In commercial real estate you frequently come across leases as part of the property performance structure. In absolutely all cases you need to look at all the leases deeply to know what they contain and how they will reflect on the sale. That then influences the sale price, the timing of the sale, and method of sale that you can use. In this article we look at how you can quickly scan leases in a preliminary sense and get your thoughts around the basic things. At a later time you can then get more deeply into the documents and the fuller occupancy issues. So these then are some of the key issues to ask about and explore regards the leases.
Gross or Net Rents - this involves the payment of rental and exactly what is included therein. It gives you a basis of understanding regards the outgoings costs and how they are recovered from the tenant. You can get to a real net rental when looking at these numbers. When you understand the types of rents that are paid, you can easily undertake an analysis of the yield that is achieved from the true net rental and its relationship to prices in the market.
Rent Reviews - this will be important in the sense that rent escalations will normally improve the property cash flow and hence the property price. There is a significant difference between rent reviews undertaken at the rate of CPI versus those that are undertaken at a fixed amount, fixed %, or market rent method. You need to see these differences in the leases quickly. Also look for ratchet clauses that stop the rent falling backward at market review time. Also look for clauses that state that the rent will be increased to the greater of two or three rent methods. In simple terms do the rent review methods in the lease strengthen or soften the future cash flow of the property for the owner. Will these rent review methods help you sell the property?
Base Year establishment and upgrade method - when it comes to some gross rentals, there can be an established base year in the lease which defines and is set for the purposes of recovery of outgoings above the base year. This rental method is quite common in office & retail premises. This will normally be an enhancement to the cash flow over coming years. You need to know when the base year is to be upgraded and the timing of any base year reset as this will change the cash flow from the lease. The lease will give you this detail.
Outgoings definition and recovery - the recovery of outgoings in leases will vary enormously and even within the same building across a number of tenancies. This means that all leases should be quickly reviewed for the type of outgoings that they allow you to recover. You also need to know when this is done and if it is currently up to date in the financial records of the building.
Permitted use profile - every tenants lease will have some relationship to a permitted use. First and foremost, you need to know that the permitted use is complimentary to other occupants in the building and that the permitted use is clearly defined. Clearly each tenant should be operating within its permitted use.
Term of Lease - the term of the lease will have relevance to the timing of any sale. You do not want the expiry of a lease and the removal of its cash flow to detract from the price that you can achieve on the sale of the property. In some cases, it is necessary to create new leases that replace those older lease documents that are soon to be expiring. To make a decision on this it is a matter of who your target purchaser for the property may be. If it is for an owner occupier, then the expiry of the lease is desirable. If however the target audience is an investor, then the expiry of leases in the near future can jeopardize the potential of the sale. Strength of leases underpins the sale price.
Option timing and strategy - many leases will have options which will need to be understood. The existence of options is regarded as a weakness to some investors who want to control or change the future of the property and start alternative leasing strategies. If a lease has many options for renewal over a lengthy period of time, an investor will be restricted as to what they can do on the property. Effectively they will have to pay to remove the tenant if they want to do some renovation, expansion, or change to the building.
Bank Guarantees or cash or bonds -many tenancies will have some form of occupancy guarantees to draw upon in the case of a default under the lease. The existence of these guarantees or bonds needs to be checked and particularly the security of it. Show some caution when you identify that the landlord or the solicitor for the landlord has this documentation. In the end result, it is important to have proof that these guarantees actually exist, so ask for copies of supporting documentation. An incoming purchaser will want to know that these matters are secure and safe.
Tenant renovation obligations -many leases provide for tenant renovation provisions during the term of occupancy. In longer leases it is common for tenants to be required to internally paint the premises every 4 or 5 years. First and foremost you need to know that these matters are up to date and have been attended to as required under the lease.
Insurance provisions - many leases have insurance clauses that impose some obligation on the tenant to insure part or all of the property in some way. When you read the lease you will see these obligations. It is then wise to seek copies of the certificates of currency that relate to the insurance requirement. These certificates should have been updated each year to ensure that the tenant is doing the right thing in accordance with the lease.
Make-good requirements -at the end of any lease term, there are normally some make good provisions which obligate the tenant to undertake certain works. The cost of these works and would normally be at the expense of the tenant and therefore it is important to understand exactly what is required at the end of the lease occupancy. It is to the landlord's advantage to have a lease that produces and delivers modern clean premises at the end of occupancy. The landlord can then proceed to again rent the premises with minimal refurbishment time and cost.
Incentive structures -many tenants will receive an incentive at the commencement of lease occupancy. The incentives will sometimes continue for a period of time well into the lease. You need to understand if these incentive active leases exist and how they affect the future cash flow. It is likely that a purchaser for a property will require the incentives to be paid out prior to any sale or settlement. This will be something that you will need to talk to the landlord about in conjunction with their solicitor and or accountant.
Re-location or demolition clauses - some leases provide for re-location of the tenant and or demolition provisions for the premises. This means that the property and the tenancy can be terminated and or changed to allow for renovation works at the discretion of the landlord. Certainly in the older properties this is quite desirable and will be an incentive for any future purchasers of the property if the then owner wants to redevelop.
Arrears -the existence of arrears in the sale of a property is of concern and needs to be explored to see if recovery of outstanding monies is possible and or is underway. In all respects, the recovery of outstanding arrears is undertaken in accordance with the terms of the lease. It is important to know that the landlord is taking the appropriate action in accordance with the lease. Seek copies of active documentation in that regard.
Existing vacancies -the existence of vacancies and soon to be vacant premises should be identified because it does impact the sale and the target market that will be active in the property promotion. Existing vacancies may have a reason for being so; therefore the history of vacancy activity in the property should be studied. A history of high vacancy will indicate a poorly performing property, a poor location, a redundant property, or poor landlord management practices.
Breach of lease matters - some leases and tenant occupancy situations will create dispute and breach of existing lease terms. This can be called a 'breach of lease'. Always ask the owner of the property about the potential of any existing situations of breach of lease. If something exists then take notes and get copies of existing documentation in that regard. Existing tenant disputes can restrict your sale strategies. Each lease can also be different when it comes to the way that any breach is to be handled. Always read the lease before making any assumptions on the method of handling the breach. Of particular interest is the definition of a breach.
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