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Why Broker Net Effective Rents are Meaningless

When a commercial real estate landlord or broker calculates net effective rent (NER), they take the total amount of concessions, such as tenant improvements, divide it by the term of the lease and then deduct that amount from the monthly asking rent. But it’s my contention that NER is meaningless. Allow me to explain. To start, lets begin with a basic leasing example.

Let’s say that you have a leasing budget to re-tenant what we will call a single-tenant building. In this particular example, with the exception of leasing commissions, your working capital account as “landlord” has exactly $80.00 per square foot remaining for tenant improvements – that’s it. To summarize, your bank account balance less leasing commissions is $8,000,000 (or $80 in Tenant Improvements x 100,000 square feet).

Table 1 has the inputs written out.
Table 1
Within a week of closing on your single-tenant building, a tenant approaches you through a broker and would like to lease the space. They are perfect candidates. Well established, willing to stay for the long haul.

But, there’s a catch. The tenant requires $150.00 per square foot in tenant improvements – not the $80.00 you had budgeted.

What do you do?

The old-time broker says “no problem, I have a spreadsheet that will compute Net Effective Rent (or N.E.R.), which will easily determine where we need to be in terms of rent to make up the difference.” The broker uses his old rule-of-thumb calculation and arrives at $30.79 per square foot in starting rent.

It is precisely at this moment that you as landlord identify two fundamental problems with this method. One, where does the additional $70.00 per square foot come from? And two, what is the cost of capital required to sign this lease?

By simply raising starting rent to $30.79 per square foot, your landlord bank account doesn’t automatically fund itself with the additional $7,000,000 required to sign the lease – it must be borrowed. This is the logical conundrum of what we now know as broker net effective rent. It not only makes no sense in pricing leases (as in this example), but also has no premise in the broader property markets where landlords must always weigh the cost of borrowing with their ability to profit. This is especially important in high interest rate environments that, though we haven’t seen in a while might only be around the corner.

Now, let’s look at direct comparison between broker net effective rent and the common net effective rent, which we will call “Net Effective Rent – Standard.” This method has been recommended by one of North America’s largest consortiums of property investors, comprised of institutional public and private investment companies, Real Estate Investment Trusts, life insurance companies and pension funds.

The key difference between the two net effective rents should be self-evident. One includes the time-value-of-money “cost of borrowing” (in either debt/equity or WACC), and the other ignores it completely.

From our example we have assumed that the debt will costs 10% per year. With this factored in, as seen in Table 2, the differences to the landlord could not be clearer.Table 2As you can see, there is a huge disparity between these two, seemingly similar methods. A building owner can be out literally millions of dollars by failing to ignore the cost of the capital for the tenants improvements. The broker’s NER is just a way for the broker to get what they want, to close the deal. But its short sightedness can be costly to both the landlords and tenants. No tenant wants to be in a building heading for financial trouble.

While dealing with the harsh realities of costs of capital and the time value of money can mean that some deals must fall through, it insures that no surprises are met down the road. Taking into consideration the amount of money and complexity that goes into the purchasing of large assets, leasing them should require the same amount of scrutiny. In the end, we should never lose scope that a commercial property is just a portfolio of well-priced leases.

As we examine all of the ways that technology is changing the CRE landscape let us not forget that so much of what we do comes down to the details. If we don’t get those right, no amount of sensors or algorithms will save us from the repercussions of a downturns that has been exacerbated by using inaccurate metrics like broker Net Effective Rent.

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