How a Bad Lease Can Damage the Value of an Industrial Building
One of the reasons people choose to invest in industrial property is that with a solid, long-term tenant in place, the owner can collect relatively passive income. This is particularly true if the tenant is on a triple-net (NNN) lease where they pay for the bulk of their expenses, and if that tenant is also paying market rents that continue to escalate from time to time.
Of course, not every owner is so lucky.
In fact, those who sign bad leases will find that long-term tenants can actually hurt the value of their industrial property.
What is a “Bad” Industrial Lease
There are a few indicators of a bad industrial lease. The first is when a property has been leased below market rents. This often happens when a long-time owner becomes complacent. They are not up to speed on current market conditions and therefore, agree to lease rates that are simply too far below average. Let’s say the market rate is $5 net/SF per year, a long-time owners may lease for $3/SF if they “feel” that’s sufficient.
Another mistake that owners make is when they sign gross leases, even if those leases are at market rents. For example, an owner might hear that the asking rate is $5/SF and in turn, they negotiate a lease at that rate—but they use a gross lease structure. Gross leases are all-inclusive. The tenant pay a lump sum each month that includes their pro rata share of the building’s taxes, utilities, insurance and other costs. Instead, the owner incurs these costs, which quickly chip away at their annual cash flow. The best industrial leases will be market-rate, NNN leases.
Long-term leases are another sign of a bad industrial lease. Some landlords will opt to sign 10, even 20-year leases with their industrial tenants. They do so for the stability that these leases provide.
Long-term leases are another sign of a bad industrial lease. Some landlords will opt to sign 10, even 20-year leases with their industrial tenants. They do so for the stability that these leases provide. The only time a landlord will want to sign such a long-term lease is if they are doing so with an extremely credit worthy tenant (e.g., Amazon leasing a distribution warehouse). Moreover, long-term leases should always be negotiated by a broker who is building in appropriate escalations to allow for regular rent increases.
How Industrial Owners End Up With Bad Leases
There are usually two reasons why industrial owners end up signing bad leases.
The first is in situations where they are desperate. This tends to happen at single-tenant buildings. If the prior tenant vacates, the owner must quickly re-lease the property. Otherwise, they end up paying for all carrying costs in the interim. A property that sits vacant for even a month or two can completely erase an owner’s cash flow for the year.
When owners are desperate, they are more willing to accept lower rents than they would otherwise. “Something is better than nothing,” they might assume. However, if they sign a long-term lease at below-market rates, this can substantially impact the building’s value.
The second situation is when owners are trying to save on broker commissions. The owner might think a lease is relatively straightforward, and in turn, may decide to negotiate with the tenant directly. This is penny-wise and pound-foolish. Owners who try to negotiate their leases directly often leave significant money on the table, especially if they negotiate a bad lease in the process.
How Bad Leases Impact Industrial Property Values Here is an example to see how a bad lease can directly impact property values.
Let’s say a 100,000 SF property is leased for $3 net/month per year. This equates to $300,000 in annual income. Because it’s a net lease, we can assume that the owner’s operating expenses are minimal. Let’s say operating expenses are $25,000 per year. This translates into $275,000 in net operating income, or NOI.
If a property is leased at too low of a rate, investors will discount the value of the property.
In commercial real estate, owners and investors use cap rates as one way to value the property. The cap rate is calculated as follows:
Cap rate = NOI / Property Value
Owners will often say they need to achieve a certain cap rate (essentially, a rate of return) on a given property. Let’s say an owner wants to get a 5% cap rate. Here’s how that impacts the purchase price.
Property Value = $275,000 / 5% cap rate
This would make that building worth $5.5 million based on existing cash flows.
Now, let’s say the property was leased for $5 net/month per year. The expenses are the same. This equates to $475,000 in NOI per year.
Property Value = $475,000 / 5% cap rate
That same property is now worth $9.5 million. This is a staggering $4 million price differential!
As you can see, investors are willing to pay more for properties based on their in-place cash flows. If a property is leased at too low of a rate, investors will discount the value of the property. In some cases, if a lease is expiring, an investor might be willing to pay more than what the cap rate would otherwise suggest—with the assumption that they’ll quickly raise the rents to market-rate which will then boost the NOI. However, if the lease allows for multiple tenant renewals at fixed rate increases, this could dramatically impact the property’s value.
If the lease allows for multiple tenant renewals at fixed rate increases, this could dramatically impact the property’s value.
How to Prevent Leases From Hurting Your Industrial Property Value
1. Always hire an experienced leasing broker. A leasing broker will be able to advise you on market conditions, market terms, and other ways to maximize the value of your industrial leases. Increasing NOI is the best way to improve your property’s value.
2. Always consider using NNN leases. NNN leases provide future owners with the greatest flexibility. It separates the base rent from expenses, and provides a cushion for owners if expenses start to rise.
3. Limit lease term and renewal options. While long-term leases can be great, they can also prove to be problematic if not negotiated carefully and with exceptional tenants. In most cases, industrial landlords will want to utilize 3-5 year leases (7 years max) with no more than 1 to 2 renewal options.
4. Do not use fixed rate escalations. Many owners will have a standard 3% escalation per year built into the terms of their lease. This approach is great if the market softens, but in other cases, landlords will quickly find themselves with below-rent leases if market conditions remain strong. This is especially true during periods of high inflation. Currently, a 3% increase would not even be keeping pace with inflation!
If you’re ready to maximize the value of your industrial property, contact us today. Our team of brokers would be happy to review your leases to ensure you’re getting the most value out of each.
About the ComReal Miami Industrial Team: The ComReal Miami Industrial Team has been assisting companies with their South Florida real estate needs for over 30 years. The industrial team specializes in the sales and leasing of industrial properties. Visit Warehouses Market and/or call 786-433-2380 for more information.
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