“The value of a building is based almost completely on the cash stream, which comes from a tenant like you paying rent every month. Without steady cash flow, the building is just an empty box with limited value as real estate.”
In other words, the rent you pay creates the value in the building that you lease!
You might remember this from 3 Things You Need to Know About Your Landlord’s Finances, where we discussed the importance of researching the debt financing and ownership structure of the building and the landlord’s portfolio.
Coupling this knowledge with a deeper understanding of how your rent creates the building’s value will enhance your negotiation position.
Let’s take a deeper dive into value creation. A general understanding of real estate investment finance will help you to elicit the lowest cost lease.
Understanding ROI and building value
Most tenants believe that their rent is essentially the return-on-investment (ROI) for the landlord. They aren’t wrong, but there is more to the story.
The landlord’s ROI is dictated by a couple of things.
- Capitalization Rate (Cap Rate)—the name for ROI percentage in real estate and
- Market conditions—impacted by interest rates, supply and demand, and opportunity costs amongst other things.
What is a Cap Rate?
A Cap Rate is similar to a Bond Yield. The length of the lease term is like a bond maturity; just like Bond Yields are inversely related to Bond Pricing, Cap Rates are inversely related to Building Valuations. They behave similarly because they are essentially the same thing:
Coupon Rate ÷ Bond Yield = Price of Bond
Annual Rent ÷ Cap Rate = Building Value
In both cases, the income stream (Coupon Rate or Annual Rent) is fixed. The investor makes money from a bond or a leased building by selling at a higher price than they bought it for—which would be at a lower cap rate/ bond yield.
While the cap rate isn’t the only determinant in building value, it is a term you’ll hear frequently, so let’s talk a bit about it.
How do Cap Rates work, in practice?
Let’s say you signed a 10-year lease for a 200,000 square foot building and you have agreed to paying a market rent of $4.00 per square foot, or $800k per year. If your landlord paid $10 million for the building, (s)he is making an 8% return—or an 8-Cap.
What if Cap Rates go up?
If later that year Cap Rates increase to a 9-Cap an investor who wants to buy a comparable leased building could expect a 9% return. In order sell the building at a competitive return, your landlord would have to sell at a lower price than (s)he bought it for. In this case, that would be around $8.9 million.
What if Cap Rates go down?
When cap rates decrease, the building is often worth much more than it was at time of purchase. For instance, if Cap Rates drop to 7%, the building would now be worth more than $11.4 million, a big premium over the $10 million that the owner paid.
How do you benefit from understanding Cap Rates and building value?
Consider how this alters your view on the rent you pay. If your rent increases from $4.00 per square foot to $4.20 per square foot, this does not mean that your landlord is simply collecting an extra twenty cents on 200,000 square feet. This means that that extra twenty cents created over $570,000 of value in your landlord’s building.
When you understand the real value of the rent you pay, you have leverage before negotiations even begin! This understanding provides you with more tools to extract the very value you are creating. Set yourself up for success by researching
- Building value,
- The landlord’s debt structure, and
- Comparable rents in the area.
Collectively, this information gives you insight into how much your landlord is hoping to earn from the rent you pay. Rent is not only a measure of how much money your landlord collects every month, but is also a critical component of creating value in his/her real estate asset!
LOWER RENT = LOWER VALUE
The landlord may say that (s)he cannot afford to lower rent any further. You’ve done your research and know that the landlord has the money, but doesn’t want to reduce the building’s value. At this point, push for concessions in other areas. Remember,
"The rent that you pay is what creates the value in the real estate.
That is pretty powerful. As a tenant, once you understand how much value you are creating, you increase your negotiation position by several orders of magnitude.
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