Practice Sale Landmines: Leases Part 2 (Improvements Built into the Rent)

Here’s a real deal with the devil. Including the costs of leasehold improvements in the base rent rate.

It seems like a great idea. It helps cash flow, does not require bank debt and often eliminates the headaches associated with a construction project.

What could be wrong with that? Plenty.

The first and most obvious is that the cost of the construction is frequently built into the rent rate forevermore.

Say fair market base rent on a space is $36,000 annually. And the landlord offers to provide “build to suit” leasehold improvements to your specifications. This could add another $20,000 in annual cost to your lease. If the rent is reduced in 5 years – great, you’ve struck a fair deal.

But, it almost never is. The renewal term frequently includes the cost of the construction from the first five years. You end up paying for the construction twice. I see this circumstance almost every time the landlord does the build-outs.

The second problem is that the landlord often charges more for the construction than it would cost if done by a third party.

Here’s an example from my practice brokerage firm. We have a seller client with a 3-year-old satellite office in downtown Cleveland. The area is booming with over 8,000 housing units within a few miles of the office. Millennials are flocking to the area.

But, my seller has learned that managing multiple offices is not as easy as it looks and wants to divest the office.

The problem: the landlord did the very nice build-outs and insisted on a 10 year lease in return.

We have a seller who is willing to assume nearly $400,000 in lease obligations under the existing lease. But, my seller is going to have to forfeit any of the goodwill built-up in the first three years of his ownership.

Stephen D. Jordan, CVA
PMAgroup, LLC

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