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Major differences in commercial versus residential leases
When evaluating commercial investment property, it’s best to take into account the major importance the property’s leases play in determining overall value of any given property. Commercial leases differ in several key ways from residential leases, and greatly affect the market valuation based on these differences. Here are the key elements that differentiate them, and why they play such a major role in property value…
Viability of tenant
In commercial property investing, always consider the credit capacity of any prospective tenant. While this is important in residential property management as well, it is more crucial in commercial investments, where longer-term leases come into play. You’ll need to feel very assured that the tenant you’re installing on a long term agreement has the capacity to pay you regularly each month. With tenants that have little or no track record, you, as their landlord, will need to ask for some form of personal guarantee to back up their lease agreement.
Length of lease term
In residential real estate, a one year lease is pretty standard. Two years would be rarer. But in commercial property investing, terms usually start at three years, and can extend many years out in many cases. Additionally, lease options allow prospective tenants to renew at certain years in their overall lease contract. Sometimes rent bumps are included as part of the overall lease. Sand sometimes rent bump options are included. As a landlord, anything you can do to lock a tenant into as long a lease term as possible is most beneficial to your bottom line. You’ll also want to keep the number of renegotiation periods (in the guise of rent bump options) down to a minimum. Not only will this help you be able to count on a set revenue stream down the road, but you won’t have the need to renegotiate at a future date with the same tenant either.
This also has a major effect on the total valuation of your commercial property. The more long term leases you can lock tenants into, without options, the more “set” you property will be for the future – especially when it comes time to sell your investment. Any new prospective investor will look at all your leases, see how set in stone they are, and a market valuation based on non-negotiable terms will be much easier to arrive at. And remember, the less future negotiating that’s required, the less turn over, with all its concomitant time, energy and fees (like commissions and repair costs) associated with installing new tenants.
Lease arrangement factors
Most property investors in commercial real estate want to try to negotiate triple net (NNN) leases with prospective tenants. In a triple net lease, a base rent is negotiated, and tenants are required to pay for all operating expenses associated with their premises. These long term leases tend to also build in rent bump increases pegged to some inflation average. This helps the landlord avoid future negotiations with his tenants. As mentioned above, it also helps “set” the future market value of any given commercial property.
Allotments for options
Commercial tenants and landlords tend to be diametrically opposed on the key issue of allowances for renewal options. While tenants like them for the ability to reevaluate their expense and space needs every few years, landlords want to ensure that tenants stay in place as long as possible, with rent increases set in stone in terms of regular inflationary bumps. So commercial landlords tend to be very stingy with requests from prospective tenants for any form of lease term option. Keep in mind that this may not always be a good decision on the part of a commercial real estate investor.
While locking tenants in is great on one hand, it also can be damaging on the other, in the fact that a landlord must then live with his decisions for a very long time. If he wanted to change the make-up of his commercial building to attract a different class or type of business operation, he would not be able to do so if he had no options built in to the original lease with his tenant. This could also affect future valuation of his property if a landlord finds, down the road, that he is lagging behind in collecting current market rents. So sometimes, locking a set of tenants into no-option style leases can be ultimately damaging to a commercial property investor.
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