It’s assumed that determining the expense of leasing property involves a simple calculation of multiplying your base rate times your square footage. In reality, the total cost of occupancy includes many additional expenses that can dramatically increase a company’s real estate expenditures. If you don’t understand all of the factors or work with a real estate adviser that does, they could cause a significant impact on your earnings and cash flow.
“Many companies make the mistake of focusing on the lease rate to determine their costs.” says David Salazar, senior vice president with CresaPartners LLC in Orange County. “They think they’ve negotiated a great deal, but they don’t understand that the total cost of occupancy includes several additional factors.”
Smart Business spoke with Salazar about some of these hidden costs and how to anticipate and minimize them.
What are the main fixed costs associated with leasing?
A number of fixed costs contribute to total leasing costs. To start, companies pay the base rate for the square footage they occupy, called usable square footage. In addition, a ‘load factor’ is added that determines the total rentable square footage. The load factor is the difference between what the tenant actually occupies plus an allocation of the common area square footage, such as corridors and the lobby area. The tenant then applies the rental rate to the total rentable square feet.
Also, if a property owner does not pay for all the construction costs for the build out or reconfiguration of the space, the tenant will have to pay the difference or ask the owner to amortize the difference into the lease rate, adding additional monthly costs.
Finally, a rate escalation may occur on the base rate on a periodic basis. The escalation may occur on an annual basis or some other interval that is negotiated.
What variable costs apply to leased real estate?
When deciding on a building, companies need to keep operational expenses in mind. For instance, as electrical and water expenses increase, they will be passed on to the tenant. Another variable cost could be a change in ownership. Every time an investor sells real estate, the government reassesses it. Taxes increase because of the higher assessment, and these costs pass through to the tenant. Other variable expenses may include:
- Parking costs, reserved and unreserved
- Insurance costs
- Capital improvements
- Property management fees
An adviser can audit the sometimes vague charges to ensure accuracy and appropriately reflect the tenant’s responsibilities.
How can companies calculate the total cost of occupancy (TCO)?
There are several methods for calculating your TCO, with the following formula providing the basic pieces:
Base Rate (+ Escalations) x Size (+ Load) + Expenses (parking, electrical, etc.) + TI Amortization = TCO
The most common way to calculate the potential leasing expense is to determine the ‘effective rate’ over the term of the lease. The effective rate is the average rate paid over the term after taking into consideration factors such as free rent and rate escalations. Rate escalations can either be fixed or be tied to an inflation index, such as the Consumer Price Index.
What other hidden costs contribute to tenants’ expenses?
Businesses should be aware of clauses that include the following;
- Capital expenditures: Many times, a landlord will build a new lobby or outdoor fountain and try to pass the cost on to the tenants. Tenants should not have to pay for capital expenditures.
- Management fees: Tenants need to pay standard property management fees, but sometimes managers will add additional charges for functions such as managing construction projects. Such expenses may not be appropriate.
- Early termination fees: Even if a lease allows a business to terminate prior to the lease expiration date, it is critical that a tenant understand the penalty involved, which may include unamortized commissions and tenant improvements.
- Hold-over costs: If tenants delay moving out of the building at the end of the lease, they should beware that penalties can be as high as 150 percent of the last month’s rent.
They key to understanding your total cost of occupancy is to retain an adviser that specializes in representing tenants/users of space and has the knowledge and experience in negotiating leases before they are signed.
DAVID SALAZAR is senior vice president with CresaPartners LLC in Orange County. Reach him at (949) 706-6600 or email@example.com.