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Commercial Leasing's Five Pools of Money: Examining the Five Financial Points That Affect Corporate Space-Users' Occupancy Costs

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Don Mitchell

During my 34 years in commercial real estate, I often speak to companies that completed lease transactions without broker representation.

When asked if they are pleased with the financial terms of their lease, they proudly say “yes” and focus the discussion on two things: base rental rate and rental abatement. While these are certainly important, there are three other “pools of money” that affect occupancy costs over the entire lease term that can become big factors.

The first of these three pools of money is the base rental increases during the lease term. We've seen the increases take markedly different shapes. From full annual increases based on the Consumer Price Index, San Diego, Orange County, or Los Angeles; to the same with minimums and maximums; to fixed increases of between 2% and 5%; to fixed currency increases like $0.60 per square foot per year; to any of the above being instituted beyond an annual increase, say every 24 to 30 months. The method and amount is truly dictated by the market and only professionals transacting every day remain up to speed. Corporate tenants can be sure landlords will push for the most advantageous increases and attempt to convince them that it is the market standard.

A second financial area overlooked by companies attempting to negotiate their own lease transaction is the tenant improvement allowance. For example, assume a company finds a location with a build-out that fits their needs and all that is necessary is new paint and carpet. If at that point the company negotiates the deal, the landlord most likely will happily provide the little improvements needed. However, if the cost for carpet and paint is only $5 to $8 per square foot on a five year lease or longer, the tenant probably left $20 to $25 per square foot on the table. For 10,000 square feet, that is $200,000 to $250,000 of negotiating power given away. The question is how much does the landlord expect to spend to re-lease the space? The answer: a lot more than one might expect. Landlords complete proformas that outline ongoing property expenses against the gross operating income to arrive at the net operating income from which they base their purchase. Therefore, they have already assumed the cost to re-lease the space as a “cost of doing business” to attain the desired net operating income. Once they purchase the property based on the anticipated net operating income, the cost of vacancy can be more of a concern than spending what's necessary to re-lease the space. To this point, $25 to $35 per square foot is not an unusual investment expectation to re-lease a facility. So, when a tenant doesn't need substantial tenant improvement funds, it's important to get some credit for that in another pool of money.

The final financial pool is Gross Lease Operating Expense Pass-Throughs, the most misunderstood charge that can be very costly. Most leases outline expenses that are initially part of the landlord's standard operating costs with liberal language that allows them to add expenses as they see necessary over time. Tenants typically sign a lease that holds them responsible for any increases in expenses over the “Base Year” –usually the calendar year in which the lease commences. If this clause is not handled carefully, the tenant will be subject to, among many other costs, the full cost of additional building expenses that the landlord adds to building operating expenses after the Base Year has passed; and/or capital improvements that the landlord makes, even if not necessary or beneficial to the tenant. Some additional examples include the costs associated with additional landlord employees, parties thrown at the building for the tenants in the project, or even costs associated with holiday gift baskets. Without protective language and limitations on exposure, a tenant can end up paying unanticipated monthly fees.

Finally, in commercial real estate the landlord pays all commissions related to leasing space and, regardless of what the landlord says, all commission expenses have been accounted for in their anticipated return on investment. Given that fact, here is our advice to companies: don't go it alone and don't mistake the tenant/landlord relationship for more than it is. As the world's largest tenant representation firm, these are issues we tackle every day for our clients. You can benefit from our experience and market knowledge at no cost to you. Don't be fooled when the landlord tells you that you will get a better deal if you don't use a broker. If you believe that, you deserve to be fooled.

About Don

Don Mitchell, Managing Principal at Cresa in San Diego, brings the experience of a distinguished commercial real estate career that began in 1980. After spending 25 years advising both tenants and landlords with CB Richard Ellis, Don joined Cresa in 2008 where he offers his insight to tenants exclusively.

About Cresa

As the world's largest corporate real estate advisory firm exclusively representing tenants, Cresa specializes in the delivery of fully integrated real estate services, including: Transaction Management, Project Management, Strategic Services, Corporate Solutions, Site Selection, Lease Administration, Capital Markets, Mission Critical Solutions, Relocation Management, and Facilities Management. For more information, visit www.cresa.com.

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Don Mitchell

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