Rent

The rents of the tenants in the rent roll tell us a few things about our business plan and historical rent trends. When we evaluate existing rents, we create a comparative market analysis to determine what we project rents should be. We are trying to acquire under-leased properties, under-leased, meaning the rents are below market or the property carries more vacancy than the rest of the market; this will be viewed as our opportunity as asset managers to achieve higher rents and fill vacancy. Looking backward at the dates when deals were signed can determine what historical rent growth has been; given you should be careful not to rely on historical growth in perpetuity and will have to use this as only one piece of the projection for future rents.

Rents above market can also raise questions about how the lease was signed. “Was this owner the best asset manager in the market?” Seems unlikely. We will begin by asking whether there is an above-market tenant improvement budget. In this case, the high rent above the market rate acts as a loan from the landlord to the tenant. Exceptionally high rents should be discounted if they deviate too far from the market, because you would not expect to replicate this if the space were vacant.

Renewal Options

Tenants are given renewal options to control the space their business operates in, while providing flexibility to move to a different space to meet their needs at the time of their lease expiration. The biggest item I do not want to see is a fixed-rate option that locks in what the tenant will pay in future years. Market rates change, and if the market drives up above the tenant’s annual increases during the term, as the landlord, we want the ability to capture that growth. This limits the deal's upside and can also hinder the timeline of a business plan.

My preferred option language includes a greater of their annual increase or market rental rate at that time. This gives the landlord the ability to capture the market growth while also being protected against a backslide in rents. It's still a renewal, so there is always a level of negotiation, but strong renewal language anchors the price in a tenant's mind, which should aid the negotiated outcome.

Fixed rent options can be detrimental when rent grows quickly

Recovery Structure

The summarized tenant recovery in the rent roll is where the most misses in initial underwriting occur, compared to when you have the lease in hand. Ideally, we are looking for a triple-net structure in which the tenant recovers common-area maintenance, insurance, and real estate taxes. The letters NNN are slapped next to the tenant name under recoveries, but items like roof maintenance, certain types of insurance, real estate taxes increased due to a sale, management fees, HVAC treatment, amortization of capital, and capped recoveries can affect how you manage cash, and also how we, as owners, will plan out maintenance of a property.

The majority of the markets we look for deals in have triple-net recovery leases, but some properties have modified gross leases. Modified gross is especially prevalent in Dayton because of the major developers there 20-30 years ago. There is an opportunity to convert these leases to triple-net. I believe it’s a bit of an overrated money maker because the gross rent will reflect the base rent plus triple-net recoveries outside the market. Modified gross leases also vary in what items are recovered and require additional investigation. If a county we are purchasing in reassesses a property's tax value upon sale, the tenant not reimbursing the taxes will cause a significant negative impact on the property's cash flow.

Term

I try to look at the term from a lender's perspective when evaluating a property. Lenders are focused on in-place ratios and backward-looking at historical performance. Ideally, I would like to see tenants that have been at the property for a long time and have varied remaining terms that stagger lease expirations and are attractive to a credit underwriter. In ideal terms, three to seven years remaining, and the tenant has been at the property ten plus years. What I do not want to see is the average remaining term under two years, with every tenant at a property on their first term of the lease. These factors suggest the property could quickly become vacant and that there is high turnover at this location. High rollover is concerning because acquiring new tenants is expensive, including leasing commissions, downtime, and potential tenant improvement costs.

These items on the rent roll affect what we can pay to successfully complete our business plan and are key considerations for any real estate investor when offering to purchase a property. Owners also have different capitalizations and situations that would lead them to view parts of the rent roll differently than I would. For example, a developer may purchase a building in a growing area, hoping the property will be vacant soon so they can develop it to a higher and better use.

Reply to this email and let me know if there are any specific topics you would like to hear about next. Thank you for reading, and stay tuned for the April Focus!

Contact Andrew:

President

513-305-9692

andrew@flex-cre.com

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