Lease Buyout Decisions
This case study shows how to quantify and visualize risk.
decisions in commercial real estate often involves more than just calculating a
capitalization rate or net present value, because there is always a component
of unknown risk. In the office leasing sector, risk is created by local market
factors, such as supply and demand for space, asking and effective rents, and
absorption rate. Other factors contributing to risk are the specifics of the situation.
Learning how to quantify and illustrate such risks to clients is a challenge,
especially in small or mid-size markets where office demand can still be
article discusses how to quantify the risk of a real-life decision: Should an
office tenant write a check for $1.5 million to accept a lease buyout offer, or
continue to market a sublease for 56,542 square feet of class A downtown office
tower space in New Orleans?
byproduct of a merger between two large oil companies, a decision was made to
relocate 250 employees from New Orleans to Houston, leaving 75,000 sf — four
floors of fully furnished class A office space — vacant with an obligation to
pay rent at $18.25 psf for 54 more months.
situation is compounded by two issues: The space represents the largest
contiguous class A office space in New Orleans, and with only 54 months left on
the lease, it is not feasible for the lessee to offer any build-out allowance.
This means the sublease space cannot compete with market-rate space.
lessor has presented an offer to take back 56,000 sf — three full floors — for
a lump sum payment of $1,500,000 rather than the current obligation of
$1,022,000 per year. The decision for the tenant is whether to pay the $1.5 million
and gain the difference or try to sublease the space to produce a greater
income. The dilemma is how to analyze the risk.
Orleans class A office tower market is approximately 9,000,000 sf, with
1,000,000 sf currently available for lease. Building occupancy rates range from
73 percent to 97 percent and 2013 absorption was 133,000 sf, or 13 percent of
available lease space. Asking rents range from $16.50 to $21.00 psf, including
build-out payments ranging from $10 to $30 psf. In competing buildings, 15,000
sf of sublease space is available at $15.00 psf and 90,000 sf was just renewed
at $12.50 psf.
glance, the answer appears to be a no-brainer: Accept the offer to pay a lump
sum of $1,500,000 rather than pay $1,022,000 annually for 54 months, equal to
$4,599,000. However, calculating the numbers on subleasing the space at the
average asking rate of $18.50 psf produces a profit of $63,609 for the
remaining period. (See Table 1.)
numbers are compelling to clients wishing to make the most of a difficult
decision. However, just because the market rate is $18.50 psf, we can’t assume
that we can immediately lease the entire space at that price. Instead, the
analysis should focus on the risk of not paying the $1,500,000 and trying to
sublease the space. At what rent do we need to sublease the space and how soon
do we need to find a tenant before we are worse off than just paying the
$1,500,000? How do we show a client that risk visually?
the critical data are how long will it take to sublease the space and at what
price. If the current market lease rate is higher than the current obligation
net of build-out allowance, the space would command a payment to the lessee
rather than a $1,500,000 payment from the lessee. But, like many markets, the
New Orleans market has a wide variance, with some class A office tower downtown
space subleased at a low of $12.50 psf and listed space quoted up to $21.00
way to analyze the decision is to first examine the worst, average, and best
outcomes, as shown in Table 2, which compares the income from a range of lease
prices psf compared to various periods remaining on the lease. The three price
levels are the actual low, middle, and high rates for class A office tower
space in downtown New Orleans.
combination of time remaining and assumed sublease price should be compared to
the net savings from the buyout offer of $1,500,000. The current obligation is
for a lease payment for 54 remaining months at $18.25 psf on 56,542 sf, for a
total of $4,643,511. The buyout offer requires a one-time payment of
$1,500,000, which is a savings of $3,143,511. ($4,643,511 minus $1,500,000
lessee could sublease the space for $12.50 psf, the space would have to be
subleased almost immediately in order to reap more income than the proposed
offer. At $15.00 psf, the space would have to be subleased within 12 months, or
have 42 months remaining in which to earn enough income. At $18.25 per square
foot, the space would have to be subleased within 18 months, in order to have
36 months remaining to produce the same savings.
information in the table can best aid the decision-making process by
illustrating it in chart form, with the dotted line depicting the savings from
the proposed offer to buy out the lease.
shows that any situation above the dotted line represents a better alternative
than the proposed offer, and any situation below the dotted line represents a
one step further to incorporate risk into the analysis produces a more-reliable
decision. We might have a higher confidence level that the space will sublease
around the $15.00 psf level, but we still don’t know how long it will take to
get it subleased. Of the 133,000 sf leased last year in New Orleans, the
subject space represents 42 percent of that supply. Of the 133,000 sf, only
three leases were 17,000-sf full floors. So the decision compares a finite cost
of $1,500,000 against several likely outcomes.
further incorporates risk by comparing the area in a blue box of all possible
outcomes above the known savings (which is a better outcome) to a red box of
all possible outcomes below the known savings (which is a worse outcome). Since
the blue box is smaller than the red box, it is less risky to pay $1,500,000 to
terminate the 56,542-sf lease than it is to try to lease the space for more
Hand, CCIM, SIOR, is owner of Louisiana Commercial Realty in New Orleans, which
specializes in aquisition and disposition of large complicated commercial
properties. Contact him at email@example.com.