After Tax Cash Flows From Operations Are Calculated As Introduction to Commercial Leases – Part 2

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Introduction to Commercial Leases – Part 2

In our last article we discussed: objectives of a lease, common types of leases, what makes a lease effective, cash flow, stop costs, maintenance of common areas as well as tax benefits of improvements.

As we move forward in this article, we will discuss additional lease types and identify additional lease clauses, strategies, and common terms used in commercial leases.

Ground Lease

A ground lease is a lease for land alone and is usually a long-term net lease. A ground lease is where the land is owned by the landlord and the improvements are owned by the tenant.

These leases can usually be found in areas with a shortage of highly desirable land and may be traditional in other areas. At the end of the lease term of a ground lease, title to the land and improvements reverts to the lessee/property owner.

Step lease

Step leases allow the agreed rent on long-term leases to vary by a predetermined amount or percentage on predetermined dates. These preset amounts or percentages are called escalations.

While lease payments vary over time and over the term of the lease, the actual payments are calculated and disclosed before signing the lease agreement.

The most common types of incremental costs may be related to real estate taxes, insurance, utilities, operations, and maintenance.

A real estate professional representing a tenant can provide historical trend information regarding this type of growth so growth can be predicted and informed decisions can be made before signing a lease.

indexed stripes

Indexed leases are those where the contracted rent is linked to movements in a pre-specified financial index; such as the Consumer Price Index (CPI). Here’s an example: If the current year’s consumer price index increases by 3 percent, the following years’ lease payments will increase by 3 percent.

Additional lease clauses

Many other options and clauses are designed to protect the needs and concerns of landlords and tenants and should be carefully and diligently negotiated.

Lease renewal option

A commercial lease usually gives the lessee the ability to renew the lease for a pre-specified period of time after the initial lease expires. However, the rate at which the lease can be renewed is specified in the initial lease agreement. A renewal option is often valuable because it eliminates the need for the tenant to provide a new location for the business before the current lease expires. Although the lessee is not obligated to renew the lease, hence the term ‘option’, the lessee is not obligated to remain under the lease and may decide to find another location for the business if the business requires it or if the lessee wishes. .

Expansion and relocation options

As businesses grow, commercial leases must provide the tenant with the right to occupy additional space within the commercial structure.

The rental rate and specified duration of this space must be negotiated prior to signing the initial lease. Often, the landlord agrees to give the tenant the right of first refusal as space becomes available in the building. If it is not possible for the tenant to provide additional adjoining space within a reasonable period of time, the landlord may agree to relocate the tenant to the building or shopping center within a specified period. These additional lease clauses should be negotiated and carefully worded.

Financial Effect of Lease Clauses

After deciding to lease a commercial space, a commercial real estate expert can be enlisted to prepare a financial report quantifying the potential tenant’s leasing costs and comparing and contrasting alternative leases.

As mentioned earlier, the final terms of the lease will depend on current local market conditions and negotiation Skills of all parties involved.

Before analyzing the economic consequences that a lease imposes on a tenant we need to upgrade our vocabulary to include commonly used terms. These terms and definitions may vary from market to market.

Basic (Contract) Rent: A specified, pre-defined contract dollar amount for periodic rent (monthly payments). The increase is based on this amount.

Total effective rent: This is the base rent after adjusting to include discounts, allowances and tenant responsibilities (such as operating expense pass-through).

Total Effective Rate: It is simply 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: It is the average annual effective rent divided by the square footage.

Cost analysis

Now that we have defined some common terms, we are able to understand the financial impact and how to analyze the real cost of a lease:

From the tenant’s perspective

In many commercial leases, the base rent does not necessarily equal the effective rent. A thorough analysis of this will include all expenses such as tenant concessions, allowances and other additional expenses.

Here is a basic formula for calculating a tenant’s effective rent:

Basic (Contract) Rent + (Additional Expenses – Concessions and/or Allowances) = Total Effective Rent Payable by the Tenant.

From the owner’s perspective

The same analysis is covered from the owner’s perspective and will also include all the owner’s costs:

Here is a basic formula for calculating effective rent from the owner’s perspective:

Base (Contract) Rent – (Net Additional Expenses – Concessions and/or Allowances) = Owner’s Total Effective Rent as Income.

Alternative policies

We’ve seen how negotiating a commercial lease can not only affect a potential tenant’s and owner’s cash flow, but also how complicated the process can be. When a potential site is properly located and analyzed, the site may or may not meet the financial requirements of the potential tenant.

With that in mind, let’s look at some alternative strategies for commercial leasing:

sub letter

A sublease is a separate lease in which the lessee may assign all or part of the leasehold interest to another lessee while the lessee retains responsibility for the property and grants the owner a primary lease.

However, subleasing carries risks that owners may not be willing to accept. These risks include:

  • Re-lease risk: Don’t know how long it will take to find a sublease.
  • Rental rate risk: Sub-letting may be required for sub-contracting rent.
  • Tenant quality risk: It may not be possible to find high quality tenants.
  • Lease-term risk: A sub-lessee wants a shorter or longer lease than the primary lease.
  • Lease Agreement Risk: The sub-lessee may want concessions, allowances and other features which are not provided in the primary lease.
  • Tenant Improvement Threat: The sub-lessee has to pay the build out cost for the sub-lessee.

assignment

An assignment of a lease means that all of the lessee’s leasehold interest in the property is transferred to a third party. Generally this will release the original lessee from any and all liability for the remaining terms of the lease at the time of assignment.

Create a suit

Build-to-suit development in which the owner agrees to develop or complete the property built to the prospective tenant’s specifications.

The cost of the improvements may be assumed to some extent by the prospective tenant and may be in the form of increased effective rent.

A build-to-suit strategy will most likely involve a potential tenant with significant financial capacity and strong creditworthiness.

Sale-leaseback

A sale-leaseback is a strategy in which an owner purchases land, builds a structure on the land for their own use, and in turn sells the entire property to an investor, retaining a long-term net lease.

Many companies use this strategy to convert their equity in real estate into working capital where they can earn higher returns from business operations and cash flow.

Summary

Although this article, aptly titled Introduction to Commercial Leases, does not cover all aspects of commercial lease implications, it has hopefully provided knowledge and information to those with a less than functional understanding of commercial leases when negotiating a commercial lease.

There are many different ways to structure lease transactions, clauses, and the financial implications of commercial real estate leases.

An important thing to remember is that many tenancy clauses will apply to the prospective tenant or owner.

A lease should be carefully reviewed by a professional or others trained to negotiate and analyze both the short-term and long-term implications and the financial obligations of all parties involved.

Careful and diligent lease negotiation and analysis will provide both prospective tenants as well as owners with the ability to profit and succeed in their individual endeavors.

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