Suppose a mid-sized accounting firm wants to expand its footprint by renting office space in a new city. After visiting several spaces, they narrowed it down to two options. The options have similar rental rates, but the company wants to save capital, so they need to figure out which one is cheaper.
To solve this problem, they need to identify and analyze all the cash flows from each lease and discount them back to the present time. This process is known as comparative rent analysis and is the subject of this article.
How to conduct a comparative lease analysis?
At its core, the process of comparing two or more leases is an exercise in identifying the detailed costs (cash outflows) associated with each, when they occur, and how much they are. Once these pieces of information are obtained, they must be “discounted” to the present time to account for the time value of money.
The time value of money is a concept that states that a dollar today is worth more than a dollar in the future because of its ability to be reinvested and earn interest. Because lease cash flows occur in the future, they must be “discounted” to the present time to determine their “present” value.
The “net effective rent” can be calculated from the present value, which is the total gross rent divided by the number of monthly periods in the lease. This figure accounts for rental concessions or free rent, so it’s an accurate measure of the true cost of the lease.
Thus, the comparative lease analysis can be reduced to two steps:
- Identify all the cash flows associated with lease payments, then calculate the net present value using a discount rate and a financial calculator or spreadsheet program such as Excel.
- Calculate the effective rent by converting the net present value into an annuity of the same level.
Once these steps are completed, the output provides an objective view of the costs associated with each lease and allows the analyst to determine which is cheaper. While these steps may seem simple in theory, they can be a bit more complex when applied to a real-life scenario. To illustrate how comparative lease analysis works, let’s look at two examples, one simple and one more complex.
Simple Comparative Rental Analysis Example
Suppose a company is trying to choose between two leases for 10,000 square feet of commercial real estate. Each of the lease terms is for three years and does not include free rent or additional payment for operating expenses.
Lease A has a base rent of $20 per square foot with an escalation of $1 per year. As a result, rents for the entire term are $20, $21, and $22 per square foot.
Lease B has a base rental rate of $19 per square foot with an escalation of $1.50 per year. As a result, rents for the entire term are $19, $20.50, and $22 per square foot.
To calculate the net present value, assume the discount rate is 10%. The following table summarizes the calculation:
The lease comparison table shows that the net present value (NPV) for lease A is $52.07 while the NPV for lease B is $50.74. This completes step 1 of the effective rent calculation.
These values are then used as input when converting to an annuity of the same level. To do this, the spreadsheet function “PMT” can be used with the following variables:
- Rate: 10.00%
- Number of periods: 3
- Future Value: $0
- Current value: NPV of lease payments
Please note that we use a discount rate of 10% and in practice this is usually your opportunity cost or cost of capital. The following table lists these values for lease A and lease B:
The result of the calculation is that lease A has an effective rent of $20.94, while lease B has an effective rent of $20.40. From this output, real estate professionals could reasonably conclude that lease B is the cheapest option.
The example above gives a good introduction to the effective rent calculation, but is too simplistic. In reality, the rental terms of commercial real estate are not that simple. There are other variables that are often included in the financial analysis, such as tenant improvement and expense reimbursements. To account for the impact of this, let’s look at a slightly more complicated example.
Example of Advanced Comparative Lease Analysis
In this example, we’re exploring two more complicated lease types, but we’re doing the same basic analysis. The proposed lease is for 3,000 square feet.
Lease Option 1
In the first option, the rent parameters are as follows:
- basic rent: $20 PSF, increasing 3% annually
- Operating costs: $5 PSF, increasing 4% annually
- Parking costs: $1.50 PSF
- Moving costs: $4,000
- Obligated Improvements for tenants: $15,000
- Improvement tenant Allowance: $10,000
- Lease term: 3 years
These additional variables complicate the lease analysis as they all need to be accounted for in a cash flow model. We prefer to use a template for this. By entering the above information, the following cash flows are projected:
In year 0 of the model, the capital expenditure line item represents the initial out-of-pocket cost of entering into the lease. $15k tenant improvements will be offset against the $10k fee and added to the $4k moving fee. The total cost for year 0 is $9,000 or $3 per square foot.
As of year 1, the base rent is $60,000 ($20 PSF, per year) and operating expenses are $19,500, which is a sum of refundable operating expenses and parking fees.
When costs are added to the base rent, the total outflow for the first year is $79,500. This increases each year based on the modeled rent and cost increases.
The net result of this analysis yields the cash flows as shown in the following table. When discounted at a rate of 8%, the net present value and annual net effective rent statistics can be calculated. A summary is shown in the table below.
Let’s see how this result compares to lease option 2.
Lease Option 2
The second option is an entirely different lease. The parameters are:
- basic rent: $19 PSF, an increase of $0.50 cents per year
- Operating costs: $6 PSF, increasing 4% annually
- Moving costs: $6,000
- Obligated Improvements for tenants: $17,500
- Improvement tenant Allowance: $12,000
- Lease term: 3 years
When these parameters are entered in the analysis template, the result is summarized in the table below:
The year 0 cash outflow is $11,500, which represents the net tenant improvement costs plus moving costs.
Year 1 cash outflow is $75,000, which equates to base rental costs plus total tenant costs. This increases each year based on percentage increases.
The cash flows are summarized in the table below in which the Net Present Value and Net Effective Rent are calculated:
With this information it is now possible to compare the two leases side by side to see which one is cheaper for the tenant.
Lease Comparison Summary
The following table shows both sets of cash flows side by side:
This result shows that lease 2 has the lower total cost, net present value, and annual net effective rent. For this reason, it can safely be concluded that this is the cheaper option. But. this does not necessarily make the better option. There may be other non-financial considerations that may lead the tenant to choose the more expensive option. Maybe it has a better location, interior functionality, covered parking, nicer finishes or is next to a train stop.
The broader point is that comparative lease analysis is useful for determining the financial costs associated with two or more options. However, the cost is only one piece of the puzzle. There are other intangible factors that a renter can take into account that could lead them to opt for the more expensive option. However, it provides an excellent starting point for comparison and should be completed when comparing two or more lease options.