Aligning the numbers when comparing multiple leases during Lease Negotiation

By | November 23, 2013

In a previous Blog posting, we introduced our readers to the Lease Analysis component of iLeasePro, our comprehensive lease management technology solution specifically designed for lessees. We indicated that Lease Analysis is an invaluable tool that supports lease negotiations and lease reassessment by providing the user with the technology for evaluating all the financial terms and conditions associated with alternative leasing opportunities and facilitating an “apples to apples” comparison of those alternatives.

A narrative description can only do so much to explain the capabilities of Lease Analysis, therefore, in this whitepaper, we present an example of a proposed transaction and how Lease Analysis can be utilized in the decision making process.

Our example company, Acme Holdings (”Acme” or “the Lessee”) must expand its operations and is evaluating three office locations with 10,000 square feet of available space. Acme has decided on a seven year lease term with no options periods and has determined that it will require tenant improvements (“TIs”) of $30 per square (total of $300,000) to outfit the space to its needs.

Lease 1 rent payment is for $25 per square foot in the first year increasing $1 per square foot each year to $31 in the final year of the lease. The landlord will not provide any TI allowance and there are $50,000 of other lease costs that must be paid by the Lessee. Additionally, for Lease 1, the landlord is proposing a lease with expense-stops and Acme is estimating that it will incur expense chargebacks of $82,813 over the seven year term of the lease based upon the base year costs and its 15% pro rata share of the property.

Lease 2 has twelve months of free rent in the first year of the lease with rent of $35 per square foot beginning in the second year and increasing $1 per square foot each year to $40 in the final year of the lease. The landlord for Lease 2 will provide a TI allowance of $150,000 with $10,000 in other lease costs that must be paid by the Lessee. For Lease 2, the landlord is proposing a lease with expense-stops and Acme is estimating that it will incur expense chargebacks of $51,529 over the seven year term of the lease based upon the base year costs and its 10% pro rata share of the property.

Lease 3 has rent beginning at $30 per square foot in the first year and increasing $1 each year to $36 in the final year of the lease. The landlord here will fund a TI allowance of $300,000 and there are other lease costs of $20,000 to be borne by the Lessee. For Lease 3, the landlord is proposing a lease with expense-stops and Acme is estimating that it will incur expense chargebacks of $99,376 over the seven year term of the lease based upon the base year costs and its 15% pro rata share of the property. Acme is using Lease Analysis to evaluate these alternatives and, in order to produce a comprehensive due diligence analysis, only certain basic information is required to be entered into iLeasePro, namely, property/unit description, square footage, lease term, rent payments, expense chargeback estimates, TI requirements, TI allowances, other lease costs, amortization period for TIs and other lease costs and a discount rate for present value calculations. Here Acme is using 6% as the discount since this is its cost of borrowing.

Lease Analysis produces the following report for the evaluation of the three alternatives.

Commencement Date

1/1/2014

Expiration Date

12/31/2020

Lease Term (Months)

84

Lease Term (Years)

7

Rentable Square Feet

10,000

Discount Rate

6.0%

 

 

 

Lease 1

Lease 2

Lease 3

Property Sq Ft

150,000

100,000

150,000

Lessee ProRata for CAM

15%

10%

15%

Base Rent PSF

$25

$35

$30

Base Rent Annual Amount

$250,000

$350,000

$300,000

Free Rent Months

0

12

0

Free Rent Amortization

0

12

0

Tenant Improvement Allowance PSF

$0

$15

$30

Tenant Improvement Allowance

$0

$150,000

$300,000

Tenant Improvement Total Cost

$300,000

$300,000

$300,000

Tenant Improvement Cost Amortization

84

84

84

Other Lease Total Cost

$50,000

$10,000

$20,000

Other Lease Total Cost Amortization

84

84

84

Rent Payments (PSF)
2014

$250,000

$0

$300,000

2015

$260,000

$350,000

$310,000

2016

$270,000

$360,000

$320,000

2017

$280,000

$370,000

$330,000

2018

$290,000

$380,000

$340,000

2019

$300,000

$390,000

$350,000

2020

$310,000

$400,000

$360,000

Base Rent

$1,750,000

$2,450,000

$2,100,000

Escalations

$210,000

$150,000

$210,000

Free Rent

$0

-$350,000

$0

Annual Rent Payment

$1,960,000

$2,250,000

$2,310,000

Present Value of Annual Rent Payment

$1,643,100

$1,835,657

$1,938,964

Average Annual Rent Payment

$280,000

$321,429

$330,000

Net Effective Annual Rent Payment

$277,676

$310,217

$327,676

Expense Chargebacks

$82,813

$51,529

$99,376

Tenant Improvements

$300,000

$150,000

$0

Other Lease Costs

$50,000

$10,000

$20,000

Total Costs

$432,813

$211,529

$119,376

Total Annual Rent Cost

$2,392,813

$2,461,528

$2,429,376

Present Value of Total Annual Rent Cost

$2,004,753

$2,011,845

$2,034,817

Average Total Annual Rent Cost

$341,830

$351,647

$347,054

Net Effective Total Annual Rent Cost

$338,794

$339,992

$343,875

 

Notice that the report displays all the critical information necessary to evaluate the lease alternatives.  The calculations of annual rent payments and annual rent costs include amortization of rental concessions, TIs and other lease costs over the term of the lease. Especially helpful are the present value and the net effective rent calculations to determine the true cost of the alternatives.  In evaluating the three alternatives, Acme has a number of variables to consider.

Lease 1 presents the lowest rent payments and notice that when other costs, such as outlays for TIs, other lease costs and expense chargebacks are considered, the total cost, average rent cost and net effective rent for this alternative are also the lowest on both an absolute and present value basis. However, with this option, Acme must make upfront cash payments of $350,000 for TI and other lease costs .  In Lease 2, Acme gets the benefit of free rent for the first year of the lease and a $150,000 TI allowance so the cash requirements in the first year are the lowest among the three alternatives. However, rent payments increase substantially over the term of the lease and total cost, average rent and net effective rent, on both an absolute and present value basis, are higher than Lease 1. Lease 3 presents the highest rent payments but also has the highest TI allowance and a rather modest amount for other leased costs. The resulting total cost, average cost and net effective rent are also higher than Lease 1.

Which lease options should Acme choose?  The answer may not be as obvious as it seems.  The initial choice might be Lease 1 because of the lowest cost results for most of the metrics. But cash payments early in the term of the lease may be a critical factor to an organization that has cash flow concerns. That might make Lease 2 or Lease 3 a more attractive alternative. Maybe Lease 2 is in a more prestigious location than Lease 1 and justifies the extra $1,198 per year effective rent.  Conversely, perhaps Acme has substantial cash at the beginning of the lease term and wants to have as low cash payments as possible over the term of the lease.  In addition, Acme may know that it will be likely to renew the lease after the seven year term and may want to enter into those negotiations with the lowest rent payments in the seventh year of the lease term. Once again, that might make Lease 1 a likely choice.

We are not here to draw a conclusion in this example. We cannot possibly know all of the considerations that would enter into a final conclusion. However, we have demonstrated that Lease Analysis can provide the user with an easy to evaluate, side by side comparison of all the relevant information necessary to draw a conclusion based on its business needs and situation. Too many times, lessees focus on only one aspect of a potential transaction when making a decision – the annual rent payments. But the other costs associated with the transaction should not be overlooked. For example, the negotiations involving the TI allowance or free rent are often critical issues for most office leases. A healthy TI allowance can mitigate much of the cost associated with setting up or moving an office. Free rent can be a critical factor for a start up entity.   Lease Analysis can be instrumental in helping the user determine how these aspects of the lease fit into the overall negotiations.

Too often lease management systems do not consider the need for a technology solution to assist in sorting out all the critical issues associated with evaluating lease alternatives and providing the user with the statistical tools for an effective negotiation. In fact, this is the most important part of the process – understanding all the aspects of the alternatives and getting the best deal. In planning iLeasePro, we were determined to develop an end to end technology solution that provided critical assistance to the user during the full life cycle of the lease. Our Lease Analysis component provides that type of critical assistance.