As the economic shutdown from the coronavirus has forced many businesses to seek financial relief in the form of deferral, commercial landlords around the world are looking to find ways to help their tenants make it through these difficult times. Many businesses are facing insolvency from lack of revenue and they are looking for ways to cut costs and defer expenses. For some, especially those in retail, the biggest fixed cost that they have is their rent. The problem is that even if landlords want to help their tenants by deferring rent payments during this lockdown, they are worried about the implications it would have on the value of their buildings, as commercial buildings are valued based on their cash flow. Beyond just a hit to their returns, this loss of value can also negatively impact their standing with lenders and impair the owner’s ability to borrow money—or even trigger covenants that require additional capital be added to maintain loan-to-value ratios.
Many have turned to a type of lease extension that is referred to as a “blend and extend” transaction. This technique, often called “make whole lease extension,” grants a rent-free period that is paid back over the course of the lease, which is also often extended to account for the unpaid months. This is a great way to find an equitable agreement in an otherwise tricky negotiation. The process of blending the payments back into the remainder of the lease, at its most basic level, is similar to amortization.
Total Deferred Rent & Costs
Total Remaining Months
= Amortization (with no interest)
To calculate it you simply take the sum total of deferred rent and costs and divide them evenly by the total remaining months. Sounds straightforward, right? Well, unfortunately, the harsh world of compound interest and value isn’t that forgiving, nor is the complex rent structure of most commercial leases. When dealing with money over time we must revisit that most fundamental of financial calculations, net present value.
In order to take into consideration the time value of money an asset’s “present value” is calculated based on its future cash flow. This factors in a “discount” rate of future inflows and outflows since money later must be discounted against money today. Elementary net present value calculations, one with a fixed payback schedule like a mortgage, can be done on a financial calculator or in Excel. But when you account for all of the extra things that get added on to most commercial leases like free-rent deferral periods, rent, rent escalations, leasing commissions, improvement allowances, additional capital, operating costs, parking revenue etc, the models quickly fall apart.
To make matters more complicated, some tenants, particularly in retail and industrial, have deferred payback commitments for expenses like taxes, insurance, and common area maintenance. This creates a negative cash outflow, or carrying cost, for the landlord during the months that rent goes unpaid.
Now you can see what this is incredibly difficult to calculate. An equation with multiple variables like this that can’t be solved by even the most powerful calculator. In most calculators or in excel your equation has fixed coefficients that are kept the same over time. But to understand what is happening with something as complicated as a lease extension, you need an algorithm that keeps all of the inputs variable while you solve for the same value over time. Doing this means that you can easily understand the rent payment repercussions of making the lease longer or shorter.
To help us understand how this would be applied in the real world, we used F9Analytics’ Property Terminal, which uses mathematical algorithms custom designed for this kind of lease optimization. To help illustrate our real world lease example, we started by calculating what a blend and extend would look like. Let’s say we have a retail anchor tenant with 10,000 rentable square feet who is two and a half years into a ten-year lease. The monthly rent started at $10.00 per square foot and has scheduled ten percent escalations scheduled every five years. Let’s also say the original lease contract had a five percent leasing commission, a $40.00 tenant improvement allowance, and a combined CAM, tax, and insurance charge of $8.00 per square foot.
So, now lets say that 31 months into the lease the tenant requested a six-month rent deferral (months 31-36) that also included non-payment of common area expenses.
How much would we have to increase rent, if we extended the original lease for an additional six months (from 120 to 126 months) by targeting the original net present value ($316,027)?
The answer is that the tenants original base rent schedule would need to be increased by precisely 11.13% beginning in month 31 for the remaining term.
This means that after the deferral period the tenant would have to pay a new base rent of $11.11 per square foot versus the current rent of $10.00 per square foot, every month including steps, for the remainder of the new “blended lease” in order to pay back the lost rent and expenses carried by landlord. With this number in hand, and the explanation of how it was calculated landlords approach struggling tenants with a truly fair arrangement. No one likes to be taken advantage of and this is a great way to make sure that no one feels that way.
While being able to calculate the payback is important, it is also critical to remember that every one of these blend and extend lease agreements is a negotiation. In a perfect world, tenants would be able to afford the additional rent and pay back their obligations over the course of the lease (plus six months added on). But, if this virus has taught us anything it is that the world we live in is not perfect. Struggling tenants might be unwilling to agree to this higher rent payment. If this is the case, it might be best to solve this for another variable. For tenants who are able to agree to an increased payment, you can then examine how much the lease would have to be extended.
If we take the same scenario that we explored earlier, we can see what this would look like in application. Let’s now say that the tenant requests a lease modification that only extends the original lease term while keeping all other financial terms equal. When solving for this, it tells us that the lease would need to be extended for another twenty-five months in order to precisely preserve the original lease’s contract value, inclusive of a one-time partial month “make-whole” payment of $301.81 due landlord by tenant.
In each of the lease scenarios above the present value increased with time, however, one can easily see that the computed annuities of the original lease and the restructured lease are targeted over time (including partial months when a one time make-whole payment is due). This is how the lease value is precisely preserved. If we take these two annuity amounts over the new lease term, we see how the original lease value and the restructured lease value are equivalent. They are in financial terms time-money equal.
Twenty five months might seem like a long time to add on to a lease, but it brings up a mathematical consideration. Leases get more valuable the longer their terms are because the cashflow is locked in for a longer period of time. But, many tenants and landlords don’t like to lock themselves into long term arrangements if the market is robust. For landlords right now, who likely expect very little price appreciation in most markets for the foreseeable future, locking these contracts in for an extended period could be a very wise move.
We are at a turning point for the real estate industry where both landlords and tenants are faced with hard decisions. The relationship between the two has always been somewhat adversarial, after all, every dollar the tenant doesn’t pay comes out of the landlord’s revenue. One of the silver linings of this pandemic is that this might change. Landlords don’t want to see their tenants break their leases or go bankrupt, especially with the uncertain economic outlook that the shutdown has created. With creative solutions like blend and extend leases the two parties can help each other weather this storm. Hopefully, this article has helped you understand the computations of this type of lease extension. For further help calculating these annuities check out this great resource.