LEASES AND HOW THEY ARE USED

VALUE CREATION

With all due respect to appraisers, buildings have no value. Yes, a building structure does have some residual value in the bricks, steel, and concrete, but the building itself is essentially worthless. The true value of any building is in the leases. The leases produce a cash flow annuity, and that annuity is what creates value. It is essential for a developer to focus on the quality of the cash flow. As a concept, consider a stock portfolio that has dividends. Each investment has risk, and as you manage a stock portfolio, you are concerned about concentrations and diversification. A building is no different; a building is nothing more than a lease portfolio. Each lease has cash flow, each tenant has a level of risk, and you want to control concentration to ensure diversification in your portfolio (of leases). If you focus on the concept that a building is nothing more than a portfolio of leases, you will have a good understanding of property investment analysis and understand how to evaluate and structure leases. It is the leases in a building that create the value of a building.

WHAT IS A LEASE?

Basically, a lease is a contract between a landlord and a tenant, and if you recall, a contract requires only an offer, acceptance, and consideration— everything else is negotiable. Accordingly, as long as a lease has the essential elements of a contract, everything else is negotiable; there is no such thing as

a boilerplate lease. A lease contract limits the common law rights granted to a leasehold in law. Not unlike a fee simple ownership interest, a leasehold interest is a bundle of rights. Both a fee simple ownership interest and a leasehold interest have the right of possession and the right of quiet enjoyment. A leasehold, on the other hand, may have the right of modification and may have the right of sale or assignment. The details of these two rights are some of the major items negotiated in a lease contract.

COMMON LEASE STRUCTURES

Broad categories of leases include a gross lease and a net lease. In a gross lease, the tenant pays an amount to the property owner that includes a base rent plus an (estimated) amount to reimburse various operating expenses. A net lease, on the other hand, is a base rent plus charges for a share of various actual expenses incurred by the property owner. Note: You should be careful when reading and evaluating a net lease. Today, most people who refer to a net lease are really referring to a triple net lease, and there are actually a single net lease and a double net lease as well. In a triple net lease, a tenant pays a share of real estate taxes, insurance, and common area maintenance expenses. In a double net lease, a tenant pays a share of real estate taxes and insurance, and in a single net lease, a tenant only pays a share of real estate taxes. To determine what kind of lease you might be evaluating, refer to the section of the lease that addresses cost reimbursement or allocation of expenses, but be sure to read the lease in its entirety.

There are several general categories of leases. The first category of lease is a graduated lease, which is nothing more than a lease where its base rent increases at some specified rate over the term of the lease. In a stairstep lease, the base rent is fixed for a period of time, and then it increases by some specified rate and is again fixed for a similar period of time. An index lease is a graduated lease where the base rent increases on the basis of changes in a predetermined index, such as the Consumer Price Index or CPI. (If the year-to-year CPI increases by 3 percent, the base rent amountthen increases by 3 percent.) With a fixed lease, the base rent is fixed for the entire term of the lease. (The most common type of fixed lease is an apartment rental lease.) A reappraisal lease is commonly associated with a ground or land lease. Ground lease rent is based on the current value of the land at the time the lease is signed. The value of the land will likely increase over the term of the lease, which in the United States is the term is often 99 years. So to better reflect the value of the land in the ground lease payment, the land may be reappraised at, say, every 25 years of the ground lease term and the rent adjusted by the same percentage that the land value increased. A percentage lease typically applies to a retail tenant. A retail tenant on a percentage lease pays a lower base rent but also pays a specified percentage of its sales (as defined in the lease) as additional rent. If you reflect upon some of the definitions of the types of leases, you will begin to understand that the lease contract is actually an exercise in economics. You are trying to structure a lease, including the rent payments, such that during the term of the lease the property owner makes a regular profit that is not reduced by increased expenses and provides adequate debt coverage to satisfy the lenders. The best example of this is choosing a gross lease over a triple net lease. Again, with a gross lease, the tenant pays one amount that covers a base rent plus a presumed allocation of expenses over the term of the lease. Let’s say that the lease term is five years. How confident do you feel deciding on rental amounts that will match or be higher than the rate of inflation for your operating expenses over the next five years? This is the dilemma faced on every lease transaction; leases are an exercise in economics and economic forecasting. As you consider the expenses you want to charge a tenant in a lease, you also need to consider how the rent will be calculated. Will the (graduated lease) rent be adjusted on annual basis? When the rent adjustment occurs, does the rent adjustment occur from a mathematical perspective at the beginning of the month or at the end of the month? These points could significantly affect the cash flows and yield of a particular lease contract and on the value of your (building) lease portfolio. When you are structuring the expense pass-through to a tenant in a lease, it is not unusual to structure an expense stop (that is, a maximum annual expense pass-through amount) or an expense base, according to which the property owner cannot pass-through expenses until the expenses exceed a predetermined amount. Again, the decisions made regarding rent escalations and expense pass-throughs have a direct economic effect on a particular lease contract and the value of your (building) lease portfolio. What types of concessions might you give a tenant? Common concessions like a period of free rent or renewal options come at a cost to the property owner. Any concessions given to a tenant should correspond with a concession given to the landlord by the tenant. Concessions vary greatly and could include equity participation, right of first refusal, and relocation options; they are not necessarily monetary in nature. The type and amount of concessions given to a tenant depend wholly on market supply-and-demand conditions and the intensity of the property owner’s desire to obtain a particular tenant. All of the terms of the lease, whether financial or legal, establish the value of a property or add to the property’s cost base. Nevertheless, remember that a building is no more than a portfolio of leases.

LEASE MANAGEMENT AND ANALYSIS

A key part of lease management includes regularly reviewing your lease plan for the size of spaces leased. You want to be sure that tenants are effectively placed within the building so that there are few odd–shaped or small leftover spaces that cannot be leased, making them non-revenue-producing and thus reducing the overall value of your building. Given the placement of tenants within a building, do not overlook the value of an effective tenant mix, balancing national tenants and local tenants, as well as tenants of different industries. This balance of tenants also extends to the lease maturities and options in their leases. In a new building, if you were to execute leases with a common maturity of five years, in five years your building could be vacant because all of the leases expired. So when evaluating leases, you should consider staggering the lease maturities as much as you possibly can so that at any given point in time, you have enough leases in place to provide, say, a minimum debt service coverage for the building. The staggering of lease maturities is not an easy task, but it is not impossible either. If you effectively stagger the lease maturities so that your building consistently has a minimum debt service coverage, and have reliable credit tenants, you can have a building cash flow that will sustain itself during downturns in the real estate cycle. In addition, a database of lease abstracts should be established for all of the leases within a building. A lease abstract is a detailed summary of the terms and conditions of a particular lease. The idea behind the lease abstract is that it saves you the time of repeatedly reading a lease contract; however, leases have become so complicated in their terms that the lease abstract can be almost as lengthy as the lease contract itself.

#organization #goodworkhabits