- Commercial real estate leases are lengthy, complex, legal documents that are critically important to understanding the specifics of the income associated with operating a commercial property.
- Beyond the basic provisions of a lease like term, rent, and square footage leased, it is important to understand whether or not a lease includes periodic rental escalations and/or expense stops.
- A rental escalation is a periodic increase in the base rent for the space. The escalations could be at regular intervals (like annually) and the increase could be a percentage of the base rental amount or a fixed dollar amount.
- Rental escalations are beneficial for property owners because the extra income can be used to offset increase in the property’s operating expenses.
- Expense stops are the maximum amount of the property’s operating expenses that the owner is responsible for paying. Above a certain limit, the tenant(s) are responsible for paying the overage.
- When evaluating a potential purchase, it is important to understand these components of the lease for each tenant in the target property and to model them into the property’s proforma financial projections.
The fundamentals of a commercial real estate lease are such that a commercial property owner agrees to lease a certain amount of space to a business. In return, the tenant/business agrees to pay a certain amount of money in rent for the privilege of using the space.
In theory, this concept is easy enough to understand, but a commercial lease is a long, dense, complex, legal document that can stretch into the dozens of pages with many different clauses that outline the specifics of the lease agreement in minute detail. For this reason, it is absolutely critical to understand the key details of the lease structure for existing tenants prior to making an investment. Beyond the basic provisions like term, rent, and square footage leased, two of the most important clauses to look for are those that contain language about lease escalations and expense stops. They are discussed in detail below.
Most leases start with some initial rental amount that increases over time. These rental increases are known as lease “escalations” and they are detailed in the contents of the lease. The general idea behind building escalations into a commercial lease is that inflation makes it more expensive to operate a property over time so they are needed to offset rising operating costs.
Depending on the needs of the tenant and the desires of the property owner, the structure of the escalations can vary, but they usually take the form of a percentage of the base rent. Sometimes the percentage is tied to the consumer price index (CPI), other times it is a fixed percentage. For example, a commercial tenant could sign a 5 year lease for a 2,500 SF space at a base rent of $15.00 per square foot. Per the terms of the lease, there will be a 3% rent increase every year. As such, the annual rental amounts are displayed in the table below:
Writing a rent escalation clause into the lease has a benefit for the property owner because they will receive more income over time with each annual increase If they are able to keep operating expenses (like property taxes) relatively flat, the increased income goes directly to the bottom line, resulting in improved Net Operating Income (NOI) and higher property values, both of which are wins. For the tenant, it is helpful to know what the lease escalations are going to be ahead of time so they can plan for them in their capital budgeting process.
From an underwriting and due diligence perspective, it is important to understand what the escalation structure is because it needs to be included in the proforma financial projections for the property. This will provide a more realistic picture of the property’s income over the course of the holding period.
While lease escalations cover the income side of the ledger, another major clause to be aware of is the expense structure.
While the property owner has the benefit of collecting rent from all of their tenants, they also have the responsibility of using that income to pay for the expenses required to operate the property. Typically, these expenses are for things like property taxes, insurance, utilities, HVAC, common area maintenance, janitorial, and landscaping. To protect themselves from ever increasing operating expenses, a property owner may seek to implement an expense stop as part of their lease negotiations. Doing so can allow them to pass some of the operating costs along to the tenant(s).
By definition, an expense stop is the maximum amount of operating expenses that a property owner is responsible for paying. Anything above the stop amount is the tenant’s responsibility. To illustrate how this works in practice, an example is helpful.
Assume that an investor is evaluating the purchase of a 20,000 SF office building. It contains two tenants, each of whom have signed a gross lease for 10,000 SF of space. The terms of the lease mandate that each tenant pay $15 PSF in rent and the owner is responsible for all of the property’s operating expenses up to $10 PSF ($200,000 total). Anything above this level is the tenant’s responsibility. The $10 PSF figure is the expense stop.
Now, assume that the investor purchased the property and at the end of the first year, they have tallied total operating expenses, which came out to $280,000. Per the lease terms, the property owner is responsible for the first $200,000 and the tenants are responsible for the $80,000 overage. Because they each lease 10,000 SF, they would each be responsible for their pro-rata share or $40,000.
The specifics of the expense stop can vary from one lease to another. In some leases, the structure may be similar to the example above, but in other cases, there may be a base year expense stop. In this case, the property owner is responsible for all of the operating expenses in year one of operations. Whatever that amount turns out to be, it sets the expense stop and any amount in excess of this figure in future years is the tenant’s responsibility.
For the property owner, the benefit of an expense stop is that they have some protection against rising operating expenses and they are able to predict what their operating expenses are going to be. For the tenant, the benefit is that their exposure to operating expenses is somewhat limited, but this may be offset by a higher base rent.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
When evaluating potential properties for purchase, we invest a significant amount of time and energy to ensure that we understand the specifics of each lease in a potential acquisition.
If you are an Accredited 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.
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