3 hr. Course on Commercial Real Estate Lease Analysis.

1. Commercial Lease Analysis
By D. Scott Smith CCIM
Commercial Manager
Professor of Real Estate
Prudential PenFed Realty
Commercial Sales and Consulting
5000 Lawndale Ave.|Baltimore, MD 21210
Office: 410-464-5500|Cell: 443-691-8153

2. We Will Review
• Types of Leases • Lease Value
• Leasing Process • Landlord Vs. Tenant
• Clauses in leases • Legal

3. Introductions

4. What is a Lease?

5. A lease is a contractual arrangement
calling for the lessee (user) to pay the
lessor (owner) for use of an asset.
For today’s class all tenants will be
considered a fixed term tenancy.

6. Several Lease Types
• Land Lease
• Capital Lease
• Operating Lease
• Gross Lease
• Modified Gross

7. Several Lease Types
• NNN Lease
• Industrial Gross Lease
• Percentage Lease
• Or any combination

8. Several Lease Types
Each asset type, as well as geographical area
will have different components
(IE. $3 a sqft vs. $36 a sqft.)
Pass through, TI, etc.

9. Lease Full Net of Modified NNN Absolute
Structure Service Elec. Gross Net
Taxes X X X
Prop. Insurance X X X
Maintenance -
Various X X X
Management X X X
Utilities X
Janitorial X X
Capital Exp. Tenant
Responsible
Most typical type Office Office Flex / Lt. Retail Single Tenant
of property using Industrial and Industrial or
this lease Industrial Retail

10. Several Lease Types
Due to a lease being legally binding we
suggest all leases be written or reviewed by
legal council.
I am not an attorney and don’t write leases.

11. Leasing Process

12. Leasing Process
• Client Application
• Needs Assessment
• Screen the client
• Screen the property

13. Leasing Process
• Build your team
Attorney
Contractor
Space Planner
Lender
• Set your timeline

14. Leasing Process
• Match Goals, Expectations with Property and
Lease
• Rentable, Useable, Core Factor, Common
Area

15. Leasing Process
• LOI
• First draft of lease
• Lease commencement
• Occupancy
• Maintenance
• Renewal

16. Leasing Process
Many steps to get through between each stage

17. Lease Clauses

18. Summary of Legal Issues
• Commencement Date • Relocation
• Use/Exclusivity • Subordination and
• Operating Expenses Nondisturbance
• Assignment/Subletting • Waiver by Tenant
• Zoning and Use
Restrictions
18

19. Commencement Date/ Tenant
Issues
Commencement Date
• Date on which the obligation to pay rent starts
• Distinguishable from execution date and occupancy date
• Issues arise when tenant improvements are
contemplated
19

20. Commencement Date/ Tenant
Issues (cont.)
1. Landlord’s Interest
a) Rent payments to commence as quickly as possible
b) Minor (punch-list) items can be completed after
commencement date
c) Minimize tenant delays
2. Tenant’s Interest
a) Sufficient time provided to complete tenant improvements
before rent commencement date
b) Reasonable cancellation rights in the event
delivery of premises is delayed
20

21. Use/Exclusivity
• Use Clause: Statement of what businesses and
activities tenant may conduct in the premises
• Exclusive Use Clause: Statement of what businesses
and activities that only tenant can conduct within the
project
• If something is not set forth in the Use Clause, the tenant
normally cannot conduct that activity in the premises.
• If something is not set forth in the Exclusive Use Clause,
then the tenant cannot stop other tenants
from conducting those activities.
21

22. Use/Exclusivity (cont.)
1. Landlord’s Interest
a) Wants a narrow Use Clause
b) Wants either no Exclusive Use Clause, or wants a
narrow one
2. Tenant’s Interest
a) Wants a broad Use Clause ... ultimately that tenant can
use the premises “for any lawful purpose”
b) Wants a broad Exclusive Use Clause
22

23. Operating Expenses
1. Expenses of operating real property, usually paid in
addition to base rent
2. Typically includes taxes, insurance, utilities, and
property maintenance costs
3. Typically excludes debt service, capital improvements,
and depreciation
4. Landlords always recoup operating expenses, whether
under NNN or FSG lease
23

24. Operating Expenses (cont.)
1. Landlord’s Interest
a) Recoup all expenses associated with operating the property
b) Seek to recoup capital expenses (i.e., roof, paving, HVAC,
capital expenses that reduce operating expenses)
c) No cap on operating expenses
2. Tenant’s Interest
a) Limit operating expenses to only those expenses associated
with operating the property
b) Cap controllable operating expenses to
3-5% annually
c) Exclude all capital improvements, if possible
24

25. Assignment and Subletting
• Assignment: The transfer of the legal rights and duties of the tenant
under a lease to a third party called an assignee
– The assignee pays its rent to the landlord, and the landlord and
assignee now owe each other the same duties that applied to the
original tenant/assignor.
• Sublease: An agreement in which the tenant contracts with a third
party to assume all or part of its rights and/or obligations under a
lease. The third party in this case is called a sublessee.
– The sublessee generally pays rent to the
sublessor (the original tenant), and has no
“privity” relationship with the landlord. The
landlord doesn’t owe duties to the sublessee.
25

26. Assignment and Subletting
(cont.)
1. Landlord’s Interest
a) The landlord would usually prefer that the tenant not have any
assignment or sublease rights (unless, of course, the
assignee or sublessee is a better tenant than the assignor or
sublessor was).
2. Tenant’s Interest
a) The tenant would like to be able to assign or sublet to anyone
he/she chooses. In both assignment and sublet situations, the
tenant is usually responsible to the landlord for rent payment.
So, the
landlord (in theory) still gets his/her
money.
26

27. Relocation
1. A relocation provision or clause in a lease allows the
landlord to move the tenant to another location in the
building.
2. Frequently, the landlord will agree to pay some amount
for the tenant’s inconvenience (i.e., moving expenses,
cost of stationery, etc.).
3. Unfortunately, tenants rarely focus on this provision.
27

28. Relocation (cont.)
1. Landlord’s Interest
a) Provides flexibility to accommodate a new or bigger
tenant in the future
2. Tenant’s Interest
a) Possible nicer suite or space in the building
28

29. Subordination and
Nondisturbance
• Subordination: A lease clause requiring the tenant of a property to
subordinate its rights under the lease to the rights of any present or
future lender on the property.
– Landlords require subordination clauses, because lender requires
it. He who has the gold makes the rules.
• Nondisturbance: A lease clause requiring the lender in a foreclosure
situation to leave the tenant’s lease in place.
– Tenants require nondisturbance clauses. If the tenant executes a
lease with a subordination clause or a subordination agreement
without a corresponding nondisturbance clause,
then the foreclosing lender could kick the tenant
out of its premises.
29

30. Subordination and
Nondisturbance (cont.)
• Why do these items matter?
– In the event of a foreclosure, the lender can remove from the
project any tenant whose lease is subordinate to the loan.
Alternatively, they can require a change in the business terms of
the lease, or change the legal terms.
– Landlord can’t remove this requirement because it greatly impacts
the landlord’s ability to finance its project.
• The compromise
– Lenders will generally agree not to kick a tenant out, or to change
the lease terms, if the tenant will agree to subordinate
the lease to the loan.
– Usually, tenants and lenders execute a document called a
subordination and nondisturbance agreement (SNDA).
30

31. Waiver by Tenant/Release of
Landlord
1. Tenant waives any claims and releases the landlord
from liability for certain acts and conditions relating to
the premises.
2. In some cases, tenant agrees to bear risk even if
landlord is at fault.
3. Provisions tend to be overly broad and unfair.
31

32. Waiver by Tenant/Release of
Landlord (cont.)
1. Landlord’s Interest
a) Shift the risk of contingent liabilities to the tenant to the
greatest degree possible.
b) Maintain income stream without unbudgeted or unexpected
expenses eating into that income stream.
2. Tenant’s Interest
a) Avoid consequences of the landlord’s negligence or failure to
perform its obligations under the lease.
b) Limit waiver to exclude negligence or
willful misconduct of landlord.
32

33. Zoning/Use Restrictions
1. Master zoning laws and use restrictions in your
market.
2. Failing to do so is a great way to bring your client
spaces that they can’t occupy.
3. Mastering these items will set you apart from most
brokers.
33

34. Zoning/Use Restrictions
(cont.)
Examples of Zoning Laws/Use Restrictions
• Downtown areas reserved for retail use defined as the
sale of goods and services
• Restaurant moratoria
• Liquor license restrictions
• Parking restrictions (medical and other uses)
• Formula retail restrictions
34

35. Commercial Lease Dos and
Don’ts
• Do use a Letter of Intent.
– Negotiate as many business issues as possible.
– Confirm that the LOI is nonbinding.
• Do advise your client to retain an attorney.
• Do stay apprised of the legal issues that the attorneys
are having trouble resolving.
• Do review the lease agreement to confirm that it contains
all of the negotiated business points.
• Do obtain a commission agreement before
the lease is signed.
35

36. Commercial Lease Dos and
Don’ts (cont.)
• Do not leave critical business issues out of the Letter of
Intent (i.e., signage, renewal options, operating
expenses, etc.).
• Do not allow the landlord to insist on the use of his own
consultants (i.e., space planners, architects, contractors,
etc.).
• Do not practice law or provide legal opinions regarding
the lease.
• Do not permit business issues to be
renegotiated during the lease negotiation
process.
36

37. Leasing Valuation

38. Assumptions
Time Value of Money
T-Bars FV PV
PRI
-VAC
=ERI
+ Other
= GROSS
-Operating
=NOI
-ADS
=CFBT

39. All Leases have at least two, possibly
Three values.

40. Land Lord Tenant
• Money • Control
• Market Rent = • Contract Rent Lower
Contract Rent than Market Rent
• Time • Occupancy Lower
than Ownership
• No a Partner

41. First the Tenants Value

42. Tenants Value
• One way or another the tenant pays its
share of all expenses either inside or
outside of base rent.
• Key to analysis and comparison is total
occupancy cost (TOC).
• TOC includes all rent and expenses over
the lease term for each alternative.
• Can be compared on a gross cost or
present value basis.

43. Total Occupancy Cost Matrix
The table below can be used to calculate and compare TOC
for like, and unlike, lease alternatives.
Base Tenant Parking Other Other Total
Rent Paid Op.
Exp.
Up-Front
Costs
Year 1
Year 2
Year 3
Year 4
Year 5
Total

44. Total Occupancy Cost
Comparison Example
Building A Building B
• 3,000 rentable square feet • 3,150 rentable square feet
(rsf) (rsf)
• 5 years • 5 years
• Rent $20.00/rsf/year full service • Rent $11.00/rsf/NNN
• Base-year op. exp. stop • NNN Exps = $6.50/rsf
• $18,000 TPTI* • Electricity = $1.75/rsf
• 10 parking spaces at • $4,000 TPTI*
$30/space/month • 6 months free
• 3 months free rent rent and NNNs
* TPTI = tenant paid tenant improvements

45. Total Occupancy Cost
Example: Building A Alternative
Base-year operating expenses are $8.50/rsf and
expected to grow at 5% per year.
Base Tenant Paid Parking Other Other: Total
Rent Op. Exp. TPTI
Up-Front $18,000 $18,000
Costs
Year 1 $45,000 $3,600 $48,600
Year 2 $60,000 $1,275 $3,600 $64,875
Year 3 $60,000 $2,614 $3,600 $66,214
Year 4 $60,000 $4,020 $3,600 $67,620
Year 5 $60,000 $5,490 $3,600 $69,090
Total $334,399

46. Total Occupancy Cost
Example: Building B Alternative
NNN expenses and electricity are expected to
grow at 5% per year.
Base Tenant Paid Parking Other: Other: Total
Rent Op. Exp. Elec. TPTI
(NNN)
Up-Front Costs $4,000 $4,000
Year 1 $17,325 $10,238 $5,513 $33,076
Year 2 $34,650 $21,499 $5,788 $61,937
Year 3 $34,650 $22,574 $6,078 $63,302
Year 4 $34,650 $23,702 $6,381 $64,733
Year 5 $34,650 $24,887 $6,700 $66,237
Total $293,285

47. Total Occupancy Cost (TOC)
Comparison Example
TOC Comparison • Based on TOC over the
Total A Total B term, Building B is
Up-Front $18,000 $4,000 preferred.
Costs
• Matrix enables analysis
Year 1 $48,600 $33,076
and comparison of
Year 2 $64,875 $61,937
unlike alternatives.
Year 3 $66,214 $63,302
• One more way to
Year 4 $67,620 $64,733
use this
Year 5 $69,090 $66,237
information.
Total $334,399 $293,285

48. Total Occupancy Cost (TOC)
Comparison Example
• calculation can be compared to other leases.
• TOC is an important figure that can be
compared in other forms.
 (TOC ÷ SF) ÷ Term = Average Annual Effective Rate
to tenant
 Example: ($334,399 ÷ 3,000 sf) ÷ 5 years =
$22.29/rsf/year

49. Present Value Analysis
• The timing of cash flows for lease alternatives
varies.
– Some have heavy up-front costs
– Sometimes rents are weighted to the later years
(stair-stepped)
– Free rent is usually given at the beginning of the term
but recovered in later rents
• Present value analysis of the cash flows takes
timing differences to arrive at a comparable
present value lease cost.

50. Present Value Analysis
Example:
Buildings C and D
TOC Comparison • Based on TOC, building
Bldg. C Bldg. D D is preferred.
Up-Front $10,000 $18,000 • Timing of cash flows are
Costs
very different.
Year 1 $25,000 $22,500
• Building D has bigger
Year 2 $35,000 $45,000
up-front costs.
Year 3 $45,000 $47,000
Year 4 $55,000 $49,000
• Building C cash flows
Year 5 $65,000 $51,000
are weighted
to later years.
Total $235,000 $232,500

51. Present Value Analysis
Example:
Buildings C and D
• Present Value Analysis accounts for differences
in timing of cash flows and arrives at Present
Value Lease Cost (PVLC) for each alternative.
• Requires a discount rate provided by the tenant.
This could be:
– Tenant’s ROI from core business
– Opportunity Cost
– Weighted cost of capital
– Provided by CFO

52. Present Value Analysis
Example:
BuildingsBldg. and D Value
Bldg. C Present Value
C D Present
Time Dollars Time Dollars
0 10,000 0 18,000
1 25,000 1 22,500
2 35,000 2 45,000
3 45,000 3 47,000
4 55,000 4 49,000
5 65,000 5 51,000
PVLC = $183,542* PVLC = $185,450*
* Using Tenant Discount Rate of 8%

53. Present Value Lease Cost
Analysis Example:
Buildings C and D
Bldg. C Present Value Bldg. D Present Value
PVLC = $183,542 PVLC = $185,450
• PV analysis using tenant discount rate
indicates building C is preferred.
• PV analysis accounts for differences in cash
flows, both timing and size.
• PV analysis assumes tenant has
sufficient capital for either alternative.

54. Total Occupancy Cost and
Present Value Lease Cost
Analysis
Pros Cons
• Provides objective • Assumptions needed for
measures of analysis and factors such as operating
comparing of alternatives expense growth
• Compares like or dislike • Does not take into account
alternatives subjective factors
• Accounts for all costs of – Location
occupancy – Amenities
• PV analysis also accounts – Impact on
for differences in timing of tenant’s
cash flows business

55. What about a sublet?
How to Value?

56. Tenants Lease Analysis Differential
Market - Contract =Differential
1 90,000 82,500 7,500
2 90,000 84,150 5,850
3 90,000 85,833 4,167
4 90,000 87,549 2,451
5 90,000 89,300 700
I = 9.5% PV = 17,050

57. Lease Analysis Sheet Tenant
Stay and Do Nothing ? Does Time Match?
Sublet ( do sublet analysis using contract and
market rents) ? Equity Stake? Expansion?
When a users contract rent is below market
rent, the user has a positive value in its lease.

58. Changing Factors
Market Conditions
Market Sentiment and Concessions
Land Lord or Tenant Objectives
Remaining Time on Lease

59. Lease Value Landlord

60. Lease Analysis and
Comparison:
Landlord View
• Same types of analysis and comparison can be
done from the landlord point of view
• Total occupancy cost analysis becomes a net
lease revenue (NLR) analysis
– In tenant TOC analysis all numbers are out of pocket
costs; TOC is a negative number
– For the landlord, revenues should exceed costs
providing value

61. Lease Analysis and
Comparison:
Landlord View
• Landlord view usually involves up-front costs
followed by net rents.
– Up-Front Costs are landlord paid tenant
improvements (LPTI), commissions, architectural
fees, etc.
– Net Rents are rents received less landlord paid
operating expenses.

62. Lease Analysis and
Comparison:
Landlord View
The table below can be used to calculate Net Lease Revenue (NLR). NLR
can be compared to other leases or the landlord’s pro forma.
LPTI, Rent LL paid Other: Total
Fees Op. Exps. (+ or -)
Up-Front
Costs
Year 1
Year 2
Year 3
Year 4
Year 5
Total

63. Lease Analysis Landlord View
Example:
• 4,500 rsf • Landlord provides $18/rsf
• 5-year term in TI
• Full-service lease • Parking: 15 spaces at
• $45/space/month,
Year 1 rent $20.00/rsf
first year free
• Rent bumps $1/sf/year
• Commissions and other
• Base year for op. exps. = fees = 6% of GLC*
$8.50/rsf
• Concession of 4 months
• Op. exps. growth at 5%
free rent up-front
per year
* GLC is gross lease consideration; total of contract rent over term

64. Lease Analysis Landlord View
Example:
The table below accounts for cash inflows and outflows for the landlord
over the term of the lease. $197,250 is the NLR.
LPTI Rent LL paid Other: Other: Total
Op. Exps. (Fees) Parking
Up-Front ($81,000) ($27,900) ($108,900)
Costs
Year 1 $60,000 ($38,250) $21,750
Year 2 $94,500 ($38,250) $8,100 $64,350
Year 3 $99,000 ($38,250) $8,100 $68,850
Year 4 $103,500 ($38,250) $8,100 $73,350
Year 5 $108,000 ($38,250) $8,100 $77,850
Total $197,250

65. Lease Analysis Landlord View
Example:
• Example NLR calculation can be compared to
other leases or landlords pro forma.
• NLR of $197,500 is an important figure that can
be compared in other forms.
 (NLR ÷ SF) ÷ Term =
Average Annual Effective Rate to landlord
 ($197,500 ÷ 4,500 sf) ÷ 5 years =
$8.78/rsf/year

66. Present Value Analysis
• The timing of cash flows for lease alternatives
impact the present value to landlord.
– Landlord may want to adopt leasing strategies that
maximize present value.
– Up-front costs have heavy (negative) impact on
present value of a lease.
– Landlord may want a leasing strategy that maximizes
property value in future years.
• Present value can be compared to other
prospective lease alternatives or the landlord’s
pro forma.

67. Present Value Analysis
Example
NLR from Prev. Example • Also referred to as net
Lease present value (NPV)
Up-Front ($108,900) – PV of future cash flows
Costs are netted against up-
Year 1 $21,750 front costs (initial
Year 2 $64,350
investment in lease).
Year 3 $68,850 • Uses landlord discount
Year 4 $73,350 rate.
Year 5 $77,850
Total $197,250

68. Net Present Value
Analysis Example
Time Dollars • NPV of $120,941 can be
0 ($108,900) compared to landlord’s pro
1 $21,750 forma on SF basis.
2 $64,350 – $120,941 ÷ 4,500 sf =
3 $68,850 $26.88/sf for proposed lease.
4 $73,350 – same SF analysis on pro
5 $77,850 forma and compared proposal
can be modified to hit targets.
Discount Rate = 9% – i.e., higher rents, lower up-
NPV = $120,941 front costs, etc.

69. Net Lease Revenue and
Net Present Value Analysis
Pros Cons
• Provides a means for LL to • Does not take into account
evaluate proposed lease other factors such as tenant
alternatives. credit worthiness.
• Provides a basis for lease
negotiation and the impact of
various terms.
• Helps LL to determine when,
and when not, to move forward
on lease.
• NPV analysis accounts for
timing differences in cash flows.

70. Just as Tenant can possibly sublet,
owner can buyout lease

71. THE LEASE BUYOUT DECISION
• Examining the current market and owner
and user motivations is key in determining
whether to negotiate a buyout of a lease
• leasehold interest may or not be of value
to the lessee or may only be of value to
the owner

72. Depending on Owners Investment
Requirements
Tenants cost of moving and occupancy

73. Owner Vs. Tenant

74. •We’re dealing with a national retail, fast food operator (Tim’s
Tacos)
who has been successfully operating from a leased location for a
long time
•The old building is 1,235 sqft and Tim’s has recently moved down
the street to build its new prototype of about 3,000sqft
•The primary lease term on the old site is about to expire but Tim’s
does have options to renew.
•The Landlord has been approached by a broker with a potential
alternative deal for the site
•Tim’s is a little concerned about competition in the market and may
wish to exercise control over the site, but, who knows………………

75. Primary Term was 15 years and it is about
to expire
The Tenant has two (2), five year options
as follows:
1-5 2,500.00/month 30,000/year
6-10 2,916.67/month 35.000/year
Original Market Value (Rent) = 15,000/year
Current Market Value (Rent) = 50,000/year

76. What is the value to the tenant?
What is the value to the landlord?
What are your options?
Be prepared to negotiate.

77. The Legal Issues of Commercial Leases
and why you should not write a lease
http://youtu.be/qkgbeGTTTZg

78. Thanks!
D. Scott Smith CCIM
Commercial Manager
Professor of Real Estate
Scott.Smith@Penfedrealty.com
Prudential PenFed Realty
Commercial Sales and Consulting
5000 Lawndale Ave.|Baltimore, MD 21210
Office: 410-464-5500|Cell: 443-691-8153