When meeting with a property owner to discuss the sale of a property you should have a good practical knowledge related to established leases in the area. This includes the rents that are achieved in the local market. It is the rents and leases that underpin the performance of the asset as an investment. This knowledge will help you identify if the property is ‘lease attractive’ or ‘lease weak’ from the perspective of the buyer; it will affect your price, the target market, and the time on market.
The important point here is that for you to sell an investment property, you need to know the rents, how they work, and what should be the best rent structure for each property type in the prevailing market. Great rents and leases produce great investments and in turn produce better sales.
Given that leases and rents change with the business sentiment and economic environment, you are the real estate professional that can help the landlord with the best strategy for the long term. It does not really matter (within reason) what the start rent is on a lease, but rather its escalation over time should be the main focus in any new lease. That should be your strategic priority.
Rents Unique
Rents are unique to the property type and the location, so even if you specialise on selling just industrial property it is very much the case that industrial property from suburb to suburb will vary in rent level, strategy, and type. You need to know how and why the changes occur. The more skilfully you can talk about that and package it to the client or the customer, the more professional you will be in the provision of commercial real estate services. When considering your competitive position that is what matters.
Variables
Rents can be gross or net by type and added to that will be the levels of outgoings that apply in each location. Outgoings in your property sale must be in parity to other properties in the location otherwise you will be trying to sell something that is different than everything else. Whilst that may be acceptable for your listing, you will have to identify why the outgoings are higher and why someone will want to buy a property like that.
The ‘golden rule’ here is that your market awareness on leasing is fundamental to your sales skills and value provided to landlords.
Some Rent Strategies
So let’s look at some rent definitions that you frequently come across.
‘Market rent’ is that rental determined by assessing a given tenancy and its location and with its size, and then comparing it to other similar tenancies. Care must be taken in locating other ‘market rents’ because they may have been established by alternate means such as CPI adjustment, Fixed % adjustment, Ratchet, or Cap and Collar. In that case they are not real market rents and are not useful in any rent comparison.
True market rent comparisons are generally not to be restricted or enhanced by Ratchet clauses (this stops the rent falling), or Cap and Collar limitations (this stops the rent rising too far or falling too far). These mechanisms do commonly exist in Commercial and Industrial type leases and tenancies. They are sometimes restricted by legislation in application in retail lease situations. Make sure you know your local legislation in that regard
‘Base rents’ are sometimes used as a ‘floor’ rent below which the tenants rent would not fall. This gives some stability to the Landlords cash flow in a new lease occupation. In a new retail property development with unstable or growing levels of trade, this is a useful tool. A lease with a ‘Base rent’ is usually enhanced with a turnover rental provision or clause, so that the success of the tenants business and sales will lift the rent level.
This ‘turnover’ is structured by some calculation from the tenants monthly trade such as:
‘The rent paid shall be the greater of the ‘Base rent’ or 10% of the lessee’s turnover for the previous month’.
In this scenario, the % may change and the method of turnover calculation may be revised at the anniversary of a nominated period. This is usually once per annum, and the adjustment for any extra rent (as a result of the turnover) above the base is calculated and charged.
Assessment of existing base and market rents and their possibility for future growth involves complete review and analysis of the tenancy schedule on a tenant-by-tenant basis. You need to cross reference the leases to the tenancy schedule so that errors do not ‘cloud’ your calculations. Growth in rent will usually be provided in a lease by one of the following mechanisms:
Structured review
Stepped increases
CPI review (or other index)
Market review
Leases are individually assessed for the benefit that they give the landlord from:
Length of term
Lease clauses
Options
Future reviews
Historical reviews (implementation)
Occupancy costs
Analysing Leases Quickly
Let’s now look at how you can quickly scan leases and get your thoughts around the key things that can affect the sale or tenancy base to the property. At a later time you can then get more deeply into the documents and the fuller occupancy issues as circumstances require. Consider these:
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 detailed 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 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.
Summary
These are the key issues that you can quickly use in your preliminary review of lease documentation when selling a property. Certainly you can go further later when time permits given that every sale is a well informed documentary event. When you have better property documents, you have better sale prices and momentum.
