Analyzing commercial real estate leases in today's rapidly changing marketplace is a daunting task. But if performed properly, this process can have a very important economic impact on landlords, owners, and investors. While there are numerous ways to analyze leases, breaking down the investment into several variables is the most effective. Upon reassembling the pieces, commercial real estate pros often can make a prudent decision.
One key variable is the method used to determine rental increases and how these calculations affect a commercial real estate investment's performance and sales potential. Analyzing various rental increase methods is the best way to maximize a property's returns and streamline lease negotiations.
Common Rental Increase Methods
Market factors largely influence the types of rental increases property owners and landlords use when structuring tenant leases. Calculating a lease's present value is a useful way to analyze the impact of rental increases on the investment. Find the PV of an income stream by taking the sum of the discounted value of each cash flow at a discount rate. Using the PV approach converts a series of future cash flows into today's dollar value using a stated discount rate. PV analysis often is performed when using the following rental increase methods.
Cost of Living Annual Increases. COLA rental increases are common for all property types. To calculate a COLA increase, the base rent is adjusted by changes in the U.S. Consumer Price Index (www.bls.gov/cpi) throughout the lease term. Many landlords prefer COLA increases because they offer some protection against inflation. For instance, suppose a lease includes a fixed rental increase clause rather than a COLA increase. If the inflation rate increases more quickly than the fixed rental rate, landlords will have to bear the higher property operating expenses. However, if the lease includes a COLA adjustment clause, inflationary increases can be passed on to tenants, who may in turn pass additional costs on to their customers or clients. Throughout the last 10 years the national average annual COLA increase has been approximately 2.89 percent, according to the Bureau of Labor Statistics.
Fixed Annual Increases. One of the most common types of rental increases, fixed annual increases are simple to calculate and oftentimes easier to negotiate. The fixed percentage varies widely from market to market, but should be close to the estimated inflation rate or COLA. For example, consider a 10-year lease that starts at $500,000 and has annual fixed increases of 3 percent. For simplicity, assume this is a net lease and disregard any purchase, sales price, financing, or capital expenditure information. The annual rental income generated by this lease will grow from $500,000 to $652,387 over the 10-year lease term. Using a before-tax discount rate of 10 percent, this lease's PV is $3,611,223.
Fixed Increases at Set Intervals. Another type of rental increase commonly seen in net-lease investments is fixed increases at set intervals, often referred to as step leases. For example, a 10-year lease may call for level rent payments for five years, a one-time 15 percent increase at the start of the sixth year, and then level rent payments at the new amount for the subsequent five years. This differs slightly from the annual rental increases in that the investment is not earning annual compounding rent. By waiting until a later date for the increased rent, the time value of money eats away at the PV of future cash flows, having a negative impact on the return.
For instance, suppose annual rental income generated by a lease remains constant at $500,000 for five years, escalates 15 percent to $575,000 at the beginning of the sixth year, and remains constant for years six through 10. When discounted at 10 percent, the lease's PV is $3,408,669.
Sensitivity on the Differential
When comparing the two 10-year leases with different methods of calculating rental increases, the PV of the lease with a 3 percent annual fixed increase is $202,554 greater than the PV of the lease with the 15 percent increase at the end of a five-year interval. Is there some percentage rate increase that should be applied at the end of the first five-year interval at which the two leases would have the same PV? This question can be answered by doing a sensitivity analysis on the rate used for the increase at the end of the five-year interval.
The first step is to calculate the differential cash flow generated by comparing each lease structure. As can be seen, after the first year, at all times during the remainder of the lease term the lease with the 3 percent annual increase produces greater annual cash flow. (See Table 1.) Through the use of sensitivity analysis, it is apparent that at a fixed rental increase at the end of the five-year interval of approximately 29 percent, the PV of the differential cash flow equals zero. (See Table 2.)
If the lease is extended to 15 years, which would have increases at two five-year intervals, a sensitivity analysis shows the five-year interval rate of increase required for the two leases' PV to be equal is approximately 22 percent. Presumably, extending the lease farther will continue to reduce the five-year interval rate increases necessary to achieve equal PV.
Effects on Projected Sales Price
Assuming that a sales value can be determined by applying a capitalization rate to the income generated from a lease, the lease with the highest income will generate the highest sales price at any cap rate. However, the timing of the rental increases can influence the optimal holding period of the property.
For instance, in Table 3, during the first four years of the lease with 3 percent annual increases, income is higher than the lease with a 22 percent increase every five years. Therefore, assuming any going out cap rate, the lease with 3 percent annual increases would generate a higher sales price. But once the first step increase is applied, for three years the revenue stream is higher from the lease with the one-time increase every five years. The number of years in which to sell the property based on the highest lease revenue and therefore the highest sales price varies depending on which lease structure is used. While it is beyond the scope of this article, it also might be valuable to calculate the PV of each lease alternative using both the annual revenue and sales proceeds from each lease using different time assumptions.
Rental increases clearly impact not only the PV of an investment's cash flows, but also the timing of a sale. To make the most profitable and practical choices, it is important to analyze how different types of rental increases affect different investments. Commercial real estate professionals also can use these analysis methods to negotiate rental increases that are acceptable to both landlords and tenants.