Continuing with the theme in my other sections of What You Should Know, let’s now review the term “market rent” as it pertains to lease renewals.
Let’s start with, rent, which has multiple industry references that could be applied; gross rent, net rent, gross effective rent and net effective rent. Make sure that, rent, is specifically defined in the lease with no ambiguity. Let me give you a few personal anecdotes to reinforce my point.
I was representing a public sector landlord in negotiations with a tenant at the property (which also happened to be a public sector organization). The tenant had the landlord convinced that renewal market rent was based on gross rent at comparable properties. And each time the lease came up for renewal, the tenant used gross rent comparisons to justify the renewal rent. Upon a fulsome review of all the historical lease documents, the definition of market rent was misapplied over the years. It actually should have been net rent at comparable properties. Call me and I can give you the longer version of this story.
Another very common mistake I see is when the original net rent included “free parking” or some other benefit that was offered by the landlord as an inducement. So when the time came for renewal discussions to determine market rent, the parties were at odds on whether the cost of parking was in or out. If you want to hear more about this exciting cliff-hanger call me to hear the ending.
Let’s continue with explaining market rent. A source of considerable debate has continued over the years (and still remains as a sore spot) is whether to include the value of existing tenant leasehold improvements in the determination of market rent. The value of tenant leasehold improvements can add several dollars to the net rent payable by the tenant.
Just a quick prelude before I continue. The net rent paid by a tenant to a landlord has two components; the economic rent attributable to the landlord’s investment in the building, and, secondly an amortization of the cost of leasehold improvements specific to the space being leased. The former is relative to investment returns required on the asset, and the latter is relative to the duration of the lease term that contemplates the diminishing utility of the leasehold improvements. One way our industry analyzes these components is through a financial measuring stick called the net effective rate, or NER to use the vernacular. It’s funny that the landlord community has re-coined the term NER to mean “not enough rent”. Give me a call and I can walk you through how the NER is calculated.
Now let’s continue. Many landlords want renewing tenants to pay net rent that includes the original leasehold amortization portion without actually offering you a new tenant improvement/inducement allowance. Make sure your lease is clear on this prevalent problem; it remains the single largest strike against creating tenant leverage in renewal negotiations.
Here is the other thing about market rent. It assumes a homogenous market with every building having similar attributes. If you happen to be in a building that has a current occupancy rate of 98% and the most recent deals completed in the market happen to be at buildings that had 85% occupancy rates you can see the potential impasse that will arise with your landlord. This is a narrow academic example however all the micro adjustments necessary to reach an agreement on which market comparables to include is a constant struggle. Yes there are some qualitative criteria that industry professionals use to assign a plus/minus on each comparable, however I’ve seen the application of this approach as more of an art than a science.