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Key Principles in Commercial Office Leases to Maximise Value

Posted by Academy on Apr 23, 2019 11:41:09 AM

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Key Principles in Commercial Office Leases to Maximise Value BY PAUL NELSON

 

Leases are the lifeblood of any commercial property investment but can be incorrectly negotiated and constructed and fail to add value. What then are the key principles to maximise value? Theses are summarised below and explained in more detail in the main body of the article.

• Tenant covenantiStock-941906652
• Length of lease / wale
• Rent review structure
• Type of rent and incentive
• Outgoings recovery
• Repairs and maintenance
• Make good
• Securities / Guarantees

The principle issue with any income stream is what is the strength of it and with a lease this is the financial covenant of the tenant. A government (local, state or national) tenant is often said to be like a government bond, as secure as you can get. Next on the hierarchy are blue chip public companies although not all listed companies are so secure. Private companies are next followed by individuals. The strength of the covenant is linked to the level of security provided and this is dealt with later.

Next is what is the length of the lease? Clearly a long lease with a good covenant is a good start to a property investment. A lease with options is not so good as the tenant has the upper hand as to whether they exercise them. A term of say 8-10 years is usually a good start. 10-15 years is even better. A 3 + 3 + 3 is not great. The first term is for the Lessor, the options are really for the Lessee. Many buildings have multiple tenancies so the combination of the leases is known as the WALE or Weighted Average Lease Expiry. A building with a good WALE (long leases) is better than a short WALE. Long WALES = value in most cases.

However a long lease without a good rent review arrangement detracts from value. Ideally the lease should have some form of annual increments (CPI or Fixed) with an opportunity to align with market say every 5 years. If you have market reviews you need to protect the bottom line with a “ratchet clause” or as a minimum a collar which may be countered with a cap to protect the tenant. For example, 5% downward collar and 10 % upward cap. Face rents must be supported by face rent reviews. Retail leases have special restraints around reviews and are not open to such escalations engineering.

Many commercial leases come with face rents and incentives which means the rent is above market or effective rent but the tenant gets an incentive often a fit-out allowance in return. Face rents don’t really add value as such but are fine as long as they are correctly managed especially rent reviews. Some would argue they are a necessary evil to attract tenants who can’t justify capex to do a fit-out but are happy to pay a premium face rent over the term instead. (See article on face rents and incentives.)

A net rental lease is key to good investment value as there is clarity and transparency to the recovery of outgoings and the net income. Gross or semi gross leases are not so common these days and should be avoided where possible although correctly structured and administered some would argue they are a good compromise for lessor and lessee. Outgoings recovery is often overlooked as a value add but it requires the items to be recovered, carefully documented and a flexible way of adjusting the % if the NLA changes.

Tenants are usually happy to pay for rates, taxes, insurance, cleaning of common areas, repairs and maintenance, utilities and management. Difficult areas are usually land tax which is generally done on a single holding basis, replacement expenses but not capital expenses (improvement costs) and often structural expenses. Repairs and maintenance is an area that needs to be better understood and maintenance (keeping in good order), repairs (fixing something broken), replacement expenses (even
large items) should be a tenant’s expense although some landlords do hold on large replacement costs.

Capital works are usually lessor’s expenses and they create an improvement to the asset. Structural expenses are usually to the lessors account but the difference between structure which creates the frame for the building and fabric which keeps it waterproof are also difficult areas. Curtain walls by their nature are not structural for instance. However most tenants would not want to be contributing to curtain wall expenses.
If you have a really long lease you may even get a so called triple net lease which in its true form is a lease where the lessor bears no expenses at all, not even capital. Great if you can get one but rents are then duly discounted.

Make good is a word bandied about but often not defined as such in a lease. Essentially, it’s about removing a tenant’s fit-out and restoring the warm shell as it’s known these days. Ideally to add value to a lessor you need options where the lessor prepares a dilapidations schedule for the tenant well before lease expiry and the lessor then negotiates a settlement. This is often better value than having the tenant do a bad job of restoring the warm shell. Some landlords even then keep or/or alter the fit-out to add even more value.

Lastly securities/guarantees under a lease need to be carefully documented in the lease, a bank guarantee is generally considered the safest option. The wording of a bank guarantee needs careful consideration. Banks are often reluctant to leave guarantees open ended but if a tenant has options you need to consider a termination date well after that distant prospect. A sensible solution instead of updating guarantees on annual rent reviews, is to estimate the average amount of rent up to the first market review (5 yrs.?) and then allow for it to be updated. A lease that takes into account these 8 key principles and where possible incorporates them adds value to the landlord. Of course a tenant rep will have the opposite point of view.
However, if you know what adds value you can negotiate around that framework. At the end of the day a lessor has to be competitive in the marketplace and therefore a fair outcome is in the interests of both parties long term.

Paul Nelson B.Sc. (Urb Est Man), EMBA, MRICS, LREA is a property professional with over 40
years’ experience in the UK, Hong Kong and Australia and a member of the PCA Academy
Property Asset Management Committee. He currently works for Knight Frank Newcastle.

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Topics: retail leases, CAPITAL MARKETS, OFFICE, COMMERCIAL

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