Overview of Commercial Real Estate
A successful real estate professional is knowledgeable about the product,
or property types, and user needs. The knowledge of product and user needs in
specific markets is critical to serving clients’ needs.
Property Types
Real estate investments can
be categorized according to the use to which the property is put. The four
primary types are: office, industrial, retail and multifamily.
Different types of
properties require different types of analysis and information before making an
investment decision. Expenses and taxes also vary by property type.
Understanding the characteristics of each commercial real estate type is
essential.
Office Properties
Office properties are
occupied by professional or business offices. The term “office” can refer to
whole buildings, floors, parts of floors, or office parks. Office space that can be used for a variety
of purposes is something referred to as “generic” office space. On the other
side of the spectrum, an office building can be built specifically to meet a
user’s functional and technical needs. The Building Owners and Managers
Association (BOMA, http://www.boma.org) distinguishes the
following three types of offices by the number of floors:
Low-rise: Fewer then seven
stories above ground level
Mid-rise: Between seven and
25 stories above ground level
High-rise: More then 25
stories above ground level
Local markets may use a
different number of stories and/or additional physical chrematistics to
distinguish among various types of offices.
The location of the property
affects market value and rent. Properties that are downtown of in the central
business district (CBD) are valued differently then suburban properties.
Office properties may be
classified as class A, B, or C. Class A properties are the most functionally
modern. Properties classes B and C in the same market typically command lower
rents because they are older and have experienced some degree of obsolescence.
They may not be as efficient or desirable as class A Properties because their
design or condition causes functional or layout problems.
Measuring Office Space: Useable
Square Footage
In multi-user office
buildings, certain areas within the building or floor are shared with other
tenants. Also, some areas are reserved for the buildings common mechanical
equipment and services. Construction features necessary to support the building
may occupy space as well.
Office building measurement
techniques take all of the se into account. When comparing spaces in comparable
buildings, the tenant is most interested in useable square footage (USF), or
the area where furnishings can be put for use.
When comparing spaces,
tenants will want to compare USP between sites and calculate a dollar per
square foot (psf) amount for that space. This way the tenants can see what is
actually being paid for what can be used. Most tenants prefer the most
efficient space possible.
Office space measurement
standards differ from market to market. The real estate professional should be
proficient in the measurement technique used in the local market and be able to
compare it to the measure technique used in other markets. BOMA provides
information on this subject, which is also supported by the American National
Standards Institute.
Industrial Properties
Industrial properties house
production, manufacturing, high-tech, distribution, or warehousing operations.
These properties also may include some office space or storage space. Like
office buildings, some industrial buildings are located in parks and can be
classified as single-tenant or multi-tenant buildings. By broad physical and
functional characteristics, industrial space falls into the following
categories.
Bulk.
These properties represent the simplest of all industrial space because they
may consist of little more then four walls, a roof and a floor. Bulk properties
can be very large, averaging 50,000 square feet (sf). Sometimes bulk properties
are measured in cubic feet because height can be critical to some industrial
tenants.
Typically, bulk properties
have little office space. They may have elaborated flooring and paving around
the building. Aprons leading up to the warehouse are made of concert to
withstand the weight of rail and truck traffic. Loading docks may be at truck
level (dock high) or have load levelers to adjust to truck bed heights.
Office/Warehouse. This category of industrial space may develop 5 percent to 25 percent
of its space to office requirements and typically is constructed of metal,
brick, block, or wood. This category typically features dock-high loading and
is located near or within city limits, with good highway access.
Office/Service. These properties tend to be more
expensive buildings located in attractive, park like settings with landscaping,
and are usually at the highest end of market rents. Office/service properties
are similar to research and development facilities comprised of more than 25
percent offices and typically are located along major arteries.
Freestanding. This category often is developed in an industrial park setting or done
as a build to suite on a selected piece of property to reduce the sf cost of
the building. Freestanding properties usually are designed for manufacturing,
distribution, assembly, packaging and similar uses. These properties vary in
their construction type, design, ceiling height, utility services, and amount
of land, and are usually built and occupied by an owner/user and therefore are
designed for a special purpose.
Multi-tenant. This is for the smallest user of industrial space (1,000 to 5,000 sf),
often situated in a complex of similar building, where necessary support
services are located in or near the complex. Multi-tenant properties might
contain incubator space for the start-up tenants renting on a short-term basis,
often for high tech, warehousing, or distribution Purposes. Buildings for such
tenants usually require 18-foot of higher ceilings, efficient truck-loading
arrangements, and space for offices.
Large manufacturing. These facilities are used for
manufacturing, production, assembly, shipping and receiving, or major
productions processes. Size is based on the user’s requirements. These
properties often are radically modified to suit a particular product or
process, and therefore are prone to functional obsolescence.
Research and Development. This category is a hybrid of office and
Manufacturing. The research and development category is the most
people-intensive of industrial properties. Tenants of these properties usually
require many improvements, such as “clean rooms” for chip manufacturing,
laboratories, cafeterias, lounges and other amenities. Research and development
propertied have rental and sale values second only to “pure” office space among
commercial properties. They often are located near universities and a
while-collar labor base.
Industrial Park. This is a planned development often controlled and administered by one
person or and investment entity such as a real estate investment trust (REIT).
The types and character of uses are controlled and protect and preserve
compatibility. Industrial parks can serve mixed-use, single-use; special
specific and technological uses, or sophisticated communication uses.
Information about industrial
and office properties can be found through the National Association of
Industrial and Office Properties (NAIOP, http://www.naiop.org)
Retail Properties
Retail Properties are used
exclusively to make and sell goods and services to a vast variety of consumers.
The configuration of these properties is designed to meet a particular
consumer’s buying preferences. Retail properties fall into general categories
such as regional malls, neighborhood shopping centers, commercial strip
properties, and single-building properties.
Shopping Center
A shopping center is a group
of commercial establishments designed, built, and managed as a unit to serve
the immediate trade area. It provides on-site parking in proportion to its
size, type, and number of stores in the center.
The international Council of
Shopping Centers (ICSC, http://www.icsc.org)
provides the following shopping center descriptions.
Neighborhood center. This center is designed to provide convenience shopping
for the day-to-day needs of consumers in the immediate neighborhood. According to the ICSC’s publication, Shopping Center Operations, Revenues, and
Expenses (SCORE), a supermarket anchors half of these centers, while about
a third have a drugstore anchors. A neighborhood center usually id configured
as an “L” or a straight-line strip with no enclosure walkway or mall area,
although a canopy may cover and connect the storefronts.
Community center. A community center typically offers a wider range of apparel and other
soft goods then the neighborhood center. Among the more-common anchors are
supermarkets, super drugstores, and discount department stores. Community
center tenants such as apparel, home improvement goods, furniture, toy,
electronics, or sporting goods.
Regional center. This center provides general merchandise, a large percentage of which
is apparel, and services in full depth and variety. Its main attractions are
its anchors: traditional, mass-market, discount department stores, or fashion
specialty stores. A typical regional center usually is enclosed with an inward
orientation of the stores connected by a common walkway with parking at the
perimeter.
Super-regional center. Similar to
regional center, but because of its large size, a super-regional center has
more anchors, a deeper selection of merchandise, and draws from a larger
population base. As with regional center, the typical configuration is as an
enclosed mall, frequently with multiple levels.
Power center.
This type of center is dominated by large retailers, including discount
department stores, off-price stores, and warehouse clubs, or “category
killers”. Category killers are stores that offer tremendous selections in a
particular merchandise category are low prices such as shoes, pet supplies, or
sporting goods.
Fashion/specialty center. This type of center is composed mainly of upscale
apparel shops, boutiques, and craft carrying selected fashion or unique
merchandise of high quality and price. These centers need not be anchored,
although sometimes restaurants of entertainment can provide an alternative to
high-profile anchors. The physical design of the center is sophisticated,
emphasizing a rich décor and high-quality landscaping. These centers usually
are found in trade areas with high income levels.
Theme/festival center. These centers typically employ a unifying theme that
is carried out by the individual shops in their architectural design and, to an
extent, in their merchandise. The biggest appeal of these centers is to
tourists; restaurants and entertainment facilities can anchor them. These
centers, generally located in urban areas, tend to be adapted from older,
sometimes historic, buildings and be part of mixed-use projects.
Outlet center. Usually located in rural or
occasionally in tourist locations, outlet centers consist mostly of
manufactures’ outlet stores selling their brands at a discount. These centers
are typically not anchored.
Freestanding store. This is a commercial establishment providing goods and services in
single or multiple-use buildings of various sizes. The larger, newer
freestanding stores also are referred to as “big boxes”
Freestanding retail
development often is created on an infill basis to fill specific market gaps or
local needs and may be found near major shopping centers and along major
corridors.
Commercial strip properties. These are strips of commercially zoned parcels
developed for retail use. They usually have a fairly narrow trade area and
offer a variety of services,
Multifamily Properties
While smaller apartment
properties are not considered a major commercial use, apartments should be
considered a product specialty because housing is a main element of the real
estate business. Many investors and real estate professionals use apartment
buildings as a point of entry to a career in commercial real estate.
Duplexes and fourplexes are
two-to four-unit buildings that may be owner occupied. They are usually an
individual’s first investment outside of a single-family residence.
Individual investors or
partnerships often own apartment buildings with four to 60 units. Apartment
propertied with more than 60 units normally are owned by experienced investors.
Larger apartment properties are referred to as multifamily properties in commercial
real estate/
Rental income form
apartments is quoted on a monthly basis.
Sources for information
about multifamily investments include the National Apartment Association (NAA, http://www.naahq.org/) and the National Multi
Housing Council (NMHC, http://www.nmhc.org/)
Other Properties
Not all properties are
categorized above. Other properties include:
Overview of users and investor
activities
The remaining portion of this module focuses on the task o services that
can provide for a user client or investor, including the different ways that
involvement in commercial real estate can be profitable.
Users. One of the first
steps to understanding the user side of the business is to learn as much as
possible about a specific product and the type of clients who use it. This is a
never-ending process, as technology, construction techniques, and client
applications always are changing.
Market Areas
The first step in positioning a property in its market
is to gain a through knowledge of the subject property’s strengths and
weaknesses. Knowledge of the immediate area around the property and the
secondary and tertiary markets the property draws from also is needed. The
subject property should be ranked in comparison to the most similar sites
closest to the subject property.
Defining the boundaries of
the market is on of the early steps in a market survey. This usually is done by
defining three rings around the property. The immediate area around the
property is the first ring special concentration is spent on comparable
properties closes to the subject property.
The second ring includes
properties that are similar to and nearby the subject property, but are not in
the immediate area. The third ring includes all other similar propertied that
might affect the subject property. Other boundaries may be defined by changes in
the landmarks—a river, a forest preserve, or a highway, for example. Boundaries
also can be defined by a change in land use--- from a residential neighborhood
to an industrial area, for example.
Market Surveys for Commercial
Properties
Office buildings are classed
as A, B, or C space. The market survey should first define which class the
subject office building is in, then identify the properties that most clearly
resemble it. For example, for a class A office space in a central business
district (CBD), the primary market may be one or two miles in any direction.
Location is also important—an office in the CBD would not be compared to a
secondary or suburban market/
Market areas for industrial
properties are determined in much the same way as office properties.
The primary market for a
retail site is its trade area—the nearby community that make up its primary
customer base. Major malls may have a county or several counties as their trade
area, whereas small retail spaces would have a tighter definition of the trade
area.
For retail properties, the
primary trade area is the area from which 70 percent to 75 percent of business
is generated. It is usually within a three-mile radius of the store. The
secondary zone represents another 20 present to 25 percent of the business
generated. It is usually within a three to five mile radius of the store. The
third zone represents the remainder of the business.
Calculating the Vacancy Rate for a submarket or the
General Market
The two ways to derive a
vacancy rate for a market area are to use total inventory or average rates for
individual buildings.
The first method (using
total inventory) is more accurate since it is a “weighted” average, while the
second method (averaging individual vacancy rates) is a “simple” average of the
vacancy rate for all buildings; it disregards that buildings can vary greatly
in size. However, it is a more subjective process to average the vacancy rates
of individual buildings because of the analyst’s selection of individual
buildings.
Vacant space
Total Space
= Vacancy rate
Example
Using information on a city
where total inventory is 1,500,000 sf and vacant (available) space is
187,442
1,500,000
= 0.125., or 12.5%
Absorption
Absorption is the amount of
inventory (housing units and square footage) that becomes occupied during a
specific time period, usually a year. Absorption Typically is reported in
square feet, that is, the number of new of existing square feet that become
occupied during a certain time period. Therefore, absorption reflects the
change in the vacancy rate over a certain time period.
Absorption can be determined
for a market of for a specific building. The same formula is used for both
types of analysis.
Calculating Absorption
To calculate absorption, the
following data is needed:
·
Total sf
occupied at the beginning of the year (BOY)
·
Total sf
occupied at the end of the year (EOY)
Using this information, the
formula for absorption is
EOY
occupied sf
- BOY occupied sf
Absorption sf
Example
Consider
the same retail submarket that has 1,312,588 sf (1,500,000-187,442) of occupied
retail space at the beginning of the year. If there were 1,420,000 sf occupied
at the end of the year, what would the absorption be for this market?
1,420,000 EOY occupies sf
- 1,312,558 BOY occupied sf
107,442 Absorption sf
Square footage figures
should include new space, as well as space either demolished or no longer
available for commercial use.
PROJECTING VACANCY AND ABSORPTION
Real estate investors who are the best as projecting vacancy and
absorption rates tend to be the most financially successful because they can
forecast the net result of future supply and demand conditions. Accurate
vacancy and absorption forecasts can provide significant insight into market
cycles and the future direction of market rents and prices.
Using Supply and Demand Forecasts
Projections based on
historical data may be relatively easy to calculate but as be inaccurate—a
projection of vacancy rates based on historical data is analogous to projecting
stock market level based on historical data.
An alternative method is to
use a more fundamental approach and forecast supply and demand separately for
some point in the future, then calculate a vacancy rate/ This method uses the
following steps:
Vacancy rates at a given point in time are the
result of the interaction between absorption and new construction. As a general
rule, if more is absorbed then built, vacancy rates decline, and vice versa.
Pros and Cons of using supple and demand forecasts
Pros
Cons
Whichever method is used to
calculate vacancy or absorption, it is the information these calculations
provide that gives the analyst insight into market changes. Vacancy rates
change over time and often in a cyclical manner. These cycles are the indicator
of price dynamics in the real estate market.
Example
Consider the case of a small
city with a total population of 123,289 people and a total employment of
35,805. Furthermore, assume that 22 percent of the total workforce, or 7,750
employees, are classified as industrial. Suppose that the local economy
forecast suggested that employment will increase to 35,805 next year.
Industrial workers currently are using 2,325,048 sf of industrial space.
Step1.
Find the total amount of industrial space that will be supported with the
inclusion of the new jobs.
Total employment is expected
to climb to 35,805. As 22 percent of those jobs will be industrial, total
industrial employment is 0.22 X 35,805, or approximately 7,877 employees – up
from the original estimate of 7,750.
Initially, the 7,750
industrial employees supported 2,325,048 sf of industrial floor space. This
suggests that each industrial employee supports 300 sf of industrial space.
Assuming that this figure remains constant over that forecast period, 7,877
industrial employees will require 2,363,100 sf of industrial floor space.
Step 2.
Calculate the predicted vacancy rate for one year from now, knowing that
2,570,000 sf of industrial space currently is available in the market, with an
additional 100,000 sf of industrial space under construction and expected to be
completed within the next year.
Given the information above
and the expectation demand for industrial space, the predicted vacancy rate one
year from now is
(2,670,000 – 2,363,100)__
2,670,000 = 0.1149, or 11.59%
INTRODUCTION TO LEASES
Virtually every aspect of a lease is negotiable and is a potential
concession. Whether representing the owner or the tenant, you will need to
understand the negotiating point of view of all parties and the significance of
each clause and/or concession.
A user’s (tenant’s) main
objective might include:
·
Obtaining a
reasonable, fairly calculated rent
·
Receiving
maximum services for goods
·
Predictable and
fair operating costs
·
Expandability of
space for future needs
·
Fitness or
adaptability for tenant’s use
·
Lease clauses
that provide maximum flexibility concerning renewals or ability to assign or
sublease
An owner’s (landlord’s/developer’s/manager’s)
main objective might include:
·
Attracting and
keeping high quality tenants
·
Ability to
finance construction (if necessary)
·
Protection of
property improvements
·
Shifting or
balancing risks
·
Ability to
regain possession
The common objectives of all
involved parties typically include:
·
An accurate
completion of the transaction
·
A binding,
clearly-worded lease document
·
Financial heath
of all parties
REQUIREMENTS OF A VALID COMMERCIAL LEASE
The requirements of valid leases are similar to the requirements for
valid contracts. Despite the wide variation in the length and complexity of
commercial leases, valid and enforceable leases usually contain the following
elements.
Names of owners and tenants. All parties to the lease should sign the document.
Description of property. Acceptable descriptions include street address and
recorded plats in urban areas, and the government rectangular survey system and
metes and bounds in a rural area. The lease also should include a brief
description of the improvements.
Consideration. This requirement usually is met by the tenant’s promise to pay a rent
and the owner’s inability to occupy the property during the lease term.
Legality of objective. The objective of the lease must not violate any
federal, state, or local law.
Offer and acceptance. These are statements to the effect that the owners
agree to lease the property for a specific period of time and that the tenants
agree to pay a certain amount of rent periodically to occupy the property.
Written form. In most states, leases for longer than one year must bi in writing
TYPES OF LEASES
The expense terminology in leases identifies who is responsible for the
payment of operating expenses. Under a gross lease, the owner pays all the
expenses associated with the operation and maintaining the property. The tenant
pays the owner a gross amount for rent. From this amount, the owner then pays
the operating expenses (property taxes, insurance, maintenance, utilities,
janitorial and security costs).
In a net lease, the tenant
pays all or some of the operating expenses. However, the lease terms should be
examined carefully, as the definition of net leases varies from market to
market.
For a given level of rent,
owners clearly prefer to pass on as much responsibility for operating expenses
to tenants as possible. However, the extent to which owners and tenants share
the payment of operating expenses depends on what currently is standard in the
market in which the property is located, and on the relative bargaining power
of the two parties or what was negotiated.
In an absolute net lease,
the tenant pays all the expenses related to operating and maintaining the
entire leasehold interest.
Sample Problem 3-1: Comparison of Gross to Net Leases
In this sample problem, the
owner is billed for all taxes and operating expenses. However, when taxes
and/or other operating expenses are partially or fully passed through to the
tenant, the amount owed by the tenant is transmitted to the owner, who pays the
bills. These dollars have a neutral effect on the bottom line since the owner
does not keep them, but rather uses these dollars to pay outstanding operating
expenses.
Assume that an office tenant
pays $10,000 per year as base rent. The tenant’s proportionate share of the
real estate taxes is $1,500. The tenant’s proportionate share of other
operating expenses in $4,000. The following table illustrates how these
payments affect the user.
In a gross lease, the owner
pays all taxes and additional expenses. In a fully net lease, the tenant pays
all taxes and operating expenses.
In this example of a net
lease, the tenant is responsible for a proportionate share of taxes and other
operating expenses.
Tenant Payments
|
|
Base Rent |
Tenant-Paid Property Taxes |
Tenant-paid Other
Operating Expenses |
Tenants Total Outlay |
|
Gross Lease |
$10,000 |
0 |
0 |
$10,000 |
|
Net lease |
$10,000 |
$1,500 |
$4,000 |
$15,500 |
Assume the base rent remains
the same, but real estate taxes increase to $1,659 and other operating expenses
increase to $4,200.
Tenant Payments
|
|
Base Rent |
Tenant-Paid Property Taxes |
Tenant-paid Other
Operating Expenses |
Tenants Total Outlay |
|
Gross Lease |
$10,000 |
0 |
0 |
$10,000 |
|
Net lease |
$10,000 |
$1,650 |
$4,20 |
$15,850 |
LEASE CLAUSES THAT AFFECT CASH FLOWS
Many commercial leases contain alternative treatments of operating
expenses. These alternatives may require owners to pay operating expenses up to
a given amount (Expense stops), allow owners to pass some of the cost of
operating the property through top the tenant (expense pass through), or allow
the owner to charge the tenant(s) for some of the increase in the cost of
operating the property.
Expense Stops
With some commercial leases,
the owner may add and expense stop clause. In this situation, the owner pays
operating expenses up to a specified amount, usually states as an amount per
square foot (psf) of rentable space in the building. Psf expenses in excess of
the expense stop are passed through to tenants based on their pro rata share of
the building’s rentable space.
For example, an office lease
may state that a tenant will pay $18 psf per year in rent and that the owner
will pay all operating expenses associated with the property – so long as
expenses not exceed $4 psf of rentable area. If the building has 50,000 square
feet (sf) of rentable area, then this clause obligates the owner to pay the
first $200,000 in annual operating expenses ($4 X 50,000).Any amount over
$200,000 will be paid by the tenant based on the percentage of the building’s
rentable area or the square footage that the tenant occupies. This clause
effectively limits – or stops – the owner’s operating expense exposure at
$200,000.
Expense stops benefit owners
by limiting their exposure to the risk of operating expenses being greater then
expected. These stops also allow owners to forecast costs based on predictable
expenses. Owners give tenants something of value in exchange for the expense
stop clause. This something of value can be lower contract rental rate if
competitive leases in the market do not contain expense stop.
Expense Pass-Trough
Operating expenses
frequently are paid by the owner and then passed-through to the tenants. This
is especially true in the multi-tenant office building and shopping centers. In
retail properties, a tenant’s share of these expenses pass-through is based on
the gross leasable area (GLA) of the tenant’s store as a proportion of the GLA
of the entire shopping center. In office properties, the pass-through s based
on the tenant’s rentable area as a percentage of the building’s total rentable
area.
As with expense stops,
owners give tenants something of value in exchange for the expense
pass-through. This something of value can be lower contract rental rate if
competitive leases in the market do not contain pass-through.
Common Area Maintenance
Common area maintenance
(CAM) charges area a common expense pass-through in shopping center leases and
other multi-tenant situations. These are the costs associated with maintaining
the common area of a property, such as hallways, lobbies, grounds and parking
lots. These costs usually are calculated on the percentage of rentable space
that the tenant is occupying. CAM clauses benefit owners in that when
maintenance costs increase, the increase is passed on to the tenants. Tenants
also benefit, at least in theory, to the extent that monies collected for CAM
are cannot be driven by other property expenses.
Tenant Improvements
Owners often incur
re-tenanting expenses when leases expire and vacant office and retail space
must be made ready for occupancy. As an example, the re-leasing of office space
often requires that substantial changes be made, such as removing or adding
walls, raising ceilings, and altering electrical capacity. In fact, many office
and retail leases provide a tenant with an improvement allowance. This lease
provision obligates the owner to incur a prespecified dollar amount of
expenditures to improve the space to the new tenant’s specifications.
Tenant Improvements and Tax Benefits
Responsibility for payment
of tenant improvements can provide tax benefits. Generally speaking, if the
owner pays for the improvements, these costs are expensed over 39 years. If the
tenant vacates and the improvements are torn out, the owner may write off the
remaining amount at that time.
If the tenant pays for the
improvements, and the changes simply maintain the value of the property, the
tenant may write off the costs in the year the improvements are done. If the
improvements increase the value of the property, the tenant may write off the
cost over 39 years or when the tenant vacates the property.
RENT TERMINOLOGY IN LEASES
A commercial lease may call
for:
·
A fixed amount
of contract rent over the entire lease term, called a fixed lease
·
Rental payments
that change, or set up, by set amounts or percentages at given dates (step
leases)
·
Variable levels
of contract rent based on changes in an index (indexed leases)
·
Variable amounts
of monthly rent based on a percentage of the tenant’s gross sales receipts
(percentage leases)
·
Periodic changes
in contract rent based on lease language
Fixed Rental
Contract rents are fixed for
the duration of the lease.
Step Leases
Contact rents on long-term
leases change by preset amounts or percentages on predetermined dates, such as
each year or every five years. Although the lease payments vary over the term
of the lease, all payments area determined and known at the beginning of the
lease agreement. Thus, unless the tenant defaults, all lease payments are known
with certainty when the lease is signed.
The base contract rate may
increase by a present amount or percentage. Such preset amounts or percentages
are called escalations. Types of costs typically having escalations may relate
to real estate taxes, insurance, utilities, operations, and maintenance.
Real estate professionals
representing the tenant provide information about historical trends so that
increases area predictable and the decisions are informed.
Indexed Leases
Contract rent is tied to
movements in a prespecified index, usually the consumer price index (CPI). For
example, it the current year’s cost of living increases by 3 percent, then the
next years lease payment will increase by 3 percent. Indexation prevents
inflation from eroding the real value of the tenant’s lease payments and passes
inflation risk from the owner to the tenant.
Percentage Rent
Percentage rent, also called
overage rent, is additional rent over a base amount that is paid by retail
tenants to owners on tenant sales over a certain dollar amount, called
breakpoint.
This clause is frequently
found in shopping center leases in which an owner manages and promotes the
entire center. The base rent is lower because the owner expects additional rent
from sales. Percentage rent usually is calculated and paid on an annual basis.
The breakpoint is calculates as:
Breakpoint = Annual
base rent
Percentage rent
Tenants like percentage rent
because it gives the owner/landlord a stake in their success, encouraging the
owner to make a solid decision on tenant mix, the attractiveness of the retail
property, signage, and maintenance that will have a beneficial effect on tenant
sales. Additionally retail tenants like percentage rent because of the cyclical
nature of their sales – retailers make most of their income during holidays or
seasonal peaks.
Sample problem: Calculating Breakpoint
If the annual base rent is
$120,000 and the percentage rate id 4 percent, then the breakpoint is $3,
000,000 (120,000 / 0.04 = $3,000,000). At sales of this amount or below, the
tenant pays only the base rent. At sales above this amount, the tenant must pay
percent of the amount over $3,000,000 as percentage rent.
If the tenant had sales or
3,500,000, the overage rent would be calculated as follows:
Total sales $3,500,000
- Breakpoint -$3,000,000
Excess sales $500,000
x Percentage rate x 0.04
Percentage rent = $20,000
The total annual rent would
be $140,000 ($120,000 base rent + $20,000 percentage rent).
Rent Concessions
Sometimes owners will offer
tenants rental concessions, such as several months of free or reduced rent or
free parking. Rental concessions more frequently are observed in over built markets
because the owners find the leasing of space more difficult or because of
unique circumstances in the tenants short term cash flow. Another explanation
is that free rent may be negotiated to help the tenants pay for tenant
improvements. Such concessions lower the tenant’s effective rent, unless the
base rate is stepped up to adjust for the initial reduced cash flow to the
owner.
OTHER IMPORTANT COMMERCIAL LEASE CLAUSES
Several other options and
clauses are designed to protect the needs and concerns of the owner and tenants
and should be negotiated carefully.
Lease Renewal Options
Many commercial lease grant
a tenant the right, but no obligation, to renew a lease for prespecified period
of time after the initial lease expires. The rate at which the lease can be
renewed is specified in the initial lease contract. A renewal option is
valuable to a tenant because it eliminates the need to find an alternative
location for the business when the current lease expires. However, because the
tenant is not obligated to renew, the tenant is free to seek another location
if the tenant desires.
Expansion and Relocation Options
Most businesses seek growth.
Thus it is important that the lease give the tenant the right to occupy
additional space in the office building or shopping center, after a specified
notice period, at market or defined rental rates. In some cases, the owner will
agree to give a tenant the right of first refusal when space becomes available
in the building or center. In other cases, the owner will agree to relocate the
tenant within the building or shopping center as soon as possible, if
additional contiguous space cannot be provided in a reasonable time frame.
Clearly, these clauses should be negotiated and worded carefully.
Important Lease Considerations for Owners
Owners of commercial
properties seek reliable tenants who pay rent on time, take care of the
property, cooperate in allowing reasonable access for inspections, and use the
property as defined in the lease.
The creditworthiness of commercial
tenants usually depends on their ability to operate a business profitably.
Thus, commercial owners usually analyze the need for a tenant’s business in the
community and the tenant’s abilities to operate the business. Additionally,
owners analyze a tenant’s management structure, financial strength based on
credit reports and financial statements, and competitive market position.
Certain types of businesses
are quite compatible with each other, whereas others detract from each other.
For example, dress shops and shoe stores help attract customers to each other,
but a mortuary could repel customers of retail stores. Reputation and prestige
also affect surrounding businesses and, ultimately, property values. Highly
regarded tenants contribute to the desirability of an office building of a
shopping center.
Many tenants require
specialized space or equipment. For example, physicians and dentists require
small rooms and specialized plumbing. Lessees usually provide any special
equipment, but they expect lessors to install items regarded as part of the
real estate, including plumbing, electrical service, sinks, stoves, and
cabinets. Who provides what should be delineated clearly in the lease.
Important Lease Consideration for Tenants
Commercial tenants have some
concerns similar to those of owners. They want properties that are compatible
with their uses, are well located for their business, are well maintained, and
enable them to operate their businesses profitably. The property’s location and
physical characteristics should meet the tenant’s needs. Many commercial
businesses rely heavily on traffic and access appropriate to their use. A good
location for a show store, for example, might not be for a physician’s office.
The physical characteristics
of the site and building must be considered. Is the size and type of space
appropriate? Is there ample parking? Is the building in good repair and well
maintained?
Negotiating techniques and
skills represent powerful tools in determining commercial lease provisions.
Owners and tenants serve themselves well by mastering the art of negotiation.
Financial Impact of Lease Clause Decisions
After a decision has been
made to lease and the markets have been researched, the client may have several
alternatives to choose from. You may be called on to prepare a report that
financially quantifies a user’s lease costs and economically compares and
contrasts alternative leases. Ad mentioned, the final lease terms will be
dependent on current local market conditions and the negation skills of the
parties involved. This section of the module analyzes the quantitative costs
that the lease imposes on the user. Some commonly used terms are defined below.
These terms and definitions often vary from market to market.
Base (contract) rent: This is a face, specific, defined, contract dollar
amount of periodic rent. The annual base rate is the amount upon which
escalations are calculated.
Total effective rent: This is the base rent adjusted for concessions and
allowances and for costs that are the responsibility of the user (such as
operating expense pass-throughs). Total effective rent is the total of all cash
flows over the term of the lease.
Total effective rate: This is the total effective rent divided by the
square footage.
Average annual effective rent: This is the total effective rent divided by the total
years of the lease term.
Average annual effective rate: This is the average annual effective rent divided by
the square footage.
Analyzing Lease Cost
User Perspective
In most commercial leases,
base rent does not equal effective rent. An in-depth analysis includes all
costs to the user.
The basic formula for
calculating the user’s effective rent is
Base (contract) rent
+ Additional Costs
- Concessions and/or allowances
Effective rent paid by tenant
Sample Problem 3-3: User’s Effective Rent
Assume that a user signed a
lease for a 1,000-sf office with a
yearly base rent of $12,000. The operating expense stop is $2 psf, but
actual expenses came in at $2.25 psf.
It costs $10,000 to improve
the space for the tenant, and the owner agreed to pay for half of the tenant
improvements. It costs the tenant $1,000 to move into the space. The owner did
not agree to pay any moving expenses. The owner agreed to two months of free rent.
No other concessions or allowances were agreed upon.
Base rent (contract rent) $12,000
+ Operating expense pass-throughs,
or CAM charges 250
+ Total tenant improvements 10,000
+ Moving costs 1,000
+ Previous lease costs (buyout) 0
+ Other costs (parking) 0
- Free rent 2,000
- Tenant improvement allowance 5,000
- Moving allowance 0
- Other concessions 0
Effective rent paid by tenant $16,250
Total year-one occupancy costs
for the user will equal $16,250, or $16.25 psf.
Owner’s Perspective
An in-depth analysis from
the owner’s perspective must include all costs.
The basic formula for
calculating the owner’s effective rent is
Base (contract) rent
- Net additional costs
- Concessions and/or allowances
Owner’s effective rent
Sample Problem 3-3, continued: Owner’s Effective Rent
Assume that a user signed a
lease for a 1,000-sf office with a yearly base rent of $12,000. The operating
expense stop is $2 psf, but actual expenses came in at $2.25 psf.
It costs $10,000 to improve
the space for the tenant and the owner agreed to pay for half of the tenant
improvements. It costs the tenant $1,000 to move into the space. The owner did
not agree to pay any moving expenses. The owner agreed to pay for two months of
free rent. No other concessions or allowances were agreed upon.
Base rent (contract rent) $12,000
- Operating expense stop 2,000
- Owner-paid tenant improvements 5,000
- Owner-paid moving costs 0
- Lease buyout costs 0
+ Other income (parking) 0
- Free rent 2,000
- Other concessions 0
Owner’s effective rent $3,000
The year one effective rent
the owner will receive is $3,000, or $3 psf.
ALTERNATIVE LEASING STRATEGIES
Ground Lease
A ground lease is for the
land alone, and is usually a long-term net lease. With the ground lease, land
ownership and improvement are kept separate, with the tenant owning land
improvements. These leases are prevalent in areas with a shortage in highly
desirable land, and are traditional in other areas. At the end of the term of a
ground lease, title to the land, and improvements reverts to the
lessor/property owner.
Sublease
A sublease is a lease in
which the tenant leases all or some portion of the leasehold interest to
another tenant while remaining liable to the owner for the rent.
Risks of Subleasing
The owner or user may be
unwilling to bear the following significant risks in subleases and buyouts.
Assignment
All of the tenant’s
leasehold interest in a property is transferred to another party. Generally,
this releases the original tenant from any responsibility to pay rent to the
owner.
Build to Suit
In a build-to-suit
development, the owner agrees to develop or finish the property or space to the
specifications of the tenant, with the cost usually partly carried by the
tenant in the form of increased rent. A build-to-suit strategy typically seeks
a tenant/user with strong creditworthiness.
Sale-Leaseback
In a sale-leaseback, the
owner purchases land, builds for its own use, sells the entire property to an
investor, and retains a long-term net lease. Companies use this strategy to
convert their equity in real estate to working capital where it hopefully can
generate a higher return from the operations of the business.
Conclusion
There are many different
ways to structure lease transactions in commercial real estate. One of the most
important things to remember is that most lease clauses are associated with a
cost to the tenant or the owner. These leases need to be reviewed carefully so
that profitability is assured.
This section presents the important factors used to
estimate NOI. The general formula for calculating NOI follows:
Potential
Rental Income
- Vacancy and Credit Losses
= Effective Rental Income
+ Other Income
= Gross Operating Income
- Operating Expenses
= Net Operating Income
Income Levels
A commercial real estate
property has four levels of income. They are potential rental income (PRI),
effective rental income, gross operating income (GOI), and NOI.
Potential Rental Income
PRI is the total rental
income a property could produce if it were 100 percent occupied and rented to
in-place tenants at existing lease rates with any unleased space or units
included at market rent. In commercial properties, market rent is expressed as
dollars per square foot (psf), usually per year. Apartment income is expressed
as dollars per month per apartment unit. Income from apartment units often is
broken down by the number of bedrooms per unit.
Potential Rental Income
- Vacancy and Credit Losses
= Effective Rental Income
+