The Invisible Hand Behind A Lease (It’s Economics)

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How is rent determined? Is it just tossed-out by one party or the other (most often the landlord) and then hashed out without reference to outside sources of information? A long time ago, market information may have been difficult to obtain. Today, that’s not the case. Those who choose to ignore market information negotiate in the dark. But, competitive rent rate information is not all that can or should go into negotiations.

If any reader is expecting Ruminations to now present a formula or algorithm that will eliminate rent negotiation, that reader gives us too much credit. We do think that the day will come when rent negotiations will be done between “machines,” but we neither see “when” that will happen or “how” that will work. Today, in what we hope will be a relatively short blog posting (for Ruminations), our goal is to toss out a theory of how rent is set while recognizing that no one will agree with us because we’ll be positing a theory involving “invisible” factors.

“Market rent” is a real thing. It may be difficult to ascertain precisely, but it is a number that reflects actual rents in the marketplace. Yes, defining the “marketplace” is an art and, yes, adjusting each lease in the market data bank to a “standard” is an art, but that doesn’t mean there isn’t such a thing as “market rent.” When one party or the other throws out a rental figure to start a leasing discussion, it is done with some sense of the market rent for the available space. The negotiations that follow, i.e., where they go from the starting figure, do so based on each party’s own sense of market rent and, even if both agree on the “market rent,” there still remains the duel between how much the tenant really wants “that” space and how much the landlord wants to lease “that” space.

Inartfully as we’ve expressed the concept that rental rates are rooted in market prices, Ruminations hopes readers get the point, basically, where there is market knowledge, rental rates remain in the marketplace “ballpark.” So, where do we go from there?

Let’s dive a little deeper into how appraisers take marketplace information and translate it into an opinion as to what the rent should be for a particular space. All of us know that in comparing properties in the database to the one for which a rent rate guess is sought, appraisers adjust for such factors as location, size, configuration, condition, and lots of other factors. Today, the point at which appraisers leave off (their opinion of value) is where we start.

Let’s assume that everyone agrees that the “market rent” for a particular space is $20 per square foot. Should the rent actually charged for that space be the same for every kind of tenant? We think the answer is, “No.” For example, a jewelry store should pay more than a cell phone store. That’s because a jewelry store brings far less customer traffic to a shopping center than does a cell phone store. And, the more traffic a shopping center has, the more its aggregate space is worth in the market place. Similarly, “brand” name stores should pay less rent than no-name or lesser-name stores for the same reason. In effect, having high traffic, well-known retailers at a property (or having destination retailers, such as sporting goods stores) boosts the average rent the property can get even though a “discount” is earned by those particular retailers.

Now comes an even more controversial thought, rooted in practical economics. Ruminations posits that such lease features as extension options, kick-outs, purchase rights, and even exclusive use protections should increase rent above the “base” market rent for a property. Patience, please. If the market rent was determined by looking at leases without extension options, then don’t such options add value to the tenant and take value from the landlord? After all, lease extension options, in nearly all cases, provide benefit to the tenant and are a detriment to the landlord. Thus, shouldn’t an extension option cost 25 cents per square foot? How about an exclusive use right? Why should the rent be the same with and without such a right? Did the “market rent” include the cost of such a right?

This isn’t a one-way street. A landlord should “pay” for a relocation right or the right to demand the tenant to remodel. And, those are just examples.

What we are thinking about are adjustments to the “market rent” based not on the physical characteristics of the space in question because those are already factored into an appraiser’s opinion of that “market rent.” We are directing our attention to specifics of the “deal” itself – the customized accessories being bought and sold beyond the physical space itself.

We know that almost all readers are now thinking: “Dream-on Ruminations, it doesn’t work that way.” What we want to know is, “How can you be so sure if we are right that these adjustment factors are invisible?” Here’s a practical application that has never ceased to amaze us. Trust us; there are lots and lots of negotiators out there for whom the following will come as a surprise lesson in “economics.”

It is not uncommon for a landlord to offer space at a particular rental rate and to include a tenant improvement allowance as part of the deal. Our impression is that when a “market rent” determination is made for office space, the market’s typical “improvement allowance” is factored into that determination. It is also our impression that retail appraisals don’t adjust for such factors because they are not common in the marketplace.

Shouldn’t the rent for a particular space with a tenant improvement allowance be higher than the same space without one? Of course! So, if the “market rent” anticipates an allowance, the “proper” rent for a space without an allowance should be lower that the nominal “market rate.” The reverse is true. Basically, a tenant improvement allowance is a loan from the landlord to the tenant, one that is repaid by way of higher rent. Surprisingly, this basic understanding comes as a surprise to a lot of lease negotiators, especially those working for tenants. And, there are a number of implications. Here are two of them.

First, if the initial lease term is 10 years, then at the end of the initial term, the rent should go down before it is further adjusted for then market conditions. To say that rent for the extension term will increase by X% above the 10th year’s rent ignores the economics. Similarly, to say that the extension rent is to be “market,” but not less than that in the 10th year is wrong. The 10th year rent included a disguised loan payment.

Second, if the allowance isn’t fully used, either the remaining amount should be paid to the tenant or the rent should be reduced downward. If the tenant improvement allowance can only be used for improvements and not for store fixtures, inventory, etc., then why should the landlord get both the higher rent and the unused cash?

How can this be handled? Here is a very basic approach, a lease provision starting point for those who haven’t seen this before:

Not later than 30 days after the later of when Tenant furnishes Landlord with a copy of the Cost Certification described below or when Tenant opens a fully fixtured, staffed, and stocked store for business with the retail public at the Leased Space, Landlord will pay Tenant a “Total Allowance” in an amount equal to $25.00 multiplied by the Floor Area of the Leased Space, in square feet, as measured on the Rent Commencement Date. Tenant, by request given in its notice, will have the right, but not the obligation, to draw less than the Total Allowance from Landlord. The amount of the Total Allowance actually drawn by Tenant from Landlord is referred to as the “Drawn Allowance.” The Total Allowance less the amount of the Drawn Allowance is the “Undrawn Allowance.” If there is an Undrawn Allowance, then the annual Minimum Rent due and payable to Landlord will be the Minimum Rent otherwise set forth in this Lease reduced by a Base Rent Reduction Amount. “Base Rent Reduction Amount” means the Undrawn Allowance divided by 10.

Adjust the economic facts as you wish. Perhaps “10” years isn’t the right number. Perhaps the adjustment should be adjusted by an implied interest rate. But, however you choose to argue with the mechanics of the “concept” clause presented above, don’t argue with its foundation – “There ain’t no such thing as a free lunch.” That can be translated into: “You don’t get something for nothing.”



  1. Just offering another method –

    When I am considering an acquisition, I do a “down and dirty” market rent assessment on a space by space basis. I consider a tenant’s expected sales – say $400/sf. I then multiply that expected sales rate by the appropriate percentage rent rate – 2-8% depending upon the category. I then factor in a sales growth rate for 4-5 years (with the logic being I want to set the rent at a rate that would allow them to achieve a natural breakpoint in 4-5 years). If it is a supermarket that I expect to do $900/sf, it becomes $900 x 2% = $18 x 1.03^4 (four years of 3% growth) = $20.26/sf.

    $20.26/sf is then the rate I use as net market for that space – plus any taxes, CAM and insurance and any amortization of TI (direct to tenant or extraordinary landlord improvements).

    I do that space by space, tenant by tenant, whether a tenant reports or not (You can do a pretty decent job estimating sales by observation).

    There are absolutely “market” rents that you can factor as you have suggested. But, I do find that if that market is too far above the method I suggest, it will be hard for a tenant to be successful in the long run. Too far below the suggested method (especially if there is not percentage rent), you are leaving too much on the table.

    • RLGunn Associates LLC says:

      Your down and dirty calculation will get you in the ball park assuming a natural breakpont for the lease. Not all retail leases have a natural breakpoint.

  2. Marc Ripp says:

    Dear Ira,

    The “use it or lose it” concept for an unexpended Tenant Improvement Allowance is eminently fair. Think of it this way. You buy a ticket to go the movies, but leave the show early; does the theater ever give you back a partial refund for the portion of the film you did not watch?



  3. The concept of “market rent” – which some refer to as the “going rate” – may be a starting point for a negotiation. But practically speaking, it’s application in a negotiation may be of only minimal value because, no matter what may be happening in other properties in the “market”, what drives any particular landlord is, not so much what others are charging but, instead, what he either: (a) needs at a minimum to satisfy his economic requirements; and/or, (b) what he can get away with charging. And each set of rental terms lives within a very broad specific contextual community. Among other things, that community is comprised of the following elements: location of property, type of property, demography, traffic count, visibility, parking, signage, co-tenancies, size of the space, length of initial lease term, renewal options, tenant credit, amount of free rent, amount of improvement allowance, amount and frequency of rent increases, rent inclusions and exclusions, space delivery condition, special considerations (such as go-dark, disability termination, assignment, expansion and purchase option provisions, etc.) and, particularly relevant – how long ago that comparative deal was structured. “Market conditions” (both on the street and within that specific property) that may have driven a deal a few – or many – years ago may be very different today. And that context reflects the degree to which a landlord may or may not be motivated to agree to any particular terms. And his willingness to grant concessions is a direct function of demand for that particular space in that particular property at that moment in time – taking into consideration his perception of current market conditions (as opposed to just rental rates). So there is no such thing as a “going rate”. Every lease negotiation is unique. If you wish to attempt to determine the worth of a lease arrangement based upon numbers that you hear on the street, make sure that you know the full context of each of those numbers in order to do an effective apples-to-apples comparison. In spite of what some might say about “market rent”, no two properties are alike (and properties which may be situated right next door to each other may have different location dynamics and landlords with different goals and capabilities), and each landlord has a unique economic model that must be satisfied for that specific space at that moment in time. So the success that a tenant might achieve in securing economic concessions from a landlord will, among other things, be a function, in no particular order, of:
    1. The demand for that space at that moment in time;
    2. The landlord’s current and projected (short term and long term) vacancy factor;
    3. His outlook on the future of the economy;
    4. His lender’s (collateral) requirements;
    5. His cash flow requirements;
    6. His property operating philosophy;
    7. His perception of the long-term viability of the prospective tenant;
    8. Leverage (perceived or real) that each player may enjoy;
    9. How much the landlord has already embedded in that space;
    10. How much he thinks he can get away with embedding in your starting rent to recoup his investment;
    11. Corporate (or stockholder) obligations;
    12. How knowledgeable the tenant or its negotiator is about the landlord’s negotiation needs and goals (and what he’s willing to trade for what – the relative value of the elements in play); and,
    13. How well the lease negotiation game is played.

    If the landlord is willing to grant some economic concessions, they may be in the form of free rent or improvement allowance or lower rent or some combination of those – depending upon the landlord’s operating philosophy, his capital resources, his obligations and the degree of risk he is willing to take with a particular tenant.

  4. RLGunn Associates LLC says:

    It’s good for attorney’s to have an understanding of the business and economic considerations. I would postulate that uniformity and predictability of the income stream has an impact on the cap rate and the overall financial strength of the lease. Uniformity and predictability in payment. Uniformity and predictability in the lease terms as well. A credit tenant can predictably pay the rent but, if the lease document is divergent from other NNN leases in the open market, that can decrease the value of the lease on the open market. Investor look for credit, term, and then start deducting for lease provisions that generate unpredictability and risk in the investment. I would suspect a doctoral thesis someplace that quantified the deductive value of non-conformative lease provisions.

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