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Commercial Lease Analysis By D. Scott Smith CCIM Commercial Manager Professor of Real Estate Prudential PenFed Realty Commercial Sales and Consulting 5000 Lawndale Ave.|Baltimore, MD 21210 Office: 410-464-5500|Cell: 443-691-8153
We Will Review• Types of Leases • Lease Value• Leasing Process • Landlord Vs. Tenant• Clauses in leases • Legal
A lease is a contractual arrangementcalling for the lessee (user) to pay the lessor (owner) for use of an asset. For today’s class all tenants will be considered a fixed term tenancy.
Several Lease Types• Land Lease• Capital Lease• Operating Lease• Gross Lease• Modified Gross
Several Lease Types• NNN Lease• Industrial Gross Lease• Percentage Lease• Or any combination
Several Lease TypesEach asset type, as well as geographical areawill have different components(IE. $3 a sqft vs. $36 a sqft.)Pass through, TI, etc.
Lease Full Net of Modified NNN AbsoluteStructure Service Elec. Gross NetTaxes X X XProp. Insurance X X XMaintenance -Various X X XManagement X X XUtilities XJanitorial X XCapital Exp. Tenant ResponsibleMost typical type Office Office Flex / Lt. Retail Single Tenantof property using Industrial and Industrial orthis lease Industrial Retail
Several Lease TypesDue to a lease being legally binding wesuggest all leases be written or reviewed bylegal council.I am not an attorney and don’t write leases.
Summary of Legal Issues• Commencement Date • Relocation• Use/Exclusivity • Subordination and• Operating Expenses Nondisturbance• Assignment/Subletting • Waiver by Tenant • Zoning and Use Restrictions 18
Commencement Date/ Tenant IssuesCommencement Date• Date on which the obligation to pay rent starts• Distinguishable from execution date and occupancy date• Issues arise when tenant improvements are contemplated 19
Commencement Date/ Tenant Issues (cont.)1. Landlord’s Interest a) Rent payments to commence as quickly as possible b) Minor (punch-list) items can be completed after commencement date c) Minimize tenant delays2. Tenant’s Interest a) Sufficient time provided to complete tenant improvements before rent commencement date b) Reasonable cancellation rights in the event delivery of premises is delayed 20
Use/Exclusivity• Use Clause: Statement of what businesses and activities tenant may conduct in the premises• Exclusive Use Clause: Statement of what businesses and activities that only tenant can conduct within the project• If something is not set forth in the Use Clause, the tenant normally cannot conduct that activity in the premises.• If something is not set forth in the Exclusive Use Clause, then the tenant cannot stop other tenants from conducting those activities. 21
Use/Exclusivity (cont.)1. Landlord’s Interest a) Wants a narrow Use Clause b) Wants either no Exclusive Use Clause, or wants a narrow one2. Tenant’s Interest a) Wants a broad Use Clause ... ultimately that tenant can use the premises “for any lawful purpose” b) Wants a broad Exclusive Use Clause 22
Operating Expenses1. Expenses of operating real property, usually paid in addition to base rent2. Typically includes taxes, insurance, utilities, and property maintenance costs3. Typically excludes debt service, capital improvements, and depreciation4. Landlords always recoup operating expenses, whether under NNN or FSG lease 23
Operating Expenses (cont.)1. Landlord’s Interest a) Recoup all expenses associated with operating the property b) Seek to recoup capital expenses (i.e., roof, paving, HVAC, capital expenses that reduce operating expenses) c) No cap on operating expenses2. Tenant’s Interest a) Limit operating expenses to only those expenses associated with operating the property b) Cap controllable operating expenses to 3-5% annually c) Exclude all capital improvements, if possible 24
Assignment and Subletting• Assignment: The transfer of the legal rights and duties of the tenant under a lease to a third party called an assignee – The assignee pays its rent to the landlord, and the landlord and assignee now owe each other the same duties that applied to the original tenant/assignor.• Sublease: An agreement in which the tenant contracts with a third party to assume all or part of its rights and/or obligations under a lease. The third party in this case is called a sublessee. – The sublessee generally pays rent to the sublessor (the original tenant), and has no “privity” relationship with the landlord. The landlord doesn’t owe duties to the sublessee. 25
Assignment and Subletting (cont.)1. Landlord’s Interest a) The landlord would usually prefer that the tenant not have any assignment or sublease rights (unless, of course, the assignee or sublessee is a better tenant than the assignor or sublessor was).2. Tenant’s Interest a) The tenant would like to be able to assign or sublet to anyone he/she chooses. In both assignment and sublet situations, the tenant is usually responsible to the landlord for rent payment. So, the landlord (in theory) still gets his/her money. 26
Relocation1. A relocation provision or clause in a lease allows the landlord to move the tenant to another location in the building.2. Frequently, the landlord will agree to pay some amount for the tenant’s inconvenience (i.e., moving expenses, cost of stationery, etc.).3. Unfortunately, tenants rarely focus on this provision. 27
Relocation (cont.)1. Landlord’s Interest a) Provides flexibility to accommodate a new or bigger tenant in the future2. Tenant’s Interest a) Possible nicer suite or space in the building 28
Subordination and Nondisturbance• Subordination: A lease clause requiring the tenant of a property to subordinate its rights under the lease to the rights of any present or future lender on the property. – Landlords require subordination clauses, because lender requires it. He who has the gold makes the rules.• Nondisturbance: A lease clause requiring the lender in a foreclosure situation to leave the tenant’s lease in place. – Tenants require nondisturbance clauses. If the tenant executes a lease with a subordination clause or a subordination agreement without a corresponding nondisturbance clause, then the foreclosing lender could kick the tenant out of its premises. 29
Subordination and Nondisturbance (cont.)• Why do these items matter? – In the event of a foreclosure, the lender can remove from the project any tenant whose lease is subordinate to the loan. Alternatively, they can require a change in the business terms of the lease, or change the legal terms. – Landlord can’t remove this requirement because it greatly impacts the landlord’s ability to finance its project.• The compromise – Lenders will generally agree not to kick a tenant out, or to change the lease terms, if the tenant will agree to subordinate the lease to the loan. – Usually, tenants and lenders execute a document called a subordination and nondisturbance agreement (SNDA). 30
Waiver by Tenant/Release of Landlord1. Tenant waives any claims and releases the landlord from liability for certain acts and conditions relating to the premises.2. In some cases, tenant agrees to bear risk even if landlord is at fault.3. Provisions tend to be overly broad and unfair. 31
Waiver by Tenant/Release of Landlord (cont.)1. Landlord’s Interest a) Shift the risk of contingent liabilities to the tenant to the greatest degree possible. b) Maintain income stream without unbudgeted or unexpected expenses eating into that income stream.2. Tenant’s Interest a) Avoid consequences of the landlord’s negligence or failure to perform its obligations under the lease. b) Limit waiver to exclude negligence or willful misconduct of landlord. 32
Zoning/Use Restrictions1. Master zoning laws and use restrictions in your market.2. Failing to do so is a great way to bring your client spaces that they can’t occupy.3. Mastering these items will set you apart from most brokers. 33
Zoning/Use Restrictions (cont.)Examples of Zoning Laws/Use Restrictions• Downtown areas reserved for retail use defined as the sale of goods and services• Restaurant moratoria• Liquor license restrictions• Parking restrictions (medical and other uses)• Formula retail restrictions 34
Commercial Lease Dos and Don’ts• Do use a Letter of Intent. – Negotiate as many business issues as possible. – Confirm that the LOI is nonbinding.• Do advise your client to retain an attorney.• Do stay apprised of the legal issues that the attorneys are having trouble resolving.• Do review the lease agreement to confirm that it contains all of the negotiated business points.• Do obtain a commission agreement before the lease is signed. 35
Commercial Lease Dos and Don’ts (cont.)• Do not leave critical business issues out of the Letter of Intent (i.e., signage, renewal options, operating expenses, etc.).• Do not allow the landlord to insist on the use of his own consultants (i.e., space planners, architects, contractors, etc.).• Do not practice law or provide legal opinions regarding the lease.• Do not permit business issues to be renegotiated during the lease negotiation process. 36
Tenants Value• One way or another the tenant pays its share of all expenses either inside or outside of base rent.• Key to analysis and comparison is total occupancy cost (TOC).• TOC includes all rent and expenses over the lease term for each alternative.• Can be compared on a gross cost or present value basis.
Total Occupancy Cost MatrixThe table below can be used to calculate and compare TOCfor like, and unlike, lease alternatives. Base Tenant Parking Other Other Total Rent Paid Op. Exp.Up-FrontCostsYear 1Year 2Year 3Year 4Year 5Total
Total Occupancy Cost Comparison ExampleBuilding A Building B• 3,000 rentable square feet • 3,150 rentable square feet (rsf) (rsf)• 5 years • 5 years• Rent $20.00/rsf/year full service • Rent $11.00/rsf/NNN• Base-year op. exp. stop • NNN Exps = $6.50/rsf• $18,000 TPTI* • Electricity = $1.75/rsf• 10 parking spaces at • $4,000 TPTI* $30/space/month • 6 months free• 3 months free rent rent and NNNs * TPTI = tenant paid tenant improvements
Total Occupancy Cost Example: Building A Alternative Base-year operating expenses are $8.50/rsf and expected to grow at 5% per year. Base Tenant Paid Parking Other Other: Total Rent Op. Exp. TPTIUp-Front $18,000 $18,000CostsYear 1 $45,000 $3,600 $48,600Year 2 $60,000 $1,275 $3,600 $64,875Year 3 $60,000 $2,614 $3,600 $66,214Year 4 $60,000 $4,020 $3,600 $67,620Year 5 $60,000 $5,490 $3,600 $69,090Total $334,399
Total Occupancy Cost Example: Building B Alternative NNN expenses and electricity are expected to grow at 5% per year. Base Tenant Paid Parking Other: Other: Total Rent Op. Exp. Elec. TPTI (NNN)Up-Front Costs $4,000 $4,000Year 1 $17,325 $10,238 $5,513 $33,076Year 2 $34,650 $21,499 $5,788 $61,937Year 3 $34,650 $22,574 $6,078 $63,302Year 4 $34,650 $23,702 $6,381 $64,733Year 5 $34,650 $24,887 $6,700 $66,237Total $293,285
Total Occupancy Cost (TOC) Comparison ExampleTOC Comparison • Based on TOC over the Total A Total B term, Building B isUp-Front $18,000 $4,000 preferred.Costs • Matrix enables analysisYear 1 $48,600 $33,076 and comparison ofYear 2 $64,875 $61,937 unlike alternatives.Year 3 $66,214 $63,302 • One more way toYear 4 $67,620 $64,733 use thisYear 5 $69,090 $66,237 information.Total $334,399 $293,285
Total Occupancy Cost (TOC) Comparison Example• calculation can be compared to other leases.• TOC is an important figure that can be compared in other forms. (TOC ÷ SF) ÷ Term = Average Annual Effective Rate to tenant Example: ($334,399 ÷ 3,000 sf) ÷ 5 years = $22.29/rsf/year
Present Value Analysis• The timing of cash flows for lease alternatives varies. – Some have heavy up-front costs – Sometimes rents are weighted to the later years (stair-stepped) – Free rent is usually given at the beginning of the term but recovered in later rents• Present value analysis of the cash flows takes timing differences to arrive at a comparable present value lease cost.
Present Value Analysis Example: Buildings C and DTOC Comparison • Based on TOC, building Bldg. C Bldg. D D is preferred.Up-Front $10,000 $18,000 • Timing of cash flows areCosts very different.Year 1 $25,000 $22,500 • Building D has biggerYear 2 $35,000 $45,000 up-front costs.Year 3 $45,000 $47,000Year 4 $55,000 $49,000 • Building C cash flowsYear 5 $65,000 $51,000 are weighted to later years.Total $235,000 $232,500
Present Value Analysis Example: Buildings C and D• Present Value Analysis accounts for differences in timing of cash flows and arrives at Present Value Lease Cost (PVLC) for each alternative.• Requires a discount rate provided by the tenant. This could be: – Tenant’s ROI from core business – Opportunity Cost – Weighted cost of capital – Provided by CFO
Present Value Analysis Example: BuildingsBldg. and D ValueBldg. C Present Value C D PresentTime Dollars Time Dollars 0 10,000 0 18,000 1 25,000 1 22,500 2 35,000 2 45,000 3 45,000 3 47,000 4 55,000 4 49,000 5 65,000 5 51,000PVLC = $183,542* PVLC = $185,450* * Using Tenant Discount Rate of 8%
Present Value Lease Cost Analysis Example: Buildings C and DBldg. C Present Value Bldg. D Present ValuePVLC = $183,542 PVLC = $185,450 • PV analysis using tenant discount rate indicates building C is preferred. • PV analysis accounts for differences in cash flows, both timing and size. • PV analysis assumes tenant has sufficient capital for either alternative.
Total Occupancy Cost and Present Value Lease Cost Analysis Pros Cons• Provides objective • Assumptions needed for measures of analysis and factors such as operating comparing of alternatives expense growth• Compares like or dislike • Does not take into account alternatives subjective factors• Accounts for all costs of – Location occupancy – Amenities• PV analysis also accounts – Impact on for differences in timing of tenant’s cash flows business
Lease Analysis Sheet TenantStay and Do Nothing ? Does Time Match?Sublet ( do sublet analysis using contract andmarket rents) ? Equity Stake? Expansion?When a users contract rent is below marketrent, the user has a positive value in its lease.
Changing FactorsMarket ConditionsMarket Sentiment and ConcessionsLand Lord or Tenant ObjectivesRemaining Time on Lease
Lease Analysis and Comparison: Landlord View• Same types of analysis and comparison can be done from the landlord point of view• Total occupancy cost analysis becomes a net lease revenue (NLR) analysis – In tenant TOC analysis all numbers are out of pocket costs; TOC is a negative number – For the landlord, revenues should exceed costs providing value
Lease Analysis and Comparison: Landlord View• Landlord view usually involves up-front costs followed by net rents. – Up-Front Costs are landlord paid tenant improvements (LPTI), commissions, architectural fees, etc. – Net Rents are rents received less landlord paid operating expenses.
Lease Analysis and Comparison: Landlord ViewThe table below can be used to calculate Net Lease Revenue (NLR). NLRcan be compared to other leases or the landlord’s pro forma. LPTI, Rent LL paid Other: Total Fees Op. Exps. (+ or -) Up-Front Costs Year 1 Year 2 Year 3 Year 4 Year 5 Total
Lease Analysis Landlord View Example:• 4,500 rsf • Landlord provides $18/rsf• 5-year term in TI• Full-service lease • Parking: 15 spaces at• $45/space/month, Year 1 rent $20.00/rsf first year free• Rent bumps $1/sf/year • Commissions and other• Base year for op. exps. = fees = 6% of GLC* $8.50/rsf • Concession of 4 months• Op. exps. growth at 5% free rent up-front per year* GLC is gross lease consideration; total of contract rent over term
Lease Analysis Landlord View Example:The table below accounts for cash inflows and outflows for the landlordover the term of the lease. $197,250 is the NLR. LPTI Rent LL paid Other: Other: Total Op. Exps. (Fees) ParkingUp-Front ($81,000) ($27,900) ($108,900)CostsYear 1 $60,000 ($38,250) $21,750Year 2 $94,500 ($38,250) $8,100 $64,350Year 3 $99,000 ($38,250) $8,100 $68,850Year 4 $103,500 ($38,250) $8,100 $73,350Year 5 $108,000 ($38,250) $8,100 $77,850Total $197,250
Lease Analysis Landlord View Example:• Example NLR calculation can be compared to other leases or landlords pro forma.• NLR of $197,500 is an important figure that can be compared in other forms. (NLR ÷ SF) ÷ Term = Average Annual Effective Rate to landlord ($197,500 ÷ 4,500 sf) ÷ 5 years = $8.78/rsf/year
Present Value Analysis• The timing of cash flows for lease alternatives impact the present value to landlord. – Landlord may want to adopt leasing strategies that maximize present value. – Up-front costs have heavy (negative) impact on present value of a lease. – Landlord may want a leasing strategy that maximizes property value in future years.• Present value can be compared to other prospective lease alternatives or the landlord’s pro forma.
Present Value Analysis ExampleNLR from Prev. Example • Also referred to as net Lease present value (NPV)Up-Front ($108,900) – PV of future cash flowsCosts are netted against up-Year 1 $21,750 front costs (initialYear 2 $64,350 investment in lease).Year 3 $68,850 • Uses landlord discountYear 4 $73,350 rate.Year 5 $77,850Total $197,250
Net Present Value Analysis ExampleTime Dollars • NPV of $120,941 can be 0 ($108,900) compared to landlord’s pro 1 $21,750 forma on SF basis. 2 $64,350 – $120,941 ÷ 4,500 sf = 3 $68,850 $26.88/sf for proposed lease. 4 $73,350 – same SF analysis on pro 5 $77,850 forma and compared proposal can be modified to hit targets.Discount Rate = 9% – i.e., higher rents, lower up-NPV = $120,941 front costs, etc.
Net Lease Revenue and Net Present Value Analysis Pros Cons• Provides a means for LL to • Does not take into account evaluate proposed lease other factors such as tenant alternatives. credit worthiness.• Provides a basis for lease negotiation and the impact of various terms.• Helps LL to determine when, and when not, to move forward on lease.• NPV analysis accounts for timing differences in cash flows.
Just as Tenant can possibly sublet, owner can buyout lease
THE LEASE BUYOUT DECISION• Examining the current market and owner and user motivations is key in determining whether to negotiate a buyout of a lease• leasehold interest may or not be of value to the lessee or may only be of value to the owner
Depending on Owners InvestmentRequirementsTenants cost of moving and occupancy
•We’re dealing with a national retail, fast food operator (Tim’sTacos)who has been successfully operating from a leased location for along time•The old building is 1,235 sqft and Tim’s has recently moved downthe street to build its new prototype of about 3,000sqft•The primary lease term on the old site is about to expire but Tim’sdoes have options to renew.•The Landlord has been approached by a broker with a potentialalternative deal for the site•Tim’s is a little concerned about competition in the market and maywish to exercise control over the site, but, who knows………………
Primary Term was 15 years and it is aboutto expireThe Tenant has two (2), five year optionsas follows:1-5 2,500.00/month 30,000/year6-10 2,916.67/month 35.000/yearOriginal Market Value (Rent) = 15,000/yearCurrent Market Value (Rent) = 50,000/year
What is the value to the tenant?What is the value to the landlord?What are your options?Be prepared to negotiate.
The Legal Issues of Commercial Leasesand why you should not write a lease http://youtu.be/qkgbeGTTTZg
Thanks!D. Scott Smith CCIMCommercial ManagerProfessor of Real EstateScott.Smith@Penfedrealty.comPrudential PenFed RealtyCommercial Sales and Consulting5000 Lawndale Ave.|Baltimore, MD 21210Office: 410-464-5500|Cell: 443-691-8153