Commercial Lease Terms
In a previous blog, I introduced Commercial Lease Terms for Due Diligence. Based on that article I have had a few requests for more information. The following are some of the most frequently asked questions after Due Diligence begins.
Tenant Improvement Allowance:
As a rule of thumb we give an allowance of about $5.00 a sq. ft. for cosmetic rehab or renewal incentive. If you are bringing in a new tenant with a complete build-out, you may be looking at closer to $15.00 a sq. ft. If you are purchasing a property with a TI be sure the work has been completed and paid for prior to the purchase or receive a credit from the seller for the liability.
I believe this one causes confusion because I have seen it used in two very different ways. Some real estate professionals will refer to a finished unit as a turnkey unit, meaning what you see is what you get. No allowance for improvements just turn the key and use the space. These types of units would have very little upfront expense for the landlord. The other way Turnkey is used is to imply completely furnished or equipped as in all the tenant needs to do is walk in. Clearly there is a wide spread in these operating costs so be sure to ask the necessary questions to determine your ongoing costs.
The next few items are numbers the lender will review.
This is the percentage of expenses to the Effective Gross Rent (EGR). When you are analyzing Office, Retail, and Industrial there will be variations based on the tenant expense reimbursement for Net, Net Net or Triple Net Lease. While apartments still have some variations, you can assume that any expense ratio under 30% may be suspect to a lender. A newer building may have an expense ratio of 30 to 35%, but most apartments will be 40 to 45%. In order to stay on top of current trends and variables, you may want to investigate the National Association of Realtors reports “Income and Expense Ratio – Apartments” and “Income and Expense Ratio – Office.”
Difference between Initial Capital Improvements and Reserves for Capital Improvement:
The Initial Capital Improvements are items that you will do within the first 12 to 18 months of ownership to improve or repair the asset. Often the lender will want to see this money in a reserve account prior to approving the loan.
Reserves for Capital Improvement are funds you are setting aside to insure the ongoing integrity of the asset.
Initial Capital Improvements will depend on the current condition of the property however the following are guidelines for a few commercial products.
Capital Expense Reserves:
- Apartments: $300 per unit per year
- Retail: between 3-5% of Effective Gross Rent
- Office: between 3-5% of Effective Gross Rent
- Industrial: between 2-4% of Effective Gross Rent
*A conduit loan may be .15 per sq. ft. per year for Office and Industrial
- Self-Storage: between 3-5% of Effective Gross Rent
- MHP: between 3-5% of Effective Gross Rent
One final item to remember is the importance of professional management in securing your financing. Even if you plan to self manage your onsite personnel, please build in approximately 5% of the EGR for asset management. If the lender will consent to self-management, the money is in the budget to compensate you. If they require licensed approved management, you have the funds to cover the expense.
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