Tuesday, October 26, 2010

How Much Does it Cost to Originate a Lease?


I provide Location Advice to owners and occupants of industrial buildings in Southern California. Location advice recently considered the question...how much does it cost to originate a lease. This is important to know when considering whether to renew an occupant at a reduced rate. "Blend and Extend" is a term that didn't exist until the last couple of years. Now virtually all occupants...especially those with leases that originated within the last four years, are looking to reduce occupancy costs in return for a lease extension. Should an owner consider this? In order to answer the question, you must understand what the cost to originate a lease would be. We will assume to be discussing a 20,000 sf industrial building with 10% office finish.
Market Rent:
At the baseline of the analysis, what is the market rent for your building? Not a "puffed up" review of asking rates in the area, but a true blue, no nonsense, "what has recently leased in my size range with identical (if available) amenities?" Is the rent trend on the up-swing or decline? Does my building have anything that makes it unique (in a positive or negative way) in the market...excess land, excess power, proximity to freeways, special purpose improvements, etc. A competent location advisor should be able to provide this information for you as an owner at no cost to you. For purposes of this analysis, let us assume that the market rent for your building is $.50 psf per month or $6.00 annually on an industrial gross basis. You will receive $10,000 per month for the first year. Presumably this rate will increase throughout the term of the lease at a 2.5% annual increase. Total for the term will be $638,254...$.531 psf per month.
Down Time and "Lost Opportunity":
If your building became vacant, how long (to achieve a market rent) would your building lay fallow
until the next occupant could be located. For our purposes, let us assume that the building would sit vacant for four months. The lost opportunity rent would be $40,000. The actual lost rent would be the debt service plus the operating expenses during the down time. We will use "opportunity rent" for our example.
Free ?? Rent:
Generally, a new occupant will ask and receive some sort of rent abatement as a move-in concession. Notice that I used the term "abated rent". I would encourage owners to classify the rent concession as abated and not free. Most leases allow a recapture of "abated rent" in the case of a tenant default...but not a recapture of the "free rent". The amount of the rent abatement is dependent upon market conditions, length of lease, credit worthiness of the occupant, etc. Abated rent can also be used to inflate the coupon rate of the lease...keep in mind the effective rate will be less. For the purpose of our analysis, let us assume that the occupant is interested in a five year lease and the market conditions, credit worthiness, and term warrant four months of abated rent. Abated Rent of $40,000.
Tenant Improvements:
Will the new occupant require any tenant improvements? For any office deal, this is a given. An industrial deal...not so defined. As any rate the building will need to be prepped for the new occupant...paint and carpet. If special purpose improvements are needed, a savvy occupant will ask that the space be delivered "turn key" with the cost, risk, and occupancy permitting assigned to the owner. For our purposes, let us assume that the improvements will be minimal...paint and carpet for the office area only in an industrial deal...$3.00 psf of office space. $6,000 of Tenant Improvements.
Brokerage Commissions:
Commissions vary by market and by market conditions. In Southern California, EVERY office deal carries a full commission to the occupant's broker PLUS a per square foot bonus. The industrial commissions are generally 4%. This percentage is paid on the TOTAL CONSIDERATION of the lease...net of any abated rent. The owner must also consider paying his representative (the listing broker). Let's assume a 6% fee for locating and securing a new occupant. Total Commission of $638,254 x 6% = $38,295.
Based upon the assumptions, the cost to originate a new occupant lease would be $124,295!! An owner will receive the $638,254 over the five year term but will spend approximately 20% of this amount in origination fees and lost opportunity costs.
Back to the question of reduced rent in return for an extended term...certainly!! If...the occupant is reasonable in his request and the reduction in rent can be justified compared to the cost to originate a new lease. An occupant will save by renewing at his present location in other ways...avoidance of moving costs, avoidance of employee disruption, avoidance of business disruption, etc. These cost issues can be used to "add back" to the owner's side of the negotiations.