- Broadly, there are two types of commercial property leases, Gross and Net.
- In a Gross Lease agreement, sometimes called a Full Service Lease, a tenant pays a base lease rate and the property owner/landlord pays the operating expenses like property taxes and insurance.
- In a Net Lease structure the tenant pays a base rental amount, plus some portion of the property’s common area maintenance expenses, depending on the type of Net Lease.
In some ways, commercial real estate (CRE) leases are similar to the casino game, Craps, which is a dice game that includes a number of different participants all using their money to bet on a specific outcome of the dice roll. If a player is unsure of a specific outcome, they can bet one a more general outcome using a “Come Bet.” For those that have not played Craps before, the Come Bet means that the player may not have what they need right now, but are willing to bet on getting what they need to win the wager in the future.
Types of Commercial Leases
Broadly, there are two types of commercial property leases, Gross and Net.
In a Gross Lease agreement, sometimes called a Full Service Lease, a tenant pays a base lease rate and the property owner/landlord pays the operating expenses like property taxes and insurance. Tenants like this arrangement because they only have to pay one amount each month, but the rental rate is usually higher than the alternative lease structure.
In a Net Lease structure the tenant pays a base rental amount, plus some portion of the property’s common area maintenance expenses, depending on the type of Net Lease. There are multiple types of net lease structures that are most commonly found when leasing office space, industrial space, and retail space. In a single net Lease, the tenant pays their base monthly rent plus property taxes. In a double net lease, the tenant pays for their base rent plus property taxes and property insurance. These types may also be referred to as a “Modified Gross Lease.” While they are frequently used, there is another type that is particularly popular with both investors and tenants known as a triple net lease.
Like the single and double net leases, the triple net lease, sometimes written as “NNN” or “NNN lease”, is a structure where the tenant pays a base rental amount plus operating expenses. However, the key difference is that in the triple net lease, the tenant is responsible for all of the building expenses including maintenance, real estate taxes, and insurance. Depending on the specifics of the lease, the tenant may occasionally be responsible for roof and structural maintenance.
How Are Leases Like Come Bets?
Unlike residential leases, commercial leases tend to have longer terms. Where a residential lease may have a 1 year lease term, a lease in a commercial building can have terms of 5 years up to 25 years, depending on the needs of the specific tenant. In addition, they often include “options” that allow the tenant to extend the term even longer.
To occupy a space for this length of time and to meet their branding and experience requirements, a commercial tenant will likely require a customized “build-out” of the space. For example, a grocery store needs rows and rows of shelving, high powered lighting, commercial grade refrigeration units, and storage space, among other things. These items are expensive and, as an incentive to sign the lease, the tenant will often request that the property owner pay for all or some portion of them. And this is how a commercial lease is like a Come Bet. Some of them require an upfront investment (the wager) in the form of a “tenant improvement allowance” but this bet pays off in the form of a long term stream of rental income and the increased property value that comes with it.
To illustrate how this works, consider the following example from a recent deal that we reviewed. The deal in question was for the purchase of a retail shopping center in a mid-sized town. We liked everything about the center including the location, tenant mix, ingress/egress, condition, and automobile traffic that passed it on a daily basis. However, there was one problem, the anchor space meant for a grocery store was vacant, causing the property to operate at a loss each month. In other words, the property didn’t have what we needed at the time of purchase (an anchor tenant), but we were willing to place a wager that we could get it in the future.
Fortunately, we were able to leverage our tenant relationships to quickly enter into negotiations with a regional grocer for a lease on the 50,000 square foot space. The tenant was willing to pay $11 PSF in rent ($550,000 annually), but in return they wanted $50 per square foot ($2.5MM) in the form of a “Tenant Improvement Allowance.” The decision to accept these terms is essentially a $2.5MM wager that we will eventually get what we need in the form of a commercial asset with a positive rate of monthly cash flow and a long term lease in the anchor space.
To analyze this deal, there are a number of items to consider:
- Strength of the Tenant: Fundamentally, the proposed lease represents a legally mandated stream of income. In return for our $2.5MM investment, we need to feel confident that the tenant has the financial strength to make all of the required payments under the terms of the lease. To assess this, we review their financial statements and past history of performing on similar leases.
- Strength of the Market: The supply and demand characteristics of the local market must be favorable to ensure the best chance that the property will appreciate in value over time.
- Other Tenants: There is a reason that the grocery store is called an “anchor” tenant. Its presence can attract a significant amount of traffic to the shopping center, which can also benefit other tenants. So, we like to review who the other tenants are, if their business is complementary to the grocer, and whether we can replace any of them with other tenants who are willing to pay higher rents to be in close proximity to the grocery store.
If the deal passes muster, we will move on to evaluating the financial impact of the “wager.”
Financial Impact of “Betting on the Come”
Fundamentally, the returns from a commercial real estate investment consist of two parts, income and appreciation. Each is valued somewhat differently when contemplating a transaction.
The income from the proposed grocery store lease, $550,000 per year, would be enough to turn the property cash flow positive in ~year 4.5. This is a little bit longer than we prefer, but the potential to add significant value to the property is illustrated when a cap rate is applied to it. In the deal we were considering, we were going to purchase the property at a Cap Rate of 7.5%. So, this means that an additional $550,000 in income on a long term lease would add $7.3MM ($550,000 / 7.5%) to the property’s value.
If we have done our research correctly and the supply and demand characteristics of the local market prove to continue to be favorable, the Cap Rate could decline, which means that the value is growing. Assume that it declines from 7.5% to 6.5% over the life of the investment holding period, the $550,000 could end up actually adding $8.4MM to the property’s value if the market moves in our favor.
The other major financial impact from “Betting on the Come” can be a little bit more difficult to quantify, but it has the potential to be equally positive. A grocery store anchor, especially a well known and popular one like Publix, Whole Foods, or Trader Joes, can attract a lot of traffic to a center, which can be a significant tailwind for the other tenants. If there are leases that are expiring shortly after we acquire the center, there is a distinct possibility that we could re-lease the space at higher rates due to the proximity to the anchor tenant. If we can do this, it will increase Net Operating Income even higher. At a 7.5% Cap Rate, every $1 added to Net Operating Income increases the property’s value by $13.33.
So, the point is this, like Craps, every commercial real estate investment involves some level of risk. At the time of purchase, all of the variables needed to predict a positive return may not always be known. In some cases, a significant investment may need to be made up front to increase the property’s value down the line. But, with hundreds of transaction repetitions over years of experience, we know when to place a strategic bet. In our office, we call this “Betting on the Come.”
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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