LeaseAlpha Calculator White Paper: Landlord point of indifference methodology to mathematically determine best possible early lease restructure deal terms for tenants.
Problem Statement
Real estate is expensive. In fact, for most tenants the cost of leasing commercial space is one of the largest operating expenses, often involving multi-year financial commitments. As leases near maturity, the decision whether to relocate or extend the lease in-place is a challenge. Relocation is difficult – it requires significant investment of time and effort to locate space, negotiate a lease and often demands large upfront out-of-pocket capital expenditures to cover the space buildout costs and potential business disruptions. Renewing or restructuring the lease in-place early also offers its own hurdles as landlords have superior knowledge resulting in stronger bargaining position. As a business owner or a corporate executive, what options are available to ensure you receive the best possible deal structure for your upcoming lease renewal? This white paper endeavors to solve this problem by putting forth a methodology for mathematically determining the best possible early lease restructure terms for a tenant with its existing landlord.
Background
When faced with a problem of evaluating a lease proposal, received from the landlord, the most common approach is benchmarking the deal against other recent deals in the market. The theory being that if the deal structure offered is on par with “comparable” transactions, then you must be getting a fair deal from the landlord. However, there are three main issues with this approach: i) comparability of transactions, ii) timing, iii) information validity.
Comparability of transactions: One must ask what is a truly “comparable” transaction? After all, real estate is not homogenous – no two deals are the same. Identical buildings sitting next to each other may differ in terms of owner’s capital stack, quality, efficiency, amenities, and maintenance level; even identical office suites in the same building may differ in terms of view, light exposure, elevator access, etc. Also, while some information such as base rent, concessions, and lease term are reported anecdotally, the specifics and nuances of any given lease deal are not generally available.
Timing of transaction: Evaluating comparable deals is always analyzing a past event – one is looking at the “rear-view mirror”. A deal must close for the lease structure to be finalized and become useful as a “comparable” transaction. As such, using this approach, decisions would be based on where the market was and not on where it is now, or where it is going to be when you will be negotiating your deal. Of course, to mitigate the timing issue, Tenant can look at the cost of relocation alternatives that exist in the market currently, as those data points are easily obtained. However, unless the process of fully negotiating potential relocation is undertaken, you would only be getting Landlord’s “asking rates”, which are almost never the final deal terms. Also, as mentioned above, no building is the same, so the deal you can get from another building in the market is not a perfect predictor of what deal you can potentially get from your current landlord. It should be noted that evaluating acceptable relocation alternative in the market can still be very useful, if used in concert with landlord point-of-indifference methodology proposed in this white paper – more on that later.
Validity of information: As a tenant, where do you get the information on comparable transactions? Information on real estate leasing deals is scarce since data is proprietary to landlords and brokers and is rarely recorded for public access. In most cases, landlords and brokers are the only original source of information on commercial real estate leasing transactions. As such, there exists a serious informational asymmetry, which makes tenants’ leasing decisions even more challenging. It should also be noted that brokers are paid when the deal closes, regardless of how good or bad lease economics are for the tenant, so the problem of informational asymmetry is exacerbated by misalignment of interests.
It’s clear that the approach of basing your analysis on comparable transactions has significant imperfections inherent in it. Therefore, we propose a mathematical model utilizing current market factors to solve the problem – more on that below.
Solution
The key to understanding the best possible financial deal for early lease restructure, that a rational landlord would grant to a tenant, is to look at the transaction’s economics from the landlord’s point of view. In other words, you need to “run numbers” as a rational landlord would, and that is precisely what landlord point-of-indifference methodology allows tenants to accomplish quickly and easily by using LeaseAlpha calculator.
The first step in the methodology is to determine landlord’s Best Alternative to Negotiated Agreement (“BATNA”) with the current tenant. Simply put, if a deal cannot be reached, and the current tenant vacates the premises at the end of its contractual lease term, then the only option landlord would have left to restore cash flow is to look for a replacement tenant in the open market to fill the vacant space. So, landlord’s BATNA is re-tenanting the vacated space and landlord point-of-indifference methodology calls for forecasting future landlord’s cash flows for this potential eventuality. In this case, landlord’s cash flow would consist of current tenant’s remaining lease obligation minus re-tenanting costs, plus replacement tenant lease obligation – let’s call this Scenario I.
Assuming that tenant initiates lease restructure negotiations early and presents a credible threat of relocation, the alternative to BATNA for the landlord is to reach a new deal with the current tenant to re-structure its lease prior to expiration. This restructure may involve certain upfront concessions, offered to tenant in exchange for executing a new deal that extends beyond the current lease expiration date. Landlord point-of-indifference methodology calls for forecasting future landlord’s cash flows for this potential eventuality. In this case, landlord’s cash flow would consist of current tenant’s restructured, longer-term lease obligation minus upfront concessions – let’s call this Scenario II.
The central premise of landlord point-of-indifference methodology is that a rational landlord would not agree to an early lease restructure deal with the current tenant that would be less profitable as compared to the alternative outcome where the tenant vacates (landlord’s BATNA). So, by that rationale, the best possible early lease restructure deal for the current tenant is the one that is equal in landlord profitability to the scenario where landlord must replace the current tenant (landlord’s BATNA). Landlord point-of-indifference methodology utilizes net present value of the future cash flows as measure of landlord profitability. As such, LeaseAlpha calculator determines the best possible early lease restructure deal by solving for economic lease terms that would equate net present values of landlord’s cash flows for Scenario I and Scenario II.
Modeling Details
The preceding section described landlord point-of-indifference modeling theory in general. This section will touch upon every component of the model in more detail.
Salient Inputs
Start Date: This is the date chosen as start of the analysis and beginning date of the restructured lease.
Analysis Duration: Total length of the analysis modeled by LeaseAlpha calculator is determined by total length of tenant’s restructured lease term, which includes remaining lease obligation between the start date and the expiration/termination date of the current lease as well as the additional term for lease extension beyond the end date of the current lease.
Discount Rate: This rate, expressed as a percentage, is chosen to be used in the net present value calculation. As default, LeaseAlpha calculator will use 8.0% discount rate. It is of paramount importance to the integrity of the model that the same discount rate is applied to both scenarios. Discount rate can be chosen in the Advanced Settings section of the calculator inputs. Generally, discount rate can be viewed as a measure of risk associated with future cash flows or as landlord’s desired return on the investment.
Note: Definition of net present value and additional information can be found by following this link: https://en.wikipedia.org/wiki/Net_present_value.
Scenario I
Remaining Lease Obligation: This component of the model consists of landlord’s cash flow scheduled between the start date and the expiration, or termination date if one exists, of the current lease. Remaining lease obligation cash flow is calculated based on the following formula: tenant base rent plus tenant’s reimbursement of property taxes and operating expenses (if required) minus concessions (if any) minus deal costs, minus lease termination fee (if applicable) minus landlord’s payment of property taxes and building operating expenses.
Re-tenanting of Vacated Space: This component of the model consists of landlord’s cash flow scheduled between the expiration/termination date of the current lease and the end date of the analysis. After current tenant vacates the premises landlord will start incurring the following re-tenanting costs:
- Downtime: This is a period of time during which the premises will not generate any income, but landlord will still be responsible for paying property taxes and building operating expenses associated with the premises. The default downtimes, used by the system, will vary depending on property type and location. For example, for office in Chicago the calculator will use 12 months downtime as default and will increase downtime length for spaces over 50,000 SF. Downtime is meant to reflect not only the amount of time it would take to find a replacement tenant and negotiate a lease, but also time necessary to complete space buildout. Obviously, downtime will greatly depend on local market conditions and premises type. Downtime can be adjusted in the Advanced Settings section of the calculator.
- Base Building Improvements: This re-tenanting cost is associated with renovating of common areas (lobbies, bathrooms, corridors) to make space more appealing for potential new tenants. This cost is mostly applicable to larger sized premises and heavily depends on existing base building conditions.
- Leasing Commissions: This re-tenanting cost consists of fees landlord pays to brokers – tenant rep. broker and landlord rep. broker. It should be noted that even though technically landlord pays brokerage fees upfront, these fees are amortized into rent and as such ultimately come out of tenant’s pocket.
- Abatements: This re-tenanting cost consists of free rent periods that landlord grants to replacement tenant as a concession in a new lease.
- Tenant Improvements Allowance: This re-tenanting cost consists of buildout allowance that landlord grants to replacement tenant as a concession in a new lease.
Replacement Tenant Lease Obligation: This component of the model consists of landlord’s cash flow scheduled between the start date and expiration date of the replacement tenant lease, following downtime. Replacement tenant lease obligation cash flow is calculated based on the following formula: tenant base rent plus tenant’s reimbursement of property taxes and operating expenses (if required) minus concessions (if any) minus deal costs, minus landlord’s payment of property taxes and building operating expenses. Replacement tenant lease obligation is determined by utilizing the building address to define current market leasing assumptions, which come from LeaseAlpha internal databases. Market leasing assumptions can be altered in the Advanced Settings section of the calculator.
It should also be noted that the term of the remaining current lease obligation added to the full term of replacement tenant lease in Scenario I may be longer than total duration of the restructured lease in Scenario II. The model is based on equating NPVs for the two scenarios and that is only possible to correctly accomplish on cash flows of the same length – matching discounting periods. As such, the model only uses the cash flow in Scenario I that fits inside of the restructured lease term. To preserve modeling integrity and to prevent unfair skewing of the results, the model automatically compensates by pro-rating all landlord’s re-tenanting costs based upon the exact proportion of replacement tenant base rent utilized in the model and accounted for during the analysis period.
Scenario II
Restructured lease obligation: This component of the model consists of landlord’s cash flow scheduled between the start date of restructured lease and the expiration date of the restructured lease. Essentially, this period of time is the total duration of the analysis. Restructured lease obligation cash flow is calculated based on the following formula: tenant base rent plus tenant’s reimbursement of property taxes and operating expenses (if required) minus concessions such as rent abatements and tenant improvements allowances (if any) minus deal costs such as leasing commissions, minus landlord’s payment of property taxes and building operating expenses..
Just like in any mathematical equation, LeaseAlpha calculator solves for one variable, while other variables are fixed. The model is set up to solve for starting net rent that would equate net present value of landlord’s cash flows of Scenario II to that of Scenario I. All other lease terms, such as annual rent increases, abatements, tenant improvements allowance, etc are drawn from LeaseAlpha internal databases. However, all lease terms variables can be altered in the Advanced Settings section to solve for any permutation of restructured lease terms.
LeaseAlpha model allows tenants to downsize their premises on lease restructure. In this case the model will automatically re-tenant the downsized space in the same manner as described above and will add resulting cash flow to Scenario II total.
Modeling Results and Potential Savings Summary
Once the LeaseAlpha calculator solves for the best possible early lease restructure deal, the system will convert that lease structure into tenant point of view cash flow and will automatically contrast it against the remaining lease obligation currently in-place over a comparable period of time. Potential savings generated by the restructured lease vs. lease in-place will be summarized in the Savings Summary report.
Advantages and Limitations of the Methodology
Any reasonable business owner or corporate executive would ask the following question: I still have term left on my current lease, why should I look at early lease restructure, which is required under the landlord point-of-indifference methodology? There are multiple advantages to employing landlord point-of-indifference methodology and restructuring your lease early – the top benefits are as follows:
- Restructuring the lease early may allow tenant to immediately reduce its cost of occupancy by lowering base rent and/or receiving abatements from landlord.
- Restructuring the lease early may allow tenant to receive a buildout allowance to be able to immediately start refresh of its premises, without waiting for current lease expiration.
- Restructuring the lease early may allow tenant to immediately downsize its footprint, if necessary.
It should also be noted that landlord point-of-indifference modeling methodology allows for fungibility of upfront concessions. If, for example, tenant’s space is dated, and the need for buildout allowance supersedes the need for rent reduction, the model can solve for lease restructure terms that increase the buildout allowance and decrease rent abatements without changing the net present value of the cash flows and therefore not altering landlord’s projected profitability. This flexibility can be applied to any variable in the restructure scenario (base rent, abatements, buildout allowance, term, etc.) – however, there are limitations. For instance, landlord may not be willing to agree to a very low base rent as it would set an undesirable precedent in the market or landlord may not want to grant an extremely large continuous rent abatement because it may interfere with landlord’s ability to service debt. A balanced deal structure is always preferrable, but there is almost always room for some flexibility.
Finally, a very important reason to explore early lease restructure is to maintain negotiating leverage. In order to achieve an optimal deal, you must start the negotiations early enough to maintain a credible threat of relocation. Start too late and the landlord knows you have little leverage with other landlords and even if a viable alternative is found, holdover penalties and business disruptions from the relocations come into play. With your leverage lost, landlord would be highly unlikely to agree to the terms provided by the LeaseAlpha model. Depending on the premises size and market conditions, finding a suitable relocation alternative, negotiating a lease, and building-out new space may take many months. Therefore, for larger tenants, it is not unreasonable to start the process a few years ahead of lease expiration date. It should also be noted that this methodology can be successfully applied if tenant’s current lease expiration date is far in the future, but tenant has an option to terminate its lease early with a penalty.
It is clear that landlord point of indifference modeling methodology for early lease restructure can potentially be very advantageous for a tenant, but why would a landlord agree to a lease extension early? The main incentive is surety of cashflow as the lease term now extends beyond previous lease expiration date. Longer in-place lease term mitigates landlords market risk of re-tenanting and increases the value of the building, which in turn allows landlord access to the most advantageous financing terms from the lenders. Additionally, it should be noted that even if landlord agrees to the best possible restructure terms for the tenant at the point of indifference, that deal would still be profitable to landlord. In vast majority of cases, restructure scenario would have a positive net present value of projected cash flows. By definition, it means that landlord’s internal rate of return (IRR) for the restructure cash flows would be significantly higher than the discount rate used in the NPV calculation, making it a desirable transaction.
Landlord point of indifference modeling methodology does have some limitations. For example, the methodology is designed for a situation where tenant is already leasing space; it is not suited for acquiring new spaces.
Additionally, as part of early lease restructure, this methodology requires lease term extension beyond current lease expiration date. In fact, longer term extension would result in a better restructure deal for tenant. As such, this methodology does not work well if the current location is not acceptable to tenant in the longer term.
Another potential limitation is the premises size for smaller tenants. The math in the model would still work, but in reality, landlord may be unlikely to focus on restructuring small size leases early.
As was stated in the previous section, this methodology works well when tenant needs to downsize as part of restructure, but if the tenant needs to expand the model would only be of partial usefulness. Since the model is based on equating net present values, the premises size must be the same for both vacate and stay scenarios. As such, the model would need to be run for best possible lease renewal/extension solution on current footprint before tackling the expansion space issue.
Landlord point of indifference modeling methodology is powered by a mathematical model, which depends on a number of user-supplied inputs. Just like in any mathematical model, the quality of inputs determines the quality of results. LeaseAlpha calculator will use internal databases to provide best available default values for advanced inputs. Although not strictly required for completing calculations, it is strongly recommended that user reviews all advanced inputs and makes changes as necessary for their current building and lease.
There are also multiple very important qualitative, non-economic factors affecting real estate leasing decisions. Such as, for example, building location, views, space layout, etc. These factors are qualitative and subjective; they are specific to each individual tenant and as such are outside of the scope of this white paper. The qualitative factors must be considered in concert with the landlord point of indifference methodology.
Finally, not every landlord is making decisions solely on economic factors – emotions are sometimes involved. Some landlords may simply refuse to negotiate based on the rational mathematical model informed by landlord’s point of indifference methodology. This issue is more common in the non-institutional segment of the market. That is why it is imperative that tenant start the process early enough to have suitable relocation options when negotiating with the landlord. This white paper talked about understanding landlord’s BATNA at length, but tenant’s understanding its own BATNA (cost of relocation options) is equally important.
Conclusion and Call to Action
Based on all the evidence presented above, it is clear that the landlord point of indifference model is the optimal methodology for determining mathematically proven best possible early lease restructure deal . However, it is only one step in the comprehensive strategy proposed for tenants’ use by Lease Alpha. We encourage every tenant to utilize the following strategy:
I: Start the process early to allow enough time to maintain negotiating leverage through credible threat of relocation.
II: Utilize LeaseAlpha calculator to determine landlord’s BATNA and solve for best possible early in-place lease restructure deal terms and start the conversation with the landlord.
III: Find acceptable relocation alternatives (tenant BATNA) to potentially move to after current lease expiration date.
IV: Compare costs of occupancy for the early lease restructure in-place to that of potential relocation options and leverage them against each other to negotiate the final deal.
LeaseAlpha recommends that tenant engages a broker knowledgeable in local market to facilitate negotiations with current landlord and to assist in finding suitable potential relocation alternatives. Utilizing LeaseAlpha calculator will provide tenant with a very important negotiating baseline, which will allow tenant to mitigate informational asymmetry that exists between tenants and brokers and manage the relationship with the broker more effectively, which should lead to better tenant outcomes.
If you engage LeaseAlpha, we will utilize our network of local tenant representatives to pair you with the best-in-class representation for your specific needs. We also provide full transparency and ensure you see what each entity involved in the transaction receives and a portion of these fees are returned to the tenant.
LeaseAlpha provides additional consulting services – we are available to advise tenants at all stages of the transaction and assist with all necessary quantitative modeling for the deal, including tenant point-of-view models comparing total cost of restructure in-place to that of potential relocation options.