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
Nov 29, 2014
Commercial Lease Analysis
By D. Scott Smith CCIMCommercial Manager
Professor of Real Estate
Prudential PenFed Realty Commercial Sales and Consulting
5000 Lawndale Ave.|Baltimore, MD 21210Office: 410-464-5500|Cell: 443-691-8153
We Will Review• Types of Leases
• Leasing Process
• Clauses in leases
• Lease Value
• Landlord Vs. Tenant
• Legal
Introductions
What is a Lease?
A lease is a contractual arrangement calling 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 Types
Each asset type, as well as geographical area will have different components
(IE. $3 a sqft vs. $36 a sqft.)
Pass through, TI, etc.
Lease Structure
Full Service
Net of Elec.
Modified Gross
NNN Absolute Net
Taxes X X X
Prop. Insurance X X X
Maintenance - Various
X X X
Management X X X
Utilities X
Janitorial X X
Capital Exp. Tenant Responsible
Most typical type of property using this lease
Office Office Flex / Lt. Industrial
Retail and Industrial
Single Tenant Industrial or Retail
Several Lease Types
Due to a lease being legally binding we suggest all leases be written or reviewed by legal council.
I am not an attorney and don’t write leases.
Leasing Process
Leasing Process
• Client Application
• Needs Assessment
• Screen the client
• Screen the property
Leasing Process• Build your team
AttorneyContractorSpace PlannerLender
• Set your timeline
Leasing Process• Match Goals, Expectations with Property and Lease
• Rentable, Useable, Core Factor, Common Area
Leasing Process• LOI
• First draft of lease
• Lease commencement
• Occupancy
• Maintenance
• Renewal
Leasing Process
Many steps to get through between each stage
Lease Clauses
• Commencement Date• Use/Exclusivity• Operating Expenses• Assignment/Subletting
• Relocation• Subordination and
Nondisturbance• Waiver by Tenant• Zoning and Use
Restrictions
18
Summary of Legal Issues
19
Commencement Date• Date on which the obligation to pay rent starts• Distinguishable from execution date and occupancy date• Issues arise when tenant improvements are
contemplated
Commencement Date/ Tenant Issues
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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 delays
2. Tenant’s Interesta) Sufficient time provided to complete tenant improvements
before rent commencement date
b) Reasonable cancellation rights in the event delivery of premises is delayed
Commencement Date/ Tenant Issues (cont.)
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• 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.
Use/Exclusivity
1. Landlord’s Interest a) Wants a narrow Use Clause
b) Wants either no Exclusive Use Clause, or wants a narrow one
2. Tenant’s Interesta) Wants a broad Use Clause ... ultimately that tenant can
use the premises “for any lawful purpose”
b) Wants a broad Exclusive Use Clause
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Use/Exclusivity (cont.)
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1. Expenses of operating real property, usually paid in addition to base rent
2. Typically includes taxes, insurance, utilities, and property maintenance costs
3. Typically excludes debt service, capital improvements, and depreciation
4. Landlords always recoup operating expenses, whether under NNN or FSG lease
Operating Expenses
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1. Landlord’s Interesta) 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 expenses
2. Tenant’s Interesta) 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
Operating Expenses (cont.)
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• 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.
Assignment and Subletting
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1. Landlord’s Interesta) 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 Interesta) 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.
Assignment and Subletting (cont.)
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1. 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.
Relocation
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1. Landlord’s Interest
a) Provides flexibility to accommodate a new or bigger tenant in the future
2. Tenant’s Interest
a) Possible nicer suite or space in the building
Relocation (cont.)
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• 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.
Subordination and Nondisturbance
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• 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).
Subordination and Nondisturbance (cont.)
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1. 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.
Waiver by Tenant/Release of Landlord
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1. Landlord’s Interesta) 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 Interesta) 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.
Waiver by Tenant/Release of Landlord (cont.)
1. 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.
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Zoning/Use Restrictions
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
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Zoning/Use Restrictions (cont.)
• 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.
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Commercial Lease Dos and Don’ts
• 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.
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Commercial Lease Dos and Don’ts (cont.)
Leasing Valuation
AssumptionsTime Value of Money
T-Bars FV PV
PRI
-VAC
=ERI
+ Other
= GROSS
-Operating
=NOI
-ADS
=CFBT
All Leases have at least two, possibly Three values.
• Money
• Market Rent = Contract Rent
• Time
• No a Partner
• Control
• Contract Rent Lower than Market Rent
• Occupancy Lower than Ownership
Land Lord Tenant
First the Tenants Value
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 Matrix
Base Rent
Tenant Paid Op.
Exp.
Parking Other Other Total
Up-Front Costs
Year 1
Year 2
Year 3
Year 4
Year 5
Total
The table below can be used to calculate and compare TOC for like, and unlike, lease alternatives.
Total Occupancy Cost Comparison Example
• 3,000 rentable square feet (rsf)
• 5 years
• Rent $20.00/rsf/year full service
• Base-year op. exp. stop
• $18,000 TPTI*
• 10 parking spaces at $30/space/month
• 3 months free rent
Building A Building B
• 3,150 rentable square feet (rsf)
• 5 years
• Rent $11.00/rsf/NNN
• NNN Exps = $6.50/rsf
• Electricity = $1.75/rsf
• $4,000 TPTI*
• 6 months free
rent and NNNs
* TPTI = tenant paid tenant improvements
Total Occupancy Cost Example: Building A Alternative
Base Rent
Tenant Paid Op. Exp.
Parking Other Other: TPTI
Total
Up-Front Costs
$18,000 $18,000
Year 1 $45,000 $3,600 $48,600
Year 2 $60,000 $1,275 $3,600 $64,875
Year 3 $60,000 $2,614 $3,600 $66,214
Year 4 $60,000 $4,020 $3,600 $67,620
Year 5 $60,000 $5,490 $3,600 $69,090
Total $334,399
Base-year operating expenses are $8.50/rsf and expected to grow at 5% per year.
Total Occupancy Cost Example: Building B Alternative
Base Rent
Tenant Paid Op. Exp.
(NNN)
Parking Other: Elec.
Other: TPTI
Total
Up-Front Costs $4,000 $4,000
Year 1 $17,325 $10,238 $5,513 $33,076
Year 2 $34,650 $21,499 $5,788 $61,937
Year 3 $34,650 $22,574 $6,078 $63,302
Year 4 $34,650 $23,702 $6,381 $64,733
Year 5 $34,650 $24,887 $6,700 $66,237
Total $293,285
NNN expenses and electricity are expected to grow at 5% per year.
Total Occupancy Cost (TOC) Comparison Example
TOC ComparisonTotal A Total B
Up-Front Costs
$18,000 $4,000
Year 1 $48,600 $33,076
Year 2 $64,875 $61,937
Year 3 $66,214 $63,302
Year 4 $67,620 $64,733
Year 5 $69,090 $66,237
Total $334,399 $293,285
• Based on TOC over the term, Building B is preferred.
• Matrix enables analysis and comparison of unlike alternatives.
• One more way to use this information.
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 AnalysisExample:
Buildings C and DTOC Comparison
Bldg. C Bldg. D
Up-Front Costs
$10,000 $18,000
Year 1 $25,000 $22,500
Year 2 $35,000 $45,000
Year 3 $45,000 $47,000
Year 4 $55,000 $49,000
Year 5 $65,000 $51,000
Total $235,000 $232,500
• Based on TOC, building D is preferred.
• Timing of cash flows are very different.
• Building D has bigger up-front costs.
• Building C cash flows are weighted to later years.
Present Value AnalysisExample:
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
PVLC = $183,542*
Present Value AnalysisExample:
Buildings C and DBldg. C Present Value Bldg. D Present Value
PVLC = $185,450*
* Using Tenant Discount Rate of 8%
Time 0
12345
Dollars10,00025,00035,00045,00055,00065,000
Time 0
12345
Dollars18,00022,50045,00047,00049,00051,000
Present Value Lease Cost Analysis Example: Buildings C and D
Bldg. C Present Value Bldg. D Present Value
PVLC = $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
• Provides objective measures of analysis and comparing of alternatives
• Compares like or dislike alternatives
• Accounts for all costs of occupancy
• PV analysis also accounts for differences in timing of cash flows
• Assumptions needed for factors such as operating expense growth
• Does not take into account subjective factors– Location– Amenities– Impact on
tenant’s business
Cons
What about a sublet?
How to Value?
Market - Contract =Differential
1 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 89,300 700
I = 9.5% PV = 17,050
Tenants Lease Analysis Differential
Lease Analysis Sheet Tenant
Stay and Do Nothing ? Does Time Match?
Sublet ( do sublet analysis using contract and market rents) ? Equity Stake? Expansion?
When a users contract rent is below market rent, the user has a positive value in its lease.
Changing Factors
Market Conditions
Market Sentiment and Concessions
Land Lord or Tenant Objectives
Remaining Time on Lease
Lease Value Landlord
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 View
LPTI, Fees
Rent LL paid Op. Exps.
Other: (+ or -)
Total
Up-Front Costs
Year 1
Year 2
Year 3
Year 4
Year 5
Total
The table below can be used to calculate Net Lease Revenue (NLR). NLR can be compared to other leases or the landlord’s pro forma.
Lease Analysis Landlord View Example:
• 4,500 rsf• 5-year term• Full-service lease• Year 1 rent $20.00/rsf• Rent bumps $1/sf/year• Base year for op. exps. =
$8.50/rsf• Op. exps. growth at 5%
per year
• Landlord provides $18/rsf in TI
• Parking: 15 spaces at $45/space/month, first year free
• Commissions and other fees = 6% of GLC*
• Concession of 4 months free rent up-front
* GLC is gross lease consideration; total of contract rent over term
Lease Analysis Landlord View Example:
LPTI Rent LL paid Op. Exps.
Other:(Fees)
Other:Parking
Total
Up-Front Costs
($81,000) ($27,900) ($108,900)
Year 1 $60,000 ($38,250) $21,750
Year 2 $94,500 ($38,250) $8,100 $64,350
Year 3 $99,000 ($38,250) $8,100 $68,850
Year 4 $103,500 ($38,250) $8,100 $73,350
Year 5 $108,000 ($38,250) $8,100 $77,850
Total $197,250
The table below accounts for cash inflows and outflows for the landlord over the term of the lease. $197,250 is the NLR.
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.
NLR from Prev. Example
Lease
Up-Front Costs
($108,900)
Year 1 $21,750
Year 2 $64,350
Year 3 $68,850
Year 4 $73,350
Year 5 $77,850
Total $197,250
• Also referred to as net present value (NPV)– PV of future cash flows
are netted against up-front costs (initial investment in lease).
• Uses landlord discount rate.
Present Value Analysis Example
Discount Rate = 9%NPV = $120,941
Time 0
12345
Dollars($108,900)$21,750$64,350$68,850$73,350$77,850
• NPV of $120,941 can be compared to landlord’s pro forma on SF basis.– $120,941 ÷ 4,500 sf =
$26.88/sf for proposed lease.– same SF analysis on pro
forma and compared proposal can be modified to hit targets.
– i.e., higher rents, lower up-front costs, etc.
Net Present Value Analysis Example
Net Lease Revenue and Net Present Value Analysis
• Provides a means for LL to evaluate proposed lease alternatives.
• 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.
• Does not take into account other factors such as tenant credit worthiness.
Pros Cons
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 Investment Requirements
Tenants cost of moving and occupancy
Owner Vs. Tenant
•We’re dealing with a national retail, fast food operator (Tim’s Tacos)who has been successfully operating from a leased location for a long time
•The old building is 1,235 sqft and Tim’s has recently moved down the street to build its new prototype of about 3,000sqft
•The primary lease term on the old site is about to expire but Tim’s does 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 about to expire
The Tenant has two (2), five year options as follows:
1-5 2,500.00/month 30,000/year6-10 2,916.67/month 35.000/year
Original 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 Leases and why you should not write a lease
http://youtu.be/qkgbeGTTTZg
Thanks!
D. Scott Smith CCIMCommercial ManagerProfessor of Real [email protected]
Prudential PenFed Realty Commercial Sales and Consulting5000 Lawndale Ave.|Baltimore, MD 21210Office: 410-464-5500|Cell: 443-691-8153