Determining The “True Cost” Of A Lease
By Jerry Snowden
Time to find new commercial space for your business? While visions of a better layout, more natural light or easier customer access may be the fun things to think about, the true costs of occupying a space is really where pencil needs to be put to paper.
The math can get complicated – but taking the time to work it out before you move in is one of the best financial decisions you can make.
The cost of occupying commercial space is generally a company’s second highest expense after its labor cost. Although shopping for new space can be exciting, comparing occupancy costs between buildings A, B, C and D can also be overwhelming.
Often times, the seemingly inexpensive “first choice” turns out to be the most expensive building. Surprisingly, the more expensive option turns out to be the “better value.” This is because lease rates are quoted differently, space is measured differently and suite improvements are handled differently. Lease rate escalations and/or lease concessions are different at each building as well. So, it’s important to go beyond the initial request for a building’s base lease rate.
The key to properly comparing costs is to calculate all of the final lease costs of each property, rather than just considering the initially quoted “price per square foot.” The primary components of calculating occupancy costs are always the same: A) lease rate, including building operating expenses, B) leasable area of space, C) cost of suite improvements, and D) rent escalations and rent concessions. The most popular way to calculate occupancy costs is to tabulate all actual and foreseeable costs on an annual basis, then divide that number by the leasable square feet of space.
Lease Rate: Gross versus Net
Lease rates for office, retail or industrial space generally fall into two primary categories; gross or net lease rates. Gross lease rates include all operating expenses. Net lease rates do not include operating expenses, but are paid in addition to the net lease rate.
Operating expenses generally include the following: property taxes, building insurance, janitorial, window cleaning, snow removal, trash, landscape, electric, heating and cooling, property management, accounting, legal, repairs and maintenance. These expenses can vary between buildings depending on the age of the building, the size of the building and the efficiency of operation.
Although initially net rates sound like the lower cost option, that might not be the case once all expenses are tabulated. And, expenses can increase each year. Conversely, a gross rate might initially sound more expensive because it includes all operating expenses. However, expenses are contained in the rate and therefore total costs are more clear and predictable.
Leasable Area: Usable versus Rentable
Usable floor area is defined as the actual floor space within the walls of the suite itself. Rentable floor area is defined as the usable area above, plus a percentage of the common area of the building.
Common areas include such things as a building’s lobby, corridors and restrooms, with costs shared by all tenants. Usable areas may initially sound like the better deal but can also mean, for instance, that a tenant must pay for the entire cost of having a restroom, a furnace room, and/or a janitorial closet within their suite, which can amount to a lot of unnecessary cost. Rentable areas often mean tenants only pay a percentage to share these important areas.
Cost of Tenant Improvements
Tenant improvements (TI) refer to physical improvements made to the space for tenant use. Examples include new carpet, paint, walls, doors, electrical, plumbing, heating and cooling, ceilings and fire exits. Tenant allowance (TA) refers to the amount of dollars a landlord is willing to contribute to improve or refurbish the space offered. Tenant improvements and allowances can vary between buildings.
Some landlords assume they will contribute dollars to modify the space that is offered. Within the quoted rate of the more expensive building, tenant improvement dollars may be anticipated. The less expensive option may not include them.
Cost of Escalations and Concessions
Rent escalations refer to increases in the lease rate or in the operating expenses of the building. Some lease rates may be “flat” with no escalations over the lease term. Other lease rates may include an increase on the base lease rate and an increase of operating expenses each year as well. Rent concessions refer to the amount of free rent or rent discount offered. Or, they include something such as a moving expense incentive. Concessions can lower occupancy costs significantly, but not all buildings offer rent concessions.
Determine Occupancy Costs and Compare
Once all of the lease costs are identified a proper comparison can be made, but methods vary. While some use a “back of the envelope” cost analysis, other professionals will use sophisticated software to calculate effective lease rates on a new present value basis. Whichever method your company uses, be sure to consider all of the costs for each building. Go beyond the initial inquiry of lease rates. Ask questions, and get good answers.
Finally, while price is important, it should not be the only determining factor in your decision of locating in a space. The best strategy is to first focus on the buildings that offer the best location, floor plan, parking, professional image, property management and all other amenities deemed important. Next, get a complete understanding of the costs and possible concessions. Personally meet with the landlord to explain your needs and learn his management style. Gather all the information you can.
In the end, you’ll be glad you spent the time to learn and compare.
Gerald Snowden is the owner of Snowden Companies and a partner in Miller Snowden Development Group, both located in Traverse City and specializing in leasing, sales, management and development of commercial real estate. Snowden has more than 25 years of experience representing tenants and landlords in commercial lease transactions.