Many tenants don’t realize that when it comes to leasing office space, they will pay for everything they ask for or are offered by a landlord. HOW a tenant pays, however, can depend on a number of factors.
To understand what is built into a typical office lease rate, let’s first look at how a landlord arrives at the Net or Basic Rent.
Net or Basic Rent vs Tenant Improvement Allowances
Say the net rent of an office space is $18.00 per square foot per annum and the landlord is including a “tenant improvement allowance” of $30.00 per square foot. What this means is that the landlord will provide the tenant with a $30.00 psf allowance toward the cost to complete whatever office improvements the new tenant is asking for as part of the $18.00 psf net rent. For a 10,000 sq ft office space, the landlord would be including a $300,000 allowance. On the landlord’s side of things, that tenant improvement allowance amount is already built into the $18.00 psf lease rate. In other words, it’s essentially being repaid by the tenant as part of their ongoing monthly lease payments over the term of their lease.
Alternatively, a landlord may offer the same lease at $12.00 per square foot per annum and state that any improvements requested by the tenant will be amortized over the term of the lease and added to the $12.00 per square foot net rent. For example, if the same $30.00 psf allowance or $300,000 based on 10,000 square feet is amortized over a 5 year lease at a discount rate of 8%, the cost per square would be $7.30 psf per annum. If we add the $7.30 psf to the net rent, the total rent the tenant will pay will be $19.30 psf per annum.
Net Effective Rates or NER
Regardless of the approach used, the landlord usually has a predetermined number they are aiming for when calculating the actual dollar amount per square foot that will be left after allowing for all the costs to either entice the tenant to lease the space and/or cover any tenant improvement allowances. This predetermined number is know as the Net Effective Rate (NER).
Essentially, enticements like free rent, tenant improvement allowances, moving allowances and real estate fees are all components of the NER calculation. In simplistic terms, if the landlord’s predetermined NER goal is, say, $10.00 psf, but the Net Rent is $15.00 psf and the total of all inducement, allowances and fees offered to the tenant equal $45.00 psf based on a 5 year lease term, the NER will work out to only $7.00 psf. The landlord, in this case, would then aim to increase the Net Rent to cover the shortfall.
Suffice to say, most if not all landlords will have done their NER math BEFORE putting together any special enticements, and as a prospective tenant it won’t be a matter of IF you’ll be paying for those enticements but rather WHEN and HOW.