Office Leasing Jargon

A few expressions are so often used by people in the real estate business that they find their way into the press and become part of the general vocabulary. As is often the case with jargon, however, these expressions oversimplify the real world and are misinterpreted. This discussion attempts to explain those terms creating the most common misconceptions.

Market rent

Because this expression is encountered so often, many people think a market price exists for office space in the same sense as it does for wheat, gold, options on IBM stock, or other items considered fungible commodities. However, this is not the case. Significant cost differences exist for space even within buildings considered to be of comparable quality and located in the same area. While it would make life simpler if market rent figures accurately reflecting space costs did exist, they never have and never will. There are too many variables in every lease transaction to allow a simple figure to be indicative of the cost of space for any given situation.

Below market rent

The expression “below market” in the context of office space rent is a huckster's term. Since a market rent does not exist, “below market rent” is nothing but puffery.

Cost per sq. ft.

Without extensive further definition, a cost per sq. ft. is a meaningless and often misleading expression. Answers to a number of  questions must be determined before the figure takes on any significance.

1. Is it a net figure, a true gross figure, a gross figure with a base year, or a gross figure with stops?

If it is anything but a true gross figure, a realistic estimate of the building's future real estate taxes and operating expenses must be determined before the figure can become meaningful. Consider the following example. A gross rent figure of $21.00 per sq. ft. with a 2003 base year is quoted. The actual combined taxes and operating expenses for the building for 2003 were $9.25 per sq. ft. The history of taxes and operating expenses indicates they have been increasing at an average annual compound rate of 6%. The proposed lease begins January 1, 2005 for a term of five years. Thus the estimated gross rent for the first year of the lease will be $22.14 rather than the $21.00 figure quoted by the landlord. If the above quoted rent was $21.00 net, the estimated gross rent for the first year would be $31.39!

Furthermore, many leases provide that the base rent will be escalated during the term. In the above example of a quoted $21.00 gross rent, if the escalation called for a 1.5% increase per year, compounded, and the taxes and operating expenses continue to increase at the 6% rate, the estimated gross rents for the second through fifth years of the lease would be $23.09, $24.06, $25.09 and $26.16, respectively. Thus the average estimated gross rent in this example comes to $24.11 per sq. ft.

2. Is it a cost per usable or rentable sq. ft.?

Usable square footage represents the area a tenant can use for his offices, furniture, and equipment. Rentable square footage is a somewhat arbitrary number, usually larger than the usable figure, established by the landlord for purposes of calculating rent. The difference between them, expressed as a percentage of the rentable square footage, is called the loss factor. Since a landlord can use a relatively high loss factor if he wants to quote a relatively low rent, and vice versa, the rate per rentable sq. ft. can be quite deceptive.

Consider that a rent of $24.00 per rentable sq. ft. in a building using a loss factor of 14.5% represents the same cost per usable sq. ft. as that of another building quoting $26.00 per rentable sq. ft., but using a loss factor of 7.4%. Because of this phenomenon, one should always use rent per usable sq. ft. when comparing proposed rents.
 
(A chart illustrating the concepts of usable and rentable square footage may be viewed by clicking here.)

3. Is it an asking figure or an effective figure?

Asking figures are, almost without exception, higher than effective figures, but the size of the difference varies greatly. An effective rate generally indicates an average over the lease term after reflecting concessions and allowances granted in the lease. However, there is no standard way of calculating an effective rent per sq. ft. Furthermore, effective rent calculations sometimes do not take into consideration the time value of money. Thus, without knowing exactly how it was calculated, an effective rate per sq. ft. can be even more deceptive than an asking rate.

As an illustration of how deceptive this figure can be, consider the following situation. A building's asking rate is $20.00 per sq. ft. net. The building is offering fifteen months of net rent abatement on a five year lease. Consequently the claim is made that the effective rate is $15.00 per sq. ft., representing a 25% discount. While this is accurate as far as it goes, the claim projects an impression of a much higher discount than is really the case.

What is not taken into effect is that the taxes and operating expenses in the first year of the lease amount to $8.00 per sq. ft. and have been increasing at an average rate of 5%, compounded annually. Additionally, the base rent is escalated at an annually compounded rate of 2%. Reflecting these costs in the calculation results in an estimated gross average annual rent for the lease term, before abatement, of $29.66 per sq. ft. Subtracting the rent abatement reduces this average figure by $5.00, representing a discount of 16.9%, rather than 25%.

4. What is “net effective rent?”

In an attempt to employ a simple measure to compare deals, landlords and brokers often talk about “net effective rent.” This figure is an expression of the dollar return per sq. ft. to the landlord, excluding real estate taxes and operating expenses. Conceptually it is a good measure;  practically it is not, for countless variations underlie its calculation.

The most common variations used in its calculation are:  (i) some people include base rent escalation while others do not; (ii) some include the cost of constructing the tenant improvements while others do not; (iii) within the group that includes the cost of tenant improvements, some amortize the entire amount over the lease term while others amortize only a portion; (iv) some reflect the time value of money in the calculation while others do not; and (v) among those that reflect the time value of money, large differences exist in the discount rate used.

The effects of these variations may be seen in the following example. Consider a deal consisting of a net base rental of $16.00 per sq. ft. with the first 4 months abated, a 10 year term, a 3% escalation of the base rate compounded annually, and a cost of $35.00 per sq. ft. for the tenant improvements. The table below shows the results of six different sets of assumptions underlying the calculation of the net effective rate. (Twelve rates are calculated — six reflecting the time value of money and six ignoring it.)


Assumption Set
A
B
C
D
E
F
Net effective rent †
$11.84
$12.36
$9.94
$10.45
$17.11
$15.20
Net effective rent ‡
$14.31
$15.18
$11.97
$12.84
$17.81
$15.47
† Discounted to present value using an APR of 10%
‡ No discounting to present value.
EXPLANATION OF ASSUMPTION SETS

A:  Base rent escalation included; 100% of tenant improvement costs amortized over the lease term.
B:  Base rent escalation included; 75% of tenant improvement costs amortized over the lease term.
C:  Base rent escalation excluded; 100% of tenant improvement costs amortized over the lease term.
D:  Base rent escalation excluded; 75% of tenant improvement costs amortized over the lease term.
E:  Base rent escalation included; tenant improvement costs excluded.
F:  Base rent escalation excluded; tenant improvement costs excluded.

As is evident from the above figures, the net effective rents vary significantly depending upon the calculation method used. When you consider that the number of combinations of the variables that enter into the calculation is infinite, you can appreciate just how specious this measure can be.

5. If cost per sq. ft. figures can be so meaningless and misleading, why are they so commonly used to describe and compare office space costs?

There are two main reasons. First of all, a cost per sq. ft. is the only way a rent can be expressed before a specific square footage requirement is established. Secondly, as alluded to in the above comments, a cost per sq. ft. figure can be used to project a particular image. Since most publicized cost per sq. ft. figures are those expressed by office space marketers, you can readily appreciate that the versions used are those that have the greatest possible advertising appeal. Those that reflect actual total costs are never publicized.

Once a specific space requirement has been established, you should no longer focus on costs per sq. ft., but rather on total costs. By so doing you will eliminate the difficulties associated with unit cost figures. Additionally, you will preclude the bias introduced by the fact that no building under consideration will be able to provide exactly the number of usable sq. ft. that you require. You will be forced to take more or less than an optimum amount because of constraints imposed by the building floor plate and the willingness of the landlord to divide the space to suit your requirements.

At this point in the process, unit costs can and should be ignored, for they have no meaning. After all, few leases specify rent in terms of dollars per sq. ft. and no tenant writes a monthly check to the landlord for some number of dollars per sq. ft. Only total dollar amounts are meaningful.

Tenant improvement (build-out) allowance

Most office leases provide for some amount of construction at the landlord's expense to build out the space for the tenant's use. The amount of the allowance, expressed as a dollars per sq. ft. figure, is established during the lease negotiation process. What seems like a very straightforward and understandable number, however, is one of the trickiest to evaluate.

The difficulty stems from two conditions. First, construction is broken into two parts by landlords: one called base building and the other called tenant improvements. The base building portion is paid for by the landlord and is not charged against the allowance for tenant improvements. However, each landlord establishes his own definition of what is included in base building, and significant differences exist from one building to the next. Second, construction costs charged by landlords for the same functional items vary from building to building.

The net effect of these two conditions is to make it quite difficult to compare the total cost of one building's proposal to that of another. The actual construction cost chargeable to the tenant will vary depending upon the building, even though the build-out of the space is functionally the same. Expressed another way, a dollar of build-out allowance from one building does not purchase the same amount of tenant improvements as a dollar from another building, and it is very difficult to determine the magnitude of the difference in purchasing power. It is entirely possible that a $25.00 per sq. ft. allowance from one building will purchase more build-out than a $28.00 allowance from another.

Because of the difficulty posed by the ambiguities inherent in build-out allowances, tenants can mistakenly select a building providing lesser value than otherwise obtainable. Additionally, they can find themselves in the position of having to come up with a sizable amount of money at the front end of the lease term to pay for construction costs exceeding the build-out allowance. Not only can this be a very unpleasant surprise, it can cause interminable negotiations over construction items and often results in a downgrading of the tenant improvements.


CONCLUSION

There are effective ways to deal with all of the problems posed by the foregoing conditions, but it is beyond the scope of this discussion to describe them. The purpose of this article is to provide some insight to tenants  to help them make good decisions regarding their office space. However, the best way to accomplish this is to take advantage of the skill and experience of a commercial real estate broker who specializes in tenant advocacy.


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