Business Plan? We Don’t Need No Stinkin’ Business Plan!

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Attention, new businesses! If you want to lease commercial space, you need a business plan. At this point in my career, I don’t even know anymore if I’m more surprised when a new business actually has a business plan or when they don’t. Needless to say, it’s frustrating and alarming how many do not; frustrating because a business plan is table stakes for leasing commercial space and alarming because leases have very real legal and financial ramifications in the case of default. I require a business plan before I represent any new business for 2 seemingly contradictory reasons: self-interest and altruism.

Self-interest

If a new business doesn’t have a business plan a landlord will not consider leasing to them, period. No lease means no commission. When you work on a contingency basis, time is money. Brokers must thus allocate time accordingly to the deals that have the greatest possibility of closing. No business plan equals no deal equals no money equals no time.

If a new business hasn’t invested the time/taken the first step, why should anyone else?

Altruism

As a broker and particularly a CCIM, I hold myself to the highest ethical standards when it comes to representing my clients. I could not in good conscience allow a client to lease space if they are not prepared to do so. As I stated, most landlords will not even consider leasing to a new business if they do not have a business plan; however, even in the case that one would, I could not allow a client to be taken advantage of like that, because that’s what it would be. The only case in which a landlord might consider such a deal would be one in which the tenant had sufficient funds to pay for the tenant improvements, in cash, and personally guarantee the lease. As rare as it would be, this would be a situation where the landlord would not care if the tenant defaulted because they could go after their personal assets.

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The purpose of a business plan is NOT to “check off the box.” Its purpose is to provide a framework for how a business will make money. Its purpose is to protect the business owner from the potential pitfalls associated with the capital expenditure and personal liability inherent in any entrepreneurial venture. Its purpose is to provide a roadmap to success. A business plan is the navigation app to help get you to where you want to go as quickly as possible, all while avoiding traffic, cops, and road hazards.

Half the Rent, Double the Fun

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In my article, Rent Free or Die, I explained how rental abatement in commercial leases typically works and showed the powerful impact it can have on the net effective rent over the lease term. At the end of the day, rental abatement has an economic value and, as a result, can be structured differently based on the tenant or landlord’s situation.

Half rent doubles the length of the reduced rent period. If a tenant is able to negotiate 6 months of rental abatement (on a 6 to 7-year lease, total 78 to 90-month lease), they might consider requesting the abatement be spread out over a year. This provides the tenant with a longer “ramp up” period, which can be particularly useful for retail tenants and/or new businesses. The concept behind leasing commercial space is that it contributes to the business’ ability to generate revenue. By increasing the time in which the tenant enjoys beneficial occupancy of the property, they are increasing the time in which they are able to grow their business and revenue.

Landlords may prefer half rent to full rental abatement because they begin collecting rent day one. Depending on the deal, asset class, etc. landlords may be required to provide sizable tenant improvement allowances to attract tenants. There is always the risk that a tenant will default before the landlord is able to recover their initial investment. Half rent allows landlords to provide the same economic incentives to lease their space while incurring less risk. The time value of money states that a dollar today is worth more than a dollar tomorrow. As a result, the income received during the (half) rental abatement period is more valuable than the income that would be received months later. This money can be reinvested or used to pay down the landlord’s out-of-pocket leasing costs.

Not every deal fits into a neat, little box. Oftentimes the difference between getting a deal done or not is the expertise and creativity of the broker negotiating it. Understanding one’s client’s needs as well as those of the opposite party is crucial in reaching a mutual agreement. If one can identify and address each party’s concerns, constraints, etc., they can effectively mitigate such issues through creative deal structuring and extract the maximum concessions from the other party.

Legal Ownership Structures: Partnerships

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One of the most fundamental decisions that a real estate investor must make is the legal ownership form under which they invest in real estate. Each have their own unique characteristics and associated legal rights. It is crucial for investors to know the pros and cons of each in order to best determine the most advantageous based on their financial resources, goals, etc. Important factors to consider are ease/cost of formation, taxation, liquidity, survivability, etc. In this article, I will discuss the various partnership forms: general partnership, limited partnership, and limited liability partnership through the lens of real estate investment.

This content is meant to be informational and not advisory. Readers are encouraged to consult an attorney or CPA when deciding on how to structure their investment holdings.

General Partnership

The default form of partnership that exists when two or more persons (or business entities) operate a business for profit as co-owners, each member being a general partner. Partnership agreements, drafted by an attorney, address issues such as profit and loss sharing, management responsibilities, etc.

Pros

  • Ease/Cost of Formation – There are no formal costs to create a general partnership.
  • Taxation – General partnerships are pass-through entities; meaning all income, deductions, etc. are reported on each partner’s individual tax return and cash distributions are generally tax-free to the extent they do not exceed the partner’s basis in the partnership.

Cons

  • Liability – Each partner has unlimited liability for any legal or financial responsibilities of the general partnership. As a result, each partner is fully liable for all of the partnership’s debts whether or not that particular partner incurred or approved of those debts and regardless of the amount invested in the partnership.
  • Liquidity – Because the title to the property is held by the partnership individual partners do not have ownership interests of the property, itself, but rather in the partnership. This can create an issue when one partner wishes to “cash out.”
  • 1031 Exchange – Related to the issue of liquidity, because partners in a general partnership do not actually own a piece of the real estate their interests are not eligible for a 1031 Exchange.
  • Survivability –General partnerships terminate with the death or withdrawal of one of the partners. Partnership agreements should thus account for the survivability of the partnership during the holding period of the investment.

While many general partnerships are formed by business entities that already have some level of liability protection, they are not the ideal business structure in which to invest in real estate due to each partner’s unlimited liability.

Limited Partnership (LP)

Limited partnerships consist of one (or more) general partner(s) and one or more limited partners, which can be individual persons or business entities. Limited partnerships must register as an LP. General partners are responsible for all management of the partnership and thus have unlimited legal and financial liability while limited partners acting as passive investors with no say in the day-to-day management of the business. The partnership agreements are crucial and should be drafted by an attorney.

Pros

  • Liability – Limited partners in an LP are generally only responsible for the amount each invested and are not responsible for the actions of the general partner.
  • Taxation – LPs are pass-through entities; meaning all income, deductions, etc. are reported on each partner’s individual tax return and cash distributions are generally tax-free to the extent they do not exceed the partner’s basis in the partnership.

Cons

  • Ease/Cost of Formation – LPs must register with the state and partnership agreements should be drafted by an attorney.
  • Taxation – Because of the passive role of limited partners they are subject to passive loss rules, which do not allow passive losses to offset active or portfolio income. The tax implications of sale may be different for the general partner and select limited partners and when conflicts of interest arise, limited partners may have no say in the matter.
  • Liquidity – Because the title to the property is held by the partnership individual partners do not have ownership interests of the property, itself, but rather in the partnership. This can create an issue when one partner wishes to “cash out.”
  • 1031 Exchange – Related to the issue of liquidity, because partners in a general partnership do not actually own a piece of the real estate their interests are not eligible for a 1031 Exchange.
  • Survivability –General partnerships terminate with the death or withdrawal of one of the partners. Partnership agreements should thus account for the survivability of the partnership during the holding period of the investment.

Limited partnerships can be effective ownership structures for real estate investment where limited partners provide the capital and general partners provide the expertise and management. Partnership agreements are especially important because, as is the case in general partnerships, the general partner can be a business entity that already enjoys some level of limited liability, which can protect them from the liabilities of the LP. If general partners no longer have unlimited legal and financial responsibility the incentive to be good stewards of the investment is removed.

Limited Liability Partnership (LLP)

Consisting of any number of limited partners, LLPs are typically used by professional organizations such as law firms where each investor has management rights.

Pros

  • Ease/Cost of Formation – Conversion from a general partnership to an LLP is not a taxable event.
  • Liability – Liability is generally limited to each investors’ ownership interest.
  • Taxation – LLPs are pass-through entities; meaning all income, deductions, etc. are reported on each partner’s individual tax return and cash distributions are generally tax-free to the extent they do not exceed the partner’s basis in the partnership. Because of each limited partner’s management rights, they are subject to active loss rules.

Cons

  • Ease/Cost of Formation – LLPs must register with the state and partnership agreements should be drafted by an attorney.
  • Liquidity – Because the title to the property is held by the partnership individual partners do not have ownership interests of the property, itself, but rather in the partnership. This can create an issue when one partner wishes to “cash out.”
  • 1031 Exchange – Related to the issue of liquidity, because partners in a general partnership do not actually own a piece of the real estate their interests are not eligible for a 1031 Exchange.

Limited liability partnerships are rarely used for real estate investment despite the limited liability of its partners. One of the key characteristics of this ownership structure is the management rights of each partner which make it more suited for the operation of a professional business rather than a mechanism to passively invest in real estate.

 

Source: CCIM Institute, Investment Analysis for Commercial Real Estate, January 2, 2018

Tysons Corner Submarket Q3 2019

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“I’m the Juggernaut, @#$%&!”

RBA: 30,096,814 SF

Vacancy Rate: 14.4%

12 Month Net Absorption: 1,400,000 SF

Average Asking Rent: $35.41

12 Month Rent Growth: 3.8%

Tysons Corner is numero uno (sorry, Reston). This “edge city” is Fairfax County’s (and arguably Northern Virginia’s) central business district and a regional commercial center; boasting the largest concentration of office space in Virginia and 3rd in the DMV behind only DC’s East End and CBD submarkets. Many of the nation’s largest companies have their corporate headquarters in Tysons Corner; including Booz Allen Hamilton, Capital One, Freddie Mac, and Hilton Worldwide. The submarket is also home to two super-regional malls, Tysons Corner Center and Tysons Galleria, the former being the largest shopping mall in both the Commonwealth and Baltimore-Washington area. With over 115,000 office and retail workers, Tysons Corner is the 12th largest employment center in the United States. In short, Tysons Corner is a veritable juggernaut.

The delivery of the Silver Line in 2014 brought 4 metro stations to the submarket, which increased density based on proximity to the metro and spurred a flurry of development; delivering over 2,000,000 SF of office and nearly 3,000 multi-family units. The most significant new developments are Capital One’s new headquarters and Meridian’s Boro Tower. Strong demand has kept vacancy rates down, which are now at a 10-year low, and as a result rent growth has been strong at 3.8% over the past year.

Tysons is a tale of two cities or, perhaps more accurately, two tiers of office space. It seems odd that despite vacancy rates in the high teens rents have steadily and significantly risen since 2015. The answer lies in the breakdown of the rents and vacancy rates between 4 & 5 Star properties and 3 Star properties. The average rental rate in Tysons Corner is $35.41/SF/yr but is $39.97/SF/yr for 4 & 5 Star properties and $27.60/SF/yr for 3 Star properties. Along the same trend, the vacancy rate and net absorption for 4 & 5 Star properties is 16.8% and +35,335 this quarter and 20.4% and (61,850) for 3 Star properties. This flight to quality trend is most likely to continue; leaving many to wonder what to do with Tysons functionally obsolete office inventory.

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DC Metro Area Market

Semiannual Snapshot Q3 2019

 

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Rentable Building Area (RBA)

  • 4 & 5 Star: 247,814,496 SF
  • 3 Star: 189,929,408 SF
  • 1 & 2 Star: 61,972,441
  • Total: 499,716,496 SF

Vacancy Rate

  • 4 & 5 Star: 14.8%
  • 3 Star: 12.8%
  • 1 & 2 Star: 6%
  • Overall: 13.0%

Average Asking Rent

  • 4 & 5 Star: $44.79/SF
  • 3 Star: $31.78/SF
  • 1 & 2 Star: $26.16/SF
  • Overall: $37.70/SF

Under Construction

  • 4 & 5 Star: 10,948,687 SF
  • 3 Star: 293,425 SF
  • 1 & 2 Star: 0 SF
  • Total: 11,242,112 SF

12 Month

  • Net Absorption: 2,900,000 SF
  • Rent Growth: 0.9%
  • Vacancy Change: (0.2%)
  • Deliveries: 5,500,000 SF
  • Sales Volume: $7,200,000,000

Money for Nothing, Rent for Free

 

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Landlords and investors must make many decisions when leasing a property. Once they set their asking rate and have a tenant interested in the space, the negotiations process begins. Landlords must analyze each deal and determine what concessions they are willing and able to make. A tenant’s profile, i.e. financial strength, size, etc. heavily influences these decisions, but is not the only factor. In fact, there is a higher “power” under which all other factors fall: the holding period.

Holding period refers to the timeframe that an investor owns an asset/property or the period between the purchase and sale of an investment. When determining whether or not to purchase an asset and at what price, investors calculate the return the asset will produce over the holding period based on the acquisition basis and projected cash flows and disposition/sales price. While market conditions can change and alter the length of the holding period, investors make asset management decisions to maximize the performance of their investment and eventual sales price. This article will discuss how landlords can use free rent as a tool to increase a property’s return based on a 3 to 5-year holding period.

While “everything is negotiable,” landlords typically have a minimum base rent that they will accept for a property regardless of the tenant. Instead of agreeing to a lower rental rate, landlords may choose to offer additional months of free rents over what might be considered market. For example, in our current office market, tenants can expect around one month of rental abatement per year of term, i.e. 5 months on a 5-year term (65 month lease). If the tenant is unable or unwilling to pay the minimum base rent required for a particular property, the landlord may choose to offer an additional 2 months of rental abatement (7 months on a 67-month term) in order to lower the tenant’s average cost of occupancy and get the deal done.

The question remains: Why would the landlord simply not lower their rental rate? The answer can be best viewed through the lens of the holding period and desired/required sales price for the investment. It takes time to lease a property. Theoretically, the higher the occupancy level the higher the gross and net operating income. Net operating income is what investors look at when measuring their return and sales prices are usually quoted in terms of cap rates, which reflect a property’s unleveraged return based on that net operating income. Time is money and landlords must constantly juggle the competing goals of leasing the property quickly and maximizing the gross operating income by leasing their property at the highest rental rate possible. Therefore, landlords have a powerful incentive to keep rents as high as possible. Free rent allows them to provide powerful economic concessions to attract tenants and achieve full occupancy quickly while still maintaining their required rental rates (those that were in their projections).

There are many old adages that help explain the underlying theory behind this strategy: taking one’s medicine, all good things come to those who wait, delayed gratification, etc. Investors can use rental abatement to attract tenants and lease up a property within their projected holding period all while maintaining the highest rents possible thus maximizing their net operating income. When it comes to sell the free rent has “burned off” and the investor is left with a property with long-term leases at strong rental rates; allowing them to sell for the highest price possible.

*Savvy investors will also structure their business holdings so that losses incurred during the rental abatement periods can offset active income elsewhere.

Rent Free or Die

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“Give me rental abatement or give me death!”

Rental abatement or free rent is one of the most powerful economic bargaining tools for both landlords and tenants. Free rent is quoted in terms of months and is a period of time in which the tenant can enjoy beneficial occupancy of a commercial space without having to pay base rent. These are important distinctions because the time provided to a tenant to build out their space is usually not considered free rent and based on the asset type and rental structure the tenant may have other occupancy costs during the free rent period.

Free rent is generally provided at the beginning of the lease term. For example, if a tenant has 3 months of free rent these would be the first 3 months of the lease term. Landlords require tenants to pay the first month’s rent at lease signing, which can cause some confusion. In the previous example the first month’s rent due at lease signing would be applied to the 4th month of the lease term. In rare cases, landlords may grant multiple months of free rent that are staggered throughout the lease term. For example, a landlord may agree to 5 months of free rent on a 5-year deal with the tenant enjoying one month of rental abatement at the beginning of each lease year. Landlords may choose to do this in order to begin collecting rent sooner and/or mitigate any perceived risk with the tenant’s financial strength.

Most free rent is “outside the term;” meaning that landlords will add the number of months of rental abatement to the overall term of the lease. For example, a 5-year lease in which the landlord agrees to provide the tenant with 5 months of free rent, the term of the lease would increase from 60 months to 65 months. At first glance this does not seem like a good deal for the tenant because the rent for the 5 additional months at the end of the term will have increased each year at the agreed upon escalation rate and thus have a higher dollar value than the 5 months at the beginning of the lease term when the rent is the lowest. The value of 5 months of free rent for a 1,000 SF space at a starting rate of $30/SF/yr equals $12,500 (1,000 SF x $30/SF/yr = $30,000 / 12 months = $2,500/month x 5 months). Based on a 3% annual escalation the rental rate for the final 5 months would be $34.78/SF/yr; resulting in a value of $14,490.93. So, what gives?

There are a number of reasons that this structure still benefits the tenant. First, rental abatement at the beginning of the lease term provides the tenant with a “ramp up” period in which to get their business going and start generating revenue. Second, there are costs associated with leasing space including but not limited to furniture, moving expenses, cabling/wiring, etc. Rental abatement frees up cash for tenants to purchase and pay for necessary infrastructure, equipment, etc. Third, the time value of money states that money today is worth more than money tomorrow. In theory, the landlord is having to wait 5 years to make that money back and with annual escalations around 2-3%, that money could have been more profitably invested in an asset or instrument with a much higher return.

Finally, the value and power of free rent can be best displayed when calculating the average cost of occupancy. In the case above, the total lease value for the 5-year, 5-month lease with 5 months of rental abatement equals $161,265.00. On a 5-year lease with no free rent the total lease value is $159,274.07. While the 5-year lease has a lower dollar value the average monthly cost of occupancy is $173.57/month higher! This is because you’re dividing the lease value by 60 months instead of 65 months. This leads an average annual rent of $31,854.81 for the straight, 5-year deal and $29,772.00 for the 65-month lease. That’s amazing when you consider the fact that the average annual rent for the 65-month lease is lower than the annual rent in the 1st year of the lease term (1,000 SF x $30/SF/yr = $30,000/year) and over $2/SF lower than the lease in which no rent was provided ($29.77/SF/yr vs. $31.85/SF/yr).

If free rent is placed “inside the term” its effects are magnified. Using the previous example, if a landlord were to agree to 5 months of free rent on a 60 month/5-year term the total lease value would decrease to $146,774.07; resulting in an average annual/monthly cost of occupancy of $29,354.81/$2,446.23 and average rental rate of $29.35/SF/yr. What’s striking is how relatively small the difference is between the free rent inside vs. outside the term (only $0.42/SF/yr)!

I will elaborate on the difference between build out periods and free rent as well as other potential costs that tenants must pay during the rental abatement period in subsequent articles; breaking down the discussion based on asset class (office, industrial, retail, etc.) and how each treat “free” rent.

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.