Hard Costs vs. Soft Costs in Real Estate Development
Anyone interested in investing in real estate development should understand the actual costs of a project. In this article, we will examine the difference between hard costs and soft costs.
Here at Feldman Equities, we’ve negotiated thousands of commercial leases over the years and understand the nuances. In this article we’ll describe some of the key attributes of leases that are involved in owning and operating a successful office building.
A commercial lease is an agreement between a landlord and tenant where the tenant is conducting some sort of business in the leased space. Commercial leases are similar in concept to residential leases, except that of course the tenant does not live in the building! Commercial leases tend to be more complex than residential leases because of the nature of the tenancy: operating a business entails more variety than residential occupancy.
Some examples of buildings that use commercial leases include
Whether it’s a large business like an Amazon fulfillment center, a large law firm, or a small optician’s office, a lease is considered commercial when the tenant is a business of any kind. The lease terms may differ, but they will all fall under the larger umbrella of commercial leases.
In fact, one of the biggest differences between residential and commercial leases is the term of length. Commercial leases tend to be longer term leases than residential. Residential leases generally max out at one year and then move to month to month. Commercial leases usually have a minimum period of one year, though typical leases are much longer than that. It’s not uncommon to have five, ten, or fifteen year commercial leases. While shorter lease terms for some types of businesses exist, they are the exception and not the norm.
Related: How to Buy Commercial Real Estate
First Central Tower / St. Petersburg, FL
The commercial lease agreement is the actual legal contract signed between the landlord and the tenant. It lays out all the details and creates a legally binding contract that tells each party what its obligations are to the other.
These are detailed documents. Whereas a residential tenant might sign an eight to ten page contract, commercial clients can expect closer to 20-30 pages. For larger tenants with more complicated lease terms, there could be more than 100 pages in a lease agreement.
Commercial lease agreements need to include every detail in writing. Who’s paying for the cleaning costs of the building? How much construction – called tenant improvements (‘TIs’) – is included in the deal upfront? What happens if the tenant or landlord defaults? What are the exact obligations of each party? It is important not to leave anything to chance in a commercial lease agreement because the last thing you want is an issue that pops up and ruins your returns on a ten year lease.
A lesser form of a commercial lease agreement is the license agreement. This is a temporary agreement to allow a licensee to use a limited space for a limited purpose over an indefinite or short-term time period. Mall kiosks, flea market tables, and other small-scale commercial space rentals are good examples of license agreements.
Depending on the tenant mix and caliber of the building manager, commercial lease renewal rates vary between 50-75%, meaning half to three quarters of tenants will typically extend the term of their lease when it comes time to renew. Tenants who have more money invested in a space and who are more dependent on the use of a particular space – for example a data center that is very difficult to relocate – are more likely to renew.
If you’re working with large clients who sign ten or fifteen year contracts with large upfront TI costs, they’re far more likely to stay put and renew. Similarly, when a tenant occupies a whole floor of your building with a fully customized space, they are generally stable. These types of tenants are most likely to renew.
Tenants that have other space options elsewhere, or who haven’t invested as much into modifying the space, are closer to the 50% chance of renewal. They don’t have as much to lose by moving or as much to gain from staying, so they require more work to encourage them to stay in place and extend their lease terms.
For longer leases and large tenants, there’s often a formal renewal option clause built into the lease agreement. This gives the tenant the choice to renew their lease for a certain number of years once the initial term ends. If they activate this option, the fair market rate of the space at the time of renewal will be laid out through pre-determined methods (appraisals, negotiations, etc.).
Renewal options often must be triggered a minimum of one year before the expiration of the lease. If you keep in contact with your tenants, as we do here at Feldman, the formal renewal clause is less likely to be triggered because you’ll already be having an ongoing discussion with them about whether or not they’d like to renew.
You can hold out and wait until the renewal clause is close to triggering before you get in touch with your tenants or you can get ahead of it. Here at Feldman Equities, we prefer the latter.
Our tenants know us on a first name basis. At least once per year we meet with our larger tenants to touch base with them and see how the space is working out for their needs. We also like to check on their plans so we always have a sense of their renewal probability. It’s our goal to know at least two years before an expiration if a tenant is likely to renew, rather than waiting until crunch time.
For larger tenants, we work with them to come up with incentives that might persuade them to extend their lease terms. Incentives can take many forms such as:
Tenant relationships are valuable. We want to know what’s going on and how we can keep occupancy high. We always have to be willing to go the extra mile for the right tenant.
Our motto is to defy the stereotype of a salesman who’s attentive until the sale and then ignores you until it’s time to renew!
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Commercial leases come in different forms. To know which kind of lease you want to use or sign, you need a basic understanding of what differentiates them. We’ll look at several of the most common lease types in the industry.
Wells Fargo Center / Tampa, FL
Gross leases, also known as full-service leases, are commercial leases where the tenant’s only financial responsibility is its rental payment, sales tax if applicable, and some outside services such as parking.
The landlord is responsible for all the normal operating costs of the building and the individual spaces inside. Usually this includes electrical, water, cleaning, maintenance, building repairs, real estate taxes, etc.
In our office buildings in Tampa, we use gross leases. Our tenants initially pay a flat rate per square foot, and we cover all the expenses associated with the buildings, minus the required sales taxes on rental payments. Over time, tenants begin to pay their proportional share of any increase in operating expenses.
Unlike gross leases, net leases push operational costs to the tenant. The landlord still pays for structural repairs, real estate taxes, and other costs of ownership, but tenants take up the costs of operating in their rented space, including cleaning, electrical, landscaping, and other costs.
You’ll often see net leases used for industrial tenants. These tenants need a large space for an affordable rate. They can get a great rate on an industrial building and cover their operational costs themselves without having to commit to fixing up larger structural issues.
Triple net leases take regular net leases a few steps further. These are leases used by building owners who want as little risk as possible. A triple net lease separates the landlord from all expenses associated with the building. Tenants are responsible for operating costs, maintenance, structural repair costs, real estate taxes, and everything else.
Lenders prefer triple net leases when it comes to loans because the income the landlord receives is all profit so it’s easier for the lender to get comfortable that their loans will remain current. The tenant takes on more risk, but the cost per square foot is also lower and the tenant has more control over its space.
Land leases are more of a financial instrument than anything else. Sometimes they’re done for family estate planning or family legacy investments. Land leases are long-term rentals, sometimes as long as 99 years. The tenant pays the lease and develops the property at their own will.
For tenants, land leases can be risky investments. Although there’s no upfront investment to purchase the land, property values for the buildings on the property often begin to go down as the lease expiration date approaches. Landowners have no obligation to renew land leases, so the developer may have to hand over whatever’s been built on the property after the lease expires.
Land lease payments take seniority over almost every other investor obligation, including the mortgage but after real estate tax. Paying other investors, mortgage payments, or other debts come after land rent. Some land leases may have extra provisions and clauses that are unfavorable to tenants as well, such as the need to get approval from the landowner before making large material changes to the property or buildings thereon.
You don’t really own your building when you enter a land lease, which can cause more problems than it’s worth for the tenant over time.
Similar to a triple net lease, double net leases pass the operational costs on to tenants. The cost of real estate taxes is also passed to the tenant. In most double net leases however, the larger repair and structural costs are still the responsibility of the landlord.
While double net leases reduce the costs for landlords, they include risks in the form of unexpected, potentially large structural repair and maintenance costs. As you might expect, lenders tend to prefer triple net leases over double leases.
Wells Fargo Center / Tampa, FL
With a modified gross lease the landlord is still responsible for the bulk of the costs of the building, but tenants take on some specific costs.
Usually these types of leases are reserved for unique cases where specific operational costs are higher than normal. For example, if a tenant has an exceptionally high-power consumption, they may be responsible for the power bill while the landlord still covers the other costs.
Related: Short Term Lease Agreements: What You Need to Know
Before you enter into any type of commercial lease arrangement with a tenant, there will be a negotiation. Here are three key points to focus on:
Is the prospective tenant a good fit for the type of building you run and the existing tenants you have in that building? What the tenant uses the space for matters. If it’s going to disturb the other tenants or the general atmosphere of the building, it may not be a good fit.
You want a sense of coherence in your buildings. For example, you probably wouldn’t want to sign a lease with a sports bar in a space surrounded by offices. The mix of businesses just doesn’t work well.
There are two ways to think about tenant credit. If a prospective tenant already has good credit, they’re an asset to you. Even if they aren’t a credit tenant, there might still be some characteristics of the lease that make you comfortable enough to sign. If it’s a legitimate business with a good business plan, you can require cash security deposits or letters of credit to boost their creditworthiness and make them a better fit for your portfolio. Other times, you may not care much about a tenant’s credit because you intend to subsidize its occupancy as an amenity for the rest of your building. A small café is a common example.
The length of a lease matters.
Push back lease terms as much as possible. You want tenants to commit to a long lease. With longer leases, you can commit to more benefits for the tenant, such as a greater construction budget. A larger budget can be justified if the expense can be amortized over the length of a long lease. It’s harder to recoup tenant improvement costs on shorter leases or if the tenant moves out.
Longer lease terms prepare you for unstable market conditions. No one knows when the next recession might happen, but a tenant portfolio full of long-term credit tenants helps to keep your building stable.
Related: How Long is the Commercial Real Estate Bid Process?
Morgan Stanley Tower / St. Petersburg, FL
Commercial leases are more complex than residential leases. This is a basic overview of what you need to know and not an exhaustive guide, but it should be enough to give you a head start. Here at Feldman, our guiding philosophy is to keep leases as long as possible with high credit tenants. “Rent and Repent,” as Larry Feldman’s father used to say – get tenants in, and keep them there. That’s the key to running a successful office building portfolio.
Sign up to learn more about how to invest in office buildings and to get early access to our next investment opportunity.
Anyone interested in investing in real estate development should understand the actual costs of a project. In this article, we will examine the difference between hard costs and soft costs.
How long should you hold onto your real estate before selling? While the final decision is up to you personally and your investment strategy, many industry veterans recommend longer holding periods. Larry Feldman has been in the office building development industry for more than 35 years; his family for over 100 years. His long-term hold strategy has helped him weather multiple downturns over the decades while continuing to grow his portfolio of buildings first in New York, and now in Tampa.
It appears that Joe Biden will be the next President of the United States, raising questions about the implications for commercial real estate.