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.

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.

Maintenance Responsibilities for Industrial Occupiers

One of the main areas I recommend industrial occupiers pay close attention to in lease negotiations are the responsibilities of who maintains, repairs, and replaces building systems and components under a lease.

Leases follow the 80/20 rule. 80% of lease content most likely won’t impact operations or P&L. 20% of lease content will. Maintenance, repair, and replacement provisions are always in the 20%. Therefore, it is smart for companies to conduct due diligence and structure maintenance, repair, and replacement provisions in a way most suitable for operations.

As a starting point, I suggest companies assess what the impact will be if operations dedicates the time and resources to maintaining, repairing, and replacing building systems during the lease. Would the company be better off if the landlord was responsible and passed through the costs? Are there reasons the company would prefer responsibility, such as site security or, for larger firms, potential cost savings. Whatever the answer, it will help to inform any initial discussions with prospective landlords.

Next, companies should conduct due diligence on what the age, condition, and useful life are of the components of the space being potentially leased. It should be standard practice to find out the age, condition, and useful life of the major building systems (structural, roof, HVAC, electrical, parking areas, etc.) before agreeing to maintain anything in the letter of intent or proposal. A property condition assessment report can be helpful in this area.

Lastly, companies should protect themselves against unfair replacement practices. Exposure to capital replacement costs should typically be limited to the amount of time remaining on the lease term and amortized according to GAAP or other reasonable useful-life schedules. Normal wear and tear should be expected in exchange for the rent.

Nothing is free. The landlord and/or the tenant will bear the costs of maintaining, repairing, and replacing within a property. Therefore, I would suggest the focus for industrial tenants should be:

  • What general maintenance, repair, and replacement arrangement is best for the operation
  • What property systems or components should not be the tenant’s responsibility
  • Preventing operational disruption by addressing the near-term replacement of building systems or components prior to signing a lease
  • Outside of requirements caused by tenant improvements, are there requirements such as ADA which are not being met in the space currently
  • Making sure there is limited exposure to unamortized capital replacements
  • If a property management fee is charged, it is commensurate with the market rate and justified by the responsibilities of the property manager

Environmental Surveys as a Pre-Marketing Requirement #CRE #Industrial #phase1

As an industrial real estate broker for over 12 years, I have learned a few key tasks every seller of industrial real estate should undertake prior to marketing their property.  Near the top of the list is having a qualified environmental consultant complete an environmental site assessment, commonly referred to as a Phase I.  The reasons are numerous but the biggies are:

  • Reveals seller’s potential environmental exposure, if any, prior to identifying a buyer.  A seller can deal with any potential environmental concerns prior to entering into an escrow, avoiding potentially costly delays and escrow terminations.
  • Gives the seller control of the environmental review process from the beginning of marketing its property.  In most transactions, the first recent environmental review of a property being sold will be when the buyer’s consultant conducts an environmental site assessment while in escrow.  In this scenario, the buyer, not the seller, has control of the process and the seller will be in a reactionary position to whatever concerns or recommendations are made by the buyer’s consultant.
  • Makes the property more marketable and can lead to a higher sale prices in a shorter amount of time.  Perhaps nothing turns away potential buyer faster than an environmental concern.  A recent environmental site assessment showing no recommendations for further inquiry can put buyers at ease that they most likely will not encounter an environmental issue in their own investigations, saving them time and money.  In some instances, an all-cash buyer may accept the seller’s environmental site assessment and therefore save the cost of conducting one themselves.

This list can also apply to a landlord as well.  In fact, many Fortune 500 companies now require a recent environmental site assessment be performed prior to executing a lease.

Seller’s may take issue with the cost of conducting an environmental site assessment or its necessity since the buyer or its bank will often conduct one anyway.  However, in my opinion this viewpoint often does not consider the points above.  Unless the seller has conducted a recent environmental site assessment, it should always consider the performance of an environmental site assessment of their property before marketing to be a worthwhile investment and in the seller’s interest.

On Leases

A client, who is a large private landlord, and I were discussing one of his tenants recently who was singing the blues about their lease and how they did not think it was fair that the landlord was enforcing certain provisions of the lease because “they had not read it”.  You would think that this is rare.  After all, it is hard to imagine something more dangerous for a business than not examining the contracts to which they are a party.  In my experience, however, this is not a unprecedented occurrence.  Business leaders whose firms lease space (tenants) seemingly have less and less time to understand a lease’s impact on their business.  Even if tenant’s hire a real estate representative and attorney to negotiate the lease, they still can be surprised by a problem during the lease term.  Yet, tenants can mitigate their risk for surprises by following a few best practices which are essential for avoiding most problems down the road.

First, tenants should fully understand their intended use in the building, both at the time their lease is negotiated and during the lease term, and make sure their present and future use is allowable under the lease and any other entitlement (i.e. zoning, code, CC&Rs, etc.).  In addition, tenants should confirm that the amenities within the premises are sufficient for its operations.  There are horror stories of industrial tenants signing long-term leases only to find out the sprinkler system required for their product is insufficient and will substantial capital to upgrade.  Problems such as these can cause significant and, sometimes, terminal disruptions to an operation.  The key is for tenants to properly convey their present and intended use to their real estate representative and attorney, and be certain their use is amenable in all respects.

Second, tenants should understand their obligations under a lease.  Leases are typically unique, and just because a lease is referred to as a net, triple net, gross, full service gross, percentage or other lease type does not mean that the actual tenant obligations in the lease will be consistent with the aforementioned descriptions.  Of particular concern are maintenance provisions, i.e. who takes care of what and when, and when rent is due and considered late.  Tenants should review all of their obligations under a lease with their real estate representative and attorney prior to signing the lease.

Third, tenants should review their leases periodically over the lease term.  Things change and even the most thorough lease at signing can be in need of amendment after a few years to reflect changes in a tenant’s business or other external factors.  Also, tenants should consider a lease audit or review of its financial obligations under its lease(s) to determine if it has overpaid for any charges levied by the landlord.

Finally, tenants should hire a qualified real estate representative and attorney to negotiate business and legal terms with the landlord and serve as a resource throughout the term of the lease.  Both can serve as insurance against entering into a lease that will prove problematic in the future.  In addition, tenants should look for a real estate representative and attorney who will be a resource in the future and, if possible, help focus the tenant’s attention on future lease obligations when necessary.