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.

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

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

Why Lease Term is Important

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

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

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

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

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

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

How Lease Term Affects Metrics

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

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

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

  • Straight-line rent
  • Effective rate

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

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

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

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

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

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

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

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

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

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

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

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

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

Example 2-Analyzing Different Properties with Similar Lease Terms

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

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

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

Graphic 2

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

Graphic 3

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

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

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

Graphic 4 above shows the effective rates for:

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

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

Graphic 5

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

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

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

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

Why Some Commercial Real Estate Lease Structures are Better than Others

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

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

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

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

Measuring

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

When to Use Certain Lease Metrics

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

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

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

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

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

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

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

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