How to Compare Lease Proposals: Net Effective Rent

Landlords quote a face rate: a rent per square foot per year. It is the number in the listing and the first line of every proposal. It is also the number a landlord least wants to reduce, because face rents influence how a building is valued and what the next tenant is quoted.

So landlords often compete in other ways. They offer months of free rent. They offer money toward construction, or build the space at their own cost. They accept a smaller deposit. A proposal with a high face rate and large concessions can cost less than a proposal with a low face rate and none.

Proposals also differ in structure. One includes operating expenses and taxes in the rent, another bills them on top. One measures the suite with a larger share of common area. One is for a longer term. Reading the face rates side by side tells you very little.

Net effective rent answers one question: averaged over the whole term, and after the value of concessions, what does this space cost per square foot per year?

In its simplest form the calculation has four steps.

1. Add up all base rent due over the term, including each scheduled increase.
2. Subtract the value of the free rent.
3. Subtract the landlord’s cash contribution to your build-out, to the extent it replaces money you would otherwise spend.
4. Divide the result by the number of years in the term, and then by the square footage.

Some analysts go further and discount future payments to present value, so that a concession received at the start of the lease counts for more than the same amount received later. Either method is acceptable if it is applied in the same way to every proposal. Mixing methods between buildings produces a comparison that means nothing.

The figures below are invented round numbers chosen to make the arithmetic easy to follow. They are not market rents, typical concessions or a description of any real building.

Assume a company needs 10,000 square feet for a five-year term and receives two proposals. To keep the example simple, neither has annual increases and both treat operating expenses identically.

• Proposal A: a face rate of $40 per square foot per year, six months of free rent, and a build-out allowance of $50 per square foot.
• Proposal B: a face rate of $36 per square foot per year, two months of free rent, and a build-out allowance of $20 per square foot.

Proposal B looks cheaper. Now run the four steps.

• Proposal A: total base rent is $2,000,000. Free rent is worth $200,000 and the allowance is worth $500,000. That leaves $1,300,000, or $26.00 per square foot per year.
• Proposal B: total base rent is $1,800,000. Free rent is worth $60,000 and the allowance is worth $200,000. That leaves $1,540,000, or $30.80 per square foot per year.

In this hypothetical, the proposal with the higher face rate costs less over the term. The result holds only if the company would really spend at least the larger allowance on construction. If the space in Proposal B needed almost no work, part of the allowance in Proposal A would have no value to the tenant, and the answer could reverse.

Net effective rent is a comparison tool, not a full budget. Several things sit outside the simple calculation and can change which proposal wins.

• Operating expenses and taxes. In a net lease they are billed on top of rent. In a gross lease with a base year, you pay increases over that year. Add a consistent estimate to every proposal.
• Measurement. Two suites with the same usable area can carry different rentable areas. Compare cost for the space you can actually use.
• Your own build-out spend. If construction will cost more than the landlord contributes, the difference is your cash and belongs in the comparison.
• Timing of cash. Free rent at the start helps a company conserve cash. The same value spread differently may not.
• Security. A large deposit or letter of credit ties up capital for years even though it is not rent.
• Term. A longer term spreads concessions over more years and commits you for longer. Proposals of different lengths need care.
• One-time and exit costs: furniture, cabling, moving, and the cost of restoring the space when you leave.
• Flexibility. Expansion rights, a termination right and workable sublease terms have real value that no rent formula shows.

A landlord may also quote a net effective rent calculated from its own side, counting its costs such as commissions. That is a different figure for a different purpose. Make sure you are comparing the tenant’s cost.

Before any calculation, normalize the proposals. This is most of the work, and where errors usually enter.

• ✓Are all proposals stated on the same area, and do we know the usable square footage of each?
• ✓Have we converted every proposal to the same lease structure, with operating expenses and taxes estimated for each?
• ✓Are annual increases included for every year of the term?
• ✓Is free rent applied to base rent only, or to operating expenses as well?
• ✓Have we priced the build-out each space needs, and compared that to what the landlord will fund?
• ✓Does an allowance have restrictions on what it can be spent on, or a deadline for using it?
• ✓Are the terms the same length, and if not, how are we treating the difference?
• ✓Have we included electricity, after-hours heating and cooling, and parking where they are charged separately?
• ✓Are we using the same method, with or without discounting, for every building?

The output should be two figures for each building: a net effective rent, and a total occupancy cost over the term that includes everything you expect to pay. Ask your finance lead or CPA how the lease will be recorded for accounting purposes, because the cash view and the accounting view of the same lease can differ.

The comparison is also a negotiating instrument. It shows which lever matters most at each building. If one landlord will not move on face rate, the analysis tells you how much additional free rent or allowance would close the gap, and you can ask for exactly that.

It also tells you what concessions are worth to you specifically. A company with a simple fit-out and limited cash may value free rent more than construction money. A company that needs an equipment room, extra cooling and a secure lab may value a larger allowance or a turnkey build. Tell your broker which matters, so the counterproposals ask for the right thing.

Building this analysis for every proposal, and using it to shape counteroffers, is part of the lease negotiation work TAG does for technology, software and data companies.