One of the most important pieces of retail investment analysis to understand is the lease. A lease is a written legal agreement between the landlord and the tenant that sets out the amount the tenant will pay in rent. How much time does the tenant legally commit to staying; any additional payment from the tenant for taxes, insurance, or maintenance, rent increases; renewal clauses and options; and all rights, privileges, and liabilities of the lessee and lessor? These are the types of leases you will face when you consider investing in shopping centers.
Everyone has their wrinkles and requirements, so pay attention to small differences:
· Gross lease:
The landlord undertakes to pay all operating expenses and charges the tenant rent in addition to operating expenses. The types of expenditures covered include taxes, insurance, management, maintenance, and all other costs associated with the operation of the property.
· Modified gross lease:
This lease is slightly different from the standard gross lease compared to certain operating expenditures — such as maintenance, insurance, or utilities — that are not paid for by the lessor and are transferred to the lessee. These expenditures are called transfer expenditures because they are transferred to the lessee. Many office buildings use modified gross leases.
· Net lease:
In a net lease, renters pay the operating costs of the property, and the homeowner earns a certain amount each month by charging the rent in addition to the total operating expenses. This lease is favorable in many respects. It is favorable to the owners because they are not responsible for the running expenses of the property. It’s favorable to tenants because they can repair their stores as they see fit and maintain and clean them. Net leases are generally customized to meet tenant requirements. This type of rental is most often used by retailers. The landlord looks after the maintenance of the common area, and the expense spreads between the tenants and is charged to them.
The various levels and types of net rentals are as follows:
· Single net lease (N):
In one net lease, the lessee undertakes to pay the property taxes. The owner assumes all other operating expenses.
· Double net lease (NN)
In a net double lease, the tenant commits to pay property taxes and insurance. All other expenses related to the operation are the responsibility of the owner.
· Triple net lease (NNN):
A triple net lease is more favorable for owners and is one of the most popular these days. Tenants agree to pay the landlord's rent plus any other expenses associated with the property, including taxes, insurance, and maintenance. The homeowner receives a real net payment. Banks, fast food restaurants, and basic renters generally use triple-net leases. Core tenants are large tenants, generally, the tenant occupying the most space. Anchor tenants are vital to giving value and safety to a retail mall investor. Their signs are usually the greatest and can be distinguished. Large retail chains are generally base renters and are referred to as such because they attract other businesses to the mall location. They "anchored" the mall.
A common clause used in net leases is the stop-spending clause, which states that any amount greater than certain fixed expenses will be billed to the tenant. The fixed expenditure is an amount agreed upon between the lessee and the owner. A major revenue generator for landlords is to construct a percentage of the sale clause in the lease. Under this clause, the lessor receives additional payment from the lessee when the latter achieves a certain volume of sales or certain profitability.
For example, suppose a hamburger restaurant agrees to pay 3% more in gross sales after sales have reached a certain level. The lessor would receive the 3 percent plus the regular lease payment. Even though retail leases are long-term — say, 5 to 15 years in length —it's not uncommon for rents to go up or up in the middle of the rental years. For example, you could get a 5 percent rent increase once every five years until your lease expires. Now that you have all this information on leases, it's time to analyze an agreement. Here’s the deal:
A 36,000-square-foot retail hub anchored by a large chain of pharmacies is in the center of the city, right on the way to progress. That's three hectares of land. The retail center is made up of eight stores of different types, ranging from a bagel store to a post office. All leases are three nets (NNN), with the landlord charging tenants to maintain the common area (CAM). The CAM for the homeowner is $3,000 per month and includes landscaping, parking, corridors, and washrooms. Now you must separate this whole thing into its three simple components of income, spending, and debt.
Here’s the income breakdown: Gross income = 287,000
In terms of the breakdown of expenses, given that it's a triple-net lease, the tenants pay all the operating expenses. The owner initially pays all maintenance expenses for the communal area, but then CAM's expense is charged and divided amongst the tenants. Therefore, there's no expense for the landlord to determine how the debt would be distributed, you need to understand what the annual loan payments would be.
We will assume that the current interest rate is 6.5 percent with a 30-year amortization period:
· The asking price is $3,100,000
· Down payment = 20 percent of the asking price, which is $620, 000
· Loan amount (principal) $3,100,000 - $620,000 = $2,480,000
· Loan payment per month$15, 675 (we used a mortgage calculator for this figure) Loan payments per year (debt service) = 15,675 * 12 months = $188,100
Now you have everything you need to determine if this agreement is making money, using these four simple steps:
· Calculate the net operating income (NOI)
Net operating income = effective gross income - operating expenses $287,000 - $0 = $287,000
· Calculate the cash flow
Annual cash flow = net operating income - debt service
$287,000 - $188,100= $98,900
· Calculate the cash-on-cash return
Cash-on-cash return = annual cash flow ÷ down payment
$98,900/$630,000= 16 percent
· Calculate the cap rate
Cap rate = net operating income ÷ sales price
$287,000/$3,100,000 = 9.3 percent