If you buy a commercial property with the intent to lease out the space, or are about to renew a lease on a property you own, here are some things to consider when determining your lease rate.
The Income Approach:
Your lease rate is used to calculate the value of your property in a valuation method called The Income Approach. Even if you don’t intend on selling your property, the valuation of your property based on the lease rate should be a deciding factor. You don’t want to devalue your property by setting the lease rate too low.
For example, if you bought a 5000 sf warehouse and paid $500,000, you would need to rent that space for $8/sf NNN. Most investors are going to want a return of 8% or so, called the cap rate (referred to as an 8 cap). The valuation is calculated as follows; 5000 sf x $8/sf=$40,000, $40,000/.08=$500,000. If you are able to get more than $8/sf, your property will be valued higher than $500k, and your return will be greater than 8%. The opposite is also true, if you get less than $8/sf. This is a very simplistic example. In reality, many other factors need to be taken into consideration, such as lease type, cap rate used, property owner expenses (if not NNN), reserves, property maintenance responsibilities, property condition, deferred maintenance, etc.
Market Rent Rates:
The Income Approach is very important, but so are market rent rates, which are ultimately based on supply and demand. If you need your space to rent for $8/sf NNN to justify the purchase price, but the market rent rate for that location is only $7/sf NNN, then you may have paid too much for the property. The property would only be valued at 5000 sf x $7/sf=$35,000/.08=$437,500. As you can see, the Income Approach valuation method should also be used when purchasing a property to determine a good purchase price.
Competition:
The last point I’ll make in this piece is to set the rent rate competitively. Hopefully, you are able to justify the property valuation and still have some flexibility with the rent rate. If you paid $400k for the same 5000 sf building at an 8 cap, you would only need to rent the space for $6.40/sf. If the market rent rate is $8/sf, you have a lot of flexibility. If other similar properties are renting for $8/sf, you may want to consider leasing your space for $7.50 or $7.75/sf. When potential tenants or their agents search for properties to lease, your property will be a first consideration. Those same potential tenants may end up offering you $8/sf depending demand and how well your property fits their business need.
I will not go into depth here, but your lease terms matter a great deal as well. What is the lease structure, how long is the lease, are their annual escalators, are there renewal options, does the tenant have Right of First Refusal (ROFR), etc.
When you are ready to sell your property, if all the above has been taken into consideration, and applied correctly, you will be able to maximize the selling price of your property.
If you have considered, or are ready to sell your property, please give me a call at (813) 995-5544 to discuss your property in detail, and how we set ourselves apart from our competition.
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