The objective of this paper is to outline "The Numbers in Real Estate" based on insights gained over an 18-year tenure as a Corporate Real Estate Manager for Fortune 500 Companies.
The following critical subjects for commercial real estate analysis will be covered:
This paper focuses on commercial real estate as used by a typical corporation, which represents a number of different types of properties, from industrial to retail, office campuses to multi-tenant office buildings. Space use can range from the corporate headquarters to research & development (R&D) to manufacturing, warehousing, to field sales offices.
Let's begin by discussing “square footage,” a term that all of us understand, right? Well, it is not quite so simple since in commercial real estate, space can be measured in a variety of ways.
First, a term frequently used when discussing commercial space is "rentable square feet," abbreviated as “rsf.” Typically, the rent, operating expenses and taxes are all invoiced based on the rentable square feet. However, the rentable square feet may, or may not, reflect the "usable square feet," or “usf.”
What determines usable square feet? Again, there are a variety of definitions that can be applied. Usually usable square feet refers to the space one actually occupies that can be "used." Practically speaking, it is the space inside the exterior walls of the leased premises.
Why must you concern yourself with the amount of usable square feet when the rent is based on the rentable square feet? Well, why are you leasing the space? To house staff, equipment, manufacturing, etc. As a user, the key to determining if the space is adequate for your needs is to determine just how many people, equipment, racks (in the case of warehousing) you will be able to accommodate in the space available. The space you are able to put to use to operate your business is thus the USABLE square feet, not the rentable!
In most standalone buildings, such as a headquarters or manufacturing facility, the rentable square footage is approximately equal to the usable square footage. In other words, nearly all of the available space can be put to use. However, it pays to get an accurate measurement. Most real estate professionals have run into at least one situation where the landlord's measurement of rentable square feet included the roof overhang and gutters, or balconies, or it just did not tie to reality at all.
So, how do you get the measurement for a standalone building? One way, albeit costly, is to hire an architect to measure the space, either physically or off as-built drawings. This approach can be expensive and should not be pursued until you have reached the “letter-of-intent” stage of the decision process. At that point, you may elect to include in your letter-of-intent the right to measure the building prior to lease execution.
Is there a cheaper way to determine a building's size? Unless the building is newly constructed, it has probably been leased before. An experienced commercial real estate broker with access to a historical database of properties can research the building’s size and let you know if the building measurements have "grown" overtime or with changes in ownership.
You may argue that it is impossible for buildings to grow, But yes, buildings do grow under certain circumstances! For example, when I was a real estate manager, my company was leasing approximately 16,900 rentable square feet on three floors in New York City. We had a change of plans for the location and it was up to me to sublease the space. There had been a change in ownership, and the new owner had decided each floor was a tad larger. Who was I to argue? Bottom line: I subleased approximately 18,500 square feet of space. The space had grown!
Another type of space, space leased in a multi-tenant building, is subject to a great deal of variation when determining the rentable and usable square feet. Usually a landlord will utilize a "factor" when determining rentable and usable square feet.
What does the factor signify in multi-tenant buildings? The factor represents how the tenant pays their proportionate share of the common areas such as the hallways, restrooms and lobby.
Terms frequently used for the factor include “load,” “loss,” and “add-on factors.” Other descriptions range from “efficiency factor” to just plain “building factor.” However you describe them, fundamentally there are just two ways of determining usable and rentable square footage: an add-on factor and a loss factor.
An add-on factor means starting with the usable square footage and then applying a percentage to determine the rentable square footage.
| Example 1: |
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A loss factor differs from an add-on factor as the loss percentage is multiplied by the rentable square feet to determine the usable square feet.
| Example 2: |
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Bottom line: Given a choice of a 15% add-on factor or a 15% loss factor, the smart landlord will choose a 15% loss factor because he, the landlord, is leasing out less usable square feet. Alternatively, if the rentable square feet and the usable square feet are fixed, the smart landlord will market space using a loss factor because the loss factor is a smaller number, e.g., a 15% add-on factor is the same as a 13.04% loss factor).
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Example 3:
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What determines the factor, and if it is to be taken into account as an add-on or loss? Typically, each city or submarket will quote space on the same basis, e.g. using an add-on or loss factor. Loss factors are generally used by more urban landlords and encountered in larger cities such as New YorK, Chicago and San Francisco.
How do you, the facilities manager, find out what the number is and how it is being calculated? The technique I used when doing a site search was as follows: while riding up the elevator to tour the space with the landlord's leasing agent, I would say, "I need to understand your building factor; so, let me ask you: if I lease 1,000 usf and there is a 15% factor, am I going to pay rent on 1,150 rsf?" If the answer was “yes,” then I knew I had an add-on factor, if “no,” then I would ask the agent to explain how they calculate the factor.
You may hear someone say the building has a load factor of 14%. Load factor has been substituted for add-on and loss factors; so, if told there is a load factor of 14%, use the approach outlined in the paragraph above to determine if the factor is an add-on or loss factor.
Is the building factor negotiable? Yes, in a soft real estate market users can sometimes negotiate the difference between rentable square feet and usable square feet. Typically, the add-on numbers can vary between 12% and 22%, with the average being 15% to 18%. Within a submarket, most buildings will have a similar number. The exception is that the higher the quality of the building, e.g., a Class A building vs. a Class B building, the higher the add-on factor.
Is there some kind of guideline to help determine how space is measured? It seems logical that a building will have a certain size, the usable square footage will be a known value and from the two values a factor is determined. However, it all depends on how you measure the space. For instance, do you measure from inside the window, outside the window, or from the middle? The Building Owner's and Managers Association (BOMA), has published the BOMA Guideline that many landlords use for measuring space. If at all possible, include language that all space will be measured according to the BOMA Guideline in your letter of intent and in the lease. Using the guideline provides you with a standard to be followed vs. having the landlord select whatever standard best fits his purposes, which probably does not best fit your purposes.
There are three fundamental types of leases: Triple net (abbreviated as NNN), Full Service and Gross. There are variations, for instance Full Service plus Tenant Electric (you will find this frequently in New Jersey), or Net where not all costs are paid by the tenant, etc. The key variable in the type of lease is how the operating expenses and real estate taxes are handled.
In triple net leases, the tenant is responsible for operating expenses, real estate taxes and insurance. Being responsible may, or may not, mean the tenant contracts directly with and pays the vendor. In standalone buildings, the tenant will usually contract for such services as janitorial, landscaping and HVAC maintenance, and pays the vendor directly. However, in a multi-tenant building, the landlord usually contracts with the vendors and the tenant pays the landlord the NNN expenses, sometimes called “additional rent.”
In a full service lease, all or part of the operating expenses and real estate taxes are included in the rent. However, the name “Full Service” is really a misnomer because the tenant is usually responsible for any operating expense or tax increase above an established amount. The tenant's portion is called the "pass-through cost." The established amount can be set at what is called a "base year," or, in some cases an "expense stop."
The key part of a Full Service lease is the base year concept, which means that when costs exceed the cost of the base amount, the tenant will pay his proportionate share of that increase. For instance, if a tenant leases space starting in February 2004 with 2004 as the base year, then the tenant will pay no operating expenses in 2004; however, in 2005, assuming the costs increase, the tenant will pay for the additional expense.
| Example 4: | Assume a full service lease, the base year cost is $8.00/sf, and in the 2nd year the actual cost increases 5%. The base year costs are used as an offset (deduction) to determine the tenant's cost. | ||
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| Year 1 | Year 2 | ||
| Actual Cost | $8.00 | $8.40 (5% increase) | |
| Base Year | ($8.00) | ($8.00) (stays the same) | |
| Tenant Pays | $0.00 | $0.40 (the difference) | |
Compare the Full Service Lease with a NNN lease where there is no offset/deduction for the base year costs included in the base rental rate.
| Example 5: | Assume a net lease, the actual cost is $8.00/sf, and in the 2nd year the actual cost increases 5%. | ||
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| Year 1 | Year 2 | ||
| Actual Cost | $8.00 | $8.40 (5% increase) | |
| Base Year | ($0.00) | ($0.00) (there is no Base Year so no offset) | |
| Tenant Pays | $8.00 | $8.40 (the difference) | |
In the third kind of lease, a gross lease, the tenant pays no pass-through costs. The rent being charged by the landlord includes operating expenses and even if the costs go up, the tenant has no exposure and there is no pass-through of additional rent. Gross leases are very rare, and in fact the only place I have consistently found them is in Wisconsin.
Now you may be thinking, “ah, this is simple, I'll just get a gross lease, or lacking that, a full service lease, because that includes the operating costs and real estate taxes for the base year.” I am sorry to say that it is not that simple.
Assume you are a landlord. You have decided you need to charge a base rent of $12.00/rsf and the operating costs for the building, at least in the first year, are $8.00/rsf. So, if you make it a NNN lease, you will charge the tenant $12.00 in base rent and let him reimburse you the NNN charges. However, if instead you decide to make it a full service lease, then you will charge the tenant $20.00 in base rent and let him pay the pass-through costs after the first year. Note: in the full service lease, the base rent charged to the tenant is the landlord's base rent PLUS the operating expenses.
Let's look at the tenant's cost using the data above and assuming the Operating Costs increase by 5% in the second year.
| Example 6: | Assume a net lease, the actual cost is $8.00/sf, and in the 2nd year the actual cost increases 5%. | ||||
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| NNN | Full Service | NNN | Full Service | ||
| Year 1 | Year 2 | Year 3 | Year 4 | ||
| Base Rent | $12.00 | $20.00 | $12.00 | $20.00 | |
| Op. Exp. Actual Cost | $8.00 | $8.00 | $8.40 | $8.40 | |
| Op. Exp. Base Year | 0.00 | ($8.00) | 0.00 | ($8.00) | |
| Total Tenant Cost | $20.00 | $20.00 | $20.40 | $20.40 | |
Bottom line: in either case, the TOTAL tenant cost is $20.00/rsf in the first year and $20.40/rsf in the second year. The ONLY difference to the tenant is in how the landlord has decided to "package" his rent.
Another important concept to understand is grossing-up the base year costs. Since in a Full Service lease, the base year costs are deducted from the rent and serve as an offset/deduction from the actual cost, it is in the landlord's interest to make the base year amount as small as possible and in the tenant's interest to make the base year as large as possible.
In a partially occupied building the base year actual costs do not reflect the actual cost of operating the building. What's the solution? In the letter of intent and the lease document, include a statement that the base year costs will be grossed-up based on 95% occupancy of the building. In other words, since the costs may only reflect a partial building occupancy, adjust the costs to reflect the building being fully occupied (or 95% occupied).
When negotiating leases, it is often beneficial to understand the landlord's costs and position, that is, his “pro-forma.”
In looking at the landlord's pro-forma the following five key variables should be considered:
Rent represents the base rent from the landlord's perspective, without operating expenses and taxes. Operating expenses and taxes are the cost of operating the building. The base rent charged to the tenant can either include the operating expenses and taxes (i.e., a full service lease) or not include operating expenses and taxes (i.e. a NNN lease). In terms of the "base rent" charged to the tenant, it is all in how the landlord wants to package his rent and also in what is typical in the landlord's particular submarket.
However, the base rent charged to the tenant includes more than the landlord's base rent and operating expenses and taxes. Also included are the amortizations of the tenant improvement costs paid by the landlord and of the commissions paid by the landlord.
What does amortization affect? In essence, it is important to realize the landlord is either borrowing the money for tenant improvements and commissions, or forgoing another investment if paying those costs out of pocket. In either case, there is an implied interest rate and a term over which the costs are amortized: the Lease Term.
Why do you care about the landlord's pro-forma? The landlord needs to make a profit to stay in business and if you understand his numbers then you will understand the relationship between rent, TI dollars, commissions and lease term. The more you understand the landlord's position, the better you will be able to negotiate for concessions.
| Example 7: |
Assume the following:
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Furthermore, assume a landlord paid a construction allowance of $15/rsf and commissions at 5%, and to keep it simple, a 10% simple interest rate on the construction allowance and commission costs.
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Landlord's Pro Forma
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Income (Cost) per Year
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What does the landlord's net income before debt service mean? It means that out the $20 you pay him, the landlord gets only $7.60, and out of the $7.60 the landlord needs to pay his mortgage, administrative salaries, fund capital improvements, etc.
Assume in the example above that the tenant decides he wants $30 for a construction allowance, what happens? If the $7.60 is inflexible, then the landlord is going to raise the base rent by $3.30 ($3.00 for the additional $15 spread over five years and $.30 for interest on the additional $15). If you want $30 in construction allowance, then the rent you will be paying will be $23.30.
Bottom line: There is no free money!
As an aside, if the rent had been increased to $23.30, the commission cost, which in this case is based on rent, would have increased by an additional $8,250 (5% of the additional rent over the term, or $.165/sf/year), then factoring in interest at 10% ($.017 = 10% of $.165), the real rent would have increased from $20.00 to $23.482 ($20.00 + $3.00 + $.30 + $.165 + $.017).
Impact of Extending the Lease TermAs shown above, the base rent is not the best metric to measure and compare costs and leasing alternatives. Comparing a NNN lease to a Full Service lease based on rent can easily lead to the wrong decision.
So, the answer is to compare the gross rent - that is, base rent plus operating costs and taxes, right? If comparing the gross rent, the difference between a NNN lease and a Full Service lease is eliminated; however, is that the best metric?
Experience has shown that a better metric is to compare Occupancy Cost to Occupancy Cost. What is the Occupancy Cost? It is the cost to move in and occupy the premises. It includes things such as base rent, operating expenses, real estate taxes, moving, construction, wiring, installing a phone switch, security, building & systems maintenance, janitorial, parking, signage, utilities, after hours HVAC, legal services, etc.
By comparing Occupancy Cost to Occupancy Cost the astute facilities manager is really acting as if the company's money is his/her own money. Also, if occupancy costs are charged back to the end-user by the corporation, the cost usually charged back is the total occupancy cost, not just the rent. Your users will thank you for giving them a true picture of how the costs of different alternatives will impact their budget.
Frequently, facilities managers are asked to justify their existence and classically asked, "What have you done for me lately?"
We have created the LseMod multiplier, a way to quantify savings to finance and end-users using terms they can relate to. This analysis tool is called the LseMod multiplier because it was inspired by using LseMod, a software program that compares Occupancy Cost to Occupancy Cost.
The LseMod Multiplier:
Convert Savings to Annual Sales
Convert Annual Sales to Lease Term Sales, the equivalent sales revenue
| Example 8: |
Assume your actions have saved the company $2 million per year Convert Savings to Annual Sales:
Convert Annual Sales to Lease Term Sales:
Formulas:
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Bottom line: A facilities manager saving $2 million annually is the same as a sales person making a $100 million dollar sale!
After reading this article, we hope you will better understand the following concepts:
About the author:
Jim Duport is in his 4th career – 10 years teaching high school math, finance manager
for GE, 18 years as a corporate real estate manager for two Fortune 500 high tech companies, and
the past five years as President of LseMod (www.LseMod.com), a software company that develops and
markets financial analysis tools for the corporate real estate industry.
© 2004 - James R. Duport, All rights reserved. http://www.LseMod.com