Real Estate Finance
The property owner is considering four separate alternatives for leasing available space in the building for the next five years. There are many things to examine when offering a space for lease. A company needs to make sure they are providing the best quality space for the best price. There is a discounted rate on each option of 9%. “Growth records suggest there is often a genuine advantage in leasing rather than in owning equipment.” (Bower, Herringer, & Williamson, 2001) When you are leasing property, and something breaks you just call the landlord. However, if you buy a property, you have to handle that something that breaks.
1) The builder is offering to rent the building at $15 dollars per square foot for the first year with an increase of $1.50 per year for the remaining four. In this option, all the operating expenses will be paid by the tenant. Moreover, at the end of the lease, the tenants will be paying $21 per square foot. With the calculations, the present value for this lease agreement with the discounts will equal $69.01.
2) Lease the space using a consumer price index adjustment. This is where the rent will increase by 3% each year. The increase and the rent will go up each years starting at $16 dollars a square foot. This option will give the renter at 9% and a total savings of $65.75.
3) Charge gross lease rental of $30 per square foot per year, and the lessor will be responsible for payment of all operating expenses. The expenses are estimated to be $9 during the first year and decreased by $1 per year thereafter. Total present value for this option is $88.79.
4) The building owner will charge lease rental with a consumer price index adjustment. In this case, the gross lease will be $22 for the first year with an increase of 3% per year after the first year. The operating expenses, in that case, will be paid by the lessor and will stop at $9 per square foot. Total present value of net lease rental, in that case, is $55.40.
In any real estate deal whether that is a purchase agreement or rental agreement, there will be a risk. This is where “the term due diligence is used in the real estate investment community to describe the investigation that an investor should undertake when considering the acquisition of a property.” (Brueggeman & Fisher, 2011) This is an investment and the less risk, the better for the lessor.
The riskiest option is the fourth option. The consumer price index is risky because of the uncertainty of the rent. Expenses will be paid by the owner of the building and are at a fixed rate. Having the building owner at a fixed rate and the lessor having uncertainty on their rent make this option the riskiest.
The second riskiest option is option two. There is much uncertainty on this lease agreement too. Here as well the rent is not guaranteed beyond the first year. Like the fourth option, this is another consumer price index lease. Without the ability to forecast the future it is hard to know cash flow and future earnings.
The third risky option is option one. This is a valid option because the tenant knows that their rent will be going up each year by $1.50, and can budget for it. So, if the tenant can keep their expenses low, this might be the best option. However, if the business is planning to expand and have more expenses, this would not be the best option.
The least risky option is the 3rd option. This is where the lessor charges a set amount per month. The operating debts are paid by the lessor. There is also the advantage of the rent decreasing by a $1 every year per square foot. The lessor gets a good deal with having a tenant in the space for a long period.
The advice is to go with the lease space option three, one, two, then four. Having a fixed rate of monthly rent and expense helps a company budget and save for the future. Having rent and expenses changes from year to year can cause a company to worry about the future and have lots of uncertainty.
Bower, Richard S, Herringer, Frank C, Williamson, J. Peter. Accounting Review. Apr6, Vol. 41 Issue 2, p257-265. 9p Database Business Source Elite http://eds.b.ebscohost.com.proxy-library.ashford.edu/eds/pdfviewer/pdfviewer?vid=10&sid=eaa77219-1010-45bc-8030-82f491bad9c6%40sessionmgr102
Brueggeman, W.B., & Fisher, J.D. (2011). Real estate finance and investments (14th ed.). McGraw-Hill Irwin. ISBN: 9780073377339