Magazine article Journal of Property Management

Leasing to Maximize Cash Flow

Magazine article Journal of Property Management

Leasing to Maximize Cash Flow

Article excerpt

In many parts of the country, the commercial real estate markets are in a state of chaos. Building foreclosures, tenant bankruptcies, and the slackening demand for space are crippling previously healthy property portfolios held by pension funds, insurance companies, corporations, and other institutional investors.

Out in the streets, competition for scarce tenants has become fierce. The combination of lower rents, higher tenant improvements, and increased free rent and moving allowances is enough to make most tenants feel that they have won the lottery.

In this difficult leasing environment, there are still some owners, advisors, and property managers who mistakenly use leasing strategies that attempt to maximize asset value, rather than net cash flow.

Two common leasing strategies are to wait for a premium rent deal or to allow a higher concession package and a higher gross rent in an attempt to maximize the property's value on paper.

This article will demonstrate why these strategies are flawed and can cause the property owner to lose money. By using the "time value of money" approach to analyzing proposed lease deals, owners can protect their own interests by maximizing the net cash flow and sale value of their properties.

DON'T WAIT FOR PREMIUM RENTS

The specific problem with holding out for premium market rates is that the old real estate adage, "the market is the market" usually holds true. When the property is leased several months later at market rates, the owner must absorb the carrying costs of that vacancy.

For example, assume we have a vacant shell office building of 40,000 square feet which has never been occupied. The fixed operating costs such as property taxes, common area maintenance, HVAC maintenance, grounds maintenance, and security must be paid by the owner if the space is empty.

On a pro-rata basis, we can determine that the monthly debt service associated with this space is $48,000, and the fixed operating expenses are $16,000, for a monthly total of $64,000 in costs.

In this instance, the owner waited an additional six months looking for the right deals before finally consenting to negotiate with prospective tenants at market rates. As a result, he incurred an extra $384,000 in carrying costs, or $0.16 per square foot, per month, based on a 60-month lease term.

The problem with this strategy is that the cost of this additional downtime is usually greater than any rent premium the building owner can achieve.

COMPARING LEASE DEALS

On the other hand, using above-standard tenant improvement allowances to achieve a higher rental rate by amortizing these excess improvements often causes an owner to lose money on a net cash flow basis. Many owners still fail to measure the time value of money on their increased expenditures.

The time value of money means that the value of money depends on when it is received. For example, a dollar today is worth more than a dollar received in one year because a dollar received today can be invested. If a dollar received today is invested at 12 percent, in one year, that dollar will be worth $1.12.

Similarly, a dollar received one year from now must be discounted to compare it to a dollar today. The rate used to discount future cash flows is called the "discount rate." Usually, the discount rate is the minimum return the investor wants to receive.

The time value of money technique is critical in measuring the value of a lease because the property owner must pay high costs up front for tenant improvements and commissions in exchange for a future rental stream. The property owner must "discount" this future rental stream.

For example, if an investor invests $5,000 and receives payments of $1,000 in Year 1, $2,000 in Years 2 and 3, and $3,000 in Year 4, he or she would calculate the present value of this future stream of cash flows by discounting each year of cash flows as follows:

(Table omitted)

The sum of the discounted cash flows represents the present value of this future stream of cash flows. …

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