Related: Price Vs. Value: Strategies for the Next Recession
What is a Commercial Lease?
A commercial lease
is an agreement between a landlord and a business that outlines the terms and conditions of a property rental. A commercial lease refers specifically to renters who use the property for business operations or other profit-seeking or commercial purposes as opposed to residential use.
Commercial Lease Rental Rates
Wells Fargo Center / Tampa, FL
We quote rental rates in the Tampa market based on “gross” rents
– meaning that all of the operating expenses, including utilities, are included in the rent.
For example, let’s look at one of our buildings in downtown Tampa; the twenty two-story building called Wells Fargo Center
. We quote rents in this building at approximately $30 per square foot, depending upon whether the quote is for a higher or lower floor. That is an annual rent, not a monthly rent. Some markets quote rental rates as monthly, like in California where you may hear a computation of $2.50 per square foot. A rental rate of $2.50 per square foot per month equates to an annualized rent of $30 per square foot.
Although it varies even within the state of Florida, here in Tampa we market as a gross rent, meaning that we, as the landlord are responsible for all of the operating expenses. The gross rent of $30 per square foot that we charge and Wells Fargo Center includes everything (i.e. it includes electricity, water, cleaning, real estate taxes etc). The only thing that we normally do not include in the rent in a downtown Tampa office building would be the cost of parking, which can vary from tenant to tenant.
Now the opposite of a gross rent is a net rent
. In the case of a net rent, the tenant pays all of the operating expenses over and above the rent to the landlord. For example, let’s assume Wells Fargo Center has roughly $11 of operating expenses. Assuming the gross rent would be $30 per square foot, we could quote it as $19 per square foot net. In this example, the tenant would pay approximately $11 per square foot of operating expenses and would be responsible for 100% of any increases in such expenses.
Some markets, like downtown West Palm Beach, certain places in Sarasota, and other areas of the state, do quote rents on a net basis. It’s very important to understand whether a rent quote is monthly or is it annual, and whether it is net or gross. These basics of rent comparison will help you make a more informed decision about whether or not a property is worth its value. Properties marketed as a net rent may have more costs later on that you’re not immediately aware of.
What are the Benefits of Commercial Tenants?
A commercial tenant versus a residential tenant is typically more creditworthy. Although it is theoretically possible that you could have a very wealthy individual renting in an apartment building, the typical net worth of an individual is not nearly as high as the typical net worth of a corporation. Therefore, this is a big differentiator between having commercial and residential tenants.
Let’s also talk about tenant credit
, relating to the amount of money that a commercial building owner can borrow and at what interest rate they can borrow. When we borrow money for an office building, we may be using such mortgage proceeds as part of the acquisition capital. Alternatively, we may be refinancing a mortgage that has reached maturity or is at a higher interest rate. In both of these events, the mortgage lender will look at how occupied the building is, and what the gross rent is and the net operating income (i.e. the net rent which is calculated as gross revenues minus operating expenses).
The lender will also review how strong the credit is behind the leases and the length of the lease terms in place. The most challenging situation for a lender would be if the building in question is fully leased to a tenant that is in financial trouble, with only one or two years left on their lease. That’s the antithesis of, let’s say, having Google lease your entire building for 20 years.
Those are the two extremes on opposite ends of the spectrum. In these two examples, the amount of loan proceeds that a lender will provide and the interest rate at which it will lend will vary significantly. For example, in the case of the week financial tenant with only one or two years remaining on its lease, the lender may only be willing to lend 50 to 60% of the value of the building and the interest rate may be as much as 2% higher. In contrast, in the Google example, the loan proceeds might be as high as 80% of the value of the building in the interest rate might be 2% lower.
Factors Affecting Commercial Rent Rates
Let’s examine some of the factors that determine how much that annual or monthly lease is going to be. Several variables can affect commercial rent rates. Competition
is a big one. Even if your building is well-appointed, if a brand-new building goes in next door, that’s what people will be talking about. Vacancy rates
are also an issue. If there are high vacancy rates, that’s going to put downward pressure on rental rates. When a landlord calculates how much they can ask for a space and what drives that, they are faced with a mix of variables.
In terms of the rents that a landlord quotes, in a utopian landlord world, we would be able to quote a very high rent which would give us a very healthy return based on our investment. Indeed, that may be something we’d be able to do depending upon the market conditions, but the first and foremost dictate of what rental rates will be are current market conditions and competition.
First Central Tower / St. Petersburg, FL
For instance, in downtown St. Petersburg in 2010, the vacancy factor ran up to about a 30 percent. Overall, the market was horrendous in the office building business. When you get up to a market-wide vacancy of 30 percent, you’re in a tenant’s market to the “nth” degree. Rolling the videotape forward into 2020, we are now experiencing vacancy levels in downtown St. Petersburg at around 6 percent. Rental rates went from about $20 per square foot when I first invested there in 2009 to the mid –$30s per square foot right now. Over the last 10 years, we’ve seen over a 65 percent appreciation in rents because of the declining vacancies and the lack of new supply.
In theory, we could even charge more. We could even go to $40 a foot and we could probably get it. I’m always thinking about the next recession, and that’s just unique to how we operate at Feldman Equities. ‘Rent and repent’ is an old expression my dad used to use, and it’s what we all live by here.
In other words, our policy is first and foremost to keep our buildings full. Our strategy is to undercut our competition with lower rental rates in order to drive occupancy up and to provide an incentive to tenants to give us longer lease terms. Longer lease terms help us obtain better financing and they let me sleep at night.
We are constrained by market conditions
and sometimes we can get a little more rent if we hold out a little bit longer, but we are inclined to fill up our buildings as quickly as we can. We are perfectly happy to concede with modestly lower rents in order to get long lease terms
from creditworthy tenants.
Measurement of Square Footage in office space
In the office building business, square footage is quoted as “Rentable square footage”. It’s important for tenants and brokers to understand how “rentable” square footage is computed. In order to understand the computation of rentable square footage, its first important to understand the definition of Usable square footage.
Usable Square Footage
Wells Fargo Center / Tampa, FL
Usable square footage is defined as the total area available exclusively to the tenant; the space within a building specifically for a company or tenant’s use. Usable square footage refers to the square footage that is inside the tenant suite and specifically excludes circulation corridors, bathrooms, stairwells etc. The usable area is sometimes loosely referred to as “carpetable area”. When calculating Usable square footage for a partial floor, you must specifically exclude the floor area in front of the elevators (the elevator landing area), as well as restrooms, electrical closets, mechanical rooms, etc.
Rentable Square Footage
The Rentable square footage
for an office building includes the Usable square feet combined with the tenant’s pro rata share part of the common areas of the building. The concept of Rentable square footage is that the landlord has paid for the construction of not just the Usable area, but is also providing circulation corridors, bathrooms, elevator landings, stairwells, lobbies, electrical and mechanical closets, etc.
The percentage relationship of Usable area versus Rentable area in a typical office building in downtown Tampa is approximately 20%. The generally accepted market practice in downtown Tampa is to first compute the Usable area using a very specific definition that excludes all common area. A factor of 20% is then typically added onto the usable computation to arrive at the Rentable footage. For example, if the Usable square footage of a tenant’s space is 1,000 ft.², then in downtown Tampa, the Rentable area would typically be 1,200 ft.²
Industry professionals use rentable square feet to determine the amount of your annual base rent expense. In order to accomplish this, multiply the rentable square feet with the annual base rental rate for the lease.
How long the lease term is and the amount of the tenant improvement cost all weigh into how much rent you’re going to quote to the particular tenant. If a tenant says, “Hey, I’m going to come into your space, take it as it is, and you don’t have to do anything, and I’m going to sign a lease and move in tomorrow morning, meaning there’s no downtime and no construction”, we might be willing to rent that space for less than our normally quoted rent of $30 per square foot. Those are the kind of factors that weigh into how rents are quoted.
Wells Fargo Center / Tampa, FL
When calculating a rent that we would quote a tenant, the most important guide is – What is the marketplace allowing us to quote
? Is the competition for an equivalent building at a rental level that is competitive. For example, in downtown Tampa for our Wells Fargo building, we’re quoting right now about $30 per square foot, as I said. If there were an equivalent quality building quoting $25 right across the street, it would be very difficult for me to quote $30.
Related: What is the difference between Class A, B, and C properties?
How It’s Calculated
As I mentioned earlier, rents are set using a set amount of dollars per square foot for the leased space, in either annual or monthly payments.
When quoting rents annually, you multiply the total amount of Rentable square footage by the agreed amount of rent per square foot. For example, let’s say you have a 2,000 square foot office space for rent at $30 per Rentable square foot, the calculation is 2,000 times $30 which equals to a yearly rent of $60,000 for that space. Rents are typically paid to the landlord monthly, so in this example, the rent would be $5000 per month.
Percentage rent leases are relegated to retail leases almost exclusively. They’re not a factor in office buildings unless that office building has retail space on the ground floor. Typically, a percentage rent will state that if a tenant generates gross revenues that exceed a certain dollar volume during a given calendar year, then that event, the tenant pays a percentage of such excess revenue as additional rent to the landlord.
For example, let’s suppose the tenant is renting for $30 per square foot in a retail space, and you agree that the “breakpoint” is $5 million. If that tenant reaches a sales level that exceeds $5 million, the landlord might receive an extra 5 percent on any incremental revenue above the $5 million. Let’s suppose in year one that tenant produces $6 million of revenue. The rent would be $30 per square foot times the square footage, plus there would be an incremental percentage rent of 5 percent times $1 million, or $50,000 more in percentage rent.
Castille at Carillon / St. Petersburg, FL
Calculating the right or wrong- rental rates can make or break a commercial real estate investment. A venture’s success hinges on the ability to generate enough revenue with the property to keep the lights on, as well as providing returns to investors. Setting rates too high will leave you with fewer tenants. Under-cutting your competition might make a lot of sense in the long run if you get long-term leases from creditworthy tenants.
Related: What are Typical Commercial Property Real Estate Management Fees?
New Investment Opportunity
Pinnacle Corporate Park
Target: 15.7% IRR, Average Cash on Cash Yield: 7.5%