Financial Modelv1.0.2

Net Effective Rent: One Lease, Two Methods

Take an executed office lease's rent schedule, free rent, tenant improvement allowance and leasing commission, and compute its net effective rent two ways: the straight-line average public REITs report, and the present value a lease or a public tenant uses to compare offers.

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Learning objective

Learners will compute the net effective rent of an executed office lease, after free rent, the tenant improvement allowance and the leasing commission, two ways: the straight-line average public REITs report and the present-value rent used to compare lease offers. They will explain why the two figures differ.

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The default deal

Zuora's 2019 office lease, as filed with the SEC: 100,328 rentable square feet for 127 months, $446,460 a month in the first year, stepping up 3% a year, seven months of free rent (months 6 to 12, $3,125,220), and a $100 per square foot TI allowance ($10,032,800). The lease does not state the leasing commission, so the model uses DLC's retail rates as an example: $2,195,284. The scheduled rent averages $61.80 per RSF a year. Spread evenly over the term, the free rent costs $2.94, the TI allowance $9.45 and the commission $2.07, and the straight-line net effective rent is $47.34. Counted in present value at 5%, the same items cost $3.68, $12.40 and $2.71, the rent itself is worth $60.97, and the net effective rent is $42.18. The same lease, two numbers: $5.16 per RSF a year apart, $518,059 a year on the whole space, 10.9% of the straight-line figure. The lease rounds each month's rent to the dollar, so its schedule totals $65,618,149 against the model's $65,617,997.

Two methods, two numbers

The same lease gives two net effective rents, depending on who computes it, and each method is consistent on its own terms. Public REITs report net effective rent as a straight-line average: PS Business Parks and Duke Realty define it as the average annual rent over the lease term, on a straight-line basis and without operating expense reimbursements, and Cousins Properties takes leasing costs off base rent to reach it; the accounting behind those reports spreads free rent evenly over the term (Orion Office REIT, Form 10-K). A lease or a public tenant that has to compare offers uses a present value: Repligen's lease defines net effective rent as the net present value of everything the tenant pays, with free rent and tenant improvement allowances taken into account, and the federal government discounts each offer year by year and counts free rent in the year it is given (GSA, RLP Template R100A, Section 4.04). No source prescribes one method for every purpose. The difference between the two numbers is the free rent and the TI allowance: the straight-line average spreads them evenly over the term, and the present value counts them when the money moves, at the start.

The leasing commission is an input

The leasing commission is an input, because the lease does not state it. The default rates come from DLC Realty's management agreement (Section 8.2): 5% of the base rent payable in the first five years of a new lease and 2.5% in the sixth through tenth years. That agreement covers retail property and the default case is an office lease, so the rates are an example of how a commission is structured, not office convention; replace them with the commission in the actual listing agreement. The model takes the commission on the rent payable after the free rent, applies the second rate to every year after the fifth (including the seven months of year 11 that DLC's ten-year schedule does not reach), and pays the whole commission at signing, where DLC pays half at signing and half over the first three months of possession.

1. The Lease

The terms of one executed office lease, each as the lease states it, and the two inputs the lease leaves open.

B7Rentable Square Feet (RSF)

100,328 SF

The premises' rentable area, the basis for rent quoted per square foot.

B8Monthly Base Rent, First Year

$446,460

The base rent due each month in the first lease year, before any free rent. Operating expense reimbursements are not part of it.

B9Annual Rent Escalation

3.00%

How much the monthly base rent steps up at the start of each lease year.

B10Lease Term

127 mo

The number of months the tenant pays rent for, including the free months.

B11Free Rent (Months, First Year)

7 mo

Months of base rent the landlord abates in the first lease year.

B12Tenant Improvement Allowance per RSF

$100.00/SF

What the landlord pays toward building out the tenant's space, per rentable square foot.

B13Leasing Commission, Years 1 to 5

5.00%

The commission rate on the rent payable in the first five lease years. Not in the lease: the default is a retail example.

B14Leasing Commission, Year 6 Onward

2.50%

The commission rate on the rent payable from the sixth lease year to the end of the term. Not in the lease: the default is a retail example.

B15Discount Rate

5.00%

The annual rate used to bring each year's money back to signing. No source prescribes it; the default is the federal government's.

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