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Protecting Against Economic Risk in Your Lease Agreements

When you’re writing up or reviewing your next lease, take time to consider how the terms included will protect you from future fluctuations in the economy. Everything from interest rates, inflation, availability of capital, to consumer confidence can cause the market to shift and lead to situations where your lease no longer provides you with the best returns possible. This article will address some of the top concerns and how to handle them.

Lease Agreements

What is a lease, and why is it important? This may seem like an obvious question, but it’s none the less useful to address for illustrative purposes. A lease is a form of agreement between two parties regarding the use and possession of a piece of property, real or personal. The intention of the lease is to protect the rights and interests of both parties; however, this is not always the result of typical negotiations.

In many cases, either due to distress or poor representation, one or the other parties stands to derive greater benefits from an agreement. This can be true in both the short and long-term. This is especially critical for long term commercial leases, where the extended duration could lock both tenants and investors into situations leading to lost opportunity costs and economic losses. Economic losses are those that occur when a property isn’t realizing its full cash-generating potential.

As a Landlord

Some of the main things to think about as a landlord when you’re preparing lease agreements is how it will protect you in the event of a sudden market correction. How will it protect your property, and how will it prevent you from spending more than you should on maintenance, property taxes, and other operational costs? If the market suddenly drops, you want to make sure that no matter how the market responds, with either an increase or decrease in lease rates, your lease agreement includes provisions that allow the rate to increase slowly over time in tandem with a price index.

If you’re new to commercial or multifamily real estate leasing, be sure to review the lease agreements you’re considering with your attorney. It’s best to have a custom agreement written up by a skilled legal professional. Using pre-printed agreements provided by agent boards or office supply stores are very basic, and do not address the variety of sensitive situations that specialized uses and markets can present.

Gross and Net Lease Agreements

It’s also important to consider the best structure for your lease. Do you want to pay the expenses, leave them to the tenant, or meet somewhere in the middle?  A common type of lease is the gross lease. The gross lease is structured so that the landlord pays all the expenses, including maintenance, taxes, utilities, insurance, and the tenant pays a flat rent. The rental rate set typically considers the amount of the property owner’s expenses.

But what if expenses rise, taxes go up, or a major capital expenditure is required? In these cases, the gross lease can leave the property owner at a disadvantage by paying increasing expenses. Another viable option in these circumstances is the modified gross lease, wherein the agreement contains provisions that allow the landlord to bill excess expenses back to the tenant as additional rent at the end of the year. The ‘net’ lease is another form that leaves the expenses to the tenant, providing a certainty of income to the landlord.

Releasing Costs & Effect on Appraised Value

When your tenant’s lease is over, or the tenant breaks the lease, how much will it cost you to refit the space for the next tenant’s use? Depending on the market, and overall level of demand, it may or may not be necessary to offer build to suit. In the case where you do, it’s important to lock in the tenant for as long as possible. This allows you to spread construction costs over the entire term of the lease, and additionally minimize the likelihood of needing to redesign the space in the short-term.

Another good reason to give additional consideration to your leases is the potential impact the terms could have on the results of a future appraisal. If your property is locked into a below market rental rate or has other specific terms that grant excessive benefits to the tenant, it can result in a low valuation. As commercial appraisers typically give most weight to the income approach in reconciling their valuations, the cap rate they apply to calculate your property’s value may yield a number that is much lower than anticipated if the NOI and rents are below market.

Terms for Growth

Lease agreements are a critical tool in protecting the long-term viability and profitability of your investment property. Take care to consult a legal professional in establishing the terms of your agreement. Exercise the same diligence in evaluating the market factors influencing your property class and include terms that will maintain the growth of your portfolio. Consider working with professional partners in developing and implementing your investment strategy to reduce your economic risk and eliminate the managerial tasks in developing your holdings.

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