Are YOU Prepared for a Rent Increase?

You've opted to lease your business location - which means every month you pay rent to a landlord. Several considerations led you to the decision to lease versus own your building. We will leave the lease versus own conversation for another day.

Today, my goal is to discuss the dynamics that will cause your rent to increase - sometimes dramatically! Hopefully, the topics discussed here will prepare you for the call that your rent will soon balloon.

When a commercial real estate lease originates, the number of years - term, rent amount, rent increases, concessions - such as abated rent, building improvements and the like are spelled out in the document you and the landlord sign.

As the term of your commercial real estate lease can dictate increases in your rent, a brief explanation about length of leases is important to review.

Depending on the size of your space, lease terms range from month-to-month to ten+ years. A smaller space - fewer than 5000 square feet - normally means a shorter term - fewer than two years. Why, you may ask? Tenants that occupy small blocks of space are frequently start-up companies without the benefit of years of financial history. In some cases, these businesses are a payment risk. Landlords counter this risk by limiting the lease term - the overall amount of rent to which a tenant is obligated. Additionally, growth trajectory is tough to quantify with a new enterprise. Therefore, these operators are reluctant to commit long term lest they outgrow their digs.

With term explanation as a back drop, there are several other factors can cause rents to rise. I've ordered these from least to greatest:

Increases in operating expenses. Operating expenses include charges for property taxes, insurance on the building, common area maintenance - landscape, trash, utilities, parking lot sweeping, a share of capital expenses - a new roof or air conditioner, and in some cases property management. All of these charges are either baked into your base rent - a gross lease, or are paid for in addition to your base rent - a NNN lease. Unless your agreement specifies otherwise, as these expenses increase over the term of your lease - yep - your rent increases.

Pre-set increases throughout the term. Leases today typically carry annual increases in the base rent of 3%-4%. Gone are the days where the amount of rent paid each year increased by the change that occurs in the Consumer Price Index. Even though three to four percent annually seems steep compared with inflation - please understand, commercial lease rates have increased approximately 70% since 2009 - a staggering 8% a year! So, if you signed a ten year lease in 2009 with annual escalators of 2.5%, prepare for a bit of a jolt next year.

The sale of your building. The largest operating expense is property taxes. Recall, these are paid as a part of your base rent or in addition to your base rent. Annually billed at one percent of the assessed value of the real estate, property taxes can increase a maximum of two percent per year - unless - the building is sold for more than the assessed value. And then, WHAM! You are stuck with a huge bill.

The expiration and renewal of an existing lease. The coup de grace these days. Many leases expire and are slated for renewal - as our volume of leasing hit a peak in 2010-2013. A seven year lease originated in 2010 expired last year as did a five year lease commenced in 2012. Shock and awe are mild adjectives to describe tenant reactions to their landlord renewal proposals. Met with a limited amount of available buildings, many tenants have been forced to swallow hard and accept that their rent might increase 30-40%! Ouch!

Next week, I will discuss some strategies for limiting your rent increases - so stay tuned, faithful readers!

Would you Own your Commercial Real Estate - If Vacant?

Frequently, if you operate a small business, owning your location can make a great deal of sense. 

Generally, it works like this - you form a Limited Liability Company personally. The LLC then buys the commercial real estate. Your business signs a lease with the LLC. Therefore, you pay rent to yourself. Brilliant! 

Ownership allows you to fix your location costs - the purchase is financed with fixed rate debt for a period of time. The occupant is under your control - after all it is your company. Personally benefited are you from the location's appreciation - if any. Finally, there are some potential tax benefits individually. Awesome!

Now, let's add a dimension which many small business owners are facing these days - someone approaches you and offers to buy your business. 

When you consider selling the business that occupies your real estate - even if the purchaser of your business signs a lease with your LLC - the question you should ask is: would I want to own this location if it were vacant? Business changes, motivation varies, locations depreciate. At the end of your tenant's lease you may be faced with a costly vacancy. 

Remember, when you are the occupant and the owner, the dynamic is different than being the owner but not the occupant. You are now an investor who must compete with many other investors for your tenant's occupancy. The cost of originating a new lease is staggering - in some cases 20-25% of your lease income. Are you prepared for that potential risk? If the answer is no, then there are steps you can take to minimize the risk of owning a vacant building. 

First, analyze your location's monthly carrying costs - debt service, taxes, insurance, common area maintenance, miscellaneous maintenance, etc. You should maintain a 9-12 month cash reserve of this total amount. 

Secondly, determine how marketable the vacant building is. A commercial real estate professional familiar with the current market can provide this for you. How many vacant buildings similar to yours exist? What is the current appetite - including market time - for such a location? What is the current vacancy rate for facilities such as yours? - like yours specifically - not a market wide vacancy of all locations. How special purpose is your space? 

Third, determine what the lease income is worth to an arm's length investor. This amount less any debt owed against the location and less any closing costs of sale and net of any taxes determines the proceeds that can be deployed into an alternate non-real estate investment. If you choose to invest in another income property, the gain may be tax deferred if the new purchase meets certain criteria. You may be wondering why you would sell one piece of real estate only to buy another? The simple answer is to lessen the risk. By selling a special purpose single tenant location and investing in a general purpose multi tenant location, the management is greater but the downside is more  manageable - akin to selling stock in a single company and buying a mutual fund of many companies.