Magazine article Journal of Property Management

To Lease or Not to Lease?

Magazine article Journal of Property Management

To Lease or Not to Lease?

Article excerpt

There you are, a seasoned asset manager, sitting in your office when the phone rings for the tenth time this morning. Once again, it is one of your on-site leasing agents calling to discuss a new lease proposal for one of your many properties.

It is time to make another decision. . . a decision that probably will include investing significant amounts of capital for tenant improvements. The question is, as usual: Is this a "market deal"? In other words, "Should you make the lease or pass?"

The reality is, however, that every lease deal is unique, and there is no such thing as a "market deal." Most leases within a given market fall within a narrow range of revenues and costs. The problem is how to determine which lease proposal is "better" for the owner when there are so many variables.

To solve this problem intelligently you need two important tools. First, you must know everything about your property, including the investment strategy, the operational/tactical objectives, the property's relative competitive position in the market, its competitive advantages and disadvantages, market and submarket supply/demand characteristics, and the prospective tenant's credit history. Second, and just as important, you must have a consistent, reliable methodology for analyzing lease economics on a comparable basis. There are dozens of methods available today to do these analyses. All the different types have one common theme: They forecast lease income and expenses over the lease term and then discount the cash flows back to the beginning of the lease term.

FIGURE 1 Two Lease Deals

Terms: $12.50 psf for base rent
$4.75 psf expense stop
$10.00 psf for TIs, 6.0% LCs
Deal A--$3.75 psf
Deal B--$2.25 psf

                              Deal A                   Deal B
                              5 years                  3 years

Income                        $12.50                   $12.50
Expenses                       (4.75)                   (4.75)

NOI                           $ 7.75                   $ 7.75
TIs                            (2.55)                   (3.87)
LCs                            (0.96)                   (0.87)

Cash Flow                     $ 4.24                   $ 3.01

All numbers are annualized and on a psf basis TIs and LCs are amortized at a
10%  annual interest rate compounded monthly

This article will focus on a lease-analysis methodology called the "level-pay" analysis. The level-pay analysis is common in the industry and has proven to be an effective analytical tool. While these analyses will not tell you whether to lease or pass on a deal, they do provide a powerful methodology to compare one lease to the next or one proposal to a counter-proposal.

How level-pay analysis works

The goal of the level-pay analysis is to calculate the annual net effective cash flow from the lease. This is usually done on a per-square-foot basis. The following equation illustrates the methodology:

Gross Effective Rent - Base-Year Operating Expenses and Taxes - Amortized Costs

= Net Effective Annual Lease Cash Flow

The gross effective rent should be the average rent over the lease term. It is calculated by adding the total rent payable over the lease term and then dividing by the number of years.

The base-year expenses (or the expense stop) are either current-year expenses or the amount of pass-throughs negotiated in the lease. For example, if the lease is triple-net, the base year would be $0 (or some minimal recoverable expense). The key is to be consistent from one analysis to another.

Amortized costs are the level payments required to fully amortize the up-front lease costs, which generally include tenant improvements, leasing commissions, moving costs, lease buy-out costs, and so forth. These costs are generally discounted by 10 percent annually for analysis purposes.

Figure 1 illustrates how this type of analysis is used for deal comparisons. …

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