Guide to Leasing
When considering an investment in commercial property, it is important to assess the lease(s) of a property as they determine the rental income and ultimately the end value of an asset.
The key components of a Loan Facility typically comprise of the:
- Facility Limit and Loan to Value Ratio (LVR);
- Interest Coverage Ratio (ICR);
- Facility term;
- Interest Cost; and
- Loan Security.
The rental rate specified in a lease determines the total rental income a property will produce over a certain period. Commercial property rent is often calculated on a rate per square metre basis determined on location, condition and age of the property, surrounding tenants, size of the space, included services and lease terms.
For example: If a tenant is contracted to pay a rental rate of $500/sqm pa over 1,000sqm of space the tenant will pay $500,000 pa in total rent.
$500/sqm pa (Rental Rate) x 1,000sqm pa (Total Area)
= $500,000 pa (Total Rent)
When considering an investment in commercial property, it is important to assess the net effective rental rates (rental rates less any tenant incentives and outgoings) within a lease as this determines the rental income of an asset and forms part of forecast Fund distributions.
Lease and Option Terms
The typical lease term for a commercial property is between three and ten years and may include an additional option period.
In addition to the initial lease term, an option period is often negotiated. An option period allows a tenant to ‘exercise’ its option to extend the lease term for an additional fixed period. This secures additional rental income for the property beyond the initial lease expiry and reduces costs associated with re-leasing.
The Weighted Average Lease Expiry or (WALE) is an important property metric that measures the average number of years before leases in a property expire and need to be re-leased. A property with a longer (higher) WALE is generally looked upon favourably due to the security in longer term income.
Rent reviews are an essential component of a commercial lease which are negotiated between the landlord and the tenant, generally based on either a:
- Fixed percentage (%);
- Consumer Price Index (CPI);
- Market review; or
- A combination of the above
In most commercial leases, the rent review is conducted and applied annually.
A Fixed Percentage Review is the most common method agreed to in commercial leases. The advantage of this method is it allows both the lessor and the lessee to budget for future income (in the case of the lessor) and rental expenses (in the case of the lessee) with certainty. The disadvantage is that it does not necessarily move in line with either the CPI or the market – which may lead to an over or under rented property.
A CPI rent review, is a review whereby the lease rental is adjusted to either increase or decrease in line with the Australian Consumer Price Index, generally conducted and applied annually. An advantage of a CPI rent review is that the change in the rent levels will track inflation or the ‘cost of living’. The disadvantage is that there is no certainty of where the rent levels are headed for either the landlord or the tenant. That is rents can go up or down by any amount.
A market review occurs when rental levels are reviewed to the current market rental taking into consideration the quality of the property, its location and the size of the specific tenancy in relation to the rent achieved in comparable properties. Most commonly, market rent reviews are only conducted if and when a tenant exercises its option for a further term and not at the (annual) rent reviews during the term certain. Occasionally larger, longer term leases will contain a midterm market rent review.
During lease negotiations, it is common for a landlord to offer some form of lease incentive to entice a potential tenant. These incentives can be offered a number of ways including:
- Rental abatements (reductions);
- Rent free (periodic);
- Fit out contribution (capital contribution); or
- A combination of the above
The incentive is often calculated in percentage terms and can be based on either the net or gross rental the tenant is charged in year one, multiplied by the number of years of the lease.
For example: If a tenant is contracted to pay $100,000pa in Year one of a three year lease term, i.e. the total rent for the term is $300,000 (excluding rent reviews), and the tenant is offered a 15% incentive, then the value of the lease incentive equates to $45,000.
$300,000 (total rental) x 15% (incentive %) = $45,000 (incentive in $ terms)
Therefore, if the incentive is taken by the tenant as a rental abatement, the tenant will receive a monthly rental rebate (discount) of $1,250 over the term of the lease.For example: $45,000 (Incentive) / 36 months (Term) = $1,250 pcm = $1,250pcm (abatement)If the incentive is taken by the tenant as a rent free period, then typically under this method the tenant will not be obligated to pay rent for the first portion of its initial term to the value of its incentive.
In this example:
Rent = $100,000 pa or $8,333.33 pcm
Incentive = $45,000
Rent Free Period = 5.4 months ($45,000/$8,333.33) over the 3 year term
If the incentive is taken by the tenant as a cash contribution to fitout, the landlord will pay the tenant the cash amount of the incentive. In this instance the incentive is ‘extinguished’ upon payment and the tenant pays the landlord rent from day one of the lease.
In the majority of leasing transactions, a guarantee of some form is obtained from the tenant as security over the performance of its lease obligations.
Standard types of lease guarantees include a bank guarantee, a rental bond, a personal (directors) guarantee, a parent company guarantee or a combination of any of these. The most preferred of these guarantees is a bank guarantee.
A bank guarantee effectively provides ‘cash on demand’ should the tenant default under its lease.
For investment grade properties, it is the lease or leases of the property which determine the rental income and ultimately the end value of an asset, coupled with the capitalisation rate or yield which an investor will accept for that same asset.
Download and print “Guide to Leasing” PDF.
Disclaimer: Issued by Centuria Property Funds Limited, ABN 11 086 553 639, holder of AFSL 231 149. The information in this document is general information only and does not take into account your personal financial circumstances, needs or objectives. We recommend you speak with your financial and/or taxation advisor before making any decisions in relation to your investment.