There is an art in negotiating a lease in the best interests of your company or customer. As commercial real estate professionals, in order to create great work, we need to be armed with the right tools to understand the operational and financial aspects of the agreements to which we are binding our company or customer.
You may have heard this line from someone recently: industrial and commercial real estate is becoming a commodity. Corporate real estate, the real estate investment trusts, brokerages, industrial properties, and others are all headed towards service and product standardization. Unfortunately, due to market forces and participants pushing us to accept the “market” way of structuring lease agreements, we may eventually get there.
However, there are several reasons to doubt the commodity-theory in the near future. One reason is companies and customers need customization in their lease agreements, achieved through creativity in negotiations, in order to meet their very real financial and operational requirements. They may have near-term capital requirements, concerns about sublease risk, cash flow requirements, and better use of capital outside of real estate.
This article is the first of a series of posts about using the variability of lease terms in order to meet company or customer requirements. It is also about creating awareness of what happens to cash flows when standard lease elements, such as the length of a lease term, are adjusted in isolation and with other lease elements to reach a desired outcome.
Ultimately, each commercial lease transaction is an opportunity to create a financial obligation for the company or customer, which will be profitable after considering the operational cash flow generated by the occupying business unit, debt, and any tax consequences. Ideally, commercial real estate professionals would include their company or customer’s operational, debt, and tax information into their analysis of the financial impact of a lease. Otherwise, the lease cash flows will be negative and there will be no ability to determine the profitability of the prospective lease commitment.
However, even if operational and tax consequences are not part of the financial analysis of a lease, it is important that commercial real estate professionals ask their companies or customers for any guidance regarding structuring such real estate cash flows. Often finance professionals with the business operation understand the proforma cash flows for a prospective operation and can convey how the operation might benefit from certain lease elements, such as rent abatement or a tenant improvement allowance for certain requirement improvements. By understanding how the certain lease elements might benefit them, we can pursue better lease structures for the customer or company.
Most companies use depreciated cash flows, or cash flows discounted to present value, when evaluating the financial impact of business decisions. Often called DCFs for short, these cash flows are the prospective financial performance of the company for a particular investment or project. DCFs are typically for a set number of years, depending on the project length and operational considerations involved. Some operational cash flows will be considered in a DCF for a period longer than the initial lease term and even beyond the terms of any options to renew. In such instances, commercial real estate professionals may be asked to make assumptions regarding real estate cash flows into the distant future.
Since this post deals with lease cash flows, I will address the metrics that will help us evaluate leases independent of any operational cash flows, debt, and tax consequences. Fortunately, there are several ways to assess lease cash flows for commercial real estate professionals to consider. I have outlined several metrics commonly used to assess leases with some of their positive and negative attributes, followed by a short summary of when and how to use them.
Initial Month or Year of Base Rent: Base rent can be net of operating expenses or gross, which includes of all or parts of estimated operating expenses. Since gross base rents often include different levels of operating expenses and may not include charges such as common area maintenance (CAM), for comparative purposes it is important to make sure the operating expense categories included in gross rents are the same among the different options. In addition, since operating expenses can account for a significant portion of the gross base rent, it is important to include them in any comparison analysis to understand the total real estate costs.
Start Rate (or coupon rate): The start rate or coupon rate is the initial month or year of base rent divided by the rentable unit of size of the premises being leased. As mentioned above, the start rate is a more accurate metric when it is derived from a gross rent versus a rent net of operating expenses.
This metric is very common and simple to obtain. When most lease terms are the same, it can be an effective barometer of cost per unit of size per unit of time. However, the start rate does not provide any information about the other elements to the lease structure, such as rent abatement, rent escalations, and tenant improvement allowances. As such, when there is variability in lease terms between options, the start rate is likely not a good metric to use.
Total Consideration: The total consideration of a lease is the sum of all the base rent to be paid under the term of a lease. Sometimes, total consideration can be reduced by any cash inducements such as a tenant improvement allowance or moving allowance. As with the initial month or year of base rent, total consideration is a more accurate estimate of costs when shown as a gross amount. However, unless the base rent is already on a gross basis with fixed increases, additional assumptions may need to be made about the rate of growth, if any, in operating expenses over the term. When comparing total consideration for different space options on a gross basis, it is important that the operating expense assumptions remain the same across all options.
Straight-line Rent: The straight-line rent is the total rent paid during the term of the lease divided by the number of months in the term. Straight-line rents are commonly used for accounting purposes. Straight-line rents typically account for rent abatement and rent escalations, but not cash inducements.
Effective Rate (or average rate): The effective or average rate is the total consideration divided by the rentable unit of size, divided by the number of years or months in the lease term. This metric can be shown as net or gross of operating expenses and, unlike the Start Rate, will account for rent abatement, rent escalations, and sometimes cash inducements (e.g. tenant improvement) if included in the total consideration calculations.
Discounted Cash Flow (DCF): The positive and negative cash flows during a specific period of time, discounted to their present value based on a selected discount rate. DCF periods are not necessarily tied to lease term length and may also incorporate operational cash flows, debt, and before/after tax analysis in addition to real estate cash flows. DCFs are typically viewed as a better financial measurement than total consideration since it incorporates the time-value of money. However, since they are based on assumptions of future performance and appropriate discount rates, DCFs are subject to being inaccurate, especially as the DCF period grows and the risk involved is unclear.
Net Present Value (NPV): Net present value is the sum of the present value of all cash flows during the cash flow period, net of any initial cash outlays or receipts. A positive net present value indicates whether future cash flows are profitable after considering an initial investment while the negative shows the opposite. In evaluating a prospective lease’s cash flows, NPV will generally be negative for a tenant and positive for a landlord due to the payment (negative) or receipt (positive) cash flows for each. Any cash inducements from a landlord, such as a tenant improvement allowance, will typically be shown at Period 0, and will be positive or negative amounts depending on whether viewed from the tenant’s or landlord’s perspective.
As a stand-alone metric, NPV’s utility is in comparison with alternative lease cash flows. A smaller negative NPV is desirable from a tenant’s perspective while a larger positive NPV is desirable from a landlord’s perspective.
As with DCFs, NPVs are often viewed as financially more accurate than total consideration because NPV accounts for the time-value of money. The discounting of future cash flows is especially useful when considering leases of different length. Normally longer leases would typically be at a disadvantage when using total consideration or effective rates because the rent many years from now has the same value as the rent today, even in a lease with no increases. NPV accounts for the fact that a $1.00 today is worth more than a $1.00 five years from now, and therefore presents a more accurate financial picture of leases with different terms.
However, NPV’s are subject to the same downsides as DCFs. Selecting the appropriate discount rate is not always clear and may be disputed among different parties. Many companies or customers may suggest an appropriate discount rate to use when calculating NPV. Often this is their weighted average cost of capital or WACC. However, others might suggest tying the discount to a perceived risk during the lease-which may change over time. You can start with a discount rate of 6%, which is equal to the firm’s WACC, but maybe later on in the term you want to use a higher discount rate to account for more uncertainty with the property’s utility or some other factor. Since the discount rate is often determined by the company or customer and has a significant impact on the NPV, it is worth making sure interested parties are aware of what discount rate(s) were used so all can agree it is the appropriate discount rate to use.
Net Present Value Rate (NPV Rate): The net present value rate is the net present value of lease cash flows divided by the number of years or months in the initial lease term. The NPV rate has the upsides and downsides of net present value. However, the NPV rate addresses a challenge of using net present value to compare leases for different sized buildings and proposed lease terms. The NPV will tell you which option has a larger discounted cash flow but it doesn’t tell you what the discounted cash flow is per unit of space per unit of time, which would average out the differences in size and lease term. The NPV rate provides the net present value as a per unit of space and time (typically per square foot/meter per month or year). Therefore, the NPV rate is very useful in comparing multiple prospective locations and leases proposals.
When to Use Certain Lease Metrics
Selecting when and how to use certain metrics to measure financial aspects of a lease is extremely important. Using the right metrics with the right audience can lead to a better terms in a negotiation, a useful variable to “goal-seek” using different lease structures, and ultimately the success of a leasing project. Obviously, the converse is true as well.
What constitutes the right metric with the right audience? It depends on the objective and ability for the parties to consent to certain assumptions. For instance, if my objective is to compare several different lease scenarios with varying terms with my internal finance team, NPV and NPV rate would be much better metrics than start rate or even effective rate. NPV and NPV rate would be more accurate financial measures of such leases and my audience would presumably be very familiar with their use.
Conversely, if my objective is to negotiate a fair market rent for a renewal option with a landlord, it probably makes sense to only focus on the start rate. The other lease terms are likely dictated in the lease and the landlord will certainly be aware of what a start rate is and not question its use in the negotiations.
Sometimes we want to use a metric to function as a financial target for adjusting terms of a lease, what you might call to “goal-seek”. Goal-seeking is useful when you have a proposed lease structure that has an acceptable metric, but not necessarily an acceptable structure. For example, a proposed lease could include no tenant improvement allowance from the landlord but has an effective rental rate which is acceptable to all parties. If the tenant wants a tenant improvement allowance, their corporate real estate professionals or consultants may adjust the cash flows to add in the desired tenant improvement, and then adjust the other lease terms until the effective rental rate equals the effective rental rate prior to the tenant improvement allowance. An argument can be made to the landlord that based on the effective rental rate, the revised lease structure should be acceptable.
The following chart plots the metrics discussed based on their complexity on the y-axis and whether their use is more likely to be exclusively internal. A metric becomes more complex when it involves a calculation, assumptions, or both. For example, NPV, NPV Rate, and DCFs involve calculations and discount rate assumptions where effective rate involves calculations. A metric is more likely to be of internal use only when it is challenging to use in discussions with an outside party, such as in a lease negotiation. Challenging could mean there needs to be agreement on assumptions, such as the appropriate discount rate with NPV, NPV Rate, and DCF, or the metric is not typically used to only analyze lease cash flows, such as a DCF.
Depending on the requirements of the lease analysis and audience, this chart can help determine an appropriate metric to use in a given situation.
One final word on measuring lease value; if you are evaluating a lease for your business or customer internally I would strongly suggest you use the appropriate sign in your cash flows. For example, rent paid to a landlord should be a negative cash flow from a tenant’s perspective while a tenant improvement allowance would be positive, and vise-a-versa from the landlord’s perspective.
Using the correct sign in lease cash flows makes it easier to avoid making mistakes when evaluating leases and combining with operational cash flows. Showing a positive cash flow from both rent paid to a landlord and a tenant improvement allowance will result in an incorrect net present value. Furthermore, a prospective lease with a positive net present value from the tenant’s perspective may lead to wildly unrealistic results when combined with the tenant’s operating cash flows.