Suite Deal

by Alice Devine

  Cost Data

  You can obtain national cost data books for construction costs from CMD (www.cmdgroup.com), but it’s best to have your local contractor help you understand unit costs, as they vary widely according to geography.

  Turnkey Versus Tenant Improvement Allowance

  Landlords typically arrange for construction via one of two methods: turnkey or tenant improvement allowance.

  Click. Turnkey is just that; the tenants open the door to their fully constructed suite. Landlords that offer turnkey improvements, based on a plan acceptable to both the tenant and landlord, wrap the costs of such planning and construction into the lease deal. While turnkey deals are likely less of an initial headache for tenants, the tenants do lose some control as they don’t review and approve each line item. Should a landlord shave some expenses during the course of construction, the landlord—rather than tenant—benefits from the savings.

  Some argue that landlords might take shortcuts in turnkey construction, leaving the tenant with lower quality suite improvements. Because tenant improvements, however, are nearly all real property (that is, permanently affixed to the property), the landlord owns them. It doesn’t make a lot of sense for a quality, long-term landlord to hurt the value of the property by installing subpar improvements. (Of course, if the landlord is unscrupulous, that’s another issue, and the improvements are only the start of the tenant’s potential problems.)

  Conversely, if unanticipated field conditions arise in a turnkey scenario, the landlord is stuck with those expenses. Generally speaking, turnkey allowances benefit smaller tenants, whose improvements might be less complicated and who hold less negotiating leverage (and usually less construction experience) than large tenants.

  Tenant improvement (TI) allowances, on the other hand, specify an amount to be spent on planning and construction on a square-foot basis. These allowances detail construction costs line by line. In tenant improvement scenarios, an accurately priced construction estimate becomes critical because lease negotiations are predicated on this anticipated cost of construction. Tenant improvement allowances require more administration and accounting time because of the tenant’s continued involvement in the construction administration process.

  Know Your Construction Unit Costs

  Good leasing representatives have a basic knowledge of common construction costs. Educate yourself by asking your contractor to give a line item price for each of the items below (including the contractor markup). That way, you’ll understand the implications of design on cost during the space planning process.

  Electrical duplex and fourplex

  One 8 foot x 10 foot partitioned office

  A sidelight window

  A sink and dishwasher (including plumbing costs)

  Paint and carpet in the building standard

  Approve the Space Plan for Construction Documents

  Once you receive the cost estimate from the contractor and have reviewed it yourself, you’ll know if you can build the suite within the deal parameters. If not, this is a good time to make any revisions to the space plan. Depending on the level of revision, the price will either stand or have to be re-estimated.

  Upon approval of both the space plan and construction arrangement, landlords typically require the tenant’s initials or signature: a signature block of approval should be stamped on the drawing for the tenant’s initials. You can order an old-fashioned rubber stamp or print out an area on the plan that reads something like this: “Reviewed and Approved for Preparation of Construction Documents” or “Reviewed and Approved for Construction,” with spaces for the date and the tenant’s signature.

  The signed space plan usually gets attached as an exhibit to the lease for signature. When the lease is signed, the plans are then converted into multipage formal construction documents. Complete construction documents (known as CDs) are multipage plans with separate sheets for the major subtrades (which include electrical, plumbing, HVAC, celling plan, finishes, etc.) and are used as working construction documents for the site.

  Chapter 7

  Analyze Financials

  “The net present value of vacant space is zero.”1

  —Bill Wilson, real estate developer, William Wilson & Associates

  Goal: Understand Fundamental Mathematical Concepts to Better Assess Financial Statements and Tenant Creditworthiness

  Landlords need to make sure their proposed tenants have the financial wherewithal to fulfill their lease commitments. So in order to evaluate prospective tenants, landlords (and their representatives, including you) request financial reports and conduct credit checks. And while you will likely have help from your accountant and financial analysts, it’s beneficial to learn about financial statements, particularly when it comes to structuring lease terms. Real estate requires the use of basic financial concepts such as the time value of money, net present value, future value, amortization, and capitalization rates. And once financials are assessed, real estate professionals employ various techniques for mitigating leasing risks.

  Real Estate Book Club

  It’s no beach read, but it is an excellent primer for math principles and their practical application to real estate: Real Estate Math Demystified by Steven P. Mooney.

  Review Fundamental Financial Concepts

  The Time Value of Money

  In business terms, time is valuable because of its opportunity cost; that is, if money isn’t tied up in one venture it could be making money in another. The major premise for the time value of money is that the sooner you have money, the more it’s worth (because of the opportunity to earn interest or invest it). The most conservative estimate of time value is a low-interest, insured investment with a guaranteed return, while the upper end of returns is anyone’s guess. As such, the value of money (in real estate lease deals) is often compared against a conservative investment alternative, such as the interest rate on a five-year certificate of deposit. At any given point in the lease term, the principal balance is equal to the present value (term discussed below) of the remaining payments.

  The time value of money applies to the rent negotiated today, as well as to your expenditures intended to entice a tenant to your property. When this concept is applied to any outlay of money—tenant improvements, commission or space planning dollars—the importance of time and outlay becomes clear.

  Net Present Value

  Another central financial concept is net present value, the discounted value (at a certain point in time) of a stream of future cash flows based on an expected rate of return (interest). This concept is closely tied to the time value of money—which requires that a rate of return be assigned to capital invested over time because a dollar today is worth more than a dollar tomorrow due to its ability to generate interest. The process known as discounting brings money back over time using such a discount rate.

  These concepts pertain to everyday leasing life in many ways. For instance, should a tenant decide it wants to terminate its lease at a certain point in time prior to the lease term expiration, you need to know the unamortized portion of leasing costs, such as tenant improvements, brokerage commissions, and future rent payments, in order to calculate an appropriate termination fee. That lease termination fee is the net present value, the amount the lease obligation is worth in today’s dollars, taking into account all the future rent discounted back to the termination date.

  Future Value

  The future value of money is the value that an amount of money today—the present value—will grow into at some future date, again, assuming a conservative return rate.

  Amortization

  Amortization refers to periodic payments, usually of equal amounts, which include repayment of the principal and the payment of interest on the declining principal balance of a loan. You charge interest for the privilege of borrowing funds, because, had you not made this loan (in the form of tenant improvem
ents, etc.), you could have earned interest on your money elsewhere. Periodic payments are typically a fixed monthly amount with the principal and interest ratio of any individual payment varying throughout the term of the loan. The variables that affect the principal and interest portion of each loan payment are the interest rate, amortization term (length of time), periodic payment (how often a loan payment will be made), and principal amount. Three of these four variables must be known before the fourth can be determined. An example might be a tenant who wants an increase in its tenant improvement allowance. Most landlords amortize this additional allowance on top of the rent—it’s a loan, with the landlord acting as the banker. Using an amortization calculation, you can help tenants understand the direct impact tenant improvements (or any other financial concessions) make on their rental rates.

  Capitalization Rates

  Long the standard valuation tool for the real estate industry, a capitalization (or cap) rate is a mathematical formula, expressed as a percentage. Cap rates are calculated by dividing the net operating income (NOI)—the income minus expenses—of a property by its purchase price. Logically, the rental derived as a result of leases plays into cap rates because of its impact on the net operating income of a property along with other revenue and expenses.

  Cap rates and interest rates have a correlation, but the relationship is complex, and the rates aren’t completely in sync with each other. It seems intuitive that interest rates and cap rates are related because the real estate’s dependence on the cost of debt is a significant factor in ownership, which affects debt service expenses and consequently, the net operating income.

  Cocktail Conversation? No. Financial Literacy? Yes. Know These Facts:

  • Interest on a one-year certificate of deposit (CD) and five-year CD

  • CPI (consumer price index) this year

  • Current Dow Jones Industrial Average; is the market trending up or down?

  • Current Nasdaq Composite; is the market trending up or down?

  • Current Federal Reserve interest rate

  Use Tools

  Software

  Many lease professionals use software to model lease deals and provide analysis. In some real estate companies, dedicated financial analysts complete the data entry and interpretation, while in others, the leasing professionals enter figures into formatted spreadsheet programs created to show the economic attributes of a proposed deal. Still others dispense with formal analysis, as they know what deals will pencil for their particular markets. Regardless of the method and tools, underlying financial concepts apply to every leasing deal.

  Financial Calculators

  Run, don’t walk, to the nearest office supply store (or to your computer) to purchase a financial calculator, an absolute must for real estate professionals. Popular models include the Texas Instruments BA II Plus, Hewlett Packard 12c, and other iterations such as Hewlett Packard’s 10bII. While the HP 12c is an older calculator, many real estate professionals like it for its compactness. Once users become accustomed to the Polish notation (i.e., reverse entry), and the functions of a dollar, the financial calculator becomes indispensable. For more assistance, online financial calculator apps are also available.

  While most lease analysis comes courtesy of robust software programs, the financial calculator is great for its flexibility. Small and portable, it’s easy to run some proposed tenant improvement numbers and understand that impact on rent. And while larger computer programs provide more detailed overviews and analysis, there are many aspects of the proposal and lease negotiation stages where you need quick feedback.

  Dry Toast

  The owner manuals that accompany financial calculators explain, in dry detail, all the functions. Many of the helpful instructions refer to leasing scenarios, such as “present value of a lease with advance payments” and “calculating a lease payment.” For more training, professional organizations, such as the Institute of Real Estate Management (www.irem.org) or the Building Owners and Managers Association (www.boma.org), offer courses utilizing these calculators.

  Applying Financial Skills to Everyday Leasing

  So now that you have a financial calculator, how do keystrokes and calculations translate into everyday leasing activities? They are integral, because every lease investment—the tenant improvements, brokerage commission, and architectural fees—are loans of a sort, extended over the period of the lease term. Because of the time value of money, you attribute an interest rate to your lease investment and amortize that over the term of the lease.

  All buildings have a pro forma rent—that is, the rent that covers the cost of the property (mortgage, insurance, etc.) with some assumed leasing expenses. Any leasing costs in excess of these amounts are typically amortized on top of the rental rate.

  Becoming proficient with these calculations allows leasing personnel to toggle rent terms up and down, as the parties negotiate the financial terms.

  Know These Financial Calculator Abbreviations

  PV: present value

  NPV: net present value

  FV: future value

  N: number of compounding periods in the calculation

  i: interest

  PMT: payment

  Amortizing Loans

  Scenario: expressing tenant improvements (or any other landlord investment) as a function of rent.

  Assume that your building is offering a suite as is with no tenant improvement allowance. Your prospective tenant loves the suite but wants funds to customize the space. You agree, saying you can, in effect, loan the tenant the improvement funds over the course of the lease term and will build it into the rent. (This scenario would also apply to any additional funds in the deal, over and above the financial package the landlord initially offers.)

  You can calculate a monthly payment for every dollar of tenant improvements (or other contributions) and see its effect on the rent amount. For example, for every additional $1 in tenant improvements that the landlord contributes to a five-year lease term at 5 percent interest, how much is the monthly rate per rentable square foot increased?

  Keystrokes

  Clear any numbers stored in the registers from prior calculations.

  Enter the 5% annual interest, expressed on a monthly basis.

  Enter the term length of 5 years, expressed on a monthly basis.

  Enter the present value: 1 ($1 per square foot).

  Solve for payment (PMT; obtains the payment, expressed on a monthly basis).

  (Display should read -.02, meaning that for every $1.00 per square foot of tenant improvements, the rent increases by $0.02 per square foot on a monthly basis, or $0.23 per square foot per year.)

  Determining Net Present Value

  Scenario: calculating a lease termination fee.

  Suppose your tenant decides to relocate its business to another state and asks about terminating the lease early. There is one year left remaining on the lease term.

  Calculate the net present value (NPV) of the following cash flow over the next twelve months with a discount rate of 5 percent.

  Because the keystrokes vary slightly among financial calculators, the best resource for the exact keystrokes is the handbook that accompanies your calculator. But, as an overall look at what you’re solving for, see below.

  Enter the number of payment months: 12

  Enter the discount rate: 5%

  Enter the payment amounts (the rental amounts by month)

  Solve for NPV

  And, if you enter into discussions to lower the interest rate for the lease termination fee, you can calculate that scenario. It’s easy to change the interest rate i, and leave the cash flows as previously entered. Then, you can calculate the NPV. Note that the NPV will increase as the discount rate decreases.

  Amortization tables typically calculate a payment at the end of
the month. To ensure your calculator is set in this manner press g then end. Pressing g then beg will calculate the amortization payment at the beginning of the month. Also, if you do not receive payments in any particular month, you must enter these as 0 (zero) in order to note the passage of a period of time, even if no payment is made.

  Online Loan Calculator

  For an easy-to-use amortization calculator, go to www.decisionaide.com and click on “Custom Loan Schedules” to access the tool.

  Calculating Capitalization Rates

  Consider a commercial office building with, for simplicity’s sake, $100,000 annual net operating income in a market with 5 percent cap rates.

  $100,000 divided by .05 equals $2,000,000 estimated market value.

  Consider the impact of rising capitalization rates. If cap rates rise by one percentage point to 6 percent, the same building loses over 16 percent of its value. The owner would need to increase net operating income by $20,000 (or a 20 percent increase in net operating income) in order to achieve the same building value. That’s a whole lot more rent or added efficiency with reduced expenses on the operating side.