The defining characteristic of commercial real estate is that it contains space that is leased to other businesses. A lease is a contract between a property owner and a tenant that requires the tenant to pay a certain amount of rent each month in return for the privilege of occupying a specific space. While most commercial real estate leases contain the same general clauses, the specific terms can vary widely which can make comparing them difficult.
In this article, we are going to discuss a technique – comparative lease analysis – that can be used to compare two or more commercial real estate leases. We will describe what the technique is, how it works, and why it is important. By the end, readers will have the information needed to compare the value of two (or more) lease options as part of their pre-investment due diligence process.
At First National Realty Partners, we specialize in the purchase and acquisition of grocery store anchored commercial centers. In every deal, we carefully analyze each lease to ensure that it contains the most favorable terms for our investors and stakeholders. If you are an accredited investor and would like to learn more about our current commercial real estate investment opportunities, click here.
What is Comparative Lease Analysis in Commercial Real Estate?
Comparative lease analysis is an analytical technique that allows real estate investors and tenants to compare the terms of two or more leases to determine the total cost over the entire term of the lease.
This type of commercial real estate lease analysis is helpful for both prospective tenants and property owners. From the tenant’s perspective it is important to determine the total cost of a lease to see which option offers the best deal. From the property owner perspective, the same is true, but they want to see which option generates the most income for their investors and stakeholders.
How To Perform Comparative Lease Analysis
True comparative lease analysis is completed using a spreadsheet program or model, like Microsoft Excel and it generally includes three steps:
- Calculate the Present Value: A typical commercial real estate lease term is in the 3-5 year range. So, the first step is to calculate the annual cash flows for each year of the lease and then discount them back to the present using a “discount rate.” This part can be a little bit tricky because it is necessary to include all cash flows – base rent, tenant improvements, lease escalations, and any pro rata share of operating expenses for the use of common areas.
- Calculate Net Effective Rent: Net effective rent is the gross rent less any incentives, like free rent. As part of the exercise of calculating the present value, it is necessary to use the net effective rent figure to make sure that the calculation is accurate.
- Net Present Value (NPV): With the cash flows and net effective rent identified, the next step is to calculate the net present value of these figures. This single value represents the total cost (or income) of the lease and it is the number that the comparison is based upon. For potential tenants, the lease option with the lowest net present value is the cheapest. For property owners, the lease option with the highest net present value is likely to be the preference.
Comparative lease analysis in commercial real estate is summarized here at a very high level. In reality, this financial analysis can be very time consuming and tedious because it requires reading each lease carefully, identifying the required lease payments/rental rate, type of lease (gross lease / net lease / triple net lease) and everything that affects it. Then, for each different lease, it is necessary to plug these values into the analysis model to get to the final value that is needed to compare the leases. This is a specific skill set and it can take years of practice to master.
What to Consider Before Performing Comparative Lease Analysis
From the description above, it is clear that there are a number of factors that must be considered when performing comparative lease analysis in commercial real estate. The most notable are described below.
Location of the Properties
Comparative lease analysis in commercial real estate is not strictly a quantitative activity. A property’s location has a major impact on the choice of property for tenants and the return on investment for property owners. In both cases, properties with close proximity to major roads and transportation options, plenty of parking, easy ingress/egress, and dedicated turn lanes are best. The commercial real estate location has a direct correlation to cost in that the best locations are usually more expensive. But, they may be worthwhile because they could result in increased sales and/or exposure for tenants seeking to grow.
Physical Aspects of the Properties
Again, this is another qualitative real estate metric, but it can have a major impact on a tenant’s decision about which lease to choose. Physical aspects of the properties include layout, finishes, and condition. For retail space, this is particularly important because tenants may have very specific branding standards and/or specifications for the space in which they lease. They may need a certain amount of square feet, a certain configuration, or a certain type of signage. Or, they may prefer certain finishes or have a requirement for a certain type of technology infrastructure.
From a property owner standpoint, the physical aspects and functionality of a commercial real estate property can have a major impact on its occupancy because tenants want to be in clean, modern, visible properties. In turn, these physical aspects can have an impact on property valuations and the rate of return as well.
Income of Properties
The location and physical aspects of commercial real estate has an impact on the rental rate / income that can be achieved. As a general rule, those properties with the best locations and finishes command the highest rents. Conversely, those with inferior locations and finishes command lower rents.
When these three factors are considered, the point is that it can be helpful to compare the cash flows of a lease in a comparative lease analysis exercise, but they aren’t the only consideration. Some tenants may be willing to pay more for a type of property that closely meets their requirements.
Comparative Lease Analysis & Private Equity Real Estate
The complexities of a commercial lease mean that it can be very tricky and/or time consuming to analyze. But, the practice of comparative lease analysis means that it is possible for tenants and property owners to make a data driven real estate investment decision. For this reason it is important.
Because it is so time consuming and complex, it can be a challenge for individual real estate investors to complete on their own. For this reason, it can be helpful to partner with a private equity firm to allocate capital to commercial property investments. In such a partnership, the private equity firm and the real estate professionals that work for it do all of the hard work of analyzing and comparing leases while individual investors reap the benefits of their work through regular distributions.
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 are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.