Most retail and office users entering into a commercial real estate lease use price per square foot as the lone metric to value a leasehold. Thereby, they use rent paid as the value of the lease, when in fact, price per square foot is far from the best way to tell if a user is potentially getting value for their expense of rents paid.
So frequently you’ll see a new retail or office user who has every single part of their business plan buttoned up. You’re talking a proforma of cash flows spread out over a decade with a sufficiently detailed analysis of the profit and loss of their business for years on end, and so on. The relationship between the earning potential of their business combined with the present value of the cost of the lease is rarely, if ever, a factor in planning and valuing a new business lease. Considering that rent is often one of a commercial user’s biggest costs, understanding the net present value of a lease should be critical to this process.
But often it isn’t.
Instead, a commercial user will take the price of prospective rent and benchmark it against the rest of the market or another competitive lease to determine whether or not an individual lease deal is good or not (Cue: Howie Mandel. Deal or No Deal).
All commercial users have what’s called an “opportunity cost of money” which is the amount of money that the user could earn in an alternative investment or, more often for a retail/service industry user, this is the after-tax yield on business operations. Taking, then, the future amount of total rent to be paid over the life of the lease and using that earning potential percentage to determine a “Net Present Value” is a far more accurate way to value a lease and tell if a deal is right for the user.
Unfortunately a lot of commercial users, and realtors for that matter, still use price per square foot as the lone metric to value a leasehold. Time and time again users can not get past that single number – price per square foot – in analyzing the value of a potential lease. Some users even putting blinders on and cross their fingers, hoping on the fact that the cash flows of business will cover the cost of the rents and that volume will make the deal a worthwhile investment. Businesses who aren’t sure exactly what it is they’re “buying” and how much the value of the lease is to the bottom line are flying blind with one of the most expensive parts of doing business.
VALUING THE LEASE
So where does that leave the value of a commercial lease?
It is important for the user of commercial space to grasp the understanding that the money they pay in total effective rent over the term of a lease add up to a future value totaling one lump sum. That lump sum has a discounted present value to the user which, when the earning potential of the user is factored in, shows the actual value of the lease to the user.
Understanding the present value of that lease today, instead of after all the rents have been paid is a critical analysis component for the user.
Simply stated, the commercial tenant needs almost to pretend that the lease they are entering into is a purchase and the total effective cost of the lease needs to be valued in full as if it were a purchase cost. The total cash flow out of the Lease would then be discounted with a discount rate (think interest rate but in reverse) by the user, with that rate being determined by the user according to their earning potential.
For example, a retail business is considering a 5-year lease on two competing 4,500 s/f retail spaces. Once space is priced at $14 PSF, fixed for the whole term but the physical space is lousy and will need $25,000 of work just to get in. In consideration of this, the Landlord throws in three months free rent up front in year one. The other location costs $13.50 PSF, and the physical space is pristine – move in ready – but the rent goes up 50 cents PSF per year every year of the lease. This user has a successful retail store and has a 15% after-tax yield. At the end of the day, they’re putting 15% to the bottom line.
How, then, does a commercial user properly value this deal?
Deal A – the one that needs work – has the user paying $299,250 in rent over the five years with a $25,000 upfront cost. Deal B – the place that’s ready to go without any renovation – has the user paying more rent, $326,250 over the five years. Let’s say the user has some capital and doesn’t mind using it to get into a space that is cheaper to lease, because after all, even with the upfront cost the total expenditure is less over the life of the lease, right?
Deal B is more expensive, but it has a Net Present Value of about $5,800 greater to the user than that of Deal A, the "cheaper" deal. Considering the user’s ability to monetize their operation at 15%, if the user paid the higher rents and took that extra $5,800 of value at their after-tax yield they could turn that into over $12,000 by the end of the term of the lease. If they sunk that money into their business instead of the landlord’s building, they would be better off.
While all of this is certainly tedious minutiae to most, it is a critical financial analysis that most commercial users – particularly service industry users – fail to consider.
In 2002, long before I was a licensed realtor, I opened a wine retail shop and was concerned only with (a) rental rates and (b) window of cash flow until I ran out of money. I certainly never sat back and analyzed the actual cost of what is was I was “buying” with my money paid to the Landlord and whether or not the deal I ultimately signed was more or less valuable than the more expensive rents offered to me across town. Looking back on that deal now, I left a lot of money on the table in search of a more favorable rent.
If you’re considering investing in a new business wouldn’t it suit you to understand just what it is you’re buying?