One of the most crucial valuation components to a piece of commercial real estate is the term left on the current tenancy’s leases. It’s a simple equation:
Longer Terms = Higher Valuation
While keeping a properties net operating income (NOI) as high as possible is also a major contributor to the valuation of a property, sometimes sacrificing a higher rent to get a tenant to extend long term can be more valuable than trying to charge them as much base rent as possible.
Let me give you an example. Let’s say you are preparing to sell one of your office buildings, and one of the major tenants expires within two years. You expect them to stay, but one of the most critical components potential buyers look for is stability. It’s also very important for financing purposes.
You could approach this tenant and try to get him to take an extension that may have been built into his lease early. Or you could even try to get him to sign long term. But form his standpoint, what motivation does he have to do this? Really none, usually.
So how do you get him to bite? Keep his rent flat, reduce his contractual increases, or even give him a little break if he signs for say five or ten years additional.
While your net operating income will suffer, having a longer term tenant and being able to showcase more stability to the market of buyers will probably increase the value of your asset much more than a marginal increase in net operating income.
Remember, this is a balancing act. I am not recommending you start calling every single one of your tenants and offer to cut their rent in half if they sign up for ten years. NOI growth is incredibly important as well.
But if you are strategic, in the right situation you can MASSIVELY increase the value of an asset with a key extension.
One last example. If you have a very high value tenant, say a grocery store who occupies 60% of a center, sometimes it is prudent to “buy” the tenant to get them to extend. There are operators who pay grocery stories hundreds of thousands or millions of dollars to take an extension early.
Why? Because at sale time, spending a million to get 6 million additional on the back end sale is good business. From an acquisition standpoint, you need to be careful when looking at assets with major tenants. Sometimes these tenants want out but the landlord “pay off” is just to lucrative to make them leave. If there is no pay off come the next renewal time, they may bail out on you.
In closing, knowing how to extend tenants and from time to time give them a “break” to get more term can take your assets to the next level.