What are “Points?”

 

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You’ve probably heard the term before or heard it referenced in a conversation between investors, but much like cap rates, “points” or “discount points” are one of those concepts that many people simply smile and nod along with and few really understand. Simply put, points are prepaid interest on a loan, which are equal to 1% of the loan amount. So, for a $100,000 loan, one point is equal to $1,000.

Most people are borrowers and thus their understanding of financing is generally limited to the nominal interest rate as a metric for analyzing the cost of financing. From the lender’s perspective the loan is an investment and if interest rates were the only tool they had to make a deal work, not many deals would get done. Real estate investors are looking for a specific return or yield on an investment and lenders are no different. There are many situations where the lender’s required yield and the borrower’s maximum monthly payments are incongruous. Discount points provide lenders with the ability to increase their yield (and reduce their risk) without affecting the borrower’s payment schedule or any balloon payments.

Basically, points lower a lender’s net investment in a loan thus allowing them to achieve a higher yield. Points can be charged as an actual fee at loan closing or their value/cost can be deducted from the actual loan amount. For example, if a lender charges 2 points on a $100,000 loan they can either charge the borrower $2,000 or only actually disburse $98,000 in funds. This increases the lender’s yield because their still receiving payments based on a $100,000 loan and their risk is reduced because the buyer has actually prepaid part of the loan or less actual money has been provided.

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Georgetown/Uptown Submarkets Q2 2019

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Georgetown

  • RBA: 3,764,891 SF
  • Vacancy Rate: 11.4%
  • 12 Month Net Absorption: (140,000 SF)
  • Average Asking Rent: $46.16
  • 12 Month Rent Growth: 0.2%

The Georgetown Waterfront is an analogy for the submarket, as a whole. The delivery of the Wharf shifted the “center” of DC to the Southwest; offering newer and better dining, boating, and working options. This has contributed to negative net absorption over the past 3 years (140,000 SF in the past 12 months, alone). The one upside for Georgetown is also one of its main weaknesses as a submarket: there have been no new deliveries since 2006 and none are planned for the next 2 years. This is not expected to change due to the lack of developable land combined with the historic nature of the neighborhood. Most of Georgetown’s inventory is comprised of small and old offices with most properties being built in the early 1900s. Lack of metro access will always be an issue in Georgetown, but with an average rental rate of $46.16/SF/yr the submarket offers a prime location with reasonable rents compared to DC’s core office submarkets.

Uptown

  • RBA: 12,205,546 SF
  • Vacancy Rate: 10.7%
  • 12 Month Net Absorption: (481,000 SF)
  • Average Asking Rent: $42.19
  • 12 Month Rent Growth: -0.4%

To Amortize or Not to Amortize, That is the Question

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Landlords must consider a number of factors when determining the asking rental rate for their property/space. The goal is to be at the market rate, which is the rate at which a willing tenant would choose to lease the space. This extends beyond the rental rate and encompasses all of the economic terms of the deal, including but not limited to rental abatement (number of months), tenant improvement allowances, etc. Landlords must stay up to date on the asking rates of comparable properties/spaces and other concessions being offered to ensure they are competitive and can attract tenants.

A landlord’s leverage is based on the desirability of the property, which in turn is based on its location, asset class, condition, etc. A landlord’s willingness to grant concessions is on a more micro level and is based in the desirability of the tenant, which in turn is based on that tenant’s financial strength, size (square footage), etc. In general though, investors purchase real estate based on certain projections and their required return. They factor in concessions into their pro forma based on market conditions (rents, vacancy levels, etc.). What this means is that when you begin negotiations with a landlord they are already prepared to make certain economic concessions in order to lease the space. Good commercial real estate brokers understand this and are knowledgeable about market conditions and concessions. The best commercial real estate brokers seek to understand the landlord’s situation and goals in order to structure the deal for their client (tenant) that extracts the most economic concessions possible through a combination of strategies.

This article will focus on tenant improvement allowances, specifically in cases where the amount needed exceeds the amount the landlord is willing to provide given the length of lease term and rental rate.

Constructions costs have been steadily rising since the Great Recession. For office spaces $50 per square foot used to be sufficient to built from shell condition. Today that number is closer to $70 per square foot depending on finishes. Five-year leases used to be sufficient but now landlords are requiring 7-year terms to justify the amount of capital outlay. For a variety of reasons, some companies may not be willing or able to sign up for a 7-year commitment. What do they do when they need more money for tenant improvements but there isn’t any more in the deal at the market rate? Tenants essentially have 2 options: 1) pay for the additional costs out of their own pocket or 2) request the landlord amortize those additional costs into the rental rate. There are pros and cons associated with each option and depending on their preferences, financial resources, tax situation, etc. can choose a combination of both to customize the deal for what works best for them.

The first option is for tenants to pay for the costs of the improvements (or the discrepancy from the total budget and that which the landlord is willing to contribute). Construction budgets are discussed in terms of price per square foot. The larger the square footage the greater amount an otherwise small number equates to. For example, $20 per square foot for 1,000 square feet is $20,000 while $5 per square foot at 4,000 square feet is the same amount. The larger a tenant’s square footage the less appealing paying for the improvements can become. If the landlord is willing to provide $50 per square feet and the project requires $70 per square foot the tenant would only have to pay $20,000 for 1,000 square feet but $200,000 if they occupied 10,000 square feet. The issue for the company to determine is whether that capital could and should be used elsewhere for a greater return, i.e. hiring additional staff to grow the business/revenue.

There are tax benefits for tenants if they choose to pay for the improvements out of pocket. Tenant improvements can be deducted on a straight-line basis over a 15-year period; however, it’s possible to accelerate the depreciation for specific line items in a construction budget, i.e. carpet. Tenants may be able to negotiate to have their $20 per square foot to be applied to such project costs thus increasing the amount that can be deducted to offset their taxable income. Companies should consult a tax professional to ensure they are in compliance with the law.

The second option is for the landlord to amortize the additional costs into the rental rate. This option is viewed negatively for the main reason that landlords typically charge anywhere from 8-10% on that money. Most companies should be able to get that money cheaper through conventional financing; utilizing an existing line of credit or obtaining a loan from their bank. Without taking into account the amortization rate, another con of this option is annual escalations. Using easy math, if an additional $20 per square foot is needed for the construction project on a 5-year lease, it would equate to an extra $4 per square foot per year ($20 per square foot divided by 5 years). If the market/asking rate is $16 per square foot the tenant would now be required to pay $20 per square foot starting in year 1. The issue is that the inflated rate would be subject to annual escalations (generally 3%). So that $4 per square foot extra is increasing each year by 3% and by year 5 has grown to $4.50 per square foot. That may seem like an insignificant amount but as square footage increases so does its significance.

Again, the benefits of using this option come in the form of taxation and how leases are reported or more accurately how the costs can be deducted to lower taxable income. Rent is usually paid monthly and escalates on an annual basis. The way rent is reported is different. Tenants must take the entire lease value and divide it over the full term. For example, if a tenant leases 1,000 square feet at $20 per square foot per year with 3% annual escalations for 5 years the total lease value is $106,182.72; meaning the company can deduct $21,236.54 per year in lease expenses to lower their taxable income. If the company had 4 months of free rent in year one for a total term of 64 months the calculations would be slightly different and they would only be able to write off $20,108.35 per year. This exemplifies how rental abatement even if put “outside the term” lowers tenants’ net rental obligation.

There is still an increased cost of funds, but if a tenant cannot accelerate the depreciation of the tenant improvements they pay for themselves and must deduct them on a straight-line basis over 15 years they are not able to lower their taxable income as much as they would by incorporating those costs under their rent which is fully deductible over the lease term. The shorter the lease term the greater the amount that must be amortized but also the greater the deduction. Tenants may choose to “take their medicine” quickly and renegotiate a renewal rate at the then market rate.

*The ability to fully deduct rental payments is one of the benefits of leasing over purchasing. Cost recovery deductions only apply to the basis of a property allocated to the improvements. Land is not depreciable. Because a tenant’s cost of occupancy is the rent they are essentially able to deduct both the costs of the improvements as well as the land.

Every company’s/tenant’s situation is different and one option may more sense for one company versus another or for one company at one time versus another. If a company is financially strong with a low interest credit line they may choose to pay for the cost of the improvements themselves instead of at the landlord’s amortized rate combined with annual escalations. If a company does not have access to capital they can request the landlord act as the bank and amortize those costs into the rent. The tenant may be paying an above market rate but because rent is 100% deductible they are able to lower their taxable income by that amount. Tenants may choose to utilize a combination of these two options to customize their tax situation based on their organizational structure and projections.

Capitol Hill Area Submarkets Q2 2019

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Southwest

  • RBA: 12,424,906 SF
  • Vacancy Rate: 11.5%
  • 12 Month Net Absorption: 664,000 SF
  • Average Asking Rent: $50.76
  • 12 Month Rent Growth: 2.2%

Southwest is rapidly becoming DC’s hottest submarket. Don’t let the vacancy rate fool you. While it may have ended Q1 2019 at 14%, the highest in the District, this was the result of 700,000 SF delivering since 2017, not a lack of demand as evidenced by the 664,000 SF of positive net absorption and 2.2% in rent growth in the past 12 months. Most of the vacancy is attributable to 3 Star properties and not the newly delivered product. In fact, 700,000 SF of additional inventory was under construction at the end of last quarter and the 2nd phase of the Wharf is set to deliver 1.25 million square feet by the end of 2022. We will see if demand can outpace supply in the long-term, but with average rates of $50.76/SF/yr, Southwest currently offers a more affordable alternative than DC’s traditionally premier submarkets like the CBD and East End.

NoMA

  • RBA: 11,552,310 SF
  • Vacancy Rate: 7.9%
  • 12 Month Net Absorption: 986,000 SF
  • Average Asking Rent: $50.76
  • 12 Month Rent Growth: 2.3%

Capitol Hill

  • RBA: 7,124,011 SF
  • Vacancy Rate: 10.8%
  • 12 Month Net Absorption: 63,200 SF
  • Average Asking Rent: $55.63
  • 12 Month Rent Growth: 3.3%

Capitol Riverfront

  • RBA: 4,168,864 SF
  • Vacancy Rate: 8.3%
  • 12 Month Net Absorption: (59,500 SF)
  • Average Asking Rent: $50.20
  • 12 Month Rent Growth: 4.0%

Catfishing or Core Factor? Usable vs. Rentable Square Feet

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Have you ever walked into two offices in different buildings with the same quoted square footage and one felt bigger or smaller than the other? Your eyes aren’t necessarily playing tricks on you. What may appear to be an optical illusion isn’t an illusion at all. It’s a characteristic of multi-tenant office buildings called load factor (or core factor), which refers to the ratio between a building’s rentable and usable square footage.

Multi-tenant office buildings are unique in that they have certain areas of the building that are shared by some or all of the tenants in the building. The most recognizable examples of these “common areas” are building lobbies, hallways, bathrooms, elevators, stairwells, etc. In newer or recently renovated office buildings, landlords may choose to set aside space or convert previously occupied or undesirable space, such as lower level, windowless space, into fitness facilities, conferencing centers, tenant lounges, etc. All of these common areas and amenities reduce the actual square footage that the landlord can lease to tenants and because landlords are not in the business of leaving money on the table they recoup the costs/square footage taken up by these areas by applying the building’s load factor to the tenant’s usable square footage; resulting in a higher, rentable square footage number.

If you’ve ever leased office space before you’ve probably seen the phrase “approximately X square feet measured in accordance with BOMA standards.” BOMA stands for the Building Owners and Managers Association and is the internationally recognized standard used to measure office space. There are two measurement methods under BOMA for determining a building’s total rentable area and, while they should produce the same results most of the time, there are subtle differences that can impact the amount based on a building’s layout and the location of its common areas.

Method A, referred to as the Per Floor Load Factor Calculation (or Legacy Method), calculates rentable area by floor. The main level/first floor/lobby of the building is used for ingress and egress by all tenants and thus the load factor for that level is calculated and applied to the rentable/usable ratios for each independent floor. This can be relevant if one tenant occupies multiple floors in an office building. The floors/levels occupied by such tenants do not have (are not required to have) common area corridors and their bathrooms are not accessible to other tenants in the building. This decreases such tenants’ load factor because of the increase in usable square footage relative to rentable square footage.

Method B (Single Building Load Factor) calculates a load factor for the entire building that is applied uniformly. Once calculated the rentable/usable ratio is applied to each tenants’ space or occupant area, as defined by BOMA. Because the actual rentable/usable ratio may vary from floor to floor this method may provide a slight benefit to some tenants over others; however, due to its simplicity this method is popular choice for many landlords.

Because tenants are charged based on their rentable square footage a building’s load factor is an important factor to know when choosing between leasing alternatives. If a tenant is looking to lease 10,000 SF and deciding between Building A which has a core factor of 15% and Building B which has a core factor of 18%, all things being equal, they should choose Building A, which provides an additional 300 SF of usable space. The impact of the load factor increases directly with the amount of square footage. At 100,000 SF that difference is 3,000 SF which at 200 SF/employee will all the tenant to accommodate 15 additional employees.

What do landlords do if their building’s load factor is higher than market and negatively impacting their ability to attract tenants? In such cases, landlords may apply an artificial cap to their building’s load factor in order to bring it in line with the competition. Class A/Trophy buildings with numerous amenities are prime candidates for the application of a market load factor and, while landlords may be foregoing some amount of rentable square footage, tenants are willing to pay higher rents exactly because these buildings provide such high-end features thus negating the aforementioned loss.

For more information you can visit www.BOMA.org

Downtown DC Submarkets Q2 2019

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Downtown DC is home to the Central Business District (CBD), East End, and West End submarkets, which are the most expensive in the region with average rents over $50/SF. The CBD and East End are also the area’s largest submarkets with an astonishing, combined inventory of over 97 million square feet. Despite weakening fundamentals in all 3 submarkets, Downtown DC still has the reputation as home to the metro’s premier office submarkets with the rents and investment capital to prove it.

Central Business District (CBD)

  • RBA: 45,305,140 SF
  • Vacancy Rate: 9.9%
  • 12 Month Net Absorption: (202,000 SF)
  • Average Asking Rent: $53.70
  • 12 Month Rent Growth: -0.1%

Over 1.5 million square feet is set to deliver in the next 2 years as developers tear down older inventory and replace it with new, trophy buildings. This supply side pressure should keep vacancy rates high and continue to put downward pressure on rents.

East End

  • RBA: 51,756,676 SF
  • Vacancy Rate: 13.4%
  • 12 Month Net Absorption: 137,000 SF
  • Average Asking Rent: $56.82
  • 12 Month Rent Growth: -0.2%

Despite weak fundamentals, the East End is still considered DC’s premier office submarket, as evidenced by continued investment amidst decreasing cap rates/rising prices. Changes in demand from the submarket’s traditional tenants, such as law firms, and over 1.1 million square feet delivering in the past year has lead to a vacancy rate well above the historical average and negative rent growth.

West End

  • RBA: 4,807,645 SF
  • Vacancy Rate: 13.7%
  • 12 Month Net Absorption: (311,000 SF)
  • Average Asking Rent: $50.99
  • 12 Month Rent Growth: -0.9%

The West End saw over 300,000 SF of negative net absorption in the past year due to tenants relocating to other submarkets. An aging inventory with no new deliveries in sight should lead to a continued rise in vacancy and negative rent growth as landlords struggle to attract new tenants.

How to Effectively Lease Up a Property in a Competitive Market

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Vacancy is a reflection of a property’s rental rate. The vacancy for any space goes to zero at a certain price or 100% at another. Would you lease 100,000 SF for $1,000/month? Would you lease 1,000 SF for $100,000/month? The intersection between the demand and supply curves for space in a particularly market, asset class, etc. determines market rents and occupancy levels.

Historically high vacancy rates are one of the many legacies of the Great Recession (for more information on the impacts of the Great Recession see my article The Great Recession’s Impact on the Office Market). Oversupply and functional obsolescence have led to a flight to quality, with many owners/landlords of Class B and C properties experiencing the lion’s share of the market’s vacancy. Spaces may sit on the market for months or even years with seemingly no end in sight.

In some cases, this is due to the unwillingness or inability of owners/landlords to lower their asking rates. Old school/long-term owners may have paid off the asset years ago and, therefore, do not necessarily need the rental income. They have their price and stick to it. Others may have purchased the property at a price based on certain assumptions. If those projections were wrong at the time or have since become outdated they may not be able to lower their rates without incurring a loss. Older (Class B & C) buildings are generally less efficient than their newer/Class A counterparts. The higher operating expenses thus compress the profit margin when netted against market rental rates.

For the rest of owners/landlords the answer is simple: lower your rental rate until you lease up your space/property. This is only one part of the answer posed by this article. The operative word is “effectively.” Certainly some money is better than none but no one wants to leave money on the table.

One of the problems with Class B & C properties is that their spaces/suites and common areas are old and tired; having suffered decades of wear and tear. In order to be more attractive to tenants these assets must undergo renovation. After renovation comes repositioning (higher rents). Many owners may be unwilling or unable to spend the money to renovate their property on a speculative basis, which makes sense. They also may not have the financial ability to provide market tenant improvement allowances depending on the size of the tenant. So, how do they get from point A to point B?

As touched on in my article, Losing Money to Make Money, landlords/owners must assess when to make short term sacrifices for long term gains. The first step is lower a property’s asking rate until, despite the property’s shortcomings, it is able to attract quality tenants (make them an offer they can’t refuse). The next step is to structure the deal in a way that minimizes the out-of-pocket costs for the owner; such as providing tenants with rental abatement in lieu of tenant improvement dollars. Similar to the concept of positive financial leverage increasing an investment’s return, if the owner can use someone else’s (the tenant’s) funds to improve their own property they will be increasing the value of their asset without incurring a dollar for dollar expense. In fact, the lack of rental income due to rental abatement decreases the owner’s taxable income and, depending on how their business is structured, can allow them to have those losses offset taxable income elsewhere.

The final step is to negotiate the shortest lease term possible while providing a renewal option for the tenant at the then market rate. Landlords understand the costs associated with moving. Unless a tenant/company has grown and requires more space (or contracted and requires less) they are likely to stay in the same space/building. When it comes time for the tenant to exercise their renewal right, the landlord is in possession of a more marketable and desirable space and one in which the tenant has made a financial investment. The landlord can, therefore, reasonably demand a higher (market) rate from their existing tenant or go to market in a significantly improved position.

For more information on listings or representation services, please contact Ryan Rauner at 703-943-7079 or Ryan@RealMarkets.com.

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Using Assessed Values to Determine Listing Price

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In 2018 I was appointed to the Fairfax County Board of Equalization of Real Estate Tax Assessments (BOE). Every year the Department of Tax Administration (DTA) is charged with determining the value of each taxable property in Fairfax County for the purposes of collecting taxes. Residential and commercial property owners have the right to contest and appeal the assessed value of their property to the BOE whose especial duty is to determine whether the DTA has done so in a fair and uniform way. As a function of its role the board has the power to increase, decrease, or keep the same assessed value upon its review.

In addition to the honor and privilege of serving the County I’ve called home my entire life, this position has provided me with exclusive and invaluable access to behind-the-scenes market data and the various methods used to value real estate assets from office buildings to golf courses, multi-million dollar homes to vacant land, and apartment projects to shopping centers. Despite having to assess hundreds of thousands of properties per year, the DTA does a surprisingly good job of determining the market value of the County’s real estate assets within an acceptable margin of error. The accuracy of the valuations though are limited by the amount of data available to the assessors and, as one can imagine, the inventory of residential properties and annual sales dwarves that of all the County’s commercial assets combined.

My 11+ years of experience as a commercial real estate broker and CCIM education combined with my insight into the valuation methods used by the DTA have led me to an interesting revelation into the current state of our real estate market and how to effectively determine the appropriate listing price for both residential and commercial properties. As a commercial broker I will focus on commercial properties and only briefly touch on the residential market.

Anyone that lives in Northern Virginia knows that this is one of the hottest and highly desirable residential real estate markets in the country, if not the world. Nearly all of Fairfax County’s residential land has been developed and, as a result, supply is relatively static (it seems like there are more tear downs and rebuilds in Fairfax County than new development of single-family homes). When you have high demand and limited supply, prices go up.

Due to the number of residential properties and sales per year, the County generally uses the sales comparable approach to valuation. Depending on the uniformity of the homes and annual nature of the assessments, this can be a very accurate method to determine market value. As a result, when determining the appropriate listing price for a residential property the assessed value provides excellent guidance. Therefore, brokers should list residential properties at or slightly above the assessed value; paying close attention to sales comparables in the past 6 months and accounting for any upgrades or renovations that add value. Due to the high demand in Fairfax County, pricing a property even slightly below market value leads to a bidding war which pushes the final sales price above “market;” setting a higher market value for the following year and increased assessed values for neighboring properties.

Everyone needs a place to live and, as a result, the market for residential properties is essentially unlimited. This is not the case for commercial properties, which makes determining their market value significantly more difficult (certainly using the sales comparables method). The buyer for a small office condo is not in the same pool as the buyer for a shopping center who is also not in the same pool as the buyer for a 100+ unit apartment building, etc. etc. The DTA does its best to accurately assess these properties, often effectively using the income approach and applying market cap rates when recent sales comps are unavailable. This leads to a problem when a property is vacant; meaning, it has no income to capitalize. Certainly, one can estimate value by applying a market rental rate to the square footage and discount that potential income stream at a higher cap rate to account for the increased risk, but this is under the assumption that there is a [leasing] market for that particular asset.

The fundamental issue behind accurately determining the appropriate listing price for a commercial property is whether or not there is a market for that particular type of asset and within that asset class for the property, itself. Demand is based on a variety of economic factors and assumptions/projections. Amazon has disrupted the retail market, essentially eliminating the need/viability of big box retailers and creating a move towards service/experienced based tenants/businesses. So how much is a vacant, big box retail store worth? Most companies lease office space due to the natural expansion and contraction of their employee base. The small remaining market of office users that do choose to purchase are often sole proprietors or small partnerships, i.e. CPAs, attorneys, etc. which generally require approximately 1,000-2,000 SF. So how much is a 4,200 SF office condo worth? The 1,500 SF office condo that sold for $200/SF is not necessarily a comp for the 4,000 SF condo in the same building because the market for that amount of space is completely different. There are far fewer buyers for 4,000 SF than there are for 1,500 SF.

The conventional wisdom in commercial real estate for years has been that a property’s assessed value is the ground floor, acceptable sales price, and for some properties this still holds true. Property owners of valuable/desirable assets will often appeal their assessed value as a means of lowering their real estate taxes, which makes them more competitive in the leasing market. These properties tend to be more accurately valued or, better put, not overvalued from an assessment standpoint because of this active management and the prevalence of sales comps due to their marketability. There are many commercial properties in Fairfax County (and Northern Virginia) that are functionally obsolete. Whether due to age, location, etc. there is little to no leasing or ownership demand. How then do you appropriately price these listings for sale?

The assessed value can provide some guidance as an objective measure of value; however, brokers must determine the marketability of the asset to determine whether to list the property above or below the assessed value. In the absence of comparable sales, the DTA will either keep the assessed value the same for a property (sometimes spanning years) or apply a percentage increase or decrease based on market trends. This means that a particular asset may have been assessed years ago prior to economic/market changes that have decreased the value of/demand for that property. The very lack of demand that decreases the property’s value also contributes to a lack of sales that would provide the DTA with evidence of the decline in value.

After considering such factors as vacancy rates, permitted uses under the property’s current zoning, market rental rates, etc. a broker can determine if the assessed value is a relatively accurate measure of the potential market value of the property. Most of the properties with marketability/demand issues are best suited for owner users and thus the cost of ownership must significantly fall below the cost of leasing comparable space. The required spread between the cost of ownership versus leasing is magnified if the property is to be purchased by an investor on a speculative basis to compensate for the risk associated with leasing the property.

Some owners may be hesitant to list their properties at or below the assessed value for fear of selling the property below the market value. They would prefer to list the property high so that they can negotiate down on the sales price. Such properties can sit on the market for months, if not years. What one needs to remember is that market value is the price that a property would bring in a competitive and open market under fair sale conditions. If the property is effectively marketed, the price even if listed below the market value would be bid up by multiple offers/buyers until the property sells thus establishing the true market value.

For more information on listings and representation services, please contact Ryan Rauner, CCIM at 703-943-7079 or Ryan@RealMarkets.com

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What is a Discount Rate?

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Discount rate is synonymous with yield and IRR. Basically, it is the interest rate an investment must earn in order to produce a given amount in the future. Discount rates are used to guide decision making. Through the discounted cash flow analysis model, future income streams for the holding period combined with the sales proceeds from disposition are discounted and converted into a present value. That present value indicates the value of those proceeds if they were received today rather than in the future with the underlying concept being that those funds might be invested elsewhere for a similar return. Cash flows can be analyzed on a before and after-tax basis as well as on a leveraged or unleveraged basis. Perhaps the most useful application of the discounted cash flow analysis is to help investors determine how much to pay for a property based on projections and their required yield. While discount rates are relatively subjective there are metrics that can provide guidance on which rate to use, which I will discuss in later articles.

Why Percentage Rent Works (for Both Landlords and Tenants)

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Percentage rent can be an extremely useful tool in customizing lease terms to fit a tenant’s specific needs and business model. The percentage, breakpoint, and base rent can all be negotiated until a deal is reached that benefits both landlord and tenant. For tenants it is crucial to understand their expense-to-sales ratio so that they can negotiate terms that minimize their fixed expenses (rent) all while maintaining a minimum level of gross profit. For landlords it is important to manage their properties efficiently and effectively to maximize the profitability of all their tenants and to understand enough about the prospective tenant’s business to accurately estimate gross sales potential. In this article, I will explain why percentage rent can be mutually beneficial to both tenants and landlords.

Percentage rent is unique to retail, particularly shopping centers and multi-tenant properties. Leases for free-standing retail properties are less likely to have percentage rent clauses because the concept behind it is that tenants benefit from the overall draw of the shopping center and their neighboring tenants. Landlords have an interest in cultivating a diverse tenant mix. The idea being to reduce competition among the various businesses thus increasing their likelihood for success. By maximizing the number of products and services offered by their tenants, landlords maximize the number of visitors to the center who may then patronize other businesses in the center. This provides a significant benefit to tenants and percentage rent is a way for landlords to share in the success promoted by their effective management. This is one part of the “why” percentage rent works.

It may seem that percentage rent only benefits the landlord, but this is not the case. Percentage rent only kicks in after a certain point in gross sales, and if the tenant does not hit the natural or artificial breakpoint they pay nothing (in percentage rent). Tenants benefit from percentage rent because it allows them to negotiate a lower base rent in return for a percentage of gross sales. Many retail businesses are seasonal and can experience periods of both feast and famine. A lower base rent coupled with percentage rent makes it easier for such tenants to succeed by reducing their fixed monthly expenses while setting a minimum level of profit (as it relates to gross sales). When the tenant wins the landlord wins. The landlord has every incentive to help the tenant reach and exceed the negotiated breakpoint so that percentage rent kicks in and they make up the difference from the base rent and market rent (if any). This is the 2nd part of “why” percentage rent works.