The goal of every commercial real estate owner is to keep the property as full as possible, at all times, with tenants who are paying as high a rental rate as possible. This certainly makes sense in theory, but it is a lofty goal. In times of economic distress companies may go out of business or consolidate their locations, leaving empty space in their wake. To find tenants to fill this space in a down market, property owners are usually reluctant to lower the rent because it can impact comps. Instead, they may offer different leasing incentives that have the same effect.
In this article, we are going to discuss a concept known as net effective rent. We will describe what it is, how it is calculated, and why it matters in a commercial real estate transaction. By the end, readers will have the information needed to calculate net effective rent on their own and incorporate this information into their pre-purchase due diligence process.
At First National Realty Partners, we specialize in the purchase and management of grocery store anchored retail centers. As part of our property management program, we make every effort to minimize leasing incentives, but recognize that it may be necessary from time to time. If you are an accredited investor and would like to learn more about our current commercial real estate investment opportunities, click here.
What is Net Effective Rent?
Net Effective Rent is a figure that expresses the average amount of a lessee’s monthly base rent over a commercial real estate lease term. This amount can differ from the contractual rent when there are leasing incentives or concessions present in the lease terms. Typically, these could include:
- Free Rent: Sometimes, a property owner will over some number of months of free rent to entice potential renters to sign a lease. This is especially common multifamily properties when an owner may offer 1 or 2 months of free rent as a move in bonus.
- Tenant Improvement Allowance (TI): In retail or industrial properties, owners may offer some amount of “tenant improvement allowance” that is meant to help a tenant offset the cost of customizing the space to their needs. Often the “TI” allowance is expressed as an amount per square foot. For example, if a tenant leasing 1,000SF of space is given a $10 PSF TI allowance, the total is $10,000.
- Leasing Commissions: In retail, industrial, or office transactions, it is common for a tenant and/or owner to be represented by a broker in the leasing transaction. When this is the case, the owner may pay a commission to the broker as a reward for securing a tenant for their space.
Any one or all of these items can result in a difference between the contractual rental rate and the net effective rate. To illustrate this point, it is helpful to understand how net effective rent is calculated.
How to Calculate Net Effective Rent (NER)
The formula used to calculate Net Effective Rent is:
Net Effective Rent: Total Gross Rent / Length of the Lease
To illustrate how this works, an example is helpful. Suppose that a multifamily property in New York (NYC) has a unit for lease that has a market rate of $1,000 per month. They are not getting any takers at this price so they decide to offer 1 month of free rent. Now, this does not actually mean that the tenant will go one full month without having to pay the rent. Instead, it means that the lease period will be 13 months (as opposed to the normal 12-month lease), but the 12 months of rent will be spread over that time.
So, if the total gross rent is $12,000, but the length of the lease is 13 months, the net effective rent is equal to $923 per month.
To drive this point home, suppose the incentive was two months of free rent. This means the same $12,000 would be spread over a 14 month term, making the net effective rent equal to $857 per month.
Net Effective Rent vs. Gross Rent
From this equation, it can be seen that gross rent is an important input into the calculation. So, it makes sense to clarify the difference between gross rent and net effective rent.
Gross rent is the amount of contractual rent described in the lease terms. Total rent is the monthly gross rent multiplied by the number of months in the lease term.
Gross rent is contrasted with net effective rent, which is the amount of gross monthly rent net of the impact of leasing incentives or inducements.
Why Investors Need to Understand NER
There are two reasons that investors need to understand net effective rent.
First, it is helpful as a tool to compare two or more leases. For example, if one lease is offering incentives and another isn’t, calculating the net effective rental payment provides a way to compare the monthly payments for both options.
Second, from a CRE investment standpoint, it can be a helpful way to quickly spot properties that are offering large incentives to potential tenants. This is a bad thing and a good thing. The bad thing is that it indicates there are issues getting tenants to lease space in the property. The good thing is that this could also be interpreted as an opportunity to close the gap through efficient management, which would serve to increase the property’s net operating income.
Net Effective Rent & Private Equity Real Estate Investing
The decision of when to offer leasing incentives and in what amount is a tough one. It requires detailed knowledge of the local real estate market and an informed point of view about macroeconomic trends. For investors who don’t work on leasing issues day in and day out, it can be easy to lose track of market conditions. For this reason (and others), it can be helpful for individual investors to partner with a private equity commercial real estate firm when allocating capital to commercial properties.
In the type of deals that we typically offer, investors partner with us to contribute capital to the deal. Once the purchase is complete, we handle the day to day operations of the property, including when to offer lease incentives. Because we are a vertically integrated firm (we handle property management in house), we are able to manage operating costs for the property and improve margins and cash flow for our investors.
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 info@fnrpusa.com for more information.
