The commercial real lease should be customized to each Landlord-Tenant relationship through negotiations. The investment in commercial real estate should reflect the risk appetite and investment requirements of the investors. How do you know if it’s a good investment, based on your standards? Commercial real estate investing should be a very tailored, customized to the investor, and the legal, regulatory landscape, as well as the economic marketplace, can affect the investment decisions. Certain information is required to be disclosed, and it’s done under GAAP standards in the United States. GAAP means Generally Accepted Accounting Principles.
How Do I Know If the Lease is a Good Investment?
Until December 2019, private companies can categorize a lease as a capital lease or an operating lease. A capital lease is reported on the balance sheet, and an operating lease is in the footnotes. This reporting loophole has been around about 40 years, and the powers that be have decided it needs to change, since it contributed (among other factors) to the Dark Times CRE endured during the early 2000s.
Investors didn’t have the information they needed to make truly good investment decisions regarding commercial real estate. So they sometimes made bad ones, and that brings us to where we are today, and the need to close this loophole.
What Difference Does It Make to an Investor?
The updated standards now provide for financing (not capital) lease and operating leases. Finance leases are treated pretty much like capital leases, though, and it all goes on the balance sheet, so all of the information is there. But it costs time and effort to track all of this and account for it on the income statement, and, of course, it affects the amount of available cash on hand. Here’s the trick: if you lease is 12 months or less, it can be an operating lease and go in the footnotes. Otherwise, it’s on the balance sheets. You want to keep that lease expense in the footnotes and off the balance sheets, it’s gotta be no more than 365 days for the term.
Short term leases are hip, trendy, and oh-so-in. Tenants like the ability to sign up for a lease that’s as agile and nimble as they are. Plus, short-term commercial real estate leases are usually gross leases. The rent payment is a premium price, but it’s a predictable. There are no pass-through expenses that fluctuate and are beyond the control of the Tenant, even though the Tenant has to pay for some or all of them. Co-working, shared space and pop-shops with curated, ever-changing content are really focused on these short-term “novelty” leases.
Now there’s even more incentive to have a short-term lease; it’s advantageous to the balance sheet reporting requirements, and the Tenant can leave if Landlord won’t negotiate a reasonable lease amount and incentivize Tenant to remain and renew.
Landlords only have rent income to cover their expenses, including building maintenance and attracting and keeping Tenants. Instead of passing through the additional expenses to Tenant, and keeping rent as income, and doing this for years, Tenants are looking for competitive rental rates. Landlord has to budget, plan, and forecast carefully to keep gross rent rates at a competitive amount in the market but enough to cover the operating expenses. Shorter-term leases mean higher expenses, as Landlord has to recoup the expenses over a less-predictable lease duration, and higher potential turnover means higher potential costs, such as advertising and marketing the now-vacant space. The long-term capital expenses and building improvements, which need to take place, won’t be predictably recaptured, because the tenant might not stick around.
The entire valuation model for a commercial building could be altered as a result. The gross lease means rent payments are going up, which further encourages shorter-term leases for tenants, who can move at the end of the term to a less-expensive space, or the Landlord has to offer financial inducements to keep Tenant in place after the expiration of the year lease ,OR there will have to be some sort of financial break for Tenantto take the hit to the balance sheet to stay in a longer-term lease.
The Landlord has less certainty. An absolute triple net lease is now more expensive to Tenant, which means less money to pay in rent to Landlord, especially when the NNN expenses, are high.
This article does not create an attorney-client relationship. This article is for general education purposes only and is not legal advice. You should consult with a qualified attorney before you rely on this information.