF tenant improvement allowance
      • 87 Month Lease Term
        • $0.98/SF Net start rate
        • 3% annual rent escalations
        • 3 months of rent abatement
        • $1.00/SF tenant improvement allowance
  • Alternative Location 2
    • 117,500 SF
      • 62 Month Lease Term
        • $1.00/SF Net start rate
        • 3% annual rent escalations
        • 2 months of rent abatement
        • $0.50/SF tenant improvement allowance
      • 87 Month Lease Term
        • $0.98/SF Net start rate
        • 3% annual rent escalations
        • 3 months of rent abatement
        • $1.00/SF tenant improvement allowance

Graphic 2 below outlines the metrics for the initial proposals above, sorted by lease term. Sorting by lease term instead of by property makes it easier to compare options, which can be clearly seen when you look at the table within Graphic 2.

Graphic 2

Even as a description of the initial proposals, Graphic 2 is showing a lot of information which may not be important to the company or customer in comparing the various options. Here I would suggest identifying one or two metrics to focus on since as we add counter proposals there is more information to consider. If the company or customer decides to focus on effective rate, we can revise Graphic 2 to show just that metric.

Graphic 3

Now that Graphic 3 shows only the effective rate for the initial proposals sorted by lease term, it is easier to see that the tenant has offered a premium to their current landlord, perhaps because it is a better building than the alternatives or they don’t want to be overly aggressive in their initial proposal, than they have to the alternative spaces. It is also apparent that the proposals for the alternative spaces have the same effective rate for similar lease terms.

Let’s assume each landlord reviews these proposals and responds to both proposed lease terms as follows:

  • Current Location
    • 115,286 SF
      • 61 Month Lease Term
        • $1.03/SF Net start rate
        • 3% annual rent escalations
        • 1 month of rent abatement
        • No tenant improvement allowance
      • 85 Month Lease Term
        • $1.00/SF Net start rate
        • 3% annual rent escalations
        • 1 months of rent abatement
        • $0.50/SF tenant improvement allowance
  • Alternative Location 1
    • 120,000 SF
      • 61 Month Lease Term
        • $1.03/SF Net start rate
        • 3% annual rent escalations
        • 1 months of rent abatement
        • $0.50/SF tenant improvement allowance
      • 86 Month Lease Term
        • $1.00/SF Net start rate
        • 3% annual rent escalations
        • 2 months of rent abatement
        • $0.75/SF tenant improvement allowance
  • Alternative Location 2
    • 117,500 SF
      • 61 Month Lease Term
        • $1.04/SF Net start rate
        • 3% annual rent escalations
        • 1 months of rent abatement
        • $0.50/SF tenant improvement allowance
      • 86 Month Lease Term
        • $1.02/SF Net start rate
        • 3% annual rent escalations
        • 2 months of rent abatement
        • $1.00/SF tenant improvement allowance
Graphic 4

Graphic 4 above shows the effective rates for:

  • the initial Tenant offer for the current and both alternative spaces
  • the Landlord’s counter offer for the current space and both alternative spaces.

Graphic 4 shows that there is a spread between the initial Tenant offer and initial Landlord counter offer, with the later being obviously higher in all cases. To evaluate each offer based on the Landlord counter offer, Graphic 5 below only shows the effective rate for those proposals.

Graphic 5

Based on the effective rate of each Landlord’s counter offer, we can see that Alternative 1 has the lowest effective rate on both a 61 month and 86 month term. This is significant, not only because the effective rate is lower than the alternatives, but also because the effective rate is essentially equal for both terms in Alternative 1, where the longer term effective rate is slightly higher for the Current space and Alternative 2.

From Example 1, we know that since the effective rates are so close despite the variance of term, all of the Landlord’s counter offers for the +/-84 month terms have lower start rates, greater rent abatement, larger tenant improvements, or a combination thereof in comparison to the +/-60 month options. This is not atypical in most marketplaces where landlords will typically incentivize the tenants to sign longer term leases if possible.

These examples are purely hypothetical with the exception of the actual 60 month renewal detailed in Example 1. However, each example shows how you might want to evaluate your company or customer’s lease term options based only on the real estate metrics. I hope they have clearly showed that lease term is an important consideration when evaluating commercial real estate leases and likely more important when there is operational context provided by the company or customer.

In the next post I will take a look at the lease termination option and its implications for both the tenant and landlord in a commercial real estate lease structure. Until then, I would appreciate any questions or comments you might have on this post. Thanks.

Why Some Commercial Real Estate Lease Structures are Better than Others

There is an art in negotiating a lease in the best interests of your company or customer. As commercial real estate professionals, in order to create great work, we need to be armed with the right tools to understand the operational and financial aspects of the agreements to which we are binding our company or customer.

You may have heard this line from someone recently: industrial and commercial real estate is becoming a commodity. Corporate real estate, the real estate investment trusts, brokerages, industrial properties, and others are all headed towards service and product standardization. Unfortunately, due to market forces and participants pushing us to accept the “market” way of structuring lease agreements, we may eventually get there.

However, there are several reasons to doubt the commodity-theory in the near future. One reason is companies and customers need customization in their lease agreements, achieved through creativity in negotiations, in order to meet their very real financial and operational requirements. They may have near-term capital requirements, concerns about sublease risk, cash flow requirements, and better use of capital outside of real estate.

This article is the first of a series of posts about using the variability of lease terms in order to meet company or customer requirements. It is also about creating awareness of what happens to cash flows when standard lease elements, such as the length of a lease term, are adjusted in isolation and with other lease elements to reach a desired outcome.

Measuring

Ultimately, each commercial lease transaction is an opportunity to create a financial obligation for the company or customer, which will be profitable after considering the operational cash flow generated by the occupying business unit, debt, and any tax consequences. Ideally, commercial real estate professionals would include their company or customer’s operational, debt, and tax information into their analysis of the financial impact of a lease. Otherwise, the lease cash flows will be negative and there will be no ability to determine the profitability of the prospective lease commitment.

However, even if operational and tax consequences are not part of the financial analysis of a lease, it is important that commercial real estate professionals ask their companies or customers for any guidance regarding structuring such real estate cash flows. Often finance professionals with the business operation understand the proforma cash flows for a prospective operation and can convey how the operation might benefit from certain lease elements, such as rent abatement or a tenant improvement allowance for certain requirement improvements. By understanding how the certain lease elements might benefit them, we can pursue better lease structures for the customer or company.

Most companies use depreciated cash flows, or cash flows discounted to present value, when evaluating the financial impact of business decisions. Often called DCFs for short, these cash flows are the prospective financial performance of the company for a particular investment or project. DCFs are typically for a set number of years, depending on the project length and operational considerations involved. Some operational cash flows will be considered in a DCF for a period longer than the initial lease term and even beyond the terms of any options to renew. In such instances, commercial real estate professionals may be asked to make assumptions regarding real estate cash flows into the distant future.

Since this post deals with lease cash flows, I will address the metrics that will help us evaluate leases independent of any operational cash flows, debt, and tax consequences. Fortunately, there are several ways to assess lease cash flows for commercial real estate professionals to consider. I have outlined several metrics commonly used to assess leases with some of their positive and negative attributes, followed by a short summary of when and how to use them.

Initial Month or Year of Base Rent: Base rent can be net of operating expenses or gross, which includes of all or parts of estimated operating expenses. Since gross base rents often include different levels of operating expenses and may not include charges such as common area maintenance (CAM), for comparative purposes it is important to make sure the operating expense categories included in gross rents are the same among the different options. In addition, since operating expenses can account for a significant portion of the gross base rent, it is important to include them in any comparison analysis to understand the total real estate costs.

Start Rate (or coupon rate): The start rate or coupon rate is the initial month or year of base rent divided by the rentable unit of size of the premises being leased. As mentioned above, the start rate is a more accurate metric when it is derived from a gross rent versus a rent net of operating expenses.

This metric is very common and simple to obtain. When most lease terms are the same, it can be an effective barometer of cost per unit of size per unit of time. However, the start rate does not provide any information about the other elements to the lease structure, such as rent abatement, rent escalations, and tenant improvement allowances. As such, when there is variability in lease terms between options, the start rate is likely not a good metric to use.

Total Consideration: The total consideration of a lease is the sum of all the base rent to be paid under the term of a lease. Sometimes, total consideration can be reduced by any cash inducements such as a tenant improvement allowance or moving allowance. As with the initial month or year of base rent, total consideration is a more accurate estimate of costs when shown as a gross amount. However, unless the base rent is already on a gross basis with fixed increases, additional assumptions may need to be made about the rate of growth, if any, in operating expenses over the term. When comparing total consideration for different space options on a gross basis, it is important that the operating expense assumptions remain the same across all options.

Straight-line Rent: The straight-line rent is the total rent paid during the term of the lease divided by the number of months in the term. Straight-line rents are commonly used for accounting purposes. Straight-line rents typically account for rent abatement and rent escalations, but not cash inducements.

Effective Rate (or average rate): The effective or average rate is the total consideration divided by the rentable unit of size, divided by the number of years or months in the lease term. This metric can be shown as net or gross of operating expenses and, unlike the Start Rate, will account for rent abatement, rent escalations, and sometimes cash inducements (e.g. tenant improvement) if included in the total consideration calculations.

Discounted Cash Flow (DCF): The positive and negative cash flows during a specific period of time, discounted to their present value based on a selected discount rate. DCF periods are not necessarily tied to lease term length and may also incorporate operational cash flows, debt, and before/after tax analysis in addition to real estate cash flows. DCFs are typically viewed as a better financial measurement than total consideration since it incorporates the time-value of money. However, since they are based on assumptions of future performance and appropriate discount rates, DCFs are subject to being inaccurate, especially as the DCF period grows and the risk involved is unclear.

Net Present Value (NPV): Net present value is the sum of the present value of all cash flows during the cash flow period, net of any initial cash outlays or receipts. A positive net present value indicates whether future cash flows are profitable after considering an initial investment while the negative shows the opposite. In evaluating a prospective lease’s cash flows, NPV will generally be negative for a tenant and positive for a landlord due to the payment (negative) or receipt (positive) cash flows for each. Any cash inducements from a landlord, such as a tenant improvement allowance, will typically be shown at Period 0, and will be positive or negative amounts depending on whether viewed from the tenant’s or landlord’s perspective.

As a stand-alone metric, NPV’s utility is in comparison with alternative lease cash flows. A smaller negative NPV is desirable from a tenant’s perspective while a larger positive NPV is desirable from a landlord’s perspective.

As with DCFs, NPVs are often viewed as financially more accurate than total consideration because NPV accounts for the time-value of money. The discounting of future cash flows is especially useful when considering leases of different length. Normally longer leases would typically be at a disadvantage when using total consideration or effective rates because the rent many years from now has the same value as the rent today, even in a lease with no increases. NPV accounts for the fact that a $1.00 today is worth more than a $1.00 five years from now, and therefore presents a more accurate financial picture of leases with different terms.

However, NPV’s are subject to the same downsides as DCFs. Selecting the appropriate discount rate is not always clear and may be disputed among different parties. Many companies or customers may suggest an appropriate discount rate to use when calculating NPV. Often this is their weighted average cost of capital or WACC. However, others might suggest tying the discount to a perceived risk during the lease-which may change over time. You can start with a discount rate of 6%, which is equal to the firm’s WACC, but maybe later on in the term you want to use a higher discount rate to account for more uncertainty with the property’s utility or some other factor. Since the discount rate is often determined by the company or customer and has a significant impact on the NPV, it is worth making sure interested parties are aware of what discount rate(s) were used so all can agree it is the appropriate discount rate to use.

Net Present Value Rate (NPV Rate): The net present value rate is the net present value of lease cash flows divided by the number of years or months in the initial lease term. The NPV rate has the upsides and downsides of net present value. However, the NPV rate addresses a challenge of using net present value to compare leases for different sized buildings and proposed lease terms. The NPV will tell you which option has a larger discounted cash flow but it doesn’t tell you what the discounted cash flow is per unit of space per unit of time, which would average out the differences in size and lease term. The NPV rate provides the net present value as a per unit of space and time (typically per square foot/meter per month or year). Therefore, the NPV rate is very useful in comparing multiple prospective locations and leases proposals.

When to Use Certain Lease Metrics

Selecting when and how to use certain metrics to measure financial aspects of a lease is extremely important. Using the right metrics with the right audience can lead to a better terms in a negotiation, a useful variable to “goal-seek” using different lease structures, and ultimately the success of a leasing project. Obviously, the converse is true as well.

What constitutes the right metric with the right audience? It depends on the objective and ability for the parties to consent to certain assumptions. For instance, if my objective is to compare several different lease scenarios with varying terms with my internal finance team, NPV and NPV rate would be much better metrics than start rate or even effective rate. NPV and NPV rate would be more accurate financial measures of such leases and my audience would presumably be very familiar with their use.

Conversely, if my objective is to negotiate a fair market rent for a renewal option with a landlord, it probably makes sense to only focus on the start rate. The other lease terms are likely dictated in the lease and the landlord will certainly be aware of what a start rate is and not question its use in the negotiations.

Sometimes we want to use a metric to function as a financial target for adjusting terms of a lease, what you might call to “goal-seek”. Goal-seeking is useful when you have a proposed lease structure that has an acceptable metric, but not necessarily an acceptable structure. For example, a proposed lease could include no tenant improvement allowance from the landlord but has an effective rental rate which is acceptable to all parties. If the tenant wants a tenant improvement allowance, their corporate real estate professionals or consultants may adjust the cash flows to add in the desired tenant improvement, and then adjust the other lease terms until the effective rental rate equals the effective rental rate prior to the tenant improvement allowance. An argument can be made to the landlord that based on the effective rental rate, the revised lease structure should be acceptable.

The following chart plots the metrics discussed based on their complexity on the y-axis and whether their use is more likely to be exclusively internal. A metric becomes more complex when it involves a calculation, assumptions, or both. For example, NPV, NPV Rate, and DCFs involve calculations and discount rate assumptions where effective rate involves calculations. A metric is more likely to be of internal use only when it is challenging to use in discussions with an outside party, such as in a lease negotiation. Challenging could mean there needs to be agreement on assumptions, such as the appropriate discount rate with NPV, NPV Rate, and DCF, or the metric is not typically used to only analyze lease cash flows, such as a DCF.

Depending on the requirements of the lease analysis and audience, this chart can help determine an appropriate metric to use in a given situation.

One final word on measuring lease value; if you are evaluating a lease for your business or customer internally I would strongly suggest you use the appropriate sign in your cash flows. For example, rent paid to a landlord should be a negative cash flow from a tenant’s perspective while a tenant improvement allowance would be positive, and vise-a-versa from the landlord’s perspective.

Using the correct sign in lease cash flows makes it easier to avoid making mistakes when evaluating leases and combining with operational cash flows. Showing a positive cash flow from both rent paid to a landlord and a tenant improvement allowance will result in an incorrect net present value. Furthermore, a prospective lease with a positive net present value from the tenant’s perspective may lead to wildly unrealistic results when combined with the tenant’s operating cash flows.

Avoiding Negative Outcomes: Risks to Consider in Industrial Real Estate Transactions

In my last post I made the case that the most important objective of any industrial real estate transaction is to avoid negative outcomes. Since risk is the probability of a negative result, evaluating and reducing risk is the way to reach the most important objectives in industrial real estate transactions. In general, a mindset which prioritizes risk avoidance is one that maintains company purpose, relationships, and leads to the best results overall.

But such a mindset is not simplistic in the sense there is more to evaluating risk than not doing or doing something. Risk avoidance in industrial real estate transactions often involves weighing a multitude of risks at the same time to understand the best course of action. Some risks, like environmental liability, can be existential risks for some companies while other risks, like opportunity risks, can be almost neutral in nature. Therefore, if you wanted to avoid a negative outcome, assuming the preceding sentence was true, you wouldn’t assume higher environmental risk just to lower your opportunity risk.

In order to properly weigh risk in an industrial real estate transaction, it is helpful to think about specific risks as relating to common elements of industrial real estate. Such common elements may include:

  • Property condition
  • Workplace environment
  • Location
  • Legal nature of agreements
  • Government or utility impacts
  • Opportunity risks

Although every transaction is unique, the type of risks are relatively constant from transaction to transaction. It is the amount of risk within those categories that must be assessed, weighted, and reduced if possible.

In this post I will cover risks and risk reduction relating to the condition of a property and the workforce environment. Subsequent posts will cover the other categories mentioned above.

Property Condition

Risks related to property condition include functional obsolescence, deferred maintenance, environmental, soils, and location-specific property condition concerns such as seismic retrofitting. Unlike some of the other categories of risk, property condition risks can usually be quantified using proper due diligence prior to entering into an agreement.

For example, functional obsolescence is usually identified when evaluating potential sites and is more likely in situations where there is a long-term hold for existing buildings being considered. Reducing the risk of functional obsolescence may include eliminating properties with older construction from consideration or adhering to a certain standard for amenities.

Many industrial properties without significant functional obsolescence may still have substantial deferred maintenance. Force majeure aside, the most consequential events during an industrial firms lease or ownership of a property are from deferred maintenance. They typically impact the utility of the property and, if the industrial firm is responsible, the overall operating costs of the operation. Consider what an electrical panel malfunction does to a manufacturing operation or what a roof replacement means if the tenant is responsible for the replacement cost. The early use of landlord questionnaires, property condition reports, and negotiating business and lease terms accordingly are a great way to reduce deferred maintenance risk.

As with deferred maintenance, reducing environmental risk should be prioritized in any real estate transaction. Due to the extremely costly nature of environmental liability, industrial firms who are exposed to environmental risk can experience a resource-draining remediation process and sometimes are forced to enter bankruptcy.

Environmental risks can also be reduced through the use of due diligence practices prior to entering an agreement with a landlord or seller. At a minimum, both prospective buyers and tenants should hire an environmental expert who will study the property’s potential for environmental liability and provide a baseline for future reference before purchasing or leasing a property.

Soil conditions are not always of concern in industrial real estate transactions. Typically, soils or geotechnical studies are recommended when there is a known concern, such as liquefaction in the area, or new development is anticipated.

Similarly, location-specific property risks are not always pertinent depending on where the property in question is located. In California, for example, seismic retrofitting may be required for certain industrial buildings to prevent their collapse during an earthquake. The best way for industrial firms to mitigate location-specific property risks is to investigate local and regional requirements which may impact the specific properties they are considering purchasing or leasing.

Workplace Environment

Risks associated with workplace environments would have been mostly addressed in property condition-related discussions in the past. Industrial firms would have sufficiently reduced the known risks to their workforce by making sure the property was in physically safe, there were no toxic or irritating substances present, and oversight agency guidelines were being followed for additional safety features.

With the advent of COVID-19, limiting the risk of illness to employees clearly requires more than just these measures. Although improvements and practices to mitigate sickness in the workforce are evolving, some of the best practices released by health and commercial real estate professionals include:

  • A workplace that can be easily and routinely cleaned
  • Isolation areas or rooms for workers who become sick on the job
  • Designing worker areas to provide isolation and physical distancing
  • Increasing ventilation and installing negative atmosphere areas where needed
  • Separate entrances and exits

This is a rapidly changing area of risk for industrial companies. Firms should continually be consulting experts in workplace safety and following their recommendations to mitigate the risk of infection to their workforce.

Avoiding Negative Outcomes: How to Focus on What is Important in Industrial Real Estate Transactions

If you were to choose the most important objective of any industrial real estate transaction, what would it be? Spectacular savings compared to market? Getting acceptance on all the important legal terms? Above market tenant improvement allowance? Operations is happy with the property condition? On-time occupancy?

While all those results would be fantastic and are certainly worthy objectives, they are not the most important objective of any industrial real estate transaction. The most important objective is to avoid negative outcomes. Why?

Because deep down in our collective psyche, avoiding negative outcomes is what people, and thus organizations, care about the most. We care about winning, but not as much as avoiding losing. In real estate terms, we care about positive results such as beating the market on pricing, but not in exchange for terms which increase risk.

This is the essence of our negativity bias and its impact on industrial real estate transactions. A negativity bias or negativity effect is when, all else being equal, things of a negative nature have a stronger impact on us than things of a neutral or positive nature. In fact, experts say that it can take five positive events to outweigh a negative one. In industrial real estate transactions, this ratio is probably understating the impact of certain negative events on what the firm would consider a successful project.

Since industrial real estate’s value to the industrial firm is largely its utility, the greatest risks lie in the inability to secure and utilize such assets while it is owned or leased. Therefore, we should focus our efforts to reduce the possibility of negative outcomes within the transaction process, both for the risk to utility but also because the industrial firm will most likely judge project success on the lack of negative results.

In other words, we should employ risk mitigation strategies to the extent they are reasonable and possible. Risk mitigation strategies are processes whereby risks are identified, prioritized, and reduced. In industrial real estate transactions, such processes should be defined and a part of the real estate organizations best practices or playbook.

C&W Updates on Industrial CRE and COVID-19

Since there is so much uncertainty out there, I thought I would share a few interesting sources of information from C&W:

https://www.cushmanwakefield.com/en/insights/covid-19/egrocery-and-grocery-industry-changes

https://www.cushmanwakefield.com/en/insights/covid-19/social-distancing-in-distribution-centers

Evaluating the Value of Tenant Credit to a Landlord based on the Market

The value of a tenant’s credit to a landlord is largely dependent on the global, national, and local marketplaces. In stronger markets, the value of a credit tenant will diminish relative to weaker markets. This is easy to see if you consider what constitutes risk in ownership of income properties. Vacancy, lease-up costs, eviction costs are all well known risks protected against by creditworthiness.

Vacancy and lease-up costs are less likely in strong markets, and therefore any hedge to protect against them will be devalued. In weak markets with higher vacancy and lease-up costs, the opposite will take place.

However, the qualitative approach above does not provide a framework to determine monetary value, only that values changed depending on the marketplace. The determination of monetary value requires quantifying the worth of credit based on its affect to the pricing terms of a transaction.

In my experience, there is limited literature online which reviews how to quantify the worth of credit in commercial real estate transactions. I am unaware of any standard process by which all tenants and landlords approach this issue internally. Whatever process is used, it must be recognizable and relatively easy to understand for all parties involved. Otherwise, it will be difficult to gain the consensus necessary to negotiate any value of creditworthiness effectively.

Tenant Credit Value via the Direct Comparison Approach

One approach to quantifying the value of tenant credit is the direct comparison approach. Tenant A leases a 100,000 square foot single tenant industrial building for $10.00 per square foot. Tenant B leases a comparable building in the same market for $11.00 per square foot. Adjusting for differences such as length of term, tenant improvements, and amenities it is determined Tenant A’s creditworthiness is worth $0.50 per square foot per year.

Despite appearing to be a simple approach to value, it is exceedingly difficult to establish that tenant credit value is the adjusted difference between two comparable lease transactions. First, there is determining how much adjustment is required for factors such as length of term, rent abatement, tenant improvements, and amenity differences.

Furthermore, there are other considerations outside of the transaction and physical differences. What about the skill of the negotiators involved, the appetite for coupon rates versus effective rates in one or both parties, the requirements of the landlord’s credit committee, etc.? The direct comparison approach, if used to determine the value of tenant creditworthiness, would likely result in more complexity in establishing a value and more challenges in finding consensus among interested parties.

Tenant Credit Value via Vacancy and Credit Loss

Therefore, a better approach to quantifying the value of tenant credit in a given market is to use standard underwriting methods which are familiar to landlords. In particular, the vacancy and credit loss percentage, used to adjust gross scheduled income for the overall risk of vacancy and credit loss in the market, can be adjusted according to the perceived risk profile of the tenant’s credit.

Any adjustment in the vacancy and credit loss percentage will impact the landlord’s anticipated net operating income, creating an opportunity to calculate comparative net operating incomes depending on tenant and market creditworthiness. As the following example will outline, it is not difficult to proforma rents based upon comparative tenant credit if there is an understanding of market rents and vacancy factors.

Assumptions

-Two tenants interested in leasing a 100,000 rentable square foot single tenant industrial property (“Premises”)

-Tenant 1 has 0% chance of default (i.e. the U.S. Government)

-Tenant 2 has average credit for the market with a 5% vacancy rate

-Market rents for the property are $10.00 per square foot annually

-Operating expenses are $2.00 per square foot annually

Tenant 1 anticipated net operating income for year 1 can be calculated as follows:

Scheduled Gross Income: $1,200,000
-Vacancy Factor:$0 (0% chance of vacancy)
+Other Income: $0
=Effective Gross Income: $1,200,000
-Operating Expenses: $200,000
=Net Operating Income: $1,000,000

Tenant 2 anticipated net operating income for year 1 can be calculated as follows:

Scheduled Gross Income: $1,200,000
-Vacancy Factor: $60,000 (5% chance of vacancy)
+Other Income: $0
=Effective Gross Income: $1,140,000
-Operating Expenses: $200,000
=Net Operating Income: $940,000

Based on our example above, Tenant 1 could argue that it should pay $60,000 less per year than the average credit tenant or $0.60 per rentable square foot per year based on 100,000 rentable square feet. In this example, Tenant 1’s credit value is $60,000 per year compared to the market.

However, in a strong landlord market with very limited market vacancy, such as 100,000 square foot industrial buildings in Southern California, the vacancy rate for comparable properties will be lower than 5% and likely closer to 0%. This lower market vacancy will reduce the comparative advantage of Tenant 1’s creditworthiness, thus reducing its credit value to the landlord.

Lastly, tenant credit is not usually equivalent to the U.S. Government and may not be average for a given marketplace either. Therefore, it is likely when two parties try to quantify the value of tenant credit, there will be a range of value due to variances in the vacancy factor used in the calculation of the net operating income.

Tenant Credit Value via Increase in Property Value

Another strategy for determining the value of a tenant’s creditworthiness to a landlord is through an increase in property value. Although considerably less precise than the adjustment of vacancy and credit loss, comparative sales of similar properties leased by credit tenants versus those leased by non-credit tenants can provide indications of how much value creditworthiness can add to a property.

For example, if comparable investment sales in a certain market indicate that investors will pay 50 basis points more for a property leased to a credit tenant than they will for a comparable property leased to a non-credit tenant, then the value of the tenant’s credit on the purchase price can be calculated using several assumptions as follows:

Two comparable 100,000 RSF buildings
Leased for similar terms at market rate of $5.00 / SF NNN

Credit Tenant
NOI = $500,000
Market cap = 5%
Income approach to value = $10,000,000

Non-Credit Tenant
NOI = $500,000
Market cap = 5.5%
Income approach to value = $9,090,909

Additional Property Value created by Credit Tenant
$10,000,000 - $9,090,909 = $909,091

Calculate Appropriate Reduction in Credit Tenant NOI
Market cap = 5%
Income approach to value from Non-Credit Tenant = $9,090,909
Adjusted NOI = $454,545


Based on the example above, a credit tenant’s value to a Landlord could equate to a $45,455 in rental value per year.

The above approaches are just three examples of ways to determine the value of a tenant’s credit based on the market. In the next few weeks I will review other considerations in determining tenant credit value such as property type, debt, and ownership profile.

Evaluating the Value of Tenant Credit to a Landlord

In our current battle against COVID-19, uncertainty is heightened and market participants are scrambling to understand what might happen today, tomorrow, and further into the future. Uncertainty and its measure, risk, are paradoxically very easy to see yet challenging to quantify, especially in the high uncertainty period we find ourselves in today. Similarly, the value of tenant creditworthiness to a landlord is apparent and yet difficult to assess, particularly right now.

Therefore, it seems like the perfect time and the worst time to discuss how we can evaluate the value of tenant credit to a landlord. The essence of creditworthiness is establishing a level of trust in another based on past actions. When there is uncertainty in a market, credit would increase in importance. However, when there is too much negative noise in the economy, the value of credit can be significantly diminished by current events because it becomes nearly impossible to quantify. Consider that Bear Sterns posted record earnings in 2006.

Evaluating the value of tenant credit to a landlord is always a relative equation involving many different variables. In other words, “it depends”. In the next few weeks I will provide a framework for thinking about how to evaluate the value of tenant credit from a landlord’s perspective. This framework is invaluable to tenants wishing to negotiate terms effectively with a landlord. By projecting the value a landlord places on credit, tenants can translate that value into leverage for better lease terms and competitive advantage over other prospective tenants.

Force Majeure

After researching an article on tenant creditworthiness, I decided to switch gears over the weekend and focus on the COVID-19 implications for CRE, specifically the Force Majeure provision of most leases. Fortunately before getting too far, an attorney named Howard F. Klien beat me to it. I am linking to Howard’s great article on Force Majeure here: https://creradio.com/can-a-tenant-stop-paying-rent-because-of-the-coronavirus/

COVID-19 and CRE

Corporate real estate often plays an important role in ensuring the safety and security of corporate employees, not just the real estate itself. Efforts such as increased cleaning of work spaces, remote worker infrastructure, security/screening of office employees and visitors, and other seemingly non-real estate related functions often are lead by corporate real estate professionals. As the COVID-19 virus spreads in the U.S. and world, I thought I would take a moment to recognize and thank the corporate real estate professionals who are leading the way in efforts to minimize the virus’ impact to their companies and everyone else.