The Ying and Yang of a Commercial Lease
When looking to buy a Commercial Property there are many factors at play that you need to dig into. Whether it’s Retail, Industrial or Office. In this instance, we’ll discuss a Retail Lease.
Agents will only highlight a few items. The rent and yield, the lease term plus any options and the covenant (tenant). The main factors for a Retail Lease are the location, the tenant, the agreed rent and the costs of doing the deal (incentives).
From a landlord's perspective the quality of the covenant (tenant) is just as important as the rent if they are looking for lease tenure, especially in suburban retail strips. If a landlord signs a national tenant on a rent that gives them a good yield (returns) for 6+ years with annual rent increases of CPI they will have a good investment.
Few tips to consider when looking to buy retail premises or negotiating a new lease considering the psyche from both sides – landlord and the tenant.
Tip 1: Location
A strong retail strip is what everyone is looking for. Naturally a retailer wants a strong retail location for higher traffic, which will hopefully lead to higher sales. Landlord wants a strong location as the property will hopefully be in high demand and easier to lease. The rent will be higher, but so will the cost of buying the property. What you need to consider as a landlord when negotiating the term? Do we need to offer a long lease term with multiple options? Can we obtain greater rental growth by renegotiating the lease to the existing or a new tenant in 5 years? Will the downtime in rent and incentives outweigh the rental growth if we replace the tenant? If the objective is to secure long-term consistent returns, then you offer the tenant a long-term lease with lease options.
Tip 2 - Options
What are the benefits of a Lease Term with options.
A tenant usually has to exercise their lease option before knowing what the new rent is. In most cases the rent review mechanism when a tenant enters a new lease option will be by Market Rent Review. A Valuer then assesses all the rents in that area, calculates the average rent and that becomes your Market Rent. Usually, rents do not decrease in a Market Review. If the property is located in a strong retail precinct with all rents increasing annually by either CPI or a fixed percentage then all rents naturally go up.
What if it’s in a location that’s not in high demand? In this instance a Retailer may have alternatives to relocate their business at the lease expiry because they can find a better deal even after fitout and relocation costs. Even with options, they won't exercise that option if the current rent being paid is too high for their business.
Tip 3 – Negotiating Options or Lease Renewals
Local agents will tell a retailer this is the market rent therefore that’s what you need to pay. Is that rent relevant to that retailer's business? Is that rent reflective of the operating costs of that retailer? Different retailers have different margins and wage costs, which in turn determines how much rent they can pay.
A medical practioner will have lower turnover, but higher margin. A café will have a higher turnover but higher wages & food costs. A Pharmacy traditionally has higher margins and pays higher rents as opposed to a discount retailer that has low margins. So, there is no one rent for all retailers.
Tip 4 – Due Diligence
There are obvious items to consider when doing your due diligence on a property. Namely the lease; such as the rent, lease terms, rent reviews, special conditions and make good clauses etc. You will no doubt get a Building and Pest report. Two items which in my experience account for 80% of all issues in retail premises.
The air conditioning and the roof. How old is the air conditioning? Has it been maintained properly with records of the servicing? The last thing you want to do when buying property is to replace the air conditioning.
What condition is the roof in? Has there been any evidence or history of leaks? Again, you don’t want to buy a building that has a roof like a patchwork quilt that you will have to replace. How do you know if these two items are an issue, especially if nothing shows up in the report? Ask the tenant! The best due diligence is to go and speak to the tenant, especially the staff that work in the store. They will tell you everything that is wrong with the building in the hope that you will but it, be a great landlord and fix all the problems.
After 20 years in the Commercial world these are just a few items I have encountered in my time. If you are looking to gain more insights into the above and how I can guide people and businesses in navigating the complexities of commercial property, please feel free to get in touch.
Peter Jarjoura