Why Split Roll Taxes will Drive More Business Out of California

With everyone in CRE making the push to defeat Prop 15 I thought I would repost this post from February

Chuck Berger

On November 3rd Californians will decide whether to partially remove property tax protections, granted under Proposition 13 in 1978, for most non-residential properties. The initiative they will vote on, the California Tax on Commercial and Industrial Properties for Education and Local Government Funding Initiative (2020), would amend the state constitution to require commercial and industrial properties be taxed at their market value.

Currently all property in California is protected by Proposition 13 (1978), which limits property taxes to 1% of the purchase price plus up to 2% of inflation per year. By removing such protections for commercial properties, some estimate the initiative will generate another $13 billion of property taxes in California. While not arguing the merits of the initiative’s objective, should the initiative pass I do think it will negatively impact California businesses in ways familiar to corporate real estate but perhaps not the general public.

The obvious impact…

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Top 10 Tips for Negotiating Improvements in Industrial Real Estate Leases

Outside of build-to-suit projects, the average dollar per square foot magnitude of improvements negotiated in industrial leases is much less than other commercial real estate product types. One reason is industrial tenants will typically pursue and lease industrial spaces which are already acceptable for their needs, with minimal to no improvement required. In addition, the utility of industrial spaces is largely in its warehouse and manufacturing areas, areas which normally do not require significant improvement following vacancies.

Therefore, tenants can lack experience and market information when improvements are needed. They may not know how to structure negotiations to maximize their benefits and realize when a landlord is being reasonable or unreasonable in their position. To help them, the following is my top 10 tips for industrial tenants who want to negotiate the best tenant improvement structure with a landlord:

10. Understand what is customary in the market in regards to tenant improvements. Is there a standard tenant improvement allowance provided by landlords? If the cost of improvements exceeds the allowance, will landlords typically amortize the excess over the lease term and at what interest rate? Will most landlords manage and complete the improvements themselves? Answering these questions will help set expectations of internal stakeholders and provide guidelines to start negotiations.

9. Visually inspect the premises for areas of deferred maintenance and any missing amenities which would normally be present. I also recommend using a landlord questionnaire but when initially touring property any sign of deferred maintenance should be noted. In addition, recording any amenity deficiencies such as a below average sprinkler system, lack of life safety equipment, or no dock equipment can provide leverage in discussions regarding improvements.

8. Clearly understand and define any required improvements before entering negotiations. A tenant should generally understand what improvements will need to be performed and be able to communicate the list of those improvements to the landlord in the initial proposal or request for proposal. This does not mean there needs to be a tremendous amount of detail for each improvement nor make the assumption that the list won’t change. However, it shows the landlord that you have taken the time to investigate your requirements and they can respond with any concerns early in the negotiation process.

7. Prioritize any desired improvements by their order of importance. Inevitably there will be situations where the tenant will choose certain improvements over others. By prioritizing their list of improvements at the beginning of negotiations, the tenant and their advisers will know which they can potentially sacrifice in order to negotiate the best lease possible.

6. When structuring improvement sections in a proposal or request for proposal, use separate provisions for any work to be performed by the landlord and work to be performed by the tenant. Well-designed improvement provisions often have a significant amount of detail including what improvements are being performed, who performs those improvements, and who pays for improvements. Separating those provisions by performance responsibilities makes it easy to categorize them further and notify the landlord of any improvements the tenant will be making themselves.

5. Watch out for construction management fees and the interest rate used in amortizing any tenant improvements. Landlord’s will often charge a fee to manage the oversight of tenant improvements, which will often be deducted from a tenant improvement allowance as a percentage of the overall hard and soft costs or the allowance itself. However, these fees are often negotiable and can sometimes be eliminated completely. Similarly, if the landlord agrees to amortize the costs of any tenant improvements above an allowance they will almost always apply interest. As with the construction management fee, the interest rate is negotiable and should be reflective of the tenant’s credit and the type of improvements being financed.

4. Consider alternatives to having the landlord manage tenant improvements. Just because the landlord is willing to manage tenant improvements under an allowance or amortized loan does not mean it is the best arrangement for the tenant. Alternatives such as hiring a general contractor, using an in-house facilities team, or financing improvements with lines of credit or existing banking relationships may be advantageous in certain situations.

3. Address restoration requirements in the proposal or request for proposal. Ideally tenants would have no obligation to remove any tenant improvement approved by the landlord. While the removal of tenant-specific improvements are understandably concerning to a landlord, improvements such as additional offices or restrooms could be difficult and costly for a tenant to remove at the end of their occupancy.

2. Know the value of tenant credit and lease term for tenant improvements. Creditworthiness is valuable to a landlord because it reduces risk. In the case of landlord funded tenant improvements, credit becomes a more significant concern because of the typical large capital outlays at the beginning of the lease. Tenants with above average credit should make the case to the landlord that they should receive better tenant improvement terms than average credit tenants have received historically. In addition, willingness to do a longer lease term usually means superior tenant improvement terms, but it is usually a good idea to ask for multiple term lengths for comparison purposes.

  1. Realize that tenant improvements are just one part of the overall real estate cash flow for a tenant and landlord. Rather than forfeit unused tenant improvements, try to negotiate an equitable benefit in free rent or a reduction in the start rate. If no tenant improvements are needed, it may be worthwhile accepting an offered tenant improvement allowance at the beginning of negotiations and then using it to trade for improving other deal points later on. Negotiating a lease mostly boils down to perceived cost over time, so if you can convince the other party of the relative savings of an action, you will most likely get them to agree to it.

Calculating Dock Position Requirements

One of the most important facility requirements for any logistics operation is the amount of dock high positions an industrial building provides. Often overlooked, dock high positions can have a significant impact on whether an operation is able to meet its key performance indicator objectives and contribute to the overall success of a company.

Determining the minimum number of dock positions needed for a facility involves an understanding of the internal and external factors which affect the amount of dock high positions required. The internal factors can include the amount of trucks serviced by the docks over a period of time (average and peak), the time to load and unload each trailer per dock, staging and cross-docking requirements, work hours over a period of time, employee breaks, drop trailer requirements, trash / bailing requirements, shifts, and shipping preferences.

External factors can include time of truck arrivals and departures, the reliability of carriers, whether carriers will back haul drop trailers, types of trailers used by carriers, and truck driver capabilities. A comprehensive understanding of these and any other internal and external factors will result in more precise understandings of an operation’s dock high requirements.

In general, the minimum number of dock high positions are calculated based upon a formula involving their use, the amount of time they can be used, and a safety factor. Below are three examples of manual calculations using some of the internal and external factors above.

  • Number of Truck Positions Needed = ((Number of Trucks per Year x Hours it takes to Load / Unload a Truck) / Work Hours per Year) x Safety Factor [1]
    • Inputs
      • 7,000 trucks per year
      • 2.5 hours for loading / unloading
      • 2080 work hours per year
      • Safety factor of 25%
    • Calculation
      • (7,000 trucks per year x 2.5 hours for loading / unloading) / 2080 work hours per year) = 8.4 x 1.25 safety factor = 10.5 docks or 11 dock high positions needed at a minimum
  • Number of Truck Positions Needed = Number of Trucks per Hour x Turnaround Time per Hour [2]
    • Inputs
      • 20 trucks per day
      • 8 hour work day
      • 150 minute turnaround time
    • Calculation
      • (20 trucks per day / 8 hour work day) = 2.5 trucks per hour x (150 minute turnaround time / 60 minutes per hour = 2.5 turnaround time) = 6.25 dock positions needed or 7 positions needed
      • If all trucks arrive in AM, then work day would be shortened to 4 hours and the dock requirements would be 12.5 or 13 positions needed
  • ((Peak trucks per day) x (Average dock time per truck) x (Safety factor of 1.5 to 2)) / Number of hours in work day [3]
    • Inputs
      • 20 trucks per day
      • 2.5 hours per truck
      • 8 hour work day
    • Calculation
      • ((20 trucks per day) x (2.5 hours per truck) x (1.5 safety factor)) / 8 hour work day = 9.375 docks required or 10 docks needed

These three calculations show that depending on the formula used, roughly the same inputs will yield slightly to drastically different minimum dock requirements. Where formulas 1 and 3 resulted in 11 and 10 positions required, formula 2 resulted in only 7. Not surprisingly, formula 2 did not employ a safety factor. Safety factors are used to account for unforeseen variability such as disruptions in deliveries or labor.

Companies may also employ manual simulations of dock requirements.  These simulations include the detailed logging of docks used by the various types of vehicles that deliver or ship to a facility.  These simulations can show how to improve dock assignments or delivery schedules for better dock utilization and determining of minimum docks required.[4]

The use of technology in determining the minimum number of dock positions required may make the use of the manual calculations above obsolete. Warehouse management systems or WMS may include dock requirements based upon much more detailed inputs and trends.  However, the manual calculations formulas above help to show the importance of understanding the external and internal factors involved with determining the minimum number of dock positions for a given operation.

[1] Mulcahy, David E. Warehouse Distribution and Operations Handbook. New York: McGraw-Hill, 1994. 4.18-.20. Print.
[2] 4Front Engineered Solutions, Inc. “Dock Planning Standards.” (n.d.): 10. Web. 31 July 2016.
[3] Gross & Associates. “Calculating Dock Door Requirements.” (n.d.): n. pag. Web. 31 July 2016.
[4] Mulcahy, David E. Warehouse Distribution and Operations Handbook. New York: McGraw-Hill, 1994. 4.18-.20. Print.

Book Value and Corporate Real Estate

The decision to sell a company property should be in alignment with the company’s financial objectives. In order to achieve such alignment, parties responsible for the oversight of company real estate should investigate the value of the property on their balance sheet, or its book value, and the related impacts its sale will have on company financials.

What is Book Value

Book value, or net book value, is the value a company attributes to assets on their balance sheets. It is calculated over time by taking the fair value of the property less any accumulated depreciation.

It is important to realize that fair value is not the same as fair market value. Fair value is often described by statute or generally accepted accounting principals (GAAP), and is subject to adjustment based on certain criteria. Fair market value is the value acceptable to a competent buyer and seller without any undue pressure to buy or sell.

While the difference between fair value and fair market value is subtle, it can be significant when establishing book value. For example, fair value only considers participants in the most advantageous market, which is between the principles. In other words, it is the value that is fair between the parties. It may or may not have any relation to the fair market value, which would be established in an open market.

Book values for real estate usually change over time, mostly due to accumulated depreciation and other deducted expenses. The net of accumulated depreciation and other deductions from fair value is also called carrying value. Importantly, book value can change due to events such as partnership changes, severe issues with the property’s condition, economic conditions, or unfavorable changes to the political climate where the property is located.

Why does Book Value Matter

A property’s book value is reported as an asset on the company’s balance sheet until it is sold. At the time of sale, the difference between its book value and sale price will largely determine the gain or loss reported on the company’s income statement.

Therefore, book value is a consideration of the sale when the resulting gain or loss reported on company financials is not in alignment with company financial objectives. Losses from property sales are sometimes discouraged or prohibited in some companies, although gains may also be problematic if not anticipated. In such cases, those responsible for the oversight of the company real estate may need to postpone the sale or find alternative transactions such as leasing the property.

Not surprisingly, there are situations where book value is more likely to become a consideration of the sale, including when:

  • Fair value is significantly above fair market value
  • There is a significant percentage of un-depreciable components such as land
  • The company is public or a quasi-private entity that rolls up to a public company
  • The gain or loss of sale will have a significant impact on the company’s financials

Since property transactions should always align with corporate objectives, book value and any impacts to the company’s financial position should be investigated by corporate real estate decision makers when considering a real estate disposition.

Insurance in Industrial Real Estate

The use of insurance in industrial real estate is designed to hedge against a variety of risks related to the ownership, occupancy, and operation of industrial property. Insurers fundamentally protect the insured from financial loss both during and after the period of ownership or tenancy.

Insurance in industrial real estate has evolved from policies to protect factories from fire damage to modern policies dealing with emerging risks facing the industrial property owner and occupant.

In many ways insurance is an unsung hero in industrial real estate. It allows interested parties to insure themselves and other parties. Without it, the financial risks associated with the ownership of and operation within industrial real estate would be discouraging, if not disqualifying, to prospective industrial property owners and occupiers.

Policy Types

Liability and property insurance are the two common insurance policy types associated with industrial real estate today. Under liability and property insurance policy types are several common subtype policies which cover specific liabilities and types of property damage.

In addition, there are many insurance policy subtypes under liability and property insurance which can insure around risks unique to the specific property or operation. There are also insurance policies designed to insure around new risks based on current events, such as pandemic insurance in the wake of COVID-19 or terrorism insurance after 9-11.

Liability Insurance

Liability insurance, sometimes called third-party insurance, is insurance designed to defend the insured against third-party claims. While other types of insurance will pay-out to the insured based on the claims of the insured, liability insurers offer protection against a third-party claim and the cost to defend against said claim. (See below for liability insurance requirements under a lease)

Commercial General Liability (CGL)

As the name implies, commercial general liability insurance covers the insured for liability from bodily injury, personal injury, and property damaged caused by the insured’s business, products, or on their premises. Whether an industrial property is owner-occupied or leased, commercial general liability insurance is standard coverage for industrial businesses.

Worker’s Compensation

Worker’s compensation insurance is a form of liability insurance which protects the wages and medical benefits of employees injured in the course of their employment. Known as a “compensation bargain”, worker’s compensation was created as a trade-off giving worker’s coverage for workplace accidents in exchange for relinquishing their rights to litigate due to their injuries.

Although not required in a few U.S. states, most industrial landlords will require tenants hold worker’s compensation coverage in the lease to mitigate their exposure to workplace accident litigation and to protect their tenant’s ability to pay rent (which would presumably be reduced if a substantial award was given to an injured worker).

Business Auto Liability

Automotive insurance is required of anyone who owns a vehicle in the U.S. but also is commonly required of a tenant in commercial lease agreements. Some lease agreements will require the tenant to add the landlord as an additional insured and obtain minimum coverage limits under their automotive and vehicle insurance policies. Both stipulations are designed to protect the landlord from liability due to vehicle-related accidents on the property.

Environmental

Environmental insurance protects the insured against the financial risks of environmental related liabilities. These policies can be obtained in the normal course of business as a protective measure against environmental risk to the tenant or landlord, and also can be purchased in specific situations to protect against unknown risks following remediation of a recognized environmental condition.

Property Insurance

Any insurance that insures against damage to property can be called property insurance, but in industrial real estate there are typically two separate types of policies. The first covers the real estate. The second covers the personal property of the occupant.

Property Insurance for Real Estate

Commercial property insurance is designed to insure the real estate against catastrophic loss. However, the amount the insurance will cover depends on whether the insurer values the improvements based on replacement value or actual cash value.

If the insurer values real property improvements on replacement value, they will typically pay the amount of cash needed to replace the insured property. Alternatively, if the insurer values real property improvements on an actual cash value, they will subtract depreciation from the replacement cost. Given the potentially significant difference in payouts, policy holders should always confirm which method their insurance provider is using.

Under most policies, property insurance covers every cause of loss except those causes that are specifically excluded. This type of policy is called special perils. Special perils policies for commercial real estate will generally exclude losses due to earthquake, flooding, governmental actions, nuclear attacks, insects, and mold.

For items excluded from a special perils policy, there are usually two options for the policyholder to gain coverage. First, they can add coverage to an existing property insurance policy as an endorsement, or a modification to an existing policy. Second, they can obtain a wholly separate policy to cover the specific risk.

Often policyholders purchase endorsements or separate policies for risks associated with a certain location. One example is earthquake coverage. Another is flood insurance. For both the costs related to the premium and deductible are largely dependent on the location of the property.

Earthquake Policy or Endorsement

In the case of earthquake, premiums are based on a varying amount per $1,000 of property valuation. The varying amount usually ranges from $1 in situations considered low risk up to $15 in high risk situations with deductibles ranging from 10% to 15% of the property valuation.

Unsurprisingly, California and the rest of the Western U.S. is on the higher end of earthquake premiums at roughly 10 times the rest of the U.S.. In these areas the cost of earthquake insurance is not nominal and can be a significant increase in operating costs for the property owner or the tenant if the cost of the policy is passed through.

Flood Policy or Endorsement

Like earthquake insurance, flood insurance cost is largely based on location. Premiums and deductibles for flood insurance policies are determined by the Federal Emergency Management Agency (FEMA) flood zones which range from coastal areas with high risk of flooding to areas with little to no risk of flooding.

Properties with government backed mortgages in areas that are considered to be at a high risk of flooding are required to have flood insurance. Since flood insurance is required in certain instances, the government via FEMA and the National Flood Insurance Program is the largest backer of flood insurance policies in the U.S. and such insurance is seen as an alternative to disaster relief.

Unlike earthquake and flood insurance, commercial property and liability insurance providers must offer terrorism insurance to policy holders according the Terrorism Risk Insurance Act (TRIA). Originally signed in 2002 following the September 11th, TRIA is a Federally supported program which originally started as a short term reinsurance program to help impacted insurers recover from terrorism events, the predecessor to TRIA has been extended through 2027.

Property Insurance for Personal Property

Since property insurance for real estate only insures improvements as defined within the policy, there is a need for insurance of affected property in addition to those covered. Typically such additional insurance is obtained to protect the value of any “personal” property on the real estate, which may include inventory, machinery, equipment, furniture, and other such items. Such policies are often mandated under lease agreements to limit potential litigation and ensure the viability of a tenant should a catastrophic event occur.

Rental Value Insurance

Another common property insurance policy found in industrial lease agreements is rental value insurance. As with personal property, property insurance on real estate may not cover the loss of rental income due to physical loss or damage to the property. Rental value insurance protects the landlord or building owner against such loss of rental income. Many industrial leases allow landlords to pass-through the premiums of rental value insurance policies to tenants as an operating expense.

Insurance Requirements in a Lease

When an owner of an industrial property also owns the business operating in the property, they typically can choose the insurance coverage they need depending on their requirements. Conversely, when an industrial company leases an industrial property, the landlord will often ask for specific insurance requirements, many of which have been discussed in this post previously.

Liability Insurance in a Lease

Generally, commercial general liability insurance is the most common policy type required in any industrial lease. Even though a tenant has leasehold ownership of a premises under a lease, the landlord also has liability risk for any accident that might take place on the premises. The liability risk to both the tenant and landlord is unique and explains why leases generally focus on liability insurance requirements to a greater extent than other policy types.

Requirements for commercial general liability insurance policies in a lease typically include the following stipulations:

  • Policy Type
    • Primary insurance policies are the insurance policies which pay claims first
    • Umbrella insurance policies are the insurance policies which typically pay after the primary insurance policy has reached its coverage limit. They provide extra coverage against liability and the cost of defending against liability lawsuits
  • Coverage Limits
    • Occurrence: The amount of liability insurance coverage per occurrence of liability. This typically is a minimum of $1,000,000 in industrial leases and are often higher.
    • Aggregate: The amount of liability insurance coverage over a period of time, usually over one year. This typically is a minimum of $2,000,000 in industrial leases and again are often higher.
    • Limits and Primary and Umbrella Policies: Leases will often state that liability coverage limits may be met with a combination of primary and umbrella policy limits.
  • Defined Liability Burden
    • The extent of property, under the lease, in which each party is liable. Typically this is defined as the Premises under the lease but it should be clearly understood by the parties where liability ends and begins.
    • The lease should also cover liability coverage for contractors and other related parties which the tenant or landlord may encounter in the course of doing business.
  • Financial Strength and Size Rating
    • Leases will sometimes require liability insurance providers have a certain financial strength rating and/or certain financial size from a stated agency, such as AM Best, S&P, Moody’s or Fitch
  • Who Obtains and Who Pays
    • Always depends on what the lease says!
    • Landlord will most often obtain (if they elect to or are required to):
      • Property insurance on the real estate
      • Rental value insurance
      • Environmental insurance
      • Additional liability policy
    • Tenant will most often obtain (if they elect to or are required to):
      • Property insurance on personal property
      • Worker’s compensation
      • Business auto liability
    • Landlord will sometimes pay for property insurance on the real estate, environmental insurance, and additional liability insurance.
    • Tenant will typically pay for most if not all of the cost of insurance, either directly or as a pass-through operating expense. Such costs are negotiable and should not be automatically borne by the tenant unless consistent with the market and reasonable for the situation.
  • Covering the Landlord on a Tenant Policy
    • Additional Insured: Tenant’s insurance provider will add the landlord entity as an additional insured party via a specific or blanket endorsement. Once added the landlord will also be covered under the tenant’s policy typically only for the property in question under the lease. There is usually minimal cost to add additional insured entities to a policy. Adding the landlord as an additional insured is a standard requirement under most leases.
    • Named Insured: Tenant’s insurance provider will add the landlord as an insured entity or person in the policy declarations. This is different than additional insured, which typically only covers the property in question and may not offer as broad of coverage to employees and other related entities of the named insured. Adding the landlord as a named insured is not typically required under most leases.
    • Interested Party: Tenant’s insurance provider will add the landlord as an interested party which identifies the landlord as having an interest in the policy. Depending on the policy, the landlord may or may not be covered by the policy if listed as an interested party. At a minimum, interested parties would receive notification of any changes to the policy such as cancellation or modification. For example, if the tenant obtains property insurance on the real estate under the lease the landlord would typically require they be listed as an interested party under such policy to insure against any lapse in coverage.
  • Cross Liability: Cross liability is when one or more parties who are insured under the same policy sue each other, the insurer should protect both parties. Since cross liability is not always part of a liability insurance policy, leases will typically mandate that only a liability insurance policy with a cross liability endorsement is acceptable.
  • Notice of Cancellation: Similar to the idea of the landlord being listed as an interested party in the liability insurance policy, leases will typically mandate that the tenant provide notice of cancellation, modification, or expiration of any policy under the lease. Furthermore, leases will sometimes require that a policy is only cancellable or able to be modified with 30 days notice from the insurer, otherwise the tenant would be in default.
  • Waiving Rights of Subrogation: Subrogation allow an insurer to see restitution from a third-party deemed responsible for their incurred claim costs. In other words, it allows an insurer to “fill the shoes” of the insured who filed the claim in order to sue for damages. Leases will commonly have the tenant, landlord, or mutual waivers of subrogation explicitly waiving the rights of the insurers or any party to subrogate. Such waivers can be unilateral, most commonly when the tenant waives their rights under a liability policy, or mutual, when both the tenant and landlord waive their insurers right to subrogate. The reason is simply to avoid costly litigation amongst the parties and to limit payouts to just the insurance claim alone.

Documentation

Evidence of insurance is typically transmitted to the parties in a lease via an insurance binder. An insurance binder will typically show the insurer information, policy duration, insured information, coverages, limits, and endorsements.

Sometimes leases will contain exhibits which show the insurance requirements and ISO or Acord forms required under the lease. This is not a standard practice since most leases will cite and rely on the policy documents and binders in question for specific details.

Additional Resources

Critical Insurance Provisions in Commercial Leases

Best Practices for Insurance in Leases

Review of NAIOP’s Rules of Thumb for Distribution / Warehouse Facility Design (2nd Edition)

When NAIOP recently released their Second Edition of Rules of Thumb for Distribution / Warehouse Facility Design (“Rules of Thumb”), I quickly jumped at the opportunity to pay $150 (or $300 for non-NAIOP members) to get it. Outside of the knowledge gleaned from experience, there are few resources which comprehensively cover the design and construction of industrial real estate and none I am aware of like Rules of Thumb.

The First Edition was released in 2005 and is produced by a partnership between HPA, Inc. architects and NAIOP. One of the founders of HPA, Byron Pinckert, serves as the lead author for the publication. While much of the structure from 2005 remains, HPA and NAIOP decided in 2019 to update the prior edition in light of several critical changes to industrial real estate design and construction in the past 15 years.

My purpose in reviewing this publication is not to specifically discuss any of its many insights on the design and construction of industrial real estate, for which there are many. Instead, I want to share generally what it covers, add some of my thoughts, and ultimately encourage other industrial real estate professionals to purchase a copy for themselves.

The overall structure of the publication is divided into five chapters which review the exterior and interior design of warehouse / distribution centers today, commentary on smaller industrial buildings, and recent changes and trends.

Rules of Thumb does a great job of relating building design to the concerns of the developer and the occupant. For the developer, designing a building only makes sense if it ultimately will be profitable. For the occupant, the property needs to be functional for the business. Finding that balance in a form that adds to the community and location is the key.

Rules of Thumb provides real world standards by which developers and occupants are currently developing and using their buildings today. Among the topics covered include some of the most important features in industrial real estate today:

  • Truck court depth
  • Truck circulation
  • Dock door spacing
  • Dock equipment
  • Storage
  • Clearance height
  • Bay spacing and types
  • Sprinkler systems
  • Slab construction and features
  • Roof and skylights

Although I have been involved in industrial real estate for almost 20 years, I learned at least 50 new things by reading Rules of Thumb (about 1 new nugget per page of content). Granted I work primarily with occupants and are not involved with a tremendous amount of design/build projects, but I really appreciated how a significant portion of the development information related to the practical requirements of the warehouse / distribution companies I represent.

Rules of Thumb is understandably less concerned with office space within the warehouse and other tenant-specific improvements such as power supply and warehouse HVAC. I greedily would have loved to have more information on those topics as I seem them becoming more important to some of my customers, but again I understand not getting to far in the weeds.

Rules of Thumb provided much more of an education than I expected and I would highly recommend it to anyone interested in industrial real estate.

Why Some Commercial Real Estate Lease Structures are Better than Others-The Starting Rental Rate

Starting rental rates are by far the most used indicator of pricing in commercial real estate. They allow interested parties to quickly gauge how expensive a property might be to lease and how the leasing cost of one property compares to the leasing cost of another.

So what is a starting rental rate? Simply, it is the amount of base rent paid during the first time period divided by the rentable square footage of the space being leased. The first time period is usually monthly or annual. The starting rental rate is sometimes referred to as the starting lease rate, contract rate, or just the starting rate.

Starting rental rates are usually described as being net or gross. A net starting rental rate is typically understood to be the base rent net of any real estate operating expenses such as property taxes, property insurance, and maintenance costs. A gross starting rental rate would typically be understood as including the base rent and any real estate operating costs for the first or base year.

Whether described as net or gross, do not assume all real estate operating costs are included or not included. For example, some net leases will be net of property taxes and property insurance costs, but include some maintenance costs in the base rent. Such net leases are called modified net leases.

Some gross leases will include base rent and real estate operating costs except certain costs borne by the landlord. Such gross leases are called modified gross leases. Despite the usefulness of describing starting rental rates as gross or net, given the variability in responsibilities for certain costs there is no substitute for reading the lease in question.

The asking and actual starting rental rate is the most common pricing metric in commercial real estate marketing, research, and transactional record keeping. For example:

  • When an asking rental rate is published by a property owner, they are providing the starting rental rate they hope to achieve
  • When someone asks, “What lease rate did you get?” in reference to a commercial real estate deal, it is understood they are asking, “What is the starting rental rate you achieved?”
  • When commercial real estate market reports track the increase and decrease in real estate leasing costs, they almost always will measure the variance in asking starting rental rates from one time period to another

The reason for the starting rental rate’s frequent usage is it is easy to standardize and quantify. It does not require any assumptions, math, or interpretation. Only descriptions, such as net or gross and annual or monthly, are necessary. Set arbitrarily by market participants, the starting rental rate is one of the foundational financial figures in commercial real estate.

However, for these reasons the starting rental rate should be viewed with caution. It does not measure the other business terms and conditions of the lease in question nor, as we pointed out before, can we assume it accurately describes base rent and real estate operating expenses.

In order to include differences in operating expenses between options, starting rental rates should be shown on an “all-in” gross basis whenever comparative evaluations are made. Real estate operating expenses vary by market and therefore the importance of converting net starting rental rates to gross starting rental rates also varies, but even small differences can be significant over a lease term.

The starting rental rate is one of seven foundational figures that describe the number and timing of real estate cash flows under an industrial lease:

  • Rentable Square Footage
  • Starting Rental Rate
  • Real Estate Operating Expenses
  • Lease Term
  • Rent Adjustments
  • Rent Abatement
  • Capital Contributions*

*Capital contributions would include tenant improvement allowances, tenant improvement expenditures, moving allowances and other cash flows typically noted as occurring at Period 0

The impact of changes in starting rental rates depend on whether the other six foundational figures remain constant or change as well. If all other figures remain constant, the following rules apply:

  • Any percentage change in starting rental rates will also apply to any cash flow metric such as total consideration, straight-line, effective rental rate, net present value (NPV), or the NPV rate
  • Any percentage change in starting rental rates and cash flow metrics will grow smaller as the starting rental rates increase
Assumes 60 month lease term, no rent abatement, 3% rent increases, and no capital contributions
  • Any fixed change in starting rental rates will also result in a fixed change in any cash flow metric
Assumes 100,000 RSF, 60 month lease term, no rent abatement, 3% rent increases and no capital contributions

The above rules useful when trying to quickly calculate the impact of starting rental rate changes on cash flow metrics. If you want to know what an increase to a starting rental rate will do to the total consideration of a lease, you only need to calculate the percentage difference between the original and increased starting rental rate, add 1, and multiply by the total consideration to get your answer.

Furthermore, if you want to know by how much the cash flow metric of a lease increases or decreases if you change the starting rental rate by a $0.01, I only need to calculate the dollar amount of change in the cash flow metric once and that amount applies to any starting rental rate increase or decrease of a $0.01.

These rules are also useful when comparing trade-offs. For example, if you calculate that increasing the starting rental rate by $0.01 results in an increase in total consideration of $70,000, and the starting gross rent is $40,000 per month, it probably does not make sense to trade the $0.01 increase for a month of rent abatement.

In practice, starting rental rates are often raised and lowered by tenants and landlords as trade-offs for increases or decreases in other foundational figures. Tenants will sometimes want to structure a lease where the starting rental rate is lower than the market starting rental rate, in exchange for greater than market rent adjustments over the lease term. Such tenants may be concerned about the amount of start-up costs of their operations but not its future viability to handle larger real estate costs.

If the landlord will consider such an alternative rent structure, the real estate cash flows can be engineered so the Tenant’s desired starting rent will result in an NPV effectively equal to the NPV of a market rental structure.

Proposal 1 has a market rent of $190,000 per annum with no increases. Proposal 2 shows a below mark starting rent in exchange for larger rent increase over the term. Both Proposals have equivalent net present values at 6%.

Some landlords will value the starting rental rate more than other foundational figures and will willingly trade higher starting rental rates for other concessions such as rent abatement. Such landlords are motivated by increasing property values based on annual net operating incomes, so trading concessions early in a lease in exchange for higher annual net operating incomes later is usually desirable.

This is an extreme example since there is $0.05/SF difference between what the Tenant and Landlord are willing to accept for a start rate.

Starting rental rates are important indicators of pricing within commercial real estate. Their impact on real estate cash flows should not be understated, but as with other foundational figures they should be viewed as a part of the cash flows resulting from the lease of commercial real estate.

Industrial Property Maintenance

A practical guide to help industrial tenants think about the best way to maintain leased property

Every company wants to avoid property maintenance issues during their occupancy of a property. While there is a common focus on the immediate economic results of leasing a property, most industrial tenants should pay closer attention to how they have negotiated property maintenance obligations. I would wager very few of them would trade allowing disruptions to their operations or surprise replacement costs in exchange for an extra penny or two per square foot in landlord concessions. Such a wager is based in the realization that the maintenance of a leased property can significantly impact an industrial operation and its financials during a lease term in ways few other lease provisions can. It is a high-risk area.

Improperly maintained properties can lead to interruptions in an industrial operation, causing widespread ramifications through a company’s supply chain. Many industrial operations have been adversely impacted by significant roof leaks, electrical interruptions, flooding, and sprinkler system failures. Operational efficiencies and key performance indicators can be reduced due to broken dock equipment, lighting ballast failure, and yard surfaces in disrepair. Employees can suffer when air conditioning, plumbing, or lighting malfunctions. Even when repairs take place, uninsured costs due to disruption, property damage, and loss of morale can far exceed the costs to repair the damaged property components.

In addition to disruptions, the industrial tenant can be exposed to the unplanned maintenance charge, a potential existential risk to their profit and loss statement for a particular operation. Some industrial property components can cost millions of dollars to repair or replace. If the industrial company is legally responsible for the cost of the repair or replacement of such a component, it will undoubtedly adversely impact its financials. A third party logistics company, for example, can wipe out the profitability of their entire customer contract with a large maintenance repair or replacement bill.

Lastly, industrial companies are not in the business of maintaining industrial property. Most companies want to dedicate all of their available resources towards achieving their business objectives. This can lead to a misalignment between the responsibilities an industrial company accepts under a lease and what they actually should perform in their best interest.

In this post I discuss what industrial property maintenance means to the industrial tenant, how industrial tenants can think about and address how an industrial property is maintained, and finally a summary of maintenance best practices to help reduce the risk of negative outcomes during the lease term.

Defining Property Maintenance

The maintenance of an industrial property under a lease consists of the answers to four questions:

  1. What is the type of maintenance being considered?
  2. Where is the maintenance being considered performed?
  3. Who is performing and paying for the maintenance being considered?
  4. How should they perform the maintenance being considered?

The type of maintenance refers to at least three categories common to the vast majority of industrial leases:

  • general cleaning and upkeep;
  • repairs;
  • and replacements.

General cleaning and upkeep includes keeping an area clean and free of debris, performing general maintenance practices such as lubrication and testing, and preventing undue wear and tear. Repairs include activities to rectify or fix a certain property component so it will continue to be operable. And last, replacements are when the replacement of a property component is deemed necessary under the lease. Industrial property replacements and some repairs would be deemed capital items under GAAP and treated accordingly by the parties.

All three types of maintenance can be performed in different areas and on different components of a property. A free standing, single-tenant building may describe maintenance responsibilities completely within one property or Premises under a lease while the lease of a multi-tenant building would typically describe maintenance responsibilities under the Premises and Common Area. Within the Premises or Common Area may be components, such as the roof, HVAC, and parking lots, that the tenant or landlord would maintain.

Maintenance can be performed by the landlord, tenant, or their vendor(s). Most leases will ascribe responsibilities strictly between a landlord or tenant but there is rarely any restrictions on whether they can hire a qualified contractor to fulfill their obligations. In addition, the same party does not need to perform and pay for the cost of maintenance. For example, the landlord or their vendor can be responsible for the maintenance of the premises and can charge the tenant for the expense. Such is the case with common area maintenance charges, since it is impractical for a tenant in part of a larger building or property to maintain the common areas of said building or property. Therefore, the landlord will maintain those areas and bill back the cost of doing so according to the tenant’s prorated share of the property.

Lastly, leases usually have performance standards for the parties responsible for maintenance. A tenant may be responsible for keeping the premises clean and the roof free of debris at all times. A landlord may be responsible for fixing any roof leaks within a certain period of time. Well-defined lease provisions regarding maintenance obligations can insure against any confusion about who is responsible and the timeframes in which they have to complete their obligations.

How Industrial Tenants Should Think About Industrial Property Maintenance

The primary consideration for the industrial company regarding maintaining a leased property is their use. How the industrial company will operate in a building or on a property should inform how they structure property maintenance responsibilities with the landlord. There are several reasons why use is the key consideration for property maintenance:

  • Use can dictate which party performs repairs or replacement
  • Use can predict the amount of utility for specific property components
  • Use can identify points of emphasis in maintenance obligations

Certain uses, such as those with high levels of security, will dictate that all property maintenance be done solely by the tenant or its approved vendors. These uses are common in property leased under an absolute triple net structure, where the tenant is responsible for all maintenance, repair, and replacements. Other uses lend themselves to sharing maintenance responsibilities with a landlord depending on the property component in question.

Some uses have such a significant amount of utility on certain property components that they only make sense for the tenant to maintain them. Data centers, for example, may be owned by an investment group with maintenance responsibility for everything other than electrical service and the IT infrastructure, which the tenant maintains for obvious reasons. Tenants in truck terminals may assume maintenance responsibility for dock equipment and yard areas since those areas are critical for their operations and are subject to greater wear and tear than other property components.

Similarly, use can help identify areas of importance when considering maintenance obligations. A manufacturing operation will likely want to prioritize the maintenance of utility services, employee services, and climate control where the warehousing operation may care more about dock equipment, truck yards, and warehouse floors.

Expected occupancy is another important industrial property maintenance consideration tied to use. Industrial companies will typically want to structure property maintenance obligations differently under a short-term lease versus a long-term lease. For example, companies will want to limit responsibility and cost for capital repairs or replacements in a short-term lease because they will likely have a very limited time in which to benefit from such costs.

Many industrial companies negotiate maintenance provisions with landlords with a focus only on cost reduction and limiting the amount of their maintenance obligations. The errors in such a strategy is it is usually not informed by the needs of the business, it assumes such costs would not be spread to other areas by the landlord, and it could result in additional unnecessary management costs. Property maintenance is not free.

Instead, the focus should be on reducing overall risk to negative outcomes such as unforeseen cost increases and operational disruptions. One of the best ways to reduce such risks is to employ a due diligence strategy. Regardless of who is responsible for maintaining a property component, industrial tenants should evaluate the condition of major property components including their age, repair history, current condition, and an expert opinion of their useful remaining life.

Landlords should be asked for answers to property condition questions before the tenant commits to any maintenance responsibilities. Any property components that are towards the end of their useful life or are in disrepair prior to the lease being signed should be replaced or repaired at the landlord’s expense according to a mutually acceptable schedule. Landlord’s limited warranties and delivery conditions are not a substitute for such due diligence.

In addition to due diligence, tenants should also look to limit their liabilities for repair or replacement pass-through or direct cost increases under the lease. Concepts such as caps on cost increases, caps on per occurrence or aggregate repair/replacement costs, reserves, and amortization of repair costs can help reduce the risk of significant unforeseen maintenance costs during the lease term. At a minimum, tenants should decline any liability for capital replacement costs which exceed the cost to replace divided by the number of months remaining in their lease term.

Performance requirements are also a significant consideration in negotiating property maintenance obligations under a lease. Regardless of responsibility for maintaining a property component, there should be a reasonable timeframe in which the component should be repaired or replaced by the responsible party. Tenants should pay particular attention to the timeframes in which a landlord is required to repair or replace. In addition, negotiating tenant rights to repair a property component which is the landlord’s responsibility should be incorporated into leases. This will provide the ability to quickly perform a required repair when the allotted timeframe for the landlord to make the repair has expired.

Lastly, industrial tenants typically have limited resources to dedicate towards the management of property maintenance. Unless the company is a large organization with a facilities management department, maintaining leased property can be a distraction away from the company’s true purpose for its employees. Therefore, most industrial tenants should try to limit their responsibilities for maintenance wherever reasonable and outsource remaining tenant responsibilities whenever possible. Unfortunately this may mean paying a little higher management fee to a landlord or entering into several different maintenance contracts, but such things should be weighed against the cost of diverting attention from the company’s primary objectives.

Summary of Maintenance Best Practices for Industrial Tenants

In closing, few provisions in a lease can impact an industrial tenant’s operations more than property maintenance. In this post I have outlined ways industrial companies can approach the maintenance of their leased properties and avoid negative outcomes during their lease terms. In summary, these concepts are:

  • Consider how the company’s use of the property can or will impact how it is maintained
  • Focus on reducing the risk of operational disruption and unplanned cost increases
  • Have a due diligence strategy regardless of who is responsible for maintenance
  • Negotiate terms which limit liability for repairs and replacements
  • Insist on clearly defined performance standards for repairs and replacements, and the ability to repair or replace if agreed upon timelines are not met
  • Consider available resources and try to align operational priorities with maintenance responsibilities

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.