Jennifer Bishop December 10, 2009 RE Book Notes Chapter 23: Leases and Property Types Introduction Lease: contract between lessor (owner) and lessee (tenant) transferring exclusive use and possession of space to tenant Leased fee interest with reversion: possessed by owner during lease ? can retake possession of property at lease expiration Every clause/provision in lease can affect property?s NOI or riskiness Lease Elements BOTH parties must be legally competent Objective must be legal Tenant-landlord agreement to enter into lease Consideration: something of value given by both parties to enter lease Ex: promise to pay rent for tenant, promise to let occupy for landlord Enforceable leases contain: Both names Description of leased property ? st. / apt # ok for small props Agreement for landlord to transfer property to tenant Start/end dates (negotiated) Description of rent (negotiated) Agreement in writing Agreement signed by all parties Quiet enjoyment: tenant given uninterrupted property use w/out interference Negotiated Lease Provisions Clauses addressing rent pmt/op exp?s affect property income Operation/property right clauses also affect property value: Use of Premises Tenant can use property at will if no actions forbidden Commercial prop leases usually specify 1 property use Uses that damage building usually forbidden Ensure space used legally Lease Term (MUST be clearly indicated) Apts: 1-year terms are standard Longer leases provide more stability ? delay releasing costs Owner may pay leasing commission to person who secures new tenants Tenant improvement allowance (TI): amt funding owner gives to tenant towards cost of refurbishing space to meet tenant?s business needs Tenants pay moving costs, lose improvements made when moving since they have become part of the RE BOTH tenants and landlords prefer LONGER leases since BOTH are negatively affected by releasing costs Reasons shorter leases preferred If tenants think market rents will fall If tenants uncertain about space needs in future If tenants think bus. will grow/if business risky or start-up If landlords think market rates will rise If landlors want small space inventory to show tenants If landlords want to alter mix of tenants frequently Long leases = reduced costs, short leases = flexibility!!! Rental Payments Residential = dollars per month Rent usually not adjusted since rent term shorter Commercial = annual cost per square foot (divided by months) Rent term longer, so rent adjusted for inflation and changing market conditions Rents changed bc of: Changed supply/demand Changes in property operating costs Rent pressures from inflation, etc. Cost of commercial lease a function of rental rate and proportion operating expenses Flat rent: simplest rent, fixed for whole term Shorter leases usually use it Leases with these usually make tenant pay for some op exs Graduated rent: pre-specified increases in contract rental rate Called ?step-ups? or ?escalations? A function of time ? can predict future payments Indexed lease: rent increase tied to changes in reported index CPI: consumer price index, most common index Index rate fixed for 1 year, adjusts annually Not just a function of time anymore!!! (not predictable) Depends on changes in CPI Shifts risk to tenants Tenants should be given lower rent for absorbing inflation risk Percentage rent: ties rent pmt to tenant?s sales revenue (comrcial) Base rent: flat/fixed component Percentage rent: owner gets % of tenant?s sales revenue Not just a function of time! (tenant sales determines rent) Operating Expenses Gross lease: owner pays all operating expenses Expected level of op exp?s built into rental rate ? assumes owner knowledgeable about competitive market Owner bears risk of unexpected changes in op exp?s Net lease: tenant responsible for % op exp?s (prop taxes) Net-Net Lease: tenant pays prop taxes and insurance Triple Net Lease: tenant pays all operating expenses Tenant bear risk of unexpected changes in op exp?s Operating expense escalation clause: only increases in 1+ op exp?s become responsibility of tenant (relative to base year) Tenant payments made by tenant or by landlord and billed back to tenant (usually the latter, pro-rata to each tenant) Concessions: reduce lease cash flows; offered to tenants as incentive to lease space Not reflected in quoted rental rate Used when space supply > demand (in form of reduced rent) TI?s a common concession in commercial properties Paid by landlord, may be significant if a ?shell? space TI usually negotiated Alterations and improvements Tenants can only make changes to RE with approval of landlord (usually) If tenant permitted by lease, boundaries should be specified Ownership of tenant improvements should be stated in lease Fixtures: personal property permanently attached to RE property ? become owner property when tenant vacates RE, unless lease says otherwise Trade fixtures: paid for/installed by tenant, can be removed by tenant when lease expires ? MUST be identified by lease! Assignment and Subletting Assignment: when all tenant?s rights/obligations transferred to another party ? assignor (1st tenant) still liable for rent Sublease: when original tenant transfers subset of rights to another party Ex: portion of property, portion of occupancy rights New tenant pays rent to original tenant, who pays landlord Original tenant still liable for rent and lease terms Why tenants use subleasing: Tenant needs more/less space, financial difficulty, etc. Both can be problems: Unqualified tenants may default on pmt, disrupt tenant mix Lease option: clause granting option holder right to do something Reduce expected PV of lease cash flow to owner If owners grant options, require higher base rent of tenants Options granted to owner may require concession to tenant Renewal options: grant tenant right (NOT obligation) to renew lease Tenants want to renew lease w/same terms as original but owners don?t Market rents may increase ? owners would have to renew at a below-market rental rate If rents decline, payoff to owner neg, and if they rise payoff 0 bc tenant won?t renew Owners won?t grant renewal option unless buyer pays higher base rent Give tenant right to renew lease at prevailing market rates Less costly for owner, but owner payoff still negative Doesn?t let owner renew to tenant that might match owner?s interests better Being able to alter tenant mix important Cancellation option: right for tenants to cancel lease before expired, with penalty In commercial, used if tenant?s sales not high enough Expansion option: lets owner give tenant adjacent space Costly for owner ? must reserve space to give tenant this option Right of first refusal: gives tenant first choice to lease adjacent space if it?s available ? less costly for owner Relocation option: right to relocate tenants within property Major tenants usually don?t let this become part of lease Smaller tenants usually allow it if guaranteed similar space, and if moving costs mostly paid for Other Common Clauses Access to Premises: gives owners right to enter/inspect leased space Allows repairs, showing of space, doesn?t disrupt quiet enjoyment Monitors use of space Only done at reasonable times w/prior notification Advertising and Signage: restricts type/location/number signs displayed on RE Keeps signs consistent w/owner?s marketing strategy Tenants in commercial spaces may be required to spend on advertising to promote business Parking: requires tenant employees to park in certain areas Lease must clarify employee vs. customer parking locations Lease must specify lighting/upkeep of parking lots Effective Rent Quoted rental rate: shows limited info about lease cost to tenant Cost influenced by rent, op exps, concessions, options held Effective rent: determines true cost of a particular lease ER for monthly pmt = level monthly pmt over term w/ same value as lease Ex: 5000 sq ft, 5yr lease office w/ $20 per sq ft rental rate, gross lease, 8 mo?s free rent concession, tenant can invest lease pmts at 10% annual return Find PV of lease pmts w/out concessions ($395,479.83) Find PV of lease pmts w/ concessions ($330,710) Find fixed monthly pmt w/ same value as lease w/ concessions ($6,968.44) Convert to annual rental rate per square foot Equivalent level rent = 12 x fixed monthly pmt / sq feet = $16.72 per sq. ft. Broader Lease Considerations Shortcomings of effective rent: 1) for specific property only Interlease risk: risk associated with replacement of a shorter lease with a lease of identical length with uncertain terms/conditions Interlease risk reduced if lease gives option to renew at original rate 2) ignores releasing costs 3) ignores desire of parties for flexibility 4) ignores desire to avoid risk of replacing leases Residential Rental Properties and Leases high-rise apartment buildings: have 10-15 stories, in large cities where land expensive midrise apartment buildings: 4-9 stories, underground/no parking, amenities garden apartments: low development, less expensive, low-rise buildings, amenities condominium: multiunit, individual owners, joint common-area ownership, mid or high-rise, owners? association lease provisions of residential rental properties nonwaivable tenant rights (can?t be removed / limited) 1) property safe/habitable/maintained 2) protection from unreasonable entry 3) right to cancel lease if RE destroyed Lease term ? usually 1 year for residential (shorter terms available) Condition of RE ? statement of condition: signed by tenant after inspection Utilities ? tenants pay for gas/electricity, utilities included in rent in older buildings, leases must specify utility conditions Rules and Regulations ? owners distribute to new tenants; protect RE/tenant safety, signed by tenant in lease Office Properties and Leases Class A: highest rent, best location/tenants, most desirable, newer Owners: pension funds, insurance co?s, REITs Older buildings can be class A if they match needs of tenants Class B: lesser rent, less desirable location/amenities, layout not as nice Class C: older, well-maintained, below market standards, rents lower 12 Criteria for office building classification: Prestige, Location, Appearance, Ease of Access, Lobby, Elevators, Corridors, Office Interiors, Tenant Services, Mechanical Systems, Management, Tenant Mix Rental Space in Offices Usually on dollar per square foot basis Usable area: sq footage bounded by walls separating tenant areas ? in sole possession of tenant Rentable area: tenant usable area plus prorated share of common areas Rentable/usable (RU) ratio: calculates tenant?s share of common area RU = Total rentable area/total usable area RU multiplied by tenant?s usable area to obtain rentable area Common Lease Provisions of Office Properties Lease Terms 5-10 years most common, more years needed to amortize cost of initiating lease Renewal options common in offices Tenants share operating expenses Operating expense escalation clauses popular (indexing less common) Expense stops: owner responsible for reimbursable op exp?s up to specified ?stop? amount per sq foot of total rentable space in building Beyond that, each tenant pays a pro rata share Good for owner ? reimburses him/her for some operating expenses Retail Properties and Leases Trade area: area from which shopping center draws customers (mile radius) Types of shopping centers: Neighborhood shopping center: for convenience of neighborhood population Convenience goods (groceries), services (videos, haircuts, laundry) Anchored by grocery store or drug store Gets customers within 2-3 mile radius Community Shopping Center: larger neighborhood shopping center Anchored by departments store, has outlets (clothes, banks, food, etc.) Leasable area 3 x more than neighborhood center Targets within 3-6 mile radius Power shopping center: high ratio of anchors to tenants 3+ retailing ?giant? anchors like Home Depot/Walmart Usually near large malls, draw from 5+ mile radius Regional Shopping Center: general merchandise, 2+ anchors Chains, local businesses, draw from mostly 10-mile radius Minor tenants between anchors to draw business Contain several stores of one type, contain food outlets Superregional malls: 5-6 anchors, hundreds of minor tenants, millions of sq ft Specialty shopping center: dominant theme/image, many in historic areas Outlet center: variation, sells name-brands @ lower prices Leasable Area in Retail Properties Gross leasable area (GLA): amount of space occupied by tenant (usable area) Gross floor area of shopping center: total GLA (sums) + common area sq. ftg. Common Lease Provisions of Retail Properties Anchor tenants: large, well-know retailers drawing most customers Usually sign longer leases Non-anchor tenants make flat/indexed rent payments, plus % of gross sales Help pay for center?s operating expenses Percent Rent Clause Property owner gets a percent of tenant sales OR a percent exceeding a certain threshold, plus base rent (sq ft) Advantages: Tenant leasing space otherwise unable to rent bc of uncertain success; increased rent conditional upon performance owner aligns owner interests with those of tenant owner cash flows determined by sum of tenants? ? owner has incentive to maintain premises, which increases tenant sales Use clauses Merchandise/services specified per tenant Large tenants restrict uses of adjacent tenant space Tenants may demand exclusives ? granted at owner discretion Radius Restrictions ? restrictions on building similar stores close to property Limits competition, 2-4 miles for shopping, 5-15 for malls Hours of Operation ? owner sets them, specifies in lease Common Area Maintenance (CAM): specifies common areas and owner responsibilities towards them Maintenance/repair costs billed to tenants Prorated among tenants based on % leasable area by tenant Other Clauses Tenant required to occupy space for entire term (continuancy occupancy) Tenant must operate continuously (continuous operation) Industrial Properties and Leases Types: 1) Large single-user Buildings: factories, 1-purpose, not easily converted Risky, avoided by investors unless specializing in that one use 2) Warehouses and Self-Storage Temporary storage of goods Easy to build, single structures, long lives, little maintenance Least vulnerable to obsolescence 3) Multitenant ?Industrial Parks" Flex space: new industrial space to accommodate tenants Rents lower here, lots of parking Lease Provisions Tenants want long-term leases (give possession and control) Warehouses usually leased on triple-net basis Few TI?s required since warehouses homogenous Releasing/moving costs low ? short term leases preferred by tenants Industrial park leases must specify tenant maintenance/repair responsibilities Interior space, mechanical equipment costs paid by tenant Roof maintenance paid by tenant Common area maintenance billed pro rata to each tenant Hospitality Properties Hotels/motels service travelers/visitors ? rooms rented daily, gross leases Success depends on management Properties owner by national chains
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