The crazy alchemy of commercial real estate; how commercial landlords turn (your) pennies into (their) dollars.

By John Jarvis

As a commercial real estate broker, sometimes I feel like I am haggling over pennies. When rental rates are quoted on a monthly basis, we can be negotiating for days over $.05 per square foot! Are we crazy? Is this sheer lunacy? It sure doesn’t sound like a lot of money when it is put in these terms. But it is a lot of money, especially for landlords. Here is why.

The value of a commercial property as a leased investment is simply a multiple of the rental rate. The multiple is called the “cap rate.” I apologize, but we are going to have use a little math here. Suppose the monthly income – rent less expenses – is $2.00 per square foot, which equates to $24.00 per square foot per year. That $24 is the annual return from the property investment. When the commercial property owner goes to sell the property, they will be selling that $24 per year income stream and looking for the highest bidder. And since the return is fixed at $24, the highest bidder is, by definition, the investor that is willing to settle for the lowest return, and by extension, offer the highest price. Get it? If they want a 10% annual return, then they are willing to pay $240 per square foot for the property. Here is the math: $240 x 10% = $24. Simple stuff, right?

What confuses most people is when we turn the equation around and call it a cap rate. The cap rate is simply the investment return, based on the known annual income. If the property yields $24 per square foot per year and it is selling at a 10-cap, then the sale price will be $240/SF. Investors today are actually willing to settle for a lot less, sometimes as low as or lower than 5%. At a 5-cap, that $24 annual rent is worth $480 per square foot! Again, here is the math, this time using division rather than multiplication: $24 / .05 = $480!

Now that you understand cap rates, we can take a fresh look at our lease negotiations from the landlord’s perspective. That $.05 per square foot per month that we are haggling over with your landlord? In today’s 5-cap environment, that $.05 per month is worth $12 per square foot when they sell the property. ($.05 per month is $.60 per year, divided by .05 equals $12). If your building is 20,000 square feet, that $.05 in monthly rental rate can deliver an extra $240,000 to the landlord when they sell the property! If your building is 80,000 square feet, that nickel is worth close to $1 million!

This helps to explain why the rental rate is often the one point on which the landlord is the least flexible. It also explains why landlords offer up “free rent” to support a higher rental rate. They may propose to raise the rent by $.10 per month, and offer a few months of free rent in exchange. Potential buyers are often willing to ignore a modest amount of free rent that was offered at the outset of a lease, which has since burned off. And using the math outlined above, $.10 per square foot per month could yield the landlord an extra $2 million on an 80,000 square foot building!

Pennies? You bet, and they certainly add up. So I will keep haggling over pennies, and nickels and dimes and dollars. As for alchemy, I’ll leave that to the landlords and lunatics.