Investor Education Series
3
Guide to Leasing
September 2012
For investment grade properties, it is the lease or leases of the property which determine the rental income and ultimately the end value of an asset, coupled with the capitalisation rate or yield which an investor will accept for that same asset. 2. Rent Reviews Aside from the rental rate itself, the key components of a lease deal typically comprise, the:
Most leases have rent reviews during the lease term.
• • • •
Lease Term Rent Review Mechanism(s) Tenant Incentives (if any); and Lease Guarantee
1. Lease Term For commercial property, the lease term (term certain) is typically between 3 and 10 years. In addition to the term certain, an option period is often negotiated. An option period allows a tenant to ‘exercise’ its option to extend the lease term for a further period. In all but a few instances only the tenant (lessee) can exercise an option to extend the lease, not the landlord (lessor). In an uncertain economic climate, the WALE of a property often dominates discussion relating to the value and market appeal of a commercial property. The acronym WALE stands for Weighted Average Lease Expiry. Essentially, the WALE of a property indicates the average (weighted) number of years before leases in the property expire and need to be re-set or re-let. Unless the property is significantly under-rented (rented at substantially lower rents than prevailing market levels) or has a higher and better redevelopment use, an asset with a longer WALE is preferred by the investor market. This is because a longer WALE is considered to represent a higher level of income security. A multi-tenant property would typically have a WALE of anywhere between 2 and 5 years.
The review mechanism negotiated between the landlord and the tenant is generally based on either a: • • • •
Fixed Percentage CPI Market Combination of the above
In most cases, the rent review is conducted annually. A Fixed Percentage Review is the most common method agreed to in commercial leases. The advantage of this method is it allows both the lessor and the lessee to budget for future income (in the case of the lessor) and rental expenses (in the case of the lessee) with certainty. The disadvantage is that it does not necessarily move in line with either the CPI or the market – which may lead to an over or under rented property. A CPI Rent Review is a review whereby the lease rental is adjusted to the change in the ‘Consumer Price Index’ over the period between the current rent review date and the previous rent review. The advantage of a CPI rent review is that the change in the rent levels will track inflation or the ‘cost of living’. The disadvantage is that there is no certainty of where the rent levels are headed for either the landlord or the tenant. That is rents can go up or down by any amount. A Market Review is when the lessee’s rent is reviewed to the then current market rental taking into consideration the quality of the property, its location and the size of the specific tenancy in relation to the rent achieved in comparable properties. Most commonly, market rent reviews are only conducted if and when a tenant exercises its option for a further term and not at the (annual) rent reviews during the term certain.