Question

a) WHY might a tenant prefer a lease with higher effective rent than an alternative with a lower effective rent?

b) describe the most common method used to specify rent changes over time for a commercial lease?

c) What factor tends to make both owner and tenants prefer longer term leases all else being equal?

d) A prospect tenant has presented two lease proposal to the owner of the office building .The first alternative has a five years term

and a contract rental rate of $ 16.00 per square foot in the first year of the lease.The rental rate then steps up 3 percent per year

over the remainder of the lease term.So ,for example ,the rental rate in year 2 (13-24) would be $16.48.

The second lease alternative is also a five year lease with an initial contract rate of 16.00 per square foot.

However the rental rate on this lease is indexed to inflation with the adjustment made at the beginning of each year based on the

actual rate of inflation in the previous year.

The owner of the office property project that inflation will run at a rate of 3 percent per year over the five -year lease term.

1) What are the owner's project payment over the five years term for the two alternative?

2) Which option in the owner likely to prefer and why?

Answer 1

In lease there is a contract between two parties for use of an asset against which rent is paid.

The person who owns the asset is called lessor,or landlord and receives the rent,

the person who uses and pays the rent is called lessee or   tenant.

a) WHY might a tenant prefer a lease with higher effective rent than an alternative with a lower effective rent?

First understand,what is effective rent it is considered to be the Present value of expected cash outflows for tenant, and inflows for lessor.

Every tenant wishes to secure his position hence fot the following reasons he prefers to have higher effective Rent because of some flexibility considerations

1.space cost= For tenant this helps to decide the term of lease if term is longer he may prefer to pay high effective rent also because he would not wish to incur releasing cost like disruption of production, reimbursement to lessor .

2..Expectation of future rent: tenantexpects that future rent may rise and if he prefers long term lease such expectation would allow him to pay higher effective rent to protect from rent rise

     

b) describe the most common method used to specify rent changes over time for a commercial lease

methods used are

1.Graduated rent:In this menthod lease payments are lower in the beginning and increase at certain fixed interval during the term of lease.It is mentioned in the contract.

2.Fixed Rental agreement:this is the most common method where a time period of lease is specified after which it renews if agreed, however in case of termination 30days notice is required .It also mentions oin the contract in expenses that has to be borne by the tenant.

3.An indexed lease: This lease is dependent upon the movement of certain index.Such index are used to adjust for change in cost of living.Index on which lease can be based could be consumer price index(CPI) most common.

4. Fixed percentage Method:this is a very straightforward method where rent will increase on the basis of fixed percentage on a specified date during the lease term.(it is usually between 2% to 5% of present rent)

c) What factor tends to make both owner and tenants prefer longer term leases all else being equal?

In leasing there is Releasing cost which the

· Cost during vacancy( Revenue lost by lessor)

· Search cost (commision to be paid,time ,delays etc)

· Moving expenses( disruption in production of the tenants business, reimbursements to lessor)

Hence both the parties lessor and lessee find it better to go for long term lease inorder to minimize their releasing cost.

Also another factor is INTERLEASE RISK(this is risk of replacing one lease with another subject to uncertainities)

Uncertainities like:Space market risk=it is associated with the market rent and demand for the space over the term of the asset, any unexpected changes in demand of the space market risk will affect the asset.

(eg if a large number of people are allowed to work on a small space area the demand for space falls hence rent is also affected)

d) PART D

1) What are the owner's project payment over the five years term for the two alternative?

Rental rate on this lease is indexed to inflation hence inflation is 3%(example of indexed lease method)

Rent per square foot	16
Projected after inflation		16.48	16.97	17.48	18.01
working		(16*1.03)	(16.48*1.03)	(16.97*1.03)	(17.48*1.03)

2. Which option in the owner likely to prefer and why?

Owner is the lessor or landlord and landlord will always try to save his cost and increase revenue.

1.Hence owner will prefer the method where rent is dependent on inflation fluctuation

2.AS unexepected rise in inflation which will increase owners operating cost hence when tied up with inflation index owner can shift the impact of inflation on tenant and recover his cost increase..

3.Therefore in this he can shift unexpected rise of inflationthe tenant as even the revenue will increase in the form of rent.