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Second Quarter 2015

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Depending on who you ask, net effective rents (NER’s) can be defined in a number of ways.  A common misconception is that the average net present value (NPV) is essentially the same as the NER, however this is not the case and this article will tell you why. The fact of the matter is there is only one definition and calculation for NER.

In order to understand what an NER is, you must first understand why it is useful.  NER’s are used to understand a Landlord’s perspective of what the real return on a lease is when taking into account all rental increases and associated landlord deal costs, such as concessions provided to a tenant (i.e., free rent, tenant improvements, moving allowances, etc.) and brokerage commissions.  From a tenant perspective, the NER can be used to help leverage negotiations across multiple buildings and often form the basis for bottom line pricing used by many brokers on both sides of the transaction. 

So now that you know what a NER is used for, let’s define what it truly is.  Net effective rent is the straight-lined cost that a tenant will pay in each lease year that will produce the same present value as the total cash flow over the life of the term.  The discount rate used to calculate the net present value varies for each company, but is ultimately the rate at which the company can borrow money. 

So how do you calculate the NER?  First, you must run a cash flow from a Landlord’s perspective accounting for all rental income and landlord expenses.  Income should consist of any rental revenue, including rent escalations over the life of the lease.  Landlord expenses will include commissions, free rent, tenant improvement costs, moving costs (if applicable) and any other expenses the Landlord is paying  out-of-pocket to complete the transaction.  That number will yield the total cash flow on a nominal basis.  The discount rate is then applied to achieve the cash flows NPV.  From this figure, the NER is derived by amortizing the NPV over the entire term of the lease (on a monthly basis) using the discount rate and assume a beginning of the month payment.  This will result in a monthly payment amount which is then multiplied by 12 to achieve an annual payment and divided by the square footage of the subject premises to reach an annual per square foot cost.  Here is an illustration applying actual nominal figures to the explanation:

Assume that you are analyzing a 10 year, 10,000 square foot lease proposal.  The starting base rent is proposed to be $12.00 net per square foot with $0.50 per square foot annual escalations.  Tax and operating expenses are expected to be $13.86 per square foot and there is a 2% annual inflation rate.  The landlord is willing to provide $10.00 per square foot in tenant improvement allowance, $2.00 per square foot in moving allowance and 10 months of gross free rent.  It will cost the landlord $1.00 per square foot in legal fees and $1.875 per square foot in commissions costs (to be calculated $/SF x lease term x total square footage).  You assume a discount rate of 8.0%.  What is the net effective rate?

Now that you understand why, what and how a NER works, you can use this helpful tool to create leverage on your next deal! 

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From a tenant perspective, the NER can be used to help leverage negotiations across multiple buildings and often form the basis for bottom line pricing used by many brokers on both sides of the transaction.  

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