Investment Analysis

Understanding Quantitative Analysis

When it comes to analyzing lease proposals for office space, know what makes for a better deal.

In simplified terms, success in commercial real estate means, at times, displaying skills for matchmaking. A client comes to you with a need — a need, for instance, to lease office space that would be an ideal fit for her and her interests.   

If only one property effectively satisfies your client’s needs, there’s no need for a process of elimination, even if it remains critical to understand the cost of occupancy. But what if a few options can check all the boxes for your client? In this case, an effective, comprehensive comparison is required.

Comparative lease analysis utilizes modeling to compare various options, addressing the quantitative aspects that go into the contract. (Qualitative aspects of the properties are also significant in occupancy decisions, but will not be addressed here.) This model will allow you to analyze leases based on total occupancy cost, annual occupancy cost, and net present value.

Economic Comparison

Comparative lease analysis examines leases for potential tenants. First, to establish a vocabulary of the most commonly used measures of occupancy, here are some terms that either are not always consistently used in the industry or their definitions vary from market to market.

  • Base (contract) rent/rate is the lease amount specified by the contract typically stated on monthly basis as a total amount or per square foot rate. The base rent/rate is the amount upon which escalations are calculated.
  • Total effective rent is the base rent adjusted downward for concessions and allowances provided by the lessor (for example, free rent and operating expense contributions) and upward for costs that are the responsibility of the lessee (such as operating expenses). Total effective rent is all cash flows over the term of the lease.
  • Total effective rate is total effective rent divided by the square footage.
  • Average annual effective rent refers to the total effective rent divided by the lease term.
  • Average monthly effective rent is total effective rent divided by the lease term (in months).
  • Average annual effective rate equals the average annual effective rent divided by the square footage.
  • Average monthly effective rate is the average monthly effective rent divided by the square footage.
  • Net present value is the cash flows over the term of the lease, discounted to a net present value.

Sample Lease Comparison

To see how a thorough comparison can inform decision-making, let’s look at a hypothetical situation where an owner has proposed two five-year lease options for 24,000 square feet of rentable office space. Rent for Proposal A is $10 psf for the first two years and $11.50 for the final three years. Proposal B starts at $10.50 with annual increases of 4 percent for the remainder of the lease (with payments made monthly).

First, the cash flows for both leases can be seen in Table 1.

Rental Cash Flow Quantitative Analysis

Next, determine effective rents and rates from lease cash flows, as you can see in Tables 2 and 3.

Annual Effective Rate Office Lease Analysis

 

Calculating Effective Rate Office Lease Analysis

Calculate the Net Present Value of Occupancy for Each Lease

In order to be effective, the lease comparison must take into account the time value of money (TVM). The value of cash flows depends on the magnitude and timing. Lease opportunities of the same length can effectively be compared as net present values of each lease. Using a discount rate specific to the user, calculate the net present value of Lease A and Lease B. Use discount rates of 8, 9, and 10 percent to calculate the net present values of the two lease alternatives.

The choice of a discount rate is very important because it will affect the net present value of the leases and may affect the client’s decision, especially if the pattern of the cash flows varies significantly across leases, as shown in Table 4.

Net Present Value Office Lease Quantitative Analysis

Advise the Client

By every measure — total effective rent and rate, average effective rent and rate, and discounted effective rent — Proposal A is superior to Proposal B. Both options will satisfy the needs of your client, including the qualitative factors that also must be considered. But Proposal A is clearly the superior choice, despite the two appearing so similar. Properly using this comparative lease analysis model shows, by crunching the numbers, a little legwork can better position your client for success in the near and long-term future. 


Editor’s note: This article was adapted from the CCIM Institute course, “User Cost of Occupancy Analysis.”

Nicholas Leider

Nicholas Leider is senior content editor for Commercial Investment Real Estate. Contact him at nleider@ccim.com.

Advertise with Us

Reach more than 45,000 top-performing commercial real estate professionals with CIRE magazine’s print, podcast, and online offerings.

Download the Media Kit

CIRE Sept/Oct 19 Cover

Recommended

Big Data, Major Demand

Fall 2021

 Considering the continued growth of big tech, data centers will be a CRE sector to monitor. 

Read More

Return Policies

Summer 2021

Institutional investment and private equity look to reenter the commercial real estate game after staying on the sidelines during COVID-19. 

Read More

Demystifying Defeasance

Summer 2021

Securitized debt can seem daunting, but it’s possible to sell or refinance assets. 

Read More

Failing to Plan

Spring 2021

Commercial real estate should be a profit generator whenever possible, which may require creative thinking.

Read More