No matter the property type or asset class, the returns from every commercial real estate (CRE) deal primarily consist of two components, appreciation and income. In some ways, the two are tied together.
The appreciation component occurs when a property is sold for more than the purchase price. The difference between the two prices is known as a “gain” and it can make up a significant portion of the overall return. To maximize the possibility for a big gain, investors and fund managers put a significant amount of resources into understanding the supply and demand characteristics of a given market and whether they offer the potential for price increases. But, the problem with a gain is that it can take a long time to materialize. Many commercial real estate investments have proposed holding periods of 5-10 years or longer. In the interim, investors rely on the income produced by the rents to provide a return.
By definition, a commercial property contains space that is rented to tenants. It could be office space, retail space, or some other type of commercial space, but as long as the income produced by the property is more than it costs to operate it, including the loan payments, the property is cash flow positive and can distribute the funds to investors. But, the income isn’t certain. It is contractually mandated by a legal agreement, known as a “lease,” the term of which can vary by tenant. Some prefer shorter term leases in the 2-5 year range. Others prefer longer term leases in the 10+ year range. Fundamentally, the purchase of a commercial real estate asset is an investment in a stream of income over a period of time. The longer, and more certain, the income stream, the more valuable it is.
What is a Commercial Real Estate Lease?
Simply, a commercial real estate lease is a legal agreement between a property owner and a tenant. In return for the property owner allowing a tenant to occupy a space in the property, the tenant agrees to pay a certain amount of rent to do so. These terms, which include the rental rate, are codified in a lease agreement
Generally, there are two different types of commercial real estate leases, gross and net. In a Gross Lease, sometimes called a “full service lease,” the tenant is responsible for paying a base rent amount and the landlord pays the property’s operating costs (like property taxes and property insurance). In a “modified Gross Lease”, sometimes referred to as a single net lease or double net lease, the tenant is responsible for paying their base rent plus some portion of the operating expenses that are typically equivalent to the pro-rata share of the square footage leased. In a triple net lease, sometimes called an NNN lease, the tenant pays a base monthly rent amount and all of the expenses required to operate the property.
Regardless of the lease type, they all have a term, which is the contractually mandated period over which the tenant must pay rent (plus additional expenses as required by the lease agreement). Smaller, local tenants typically have shorter term leases in the 2-5 year range. Other larger tenants who really want to commit to a location may prefer a longer term lease of 10-25 years. In addition, some tenants (or property owners) may negotiate a series of “options” that will allow a tenant to extend their lease beyond the initial term if they choose to do so.
Put As the title of this article suggests, the length of a lease’s term has a major impact on the property’s value in a purchase or sale transaction.
Why Lease Term Impacts Value
In a word, it is all about risk. Beyond ownership of a physical asset, a commercial real estate investor is purchasing a stream of income when they acquire an asset. The length and certainty of that income stream is closely correlated to the amount of risk in the transaction.
For example, assume that an investor is trying to decide between the purchase of two different properties. Both of them have 50,000 square feet of leasable space and a grocery store as an anchor tenant who occupies 25,000 square feet, or half of the overall space. In property one, the grocery store has 3 years remaining on their lease and they have indicated they are as yet uncertain about renewing it. They are considering other locations in newer centers and have not, and will not make a decision until the final year of their lease. In property two, the grocery store recently renewed their lease for a 15 year term and they have indicated that they are very committed to the location. Which property do you think would sell for a higher price. Clearly, it would be property two. But, why?
With property one, there is a very real risk that the tenant could choose not to renew their lease and move to a different location. If this were to happen the new property would immediately be faced with two significant issues. First, they would immediately lose 50% of the property’s income which would likely threaten the property’s ability to make the required loan payments. Second, the property owner is faced with the prospect of having to re-lease the space at a rate that could be more or less than what the grocery store was paying. In addition, they may need to invest a significant sum in tenant improvements as an incentive to sign a lease. In short, it adds a degree of uncertainty and risk to the transaction.
In property two, the investor has the comfort of knowing that the grocery store anchor just renewed their lease for 15 years and have indicated they are committed to the location. The certainty of knowing this lowers the risk in the transaction, which means that the investor is likely willing to pay more for the asset.
How Leases Can be Used to Position a Property for Sale
When we know that we are approaching the sale date of a particular asset, one of the ways that we “position” the property is to review all leases for their remaining term. For those that have expiration dates within the next 1-3 years, we actively work to extend the term and increase the property’s value in the process. To convince a tenant to extend a lease term or sign a renewal, there are a number of incentives that we can offer:
- Ask: If a tenant has renewal options built into their lease, we can simply ask if they will exercise them early. If the tenant is committed to a location and happy with their situation, they may oblige.
- Lower Contractual Rental Increases: Some leases contain contractually mandated increases in the rental amount at regular intervals throughout the term. For example, a lease could say that the rent goes up by 3% annually. To entice a tenant to extend the term or exercise a renewal option, we can offer to decrease or eliminate the rental increases. Net Operating Income may suffer in the short term, but property value could benefit as a result.
- Offer Rent Relief: If we need to offer a stronger incentive, the next most obvious choice is to offer to lower the tenant’s rent. For example, say that a tenant has one year left on their lease at $15 per square foot. We could approach them and say, if you renew your lease for five years, we will lower your rent to $14.50 per square foot. This is a win/win situation. The tenant gets lower rent and we get the certainty of a longer term on their lease.
By leveraging our operational expertise, experience, and tenant relationships we can utilize one or all of these strategies to both increase lease terms and the value of the property as we approach a sale date.
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.
To learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.