Commercial lease analysis

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3 hr. Course on Commercial Real Estate Lease Analysis.

3 hr. Course on Commercial Real Estate Lease Analysis.

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  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • Keller Williams Commercial 10/27/12 KWC 300 Commercial Property Lease Analysis
  • This very simple table, or some expanded form of this table, can be used to evaluate the total occupancy costs for any lease alternative, which can then be compared to the results for other alternatives. As we see, the table breaks down both the category of costs, such as base rent, tenant-paid operating expenses, parking, etc., and the timing of those expenses. We can input those costs that occur up-front, that is, at or before the commencement date, as well as expenses for year one, year two, etc. Typically base rent and parking charges are clearly stated in the lease, and therefore can be precisely determined for each year, or even each month of the lease. Other items, including expenses, are not so clearly defined. Under these circumstances, we often need to make certain assumptions about how those expenses will change over time, typically increasing from one year to the next. We can try to project on behalf of our tenant, for instance, how a property tax expense of $5,000 in the first year of the lease might increase in the second year, third year, fourth, and beyond. We can commonly assign a growth rate, such as the national or regional consumer price index (CPI), to escalate the year one expenses into future years. Although no one has a crystal ball, and it is very difficult to determine precisely how those expenses will increase from one year to the next, this analysis nonetheless provides a more realistic representation of what actual expenses will be, as opposed to a static analysis where no such increases are reflected. Once we have input all of the figures that pertain to a particular lease alternative into this table, we can add up the costs for each year, by totaling the numbers from left to right. In addition, we can then add up the total upfront and annual costs to arrive at the TOC figure, which would be the number in the lower right-hand corner of our table. This is a very important number, in that it can be easily compared to other lease alternatives. As we will see later, we can also use the right-hand most column—the totals for the up-front costs and annual expenses—to conduct a present value analysis for each alternative.
  • To demonstrate the usefulness of our total occupancy cost matrix, and how it can be used to analyze the cost of a lease alternative, let’s look at an example. After researching the market thoroughly, with the assistance of his KW Commercial Agent, the tenant has narrowed the selection to building A and building B. This example is not unlike many real-world situations, where a tenant must consider competing lease proposals. The building A alternative has 3000 square feet, and is a 5-year term. The rent quoted on a full service basis is $20.00 per rentable square foot per year. Operating expenses will be subject to a base year operating expense. The landlord will provide some of the tenant improvement money. However, in addition to what the landlord is providing, the tenant must provide $18,000 for tenant paid tenant improvements (TPTI). The tenant will also need ten parking spaces, in the building parking garage, which are priced at $30.00 per space per month. In order to further persuade the tenant to select his building, the agent for building A has granted a concession of three months free rent, to be taken at the beginning of the lease term. For building B, the available space being offered has 3,150 rentable square feet. The lease proposal is also for five years. Rent for building B is $11.00 per square foot triple net. The triple net expenses are $6.50 per rentable square foot. And electricity is $1.75 per rentable square foot. As in the building A alternative, the tenant will have to come out-of-pocket for $4,000 in TPTI. The concession for selecting building B is six months of free base rent, and triple net expenses. The tenant will perform their own janitorial services, therefore those expenses are not included as part of our evaluation.
  • In the table above, we calculated the rent and expenses for the building A alternative. In order to calculate expected operating expense pass thrus to the tenant, we have assumed for the purpose of this analysis that operating expenses will grow at 5% per year. A phone call to the property manager for building A , has indicated that the base-year operating expenses are expected to be $8.50 per rentable square foot. If we recall from earlier discussions regarding operating expenses and lease structures, we know that in a full service lease such as this, with base-year operating expenses ($8.50 per square foot in this example), the tenant will only be responsible for increases in operating expenses in future years. As we see in column two, tenant-paid operating expenses, we show the amount the tenant would be required to pay in year two, three, four, and five, if the $8.50 per square foot expense grows by 5% per year, with the tenant paying only the increase above $8.50. You can see also in this example the up-front TPTI expense of $18,000, as well as the three months of free rent, in the year one base rent amount. And finally the parking expenses are a fairly straight-forward $3,600 per year. If we add left-to-right, we have in the right-hand column, total, the up-front costs, as well as the annual expenses for each year of the lease. In the lower right-hand corner, we have the total occupancy cost of $334,399 for this lease alternative. This is a very valuable number, in that it indicates to the tenant what he might expect as his total expenditures, should he select building A. In addition, this number can now be compared to the total occupancy cost for other alternatives.
  • In the table above, we can see the building B lease terms reflected in our total occupancy cost matrix. It is important, especially when comparing one alternative to another, that the assumptions remain consistent, unless there is a specific reason to believe that such assumptions would be different for one alternative, as opposed to the other. Therefore, in our building B example, we also assume that expenses, including electricity, would be expected to grow at 5% per year. We see tenant’s initial out-of-pocket cost being $4,000 of TPI. Base rent in year one reflects six months free rent. The building B example proposal also calls for six months of free triple net expenses, as reflected in the year one amount. Electricity however was not covered in the free rent, and therefore the tenant is shown here paying the full amount of electricity from the commencement of the lease. Once again, as we add the expenses left-to-right, we come up with annual totals in the right-hand column. We can add those to arrive at our total occupancy cost for the building B alternative of $293,285. We can see right away that this is slightly less than our building A alternative.
  • Now that we have completed our total occupancy cost (TOC) calculation for both alternatives, we are able to compare them side-by-side in total expenses , up-front, and annual expenditures for each year. This side-by-side comparison provides the tenant with valuable information that may be utilized in finalizing a building selection. This comparison doesn’t necessarily reflect final terms for either lease. But it is a powerful tool for negotiating further with either, or both, buildings. Also, depending on the tenant’s preference, and budgetary considerations, we can see clearly that one alternative, building A, in addition to being slightly more expensive over the term, has much larger up-front costs. One thing that should be pointed out here is that important final decisions are rarely made on numbers alone. The purpose of this analysis is to, as objectively as possible, compare the economic factors of the two alternatives. This analysis in no way takes into account objective and subjective factors, such as: location, accessibility, image, view, proximity of customers, competition, employees, etc. Economic factors are a major consideration. But not the only factor utilized when making the final decision that the tenant will have to live with for the next three, five, or ten years. Notes:
  • As previously mentioned, total occupancy cost (TOC) is a very useful figure, in that it can be easily compared between lease alternatives. This number is also important because it can be used as a starting point to evaluate the lease economics on a different basis. For instance, a common evaluation of lease alternatives, as well as, a means of comparison, is to calculate the TOC on an annual per square foot basis, commonly referred to as average annual effective rate. If as in our example, building A, the TOC reflects a 5-year term for 3,000 square feet, then to calculate the average annual effective rate requires just two steps. 1) TOC is divided by square footage, and then 2) that number is divided by the lease term in years, to equal the average annual effective rate to the tenant. In the building A example, TOC of $334,399 divided by 3,000 square feet, and in turn, divided by five years equals $22.29 per rentable square foot per year. This is an important unit of comparison. As opposed to the base rent quoted by the landlord, this number takes into account free rent, tenant out-of-pocket, up-front costs, increases in expenses, parking charges, etc., to arrive at the average annual effective rate to the tenant. Notes:
  • As noted in the previous module, two lease alternatives, although close in total occupancy cost, may vary significantly in the timing of the cash flows . For instance, some lease alternatives may have heavy up-front costs, while other leases have their costs weighted more heavily toward later years. Free rent is generally given at the beginning of the lease term, and landlords, and some tenants, often will want to stair-step rents. That is, have lower rents in earlier years, and step them up, as the term progresses. As we know from our investment analysis courses, the value of money has a time component. A dollar today is worth more than a dollar to be received at some point in the future. All things being equal, a lease alternative that is heavily weighted with cash flows in the early years, will have a higher present value cost than another alternative that has its costs weighted toward the later years of the lease. Therefore, in order to accurately compare two alternatives on a present value lease cost basis, we must conduct a present value analysis. Notes:
  • To illustrate our point about present value differences, let’s look at an example between two lease alternatives, buildings C and D. We can see in the table above, the up-front costs and annual expenditures for both building alternatives. Note that the TOC for both alternatives are very similar: $235,000 for building C and $232,500 for building D. Based on TOC alone, building D would be our preferred alternative, even though it’s TOC is a mere $2,500 less than building C. Note however that there is a significant difference in the timing of the cash flows between the two alternatives. Building D has bigger up-front, and early-year costs. While building C has smaller up-front costs, but with expenses more heavily weighted to the later years of the lease. Notes:
  • In order to evaluate the impact of timing differences of the cash flows between buildings C and D, we must perform a present value analysis to arrive at a present value lease cost (PVLC) for each alternative. To perform a present value analysis, we need to utilize a discount rate. The discount rate for a lease analysis is generally provided by the tenant and could be any number the tenant elects. However, it is generally based on one or more key financial figures for the tenant. For instance, the tenant’s discount rate could be the tenant’s return on investment from its core business. The discount rate could reflect the opportunity cost for the tenant. That is, if the tenant didn’t invest capital in this lease, what alternative investment would the tenant invest in? What alternative investment could the tenant place that money, which would result in a return that could be used as the discount rate? The tenant’s discount rate could be a blended rate, such as a weighted average cost of capital, or the number could simply be provided by the CFO. In any case, the discount rate is used to take anticipated future cash flows (negative cash flows or expenses, in this case), and discount them back to the present. All other things being equal, a higher discount rate will result in a smaller present value. For the purpose of comparing two alternatives, we should always use the same discount rate for both alternatives. Notes:
  • In the above timelines, or T-Bars, we show the cash flows from both alternatives, buildings C and D. On the left-hand side of the T-Bar we have time periods representing years. Time period zero represents the commencement of the lease, and in turn reflects those up-front dollars needed, prior to, or at the commencement of the lease term, such as tenant paid tenant improvements (TPTI), etc. For the purposes of this example, our tenant has provided us with a discount rate of eight percent. Using a financial calculator or computer, to perform the present value analysis, we see that the result for building C is a PVLC of $183,542. The same analysis produces a result of $185.450 for building D. If you recall, on a TOC basis, building D was the preferred alternative. However, given the heavier up-front costs of building D, the resulting PVLC gives building D the higher present cost. Based on this analysis, building C would be preferred. Notes:
  • This type of lease analysis and comparison is a very common and important analysis performed for corporate tenants. This analysis takes our total occupancy cost calculation one step further by accounting for the differences in timing of the cash flows between alternatives. This analysis also assumes that the tenant has sufficient capital for either alternative. That is, in comparing two alternatives, if one requires a significant up-front cost, the analysis assumes that the tenant is capable of incurring that expense. If the tenant only has sufficient funds to select one alternative, (the smaller up-front expense), then the analysis is moot. Notes:
  • The TOC and PVLC analysis tools are simple, but extremely valuable for KW Commercial agents and their tenant clients. These powerful tools have many advantages. Although, they, like any other tool, they are not perfect, and do not take all factors into consideration. Some of the advantages are: They provide an objective measure of evaluating the costs for a lease alternative, and for comparing to other alternatives. If done properly, they can take apples, oranges, bananas, and pears, and compare them on an apples-to-apples basis. These tools account for all costs of occupancy, including anticipated future increases in any of those costs. And the present value analysis also takes into consideration the timing of the cash flows. There some shortcomings, however. For instance, assumptions need to be made, especially in regard to things such as, the rate of increase of expenses in future years. Also, and perhaps most significantly, these analyses do not take into account other objective factors, as well as any subjective factors, such as location, amenities, view, image, impact on tenant’s business, etc. Notes:
  • The same types of analysis and comparison that we utilized on behalf of the tenant in previous modules can also be done from the landlord point of view. Total occupancy cost analysis (TOC), as performed for the tenant, becomes a net lease revenue (NLR). In doing the tenant TOC analysis, all of the numbers shown are negative numbers. That is every rent expense, parking, etc/ number that we have shown in our analysis represents money out of the tenant’s pocket. In the landlord point of view, however, there are both positive and negative cash flows. Notes:
  • In looking at cash flows from the landlord point of view, for a typical lease, we will often see negative cash flows at the beginning of the lease term, for things such as landlord paid tenant improvements (LPTI), commissions, architectural or planning fees, etc. Followed by positive cash flows. The positive cash flows represent the net cash flows, which are a result of rents received minus operating expenses, or, minus expenses that the landlord must pay, which is dependent upon the lease structure, as previously discussed. Notes:
  • Use the table above in the same manner as the tenant’s total occupancy cost table, to analyze the net lease revenues for the landlord. Ultimately, this is a very valuable tool for the landlord. The landlord can utilize the results to evaluate whether or not to proceed with this lease alternative (typically in the negotiation phase). One way the landlord can do this is by comparing the results to his pro forma lease terms for the particular building or space. For budgeting purposes, to meet loan obligations, etc., the landlord will typically have pro forma lease terms. These terms generally include target rents, budgets for tenant improvements, operating expenses, parking revenues, etc. As we can see from the table above, the cash flows we will input can be either negative or positive. LPTI and fees, such as commissions, space planning, etc. will typically be negative cash flows, and paid up-front. Base rent is shown in the second column and will be a positive cash flow. Landlord paid operating expenses, or negative cash flows, and other cash flows, such as parking revenues, can be either positive or negative. By adding the totals from left to right, we arrive at a net cash flow for each time period, from up-front costs, through the term of the lease. By adding those cash flows in the right-hand column, we arrive at a total figure, which represents the net lease revenue anticipated for this lease alternative.
  • Let’s look at an example that involves several cash flows, both positive and negative, and reflects terms similar to what may be seen in a real-world lease. In our example, an agent representing a prospective tenant has just given us a Letter of Intent to lease 4,500 square feet in our building. The terms proposed are 5 years with a full-service lease structure. The first year’s rent is $20.00 per square foot, with the base rent stepping up, or being “bumped” $1.00 per square foot per year. The base year for operating expenses, which we have previously given to the tenant’s agent, is $8.50 per rentable square foot (rsf). We anticipate our operating expenses to grow at 5% per year. And the tenant is requesting that the landlord provide $18.00 per rsf in an up-front tenant improvement allowance. The tenant requires fifteen spaces, at $45.00 per space, per month, with the first year of parking rents to be abated. The commissions and other fees the landlord anticipates paying will equal 6% of the gross lease consideration (GLC). The GLC is the total of the contract base rent to be received over the term. The tenant is also asking for four months of free rent up-front. Notes:
  • In the table shown above, we input the terms of the Letter of Intent presented to us by the tenant’s agent. Eighteen dollars per square foot of landlord paid tenant improvements is shown as $81,000 up-front costs. Other up-front costs include $27,900, which is the 6% total fees (commissions and space planning) of gross lease consideration (GLC). We calculated this figure by totaling the rent in column two, and multiplying that sum by 6%. This gives the landlord total up-front costs of $108,900. Note that in addition to the rent figures shown, the landlord paid operating expenses remain the same at $38,250 per year. This is because the landlord has stopped his expense responsibilities at $8.50 per square foot per year. As operating expenses exceed that figure, those costs are passed on directly to the tenant, and therefore, are not part of the landlord’s analysis. Finally, parking revenues are shown in years two through five, which reflects parking charges, and the first year parking rental abatement. By totaling the numbers across from left-to-right, we see our net leased revenues (NLR) for each time period. In addition to the up-front costs, we have net revenues of $21,750 in the first year through $77,850 in year five. Totaling the right-hand column gives us an NLR for this alternative of $197,250.
  • From the previous example, this NLR figure can now be compared to other possible lease alternatives for the landlord’s pro forma for this building, or this space. Generally the landlord’s pro forma is expressed in terms of per square foot amounts, and the NLR figure can easily be converted to a square footage amount. The NLR of $197,000 is divided by the square footage, and then divided by the term, to give us an average annual effective rate to the landlord. In this example, $197,500 of NLR divided by 4,500 square feet, is then divided by five years, to equal $8.78 per rentable square foot per year. This figure can easily be compared to the landlord’s pro forma. The landlord can then decide whether to pursue this lease on these terms, counter the Letter of Intent with terms more favorable to the landlord, or walk away from the deal. Notes:
  • The timing of cash flows for lease alternatives impact the present value to landlord, just as they did in the tenant lease analysis. The annual cash flows also vary as in the tenant total occupancy cost analysis. In order to accurately reflect the time value of money, and compare lease alternatives, or compare a proposed lease to landlord’s pro forma, we must perform a present value analysis. In addition to performing a present value analysis to evaluate alternatives, the landlord may specifically want to adopt leasing strategies that maximize the present value of a lease, which would then be reflected in his pro forma. Alternatively the landlord may be less concerned with present value, or even up-front costs, but rather focused on a strategy of maximizing revenues, with the intent of maximizing the value of the property in later years, should the landlord intend to sell, or refinance the property somewhere down the road. Regardless of what strategy the landlord may be pursuing, an accurate apples-to-apples comparison needs to include a time value of money component, and therefore, a present value analysis. Notes:
  • In the table above, we see the annualized totals from the previous example. Once again using our financial calculator or computer, we can input these numbers, and perform a present value analysis. Often this type of analysis is referred to as a net present value analysis (NPV). An NPV is so called, because the initial investment $108,900 is netted against the present value of the future cash flows. That is, the landlord is investing $108,900 in this lease today (time period zero), and needs to determine if the present value of the future net cash flows he anticipates receiving will exceed his initial investment, and if so, by how much? This is a very useful number for both comparison and decision making. This number can be compared to other lease alternatives, or the landlord’s pro forma, in order to determine if the landlord should do the lease at all, or what terms the landlord may use to counter the current proposal, in order to bring the net present value number up to an acceptable level. Notes:
  • In the timeline above, we laid out the cash flows from the up-front costs and time period zero through the net lease revenue in year five. Using the landlord’s discount rate of 9%, we calculate a net present value for this proposed lease of $120,941. That is, if we discount all of the positive cash flows from year one through five, back to time period zero at 9%, and add them all up, and then net or subtract our initial investment of $108,900, the result is $120,941. This figure can now be compared to the landlord’s pro forma on a square foot basis. $120,941 divided by 4,500 square feet equals $26.88 per square foot, for the proposed lease. This figure is only comparable, of course, to other leases, or pro formas for a five year term. That is $26.88 divided by five years will give us our average annual present value per square foot. Notes:
  • Calculating net lease revenue and the net present value analysis for lease alternatives on behalf of the landlord is a valuable evaluation and negotiating tool. In the back-and-forth of a typical negotiation, each addition or subtraction from base rent, tenant improvements, concessions, etc. can instantly be analyzed, and its impact accessed. And finally, the net present value analysis also takes into account the timing and size differences in the cash flows. Like the types of analysis we use for the tenant, these analyses for the landlord are excellent for evaluating objective factors, but they do not take everything into account, e.g., the tenant’s credit worthiness. The credit worthiness of the tenant is a significant factor that the landlord must evaluate, in that it determines to a large extent the risk associated with executing a lease with this tenant. Notes:


  • 1. 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
  • 2. We Will Review• Types of Leases • Lease Value• Leasing Process • Landlord Vs. Tenant• Clauses in leases • Legal
  • 3. Introductions
  • 4. What is a Lease?
  • 5. 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.
  • 6. Several Lease Types• Land Lease• Capital Lease• Operating Lease• Gross Lease• Modified Gross
  • 7. Several Lease Types• NNN Lease• Industrial Gross Lease• Percentage Lease• Or any combination
  • 8. 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.
  • 9. 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
  • 10. 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.
  • 11. Leasing Process
  • 12. Leasing Process• Client Application• Needs Assessment• Screen the client• Screen the property
  • 13. Leasing Process• Build your team Attorney Contractor Space Planner Lender• Set your timeline
  • 14. Leasing Process• Match Goals, Expectations with Property andLease• Rentable, Useable, Core Factor, CommonArea
  • 15. Leasing Process• LOI• First draft of lease• Lease commencement• Occupancy• Maintenance• Renewal
  • 16. Leasing ProcessMany steps to get through between each stage
  • 17. Lease Clauses
  • 18. Summary of Legal Issues• Commencement Date • Relocation• Use/Exclusivity • Subordination and• Operating Expenses Nondisturbance• Assignment/Subletting • Waiver by Tenant • Zoning and Use Restrictions 18
  • 19. 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
  • 20. 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
  • 21. 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
  • 22. 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
  • 23. 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
  • 24. 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
  • 25. 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
  • 26. 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
  • 27. 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
  • 28. 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
  • 29. 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
  • 30. 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
  • 31. 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
  • 32. 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
  • 33. 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
  • 34. 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
  • 35. 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
  • 36. 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
  • 37. Leasing Valuation
  • 38. AssumptionsTime Value of MoneyT-Bars FV PVPRI-VAC=ERI+ Other= GROSS-Operating=NOI-ADS=CFBT
  • 39. All Leases have at least two, possibly Three values.
  • 40. Land Lord Tenant• Money • Control• Market Rent = • Contract Rent Lower Contract Rent than Market Rent• Time • Occupancy Lower than Ownership• No a Partner
  • 41. First the Tenants Value
  • 42. 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.
  • 43. 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
  • 44. 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
  • 45. 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
  • 46. 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
  • 47. 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
  • 48. 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
  • 49. 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.
  • 50. 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
  • 51. 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
  • 52. 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%
  • 53. 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.
  • 54. 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
  • 55. What about a sublet? How to Value?
  • 56. Tenants Lease Analysis DifferentialMarket - Contract =Differential1 90,000 82,500 7,5002 90,000 84,150 5,8503 90,000 85,833 4,1674 90,000 87,549 2,4515 90,000 89,300 700I = 9.5% PV = 17,050
  • 57. 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.
  • 58. Changing FactorsMarket ConditionsMarket Sentiment and ConcessionsLand Lord or Tenant ObjectivesRemaining Time on Lease
  • 59. Lease Value Landlord
  • 60. 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
  • 61. 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.
  • 62. 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
  • 63. 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
  • 64. 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
  • 65. 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
  • 66. 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.
  • 67. 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
  • 68. 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.
  • 69. 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.
  • 70. Just as Tenant can possibly sublet, owner can buyout lease
  • 71. 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
  • 72. Depending on Owners InvestmentRequirementsTenants cost of moving and occupancy
  • 73. Owner Vs. Tenant
  • 74. •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………………
  • 75. 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
  • 76. What is the value to the tenant?What is the value to the landlord?What are your options?Be prepared to negotiate.
  • 77. The Legal Issues of Commercial Leasesand why you should not write a lease
  • 78. 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