Financial Analysis for Office Lease Transactions

by CoyDavidson on September 17, 2009

hp 12c

Making Informed Lease Decisions

Financial Analysis is defined as the set of principles, procedures and tools that help organize and interpret financial data. Making informed real estate decision requires utilizing economic models designed to improve the quality of  the  lease or facility decision. More than just a software program, this analysis is the product of formal training in finance combined with years of experience in the commercial real estate marketplace.

Evaluating Leases

The decision to renew a lease or relocate your office facilities requires thorough financial analysis of the anticipated lease costs within the marketplace. This requires the technical ability to analyze the cost associated with various facility decisions. To assist in the decision making process it is prudent to compare “Occupancy Costs” of various alternatives in an “apples to apples” format. This approach is important because what often appears to be the most economical deal on the surface in reality may not be the best alternative after evaluating all economic components of the proposed transaction. Although the concept of leasing office space is simple, commercial leases have an increasingly complex financial structure. How does a tenant go about determining the true cost of such a lease? A typical office building lease may include the following:

  • Base Rental Payments (fixed or escalated)
  • Additional rent provisions for increases in operating expenses
  • Caps or ceilings on operating expense escalations
  • Periods of abated or reduced rent
  • Contributions (loans) by the landlord for leasehold improvements, architectural fees, IT cabling, moving expenses, leasing commissions and existing lease obligations
  • Parking charges
  • Various options (renewal, expansion, contraction and cancellation)
  • Electrical Capacity (watts per square foot) and H.V.A.C. charges
  • Add on Factors (Rentable vs. Usable Square Feet)
  • Costs to comply with government regulations (ADA )
  • Fees for Construction Management
  • Interest fees for above standard leasehold improvements

Comparing Occupancy Costs

Once occupancy costs associated with various lease alternatives are identified and the underlying economics of the proposed lease transaction are understood, the projection of the total occupancy costs over the term of the lease and on an annual basis is calculated.  These projected annual cash flows are subjected to discounted cash flow analysis (net present value) at an appropriate discount rate (cost of capital) to account for the time value of money. The results are the Net Present Value or “the price of the deal”. To clarify for comparison purposes, I express the discounted present value of the lease as a level rate per square foot which enables the tenant to measure the financial structure of the lease proposals on an “apples to apples” basis. The impact of income taxes can be accounted for by discounting cash flows at a rate reflective of the tenant’s after tax cost of debt. When comparing alternatives, occupancy cost levels both absolute and present value basis are analyzed in terms of rentable and usable square feet to account for differences in common area factors and space efficiency. The result is the “effective occupancy cost per square foot” which provides a meaningful comparison of various lease proposals.

Today, technology provides us with the software to easily implement the financial analysis of lease transactions.  Popular programs include Lease Matrix, REI Wise,  ProCalc and CoStar Lease Analysis. I learned how to analyze a deal with a HP-12C calculator, which kind of gives away my age. However, it is important to understand the principles of this analysis and how various cash flows impact the overall cost particularly when it comes to the art of negotiation.

Financial Analysis as a Negotiation Tool

Effective negotiations require a thorough understanding of the underlying economics of the transaction.  I believe great deals are not only found but also negotiated. My financial skill allows me to measure the impact of various economic components on the value of the lease and to quantify the landlord’s effective rental rate. In essence, the landlord’s effective rental rate is the net profit level from the lease before the building’s debt payments expressed on a square foot basis. By viewing the lease from the landlord’s perspective it is relatively simple to benchmark the landlord’s projected return and measure the impact of various changes in financial components of the lease on the landlord’s bottom line. While comparing rental rates and negotiated concessions to other transactions in the market is an excellent indicator of achievable terms the landlord’s effective rate is where the “rubber meets the road”. No two lease transactions even with identical rental rates yield the same return to the landlord. My objective is structure a “win – win” transaction while not leaving any money on the negotiation table. Evaluating the landlord’s effective rate during negotiations is a key tool in determining the landlord’s bottom line.

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