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