CCIM Intro Course, Study Guide: Module 3

INTRODUCTION TO COMMERCIAL INVESTMENT REAL ESTATE ANALYSIS

Study Guide for Module 3:

The Commercial Lease
Learning Objectives .................................................................................................................. 1
Requirements of a Valid Commercial Lease .................................................................................. 2
Types of Leases ....................................................................................................................... 2
Lease Clauses That Affect Cash Flows ......................................................................................... 3
Rent Terminology in Leases ....................................................................................................... 5
Effective Rent ......................................................................................................................... 6

Learning Objectives

Understand gross and net leases

Quantify the differences between gross and net leases
Understand percentage leases
Quantify percentage leases
Quantify the effect of lease clauses

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CCIM Intro Course, Study Guide: Module 3

Requirements of a Valid Commercial Lease

The requirements of valid leases are similar to the requirements for valid contracts.
Despite the wide variation in the length and complexity of commercial leases, valid
and enforceable leases usually contain the following elements.
Names of owners and tenants. All parties to the lease should sign the
document.
Description of property. Acceptable descriptions include street addresses and
recorded plats in urban areas, and the government rectangular survey system and
metes and bounds in rural areas. The lease also should include a brief description of
the improvements.
Consideration. This requirement usually is met by the tenants promise to pay
rent and the owners inability to occupy the property during the lease term.
Legality of objective. The objective of the lease must not violate any federal,
state, or local law.
Offer and acceptance. These are statements to the effect that the owners
agree to lease the property for a specified period of time and that the tenants agree
to pay a certain amount of rent periodically to occupy the property.
Written form. In most states, leases for longer than one year must be in writing
to be valid and enforceable.
Types of Leases
The expense terminology in leases identifies who is responsible for the payment of
operating expenses. Under a gross lease, the owner pays all expenses associated
with operating and maintaining the property. The tenant pays the owner a gross
amount for rent. From this amount, the owner then pays the operating expenses
(property taxes, insurance, maintenance, utilities, janitorial, and security costs).
In a net lease, the tenant pays all or some of the operating expenses. However, the
lease terms should be examined carefully, as the definition of net leases varies from
market to market.
For a given level of rent, owners clearly prefer to pass on as much responsibility for
operating expenses to tenants as possible. However, the extent to which owners
and tenants share the payment of operating expenses depends on what currently is
standard in the market in which the property is located, and on the relative
bargaining power of the two parties or what was negotiated.
In an absolute net lease, the tenant pays all expenses related to operating and
maintaining the entire leasehold interest.
Sample Problem 3-1: Comparison of Gross to Net Lease
In this sample problem, the owner is billed for all taxes and operating
expenses. However, when taxes and/or other operating expenses are
partially or fully passed through to the tenant, the amount owed by the
tenant is transmitted to the owner, who pays the bills. These dollars have a
neutral effect on the bottom line since the owner does not keep them, but
rather uses these dollars to pay outstanding operating expenses.

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CCIM Intro Course, Study Guide: Module 3

Assume that an office tenant pays $10,000 per year as base rent. The
tenants proportionate share of real estate taxes is $1,500. The tenants
proportionate share of other operating expenses is $4,000.
In a gross lease, the owner pays all taxes and additional expenses. In a fully
net lease, the tenant pays all taxes and operating expenses.
In this example of a net lease, the tenant is responsible for a proportionate
share of taxes and other operating expenses.
The following tables illustrate how these payments affect the user.

Base
Rent

Gross Lease

$10,000

Net Lease

$10,000

Tenant Payments
Tenant-Paid
Tenant-Paid
Property
Other
Taxes
Operating
Expenses
0
0
$1,500

$4,000

Tenants
Total Outlay

$10,000
$15,500

Assume the base rent remains the same, but real estate taxes increase to
$1,650 and other operating expenses increase to $4,200.
Base Rent

Gross Lease

$10,000

Net Lease

$10,000

Tenant Payments
TenantTenant-Paid
Paid
Other
Property
Operating
Taxes
Expenses
0
0
$1,650

$4,200

Tenants
Total Outlay
$10,000
$15,850

Lease Clauses That Affect Cash Flows

Many commercial leases contain alternative treatments of operating expenses.
These alternatives may require owners to pay operating expenses up to a given
amount (expense stops), allow owners to pass some of the cost of operating the
property through to the tenant (expense pass-throughs), or allow the owner to
charge the tenant for some or all of the increase in the cost of operating the
property.
Expense Stops
With some commercial leases, the owner may add an expense stop clause.
In this situation, the owner pays operating expenses up to a specified
amount, usually stated as an amount per square foot (psf) of rentable space
in the building. Psf expenses in excess of the expense stop are passed
through to tenants based on their pro rata share of the buildings rentable
space.

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CCIM Intro Course, Study Guide: Module 3

Expense stops benefit owners by limiting their exposure to the risk that
operating expenses could be greater than expected. These stops also allow
owners to forecast costs based on predictable expenses. Owners give tenants
something of value in exchange for the expense stop clause. This something
of value can be a lower contract rental rate if competitive leases in the market
do not contain expense stops.
Expense Stop, Example
For example, an office lease may state that a tenant will pay $18 psf per year
in rent and that the owner will pay all operating expenses associated with the
propertyso long as expenses do not exceed $4 psf of rentable area. If the
building has 50,000 square feet (sf) of rentable area, then this clause
obligates the owner to pay the first $200,000 in annual operating expenses
($4 x 50,000). Any amount over $200,000 will be paid by the tenant based
on the percentage of the buildings rentable area or the square footage that
the tenant occupies. This clause effectively limitsor stopsthe owners
operating expense exposure at $200,000.
Expense Pass-Throughs
Operating expenses frequently are paid by the owner and then passedthrough to the tenants. This is especially true in multi-tenant office buildings
and shopping centers. In retail properties, a tenants share of these expense
pass-throughs is based on the gross leasable area (GLA) of the tenants store
as a proportion of the GLA of the entire shopping center. In office properties,
the pass-through is based on the tenants rentable area as a percentage of
the buildings total rentable area.
As with expense stops, owners give tenants something of value in exchange
for the expense pass-through. This something of value can be a lower
contract rental rate if competitive leases in the market do not contain passthroughs.
Common Area Maintenance
Common area maintenance (CAM) charges are a common expense passthrough in shopping center leases and other multi-tenant situations. These
are the costs associated with maintaining the common areas of a property,
such as hallways, lobbies, landscaping, and parking lots. These costs usually
are calculated on the percentage of rentable space that the tenant is
occupying. CAM clauses benefit owners in that when maintenance costs
increase, the increase is passed on to the tenants.
Tenant Improvements
Owners often incur re-tenanting expenses when leases expire and vacant
office or retail space must again be made ready for occupancy. As an
example, the re-leasing of office space often requires that substantial changes
be made, such as removing or adding walls, raising ceilings, and altering
electrical capacity. In fact, many office and retail leases provide a new tenant
with an improvement allowance. This lease provision obligates the owner to

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CCIM Intro Course, Study Guide: Module 3

incur a prespecified dollar amount of expenditures to improve the space to

the new tenants specifications.
Rent Terminology in Leases
A commercial lease may call for:
Fixed rent (contract rent). Contract rent is a fixed amount of rent over the
entire lease term.
Step leases. Rental payments that change, or step up, by set amounts or
percentages at given dates. Contract rents on long-term leases change by preset
amounts or percentages on predetermined dates, such as each year or every five
years. Although the lease payments vary over the term of the lease, all payments
are determined and known at the beginning of the lease agreement. Thus, unless
the tenant defaults, all lease payments are known with certainty when the lease is
signed.
The base contract rate may increase by a preset amount or percentage. Such preset
amounts or percentages are called escalations. Types of costs typically having
escalations may relate to real estate taxes, insurance, utilities, operations, and
maintenance.
With a step lease, the tenant risks tax and operating cost increases, which are
passed through on a pro rata basis.
Real estate professionals representing the tenant provide information about historical
trends so that increases are predictable and the decisions are informed.

Indexed leases. Variable levels of contract rent based on changes in an index.

Indexed leases are variations of step leases. Instead of preset amounts or

percentages, contract rent is tied to movements in a prespecified index, usually the
consumer price index. For example, if the current years cost of living increases by 3
percent, then next years lease payments will increase by 3 percent. Indexation
prevents inflation from eroding the real value of the tenants lease payments by
passing inflation risk from the owner to the tenant.
Percentage rent. Variable amounts of monthly rent based on a percentage of
the tenants gross sales receipts.
Percentage rent is additional rent over a base amount that is paid by retail tenants to
owners on tenant sales over a certain dollar amount, called the breakpoint.
This clause frequently is found in shopping center leases in which an owner manages
and promotes the entire center. The base rent is lower because the owner expects
additional rent from sales. Percentage rent usually is calculated and paid on an
annual basis.
The breakpoint is calculated as:
Breakpoint = Annual base rent Percentage rate

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CCIM Intro Course, Study Guide: Module 3

Tenants like percentage rent because it gives the owner/landlord a stake in their
success, encouraging the owner to make solid decisions on tenant mix, the
attractiveness of the retail property, signage, and maintenance that will have a
beneficial effect on tenant sales. Additionally, retail tenants like percentage rent
because of the cyclical nature of their salesretailers make most of their income
during holidays or seasonal peaks.
Sample Problem 3-2: Calculating Breakpoint
If the annual base rent is $120,000 and the percentage rate is 4 percent,
then the breakpoint is $3,000,000 (120,000 0.04 = $3,000,000). At sales
of this amount or below, the tenant pays only the base rent. At sales above
this amount, the tenant must pay 4 percent of the amount over $3,000,000
as percentage rent.
If the tenant had sales of $3,500,000, the overage rent would be calculated
as follows:
Total sales of $3,500,000 Breakpoint sales of $3,000,000 = Excess sales of
$500,000
Multiply excess sales of $500,000 by the percentage rate of 0.04 =
Percentage rent of $20,000
The total annual rent would be $140,000 ($120,000 base rent + $20,000
percentage rent).
Rent Concessions
Sometimes owners will offer tenants rental concessions, such as several
months of free or reduced rent or free parking. Rental concessions more
frequently are observed in overbuilt markets because owners find the leasing
of space more difficult or because of unique circumstances in the tenants
short-term cash flow. Another explanation is that free rent may be
negotiated to help the tenant pay for tenant improvements. Such
concessions lower the tenants effective rent, unless the base rate is stepped
up to adjust for the initial reduced cash flows to the owner.
Effective Rent
Total effective rent. This is the base rent adjusted for concessions and
allowances and for costs that are the responsibility of the user (such as operating
expense pass-throughs). Total effective rent is the total of all cash flows over the
term of the lease.
Total effective rate. This is the total effective rent divided by the square
footage.
Average annual effective rent. This is the total effective rent divided by the
total years of the lease term.
Average annual effective rate. This is the average annual effective rent
divided by the square footage.

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CCIM Intro Course, Study Guide: Module 3

Sample Problem 3-3: Users Effective Rent

In most commercial leases, base rent does not equal effective rent. An indepth analysis includes all costs to the user.
The basic formula for calculating the users effective rent is
Base (contract) rent + Additional costs Concessions and/or allowances =
Effective rent paid by tenant
Assume that a user signed a lease for a 1,000 sf office with a yearly base rent
of $12,000. The operating expense stop is $2 psf, but actual expenses came
in at $2.25 psf.
It costs $10,000 to improve the space for the tenant, and the owner agreed
to pay for half of the tenant improvements. It costs the tenant $1,000 to
move into the space. The owner did not agree to pay any moving expenses.
The owner agreed to two months of free rent. No other concessions or
allowances were agreed upon.
The effective rent paid by the tenant for the first year would be
$12,000

+
+
+
+

Base rent (contract rent)

Operating expense pass-throughs,
or CAM charges
Total tenant improvements
Moving costs
Previous lease costs (buyout)
Other costs (parking)
Free rent
Tenant improvement allowance
Moving allowance
Other concessions

Effective rent paid by tenant

$16,250

250
10,000
1,000
0
0
2,000
5,000
0
0

Total Year 1 occupancy costs for the user will equal $16,250, or $16.25 psf.
Sample Problem 3-4: Owners Effective Rent
An in-depth analysis from the owners perspective must include all costs.
The basic formula for calculating the owners effective rent is

Base (contract) rent

Net additional costs
Concessions and/or allowances
Owners effective rent

Assume that a user signed a lease for a 1,000-sf office with a yearly base rent
of $12,000. The operating expense stop is $2 psf, but actual expenses came
in at $2.25 psf.

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CCIM Intro Course, Study Guide: Module 3

It costs $10,000 to improve the space for the tenant, and the owner agreed
to pay for half of the tenant improvements. It costs the tenant $1,000 to
move into the space. The owner did not agree to pay any moving expenses.
The owner agreed to pay for two months of free rent. No other concessions
or allowances were agreed upon.

Base rent (contract rent)

Operating expense stop
Owner-paid tenant improvements
Owner-paid moving costs
Lease buyout costs
Other income (parking)
Free rent
Other concessions

$12,000
2,000
5,000
0
0
0
2,000
0

Owners effective rent

$ 3,000

The Year 1 effective rent the owner will receive is $3,000, or $3 psf.

Copyright 2002 CCIM Institute. All rights reserved.