How Complicated Can We Make It?

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Last week, we presented a wonky piece about present value calculations and their use. We won’t repeat that or extend those thoughts this week, but within last week’s quantitative jungle was a qualitative thought. Basically, we showed that stepping through annual rent increases doesn’t really produce a much different “total rent” than “keeping it simple” by using a level, average rent over the term of the normal lease. Today, we will spit out some other places where “going complicated” or trying to “refine” the financial terms in a lease also show little benefit and some offsetting detriment.

Before we do so, here’s a little more about setting rent. Last week, we suggested that instead of doing a five year lease with per square foot rents of $10, $11, $12, $13, and $14 over the five years, using the average rent of $12 per square foot would be almost the same in “present dollars” as using the $1 annual increases. We thought a reader or two would point out that there are non-economic reasons to use a graduated rent table. We would point out, that aside from the gender clause (and the like), all provisions of a lease are economic. No reader pitched in. So, we’ll do so (a little) on our own.

First, there is a psychological basis for starting with $10 and not $12. It seems cheaper. It isn’t, but $10 and rising just seems like a better deal than starting at $12.

Next, hope springs eternal and starting at a new location could be financially risky (for a “small” business) and $10 per square foot is easier to pay when the doors first open. Of course, $14 per square foot at the end of the lease’s term might be a little difficult to swallow for that same business, but hope springs eternal and maybe annual revenue will grow at, or more than, the rate at which the rent increases take hold.

Being at $14 per square foot at the time of lease renewal, instead of at $12 per square foot, sets an “anchor” for the rent after the 5- year term. Of course, the “right” rent at any time is “market” rent, but expectations are important factors when it comes to negotiation.

[A website out of Harvard University offers this explanation of “anchoring”:

Anchoring is a cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered (the “anchor”) when making decisions. During decision making, anchoring occurs when individuals use an initial piece of information to make subsequent judgments.]

Lastly, not all lenders and buyers do “fancy” present value calculations and will look at the higher rents in the later years of a lease as an indication as to what the property’s revenue will be.

Except for our observation that we sometimes complicate things to no economic advantage, none of what preceded this point is what we had in mind for today. Here’s what we had in mind.

We’re thinking things like the landlord who wants a lease with annual percentage rent increases of, say, 3% over the course of a 10- year lease, but is afraid of “inflation.” So the landlord negotiates for annual increase of the greater of 3% or the previous year’s increase in the Consumer Price Index (CPI). The wrinkle is that the landlord offers a fixed rent table over the ten years and only deviates from the pre-determinable annual rent if the CPI for that year turns out to be more than 3%. Said simply, after a great deal of back and forth with its prospective tenant, the lease calls for each year’s assumed rent to be based on a fixed schedule of 3% increases except for years where the CPI increase for the previous year exceeds 3%. After those years, the rent table “snaps back” to the 3% annual increase “table” subject to some minor adjustment if the CPI continues to exceed 3%.

For those who are wondering, here is a table of CPI increases over the last 10 years (using a national index):

2016                1.3%

2015                0.1%

2014                1.6%

2013                1.5%

2012                2.1%

2011                3.2%

2010                1.6%

2009                -0.4%

2008                3.8%

2007                2.8%

2006                3.2%

Of course, we don’t have a crystal ball, but we can tell you that the expected “extra” rent resulting from years where the CPI exceeds 3% is unlikely to cover the legal fees for drafting the provision and the rent negotiation will likely delay the store’s opening.

But, this customized way of dealing with CPI- adjusted rent increases just seems “smarter.”

[We readily concede that landlords and tenants are entitled to make their own business deals and there is no reason why those deals need to match the “norm.” And, if convolutions are needed in order that parties can agree on a deal’s business terms, then that’s a good thing. But, sometimes complicated deals are just that – complicated, and nothing more.]

How about going back and forth to refine a negotiated “month-to-month” written lease? How much is it worth to have one’s attorney’s draft such a lease? After all, if the landlord doesn’t like the tenant (or vice versa), can’t it just terminate the lease? The same can be said for obsessively negotiating a one- year lease.

We could create a long list of minor items, insisted on upon by one party or the other, that delayed getting to execution or disproportionately increased the cost of getting to an executed lease. And, we would only list items that really have no measurable effect on the overall economics of a deal. We won’t. If, however, any readers want to offer “war stories” along that line, we invite them to do so.

Years ago, we invited chief executive officers of engineering and defense businesses to write short essays for graduating engineers, essentially giving those graduating engineers a “little piece of career advice.” We received pieces from the heads of some of the largest such companies in the United States. We remember only one of those pieces of career advice, an essay imploring those graduates to “think green” in their engineering projects – Don’t let the perfect be the enemy of the good. That’s pretty good advice for our business as well. Sometime, we should let well enough alone.

Bonus – Ruminations has one more tidbit of a thought and has never found a way to make a worthwhile blog posting solely about this thought. So, we decided to append it to the end of today’s posting. Here it is.

Who thinks that underlining or bolding or italicizing words in an agreement changes the meaning or interpretation of those words? Has any reader ever seen the result of a contract dispute turn on those? If you have any thoughts or experience in this regard, please share it with our other readers.

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Comments

  1. Bolding or italicizing is to make it harder to claim the other side didn’t know what they were agreeing to. Some laws require certain provisions to be prominently displayed for the same purpose. So it doesn’t change the meaning but it does weaken a defense.

    I see annual escalations more with unsophisticated tenants. You can’t tell them to pay $12 for 5 years if the going rent for a 1 year deal is $10. They hope to be around 5 years but don’t know that they will be.

    The CPI clause is a form provision and costs pennies to draft (changing the % and adding the month of escalation. We older folks — you included — lived through higher inflation days and saw their effects on fixed rent deals. So of my clients prefer them.

  2. Marc Ripp says:

    Underlining, italicizing, bolding, capitalizing and enlarging font size are all stylistic techniques that convey urgency, create emphasis and focus attention on the effected words. In so many jurisdictions, “time is of the essence” clauses that are not clearly and unambiguously dramatized in this way risk being struck down as unenforceable.

  3. Howard Burns says:

    $10 now or $12 now makes a huge difference with low cap rates and the Landlord selling immediately AND selling will likely trigger a big tax increase expense on the tenant in a NNN lease. How about $12 flat for TEN years, not five as the profit potential on a quick sale after lease signed could be huge

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