Commercial lease analysis

78
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

description

3 hr. Course on Commercial Real Estate Lease Analysis.

Transcript of Commercial lease analysis

Page 1: Commercial lease analysis

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

Page 2: Commercial lease analysis

We Will Review• Types of Leases

• Leasing Process

• Clauses in leases

• Lease Value

• Landlord Vs. Tenant

• Legal

Page 3: Commercial lease analysis

Introductions

Page 4: Commercial lease analysis

What is a Lease?

Page 5: Commercial lease analysis

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.

Page 6: Commercial lease analysis

Several Lease Types

• Land Lease

• Capital Lease

• Operating Lease

• Gross Lease

• Modified Gross

Page 7: Commercial lease analysis

Several Lease Types

• NNN Lease

• Industrial Gross Lease

• Percentage Lease

• Or any combination

Page 8: Commercial lease analysis

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.

Page 9: Commercial lease analysis

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

Page 10: Commercial lease analysis

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.

Page 11: Commercial lease analysis

Leasing Process

Page 12: Commercial lease analysis

Leasing Process

• Client Application

• Needs Assessment

• Screen the client

• Screen the property

Page 13: Commercial lease analysis

Leasing Process• Build your team

AttorneyContractorSpace PlannerLender

• Set your timeline

Page 14: Commercial lease analysis

Leasing Process• Match Goals, Expectations with Property and Lease

• Rentable, Useable, Core Factor, Common Area

Page 15: Commercial lease analysis

Leasing Process• LOI

• First draft of lease

• Lease commencement

• Occupancy

• Maintenance

• Renewal

Page 16: Commercial lease analysis

Leasing Process

Many steps to get through between each stage

Page 17: Commercial lease analysis

Lease Clauses

Page 18: Commercial lease analysis

• Commencement Date• Use/Exclusivity• Operating Expenses• Assignment/Subletting

• Relocation• Subordination and

Nondisturbance• Waiver by Tenant• Zoning and Use

Restrictions

18

Summary of Legal Issues

Page 19: Commercial lease analysis

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

Page 20: Commercial lease analysis

20

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.)

Page 21: Commercial lease analysis

21

• 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

Page 22: Commercial lease analysis

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

22

Use/Exclusivity (cont.)

Page 23: Commercial lease analysis

23

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

Page 24: Commercial lease analysis

24

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.)

Page 25: Commercial lease analysis

25

• 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

Page 26: Commercial lease analysis

26

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.)

Page 27: Commercial lease analysis

27

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

Page 28: Commercial lease analysis

28

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.)

Page 29: Commercial lease analysis

29

• 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

Page 30: Commercial lease analysis

30

• 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.)

Page 31: Commercial lease analysis

31

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

Page 32: Commercial lease analysis

32

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.)

Page 33: Commercial lease analysis

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.

33

Zoning/Use Restrictions

Page 34: Commercial lease analysis

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

Zoning/Use Restrictions (cont.)

Page 35: Commercial lease analysis

• 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

Page 36: Commercial lease analysis

• 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

Commercial Lease Dos and Don’ts (cont.)

Page 37: Commercial lease analysis

Leasing Valuation

Page 38: Commercial lease analysis

AssumptionsTime Value of Money

T-Bars FV PV

PRI

-VAC

=ERI

+ Other

= GROSS

-Operating

=NOI

-ADS

=CFBT

Page 39: Commercial lease analysis

All Leases have at least two, possibly Three values.

Page 40: Commercial lease analysis

• Money

• Market Rent = Contract Rent

• Time

• No a Partner

• Control

• Contract Rent Lower than Market Rent

• Occupancy Lower than Ownership

Land Lord Tenant

Page 41: Commercial lease analysis

First the Tenants Value

Page 42: Commercial lease analysis

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.

Page 43: Commercial lease analysis

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.

Page 44: Commercial lease analysis

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

Page 45: Commercial lease analysis

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.

Page 46: Commercial lease analysis

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.

Page 47: Commercial lease analysis

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.

Page 48: Commercial lease analysis

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

Page 49: Commercial lease analysis

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.

Page 50: Commercial lease analysis

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.

Page 51: Commercial lease analysis

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

Page 52: Commercial lease analysis

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

Page 53: Commercial lease analysis

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.

Page 54: Commercial lease analysis

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

Page 55: Commercial lease analysis

What about a sublet?

How to Value?

Page 56: Commercial lease analysis

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

Page 57: Commercial lease analysis

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.

Page 58: Commercial lease analysis

Changing Factors

Market Conditions

Market Sentiment and Concessions

Land Lord or Tenant Objectives

Remaining Time on Lease

Page 59: Commercial lease analysis

Lease Value Landlord

Page 60: Commercial lease analysis

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

Page 61: Commercial lease analysis

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.

Page 62: Commercial lease analysis

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.

Page 63: Commercial lease analysis

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

Page 64: Commercial lease analysis

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.

Page 65: Commercial lease analysis

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

Page 66: Commercial lease analysis

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.

Page 67: Commercial lease analysis

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

Page 68: Commercial lease analysis

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

Page 69: Commercial lease analysis

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

Page 70: Commercial lease analysis

Just as Tenant can possibly sublet, owner can buyout

lease

Page 71: Commercial lease analysis

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

Page 72: Commercial lease analysis

Depending on Owners Investment Requirements

Tenants cost of moving and occupancy

Page 73: Commercial lease analysis

Owner Vs. Tenant

Page 74: Commercial lease analysis

•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………………

Page 75: Commercial lease analysis

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

Page 76: Commercial lease analysis

What is the value to the tenant?What is the value to the landlord?

What are your options?Be prepared to negotiate.

Page 77: Commercial lease analysis

The Legal Issues of Commercial Leases and why you should not write a lease

http://youtu.be/qkgbeGTTTZg

Page 78: Commercial lease analysis

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