Making Informed Lease Decisions
Financial Analysis is defined as the set of principles, procedures, and tools that help organize and interpret financial data. Making informed real estate decisions requires utilizing economic models designed to improve the quality of the lease or facility decision. More than just a software program, this analysis is the product of formal training in finance combined with years of experience in the commercial real estate marketplace.
Evaluating Leases
The decision to renew a lease or relocate your office facilities requires a thorough financial analysis of the anticipated lease costs of various options within the marketplace. This requires the technical ability to analyze the cost associated with various facility decisions. To assist in the decision-making process it is prudent to compare the “Occupancy Costs” of various alternatives in an “apples to apples” format.
This approach is important because what often appears to be the most economical deal on the surface in reality may not be the best alternative after evaluating all economic components of the proposed transaction. Although the concept of leasing office space is simple, commercial leases have an increasingly complex financial structure. How does a tenant go about determining the true cost of such a lease? A typical office building lease may include the following:
- Base Rental Payments (fixed or escalated)
- Additional rent provisions for increases in operating expenses
- Caps or ceilings on operating expense escalations
- Periods of abated or reduced rent
- Contributions (loans) by the landlord for leasehold improvements, architectural fees, IT cabling, moving expenses, leasing commissions, and existing lease obligations
- Parking charges
- Various options (renewal, expansion, contraction, and cancellation)
- Electrical Capacity (watts per square foot) and H.V.A.C. charges
- Rent and Electricity for Signage
- Common Area Factors (Rentable vs. Usable Square Feet)
- Costs to comply with government regulations
- Fees for Design & Construction Management
- Interest fees for above-standard leasehold improvements
Sample Lease Analysis by Coy Davidson
Comparing Occupancy Costs
Once occupancy costs associated with various lease alternatives are identified and the underlying economics of the proposed lease transaction is understood, the projection of the total occupancy costs over the term of the lease and on an annual basis is calculated. These projected annual cash flows are subjected to discounted cash flow analysis (net present value) at an appropriate discount rate (cost of capital) to account for the time value of money. The results are the Net Present Value or “the price of the deal”. To clarify for comparison purposes, I express the discounted present value of the lease as a level rate per square foot which enables the tenant to measure the financial structure of the lease proposals on an “apples to apples” basis. The impact of income taxes can be accounted for by discounting cash flows at a rate reflective of the tenant’s after-tax cost of debt.
When comparing alternatives, occupancy cost levels both absolute and present value basis are analyzed in terms of rentable and usable square feet to account for differences in common area factors and space efficiency. The result is the “effective occupancy cost per square foot” which provides a meaningful comparison of various lease proposals.
Today, technology provides us with the software to easily implement the financial analysis of lease transactions. Popular programs include Lease Matrix, ProCalc, and CoStar Lease Analysis. I learned how to analyze a deal with an HP-12C calculator, which kind of gives away my age. However, it is important to understand the principles of this analysis and how various cash flows impact the overall cost particularly when it comes to the art of negotiation.
Net Effective Rents
“Where the Rubber Meets the Road”
Effective negotiations for an office lease require a thorough understanding of the underlying economics of the transaction. Great deals are not only found but also negotiated.
There are several factors that can impact the terms an office tenant and his broker can negotiate such as:
- The Tenant’s attractiveness to the Landlord and negotiation leverage
- Size and creditworthiness of the Tenant
- Market conditions and the position of the building within the marketplace
- Timing and positioning of the negotiations
- The overall negotiation skills of the participants involved
Having the financial skills to measure the impact of various economic components on the value of the lease and to quantify the landlord’s effective rental rate is a valuable tool.
By viewing the lease from the landlord’s perspective it is relatively simple to benchmark the landlord’s projected return and measure the impact of various changes in the financial components of the lease on the landlord’s bottom line. In essence, the landlord’s “effective rental rate” is the net profit level from the lease before the building’s debt payments expressed on a square foot basis.
The Anatomy of the Effective Rental Rate
Net effective rent is a term used to describe the rent that a tenant pays after taking into account any concessions or incentives that may have been offered by the landlord.
Concessions are discounts that a landlord may offer to a tenant in order to entice them to lease the space. These concessions can include things like free rent for a certain period of time, tenant improvement allowances, or waived or reduced fees.
Understanding how a landlord will proforma his building is important. They have to project their effective rental rates. This is what is left over to service the debt on the building and provide a return to the building investors. To determine their projected effective rent structure they look at:
- Market Rental Rates for Comparable Buildings: What can they charge?
- Operating Costs: What does it cost to operate the building?
- Transaction Costs: Tenant Improvements, Commissions, Free rent, etc.
In simple terms, it is a calculation of all the projected in-flows and outflows of cash from leasing and operations. They do project vacancy periods for unoccupied space, but they basically are targeting an effective rent structure that forms a basis for leasing decisions.
Comparing effective rental rates among various proposals and other transactions in the building is an excellent indicator of achievable terms. Rarely do two lease transactions even with identical rental rates yield the same return to the landlord.
Effective Rental Rates are where the rubber meets the road and by utilizing this analysis you can more closely pinpoint the Landlord’s bottom line and prevent leaving money on the negotiation table.
Learning to Think and Speak Like a CFO
The newbie that enters the commercial real estate brokerage industry has much to learn and typically the first piece of advice they get from senior brokers is to learn the marketplace. For leasing brokers, both landlord agents and tenant representatives, this means getting very familiar with the space inventory in the market you plan to serve. You are expected to be an expert on the market so that means what space is vacant, what it rents for as well as the physical characteristics and nuances of all the properties in your market area.
Equally as important is the comprehensive understanding of the economic components of a lease transaction and for tenant reps, the technical ability to measure occupancy costs. Every office tenant wants the highest quality office space available that fits within their budget. In other words, they want the best value that fits within their total overhead cost structure.
That’s an Impressive Spreadsheet…What Does it Mean?
Today, computer software makes it relatively easy to crunch the numbers and produce impressive-looking reports. However, I am often surprised at how many agents even with a few years of experience lack the financial expertise to speak the CFO’s language and effectively advise their clients.
I learned the economics of a lease transaction with a financial calculator and a legal pad and I think young brokers should do the same. If you are going to provide a client with that impressive spreadsheet you should be able to explain what the numbers mean and how they impact the transaction.
