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Net effective rent (NER) refers to the amount of money a landlord gets to keep from a commercial lease. It's also one of the primary financial measures property owners use to negotiate leases with their tenants. When you understand how net effective rent works, you can also turn it into a negotiating tool for you when you are seeking out business space.
This guide offers an in depth look at net effective rent, including how it is calculated, factors which impact net effective rent, and how landlords use net effective rent to their advantage. Our intent is that you have the financial skills to analyze a deal and understand the value of the lease for you and your potential landlord. You don't need to be an expert, but some rudimentary knowledge will at least help you understand the terms of your lease when you are dealing with a skilled commercial leasing agent.
From a broad perspective, the concept of net effective rent encompasses the idea of cash flow for a property, most often used in commercial real estate. NER has many moving parts; it is calculated per year over the length of the lease on a dollar per square foot basis. Net effective rent also takes into account the time value of money. The formal definition of net effective rent is:
A dollar amount expressed in dollars per square foot of the rental rate realized by a landlord after eliminating landlord costs such as free rent, brokerage commissions, landlord’s work and tenant improvement allowances.
These moving parts allow leasing agents, landlords, and tenants an even playing field when comparing leases. They can accurately measure "the best" deal by looking at length, rent amounts, property sizes, and inducements which might attract you to a particular space.
For your landlord, net effective rent includes the base rent you owe according to your lease less the costs the landlord has for leasing the space, such as rent concessions, real estate commissions, and construction costs for build outs or renovations. The difference between what you owe and the upfront costs your landlord has incurred is the amount of money available for the landlord to pay the mortgage on the property, save money for improvements, and generate a return on the property.
Rent is often the largest expense for businesses, and in a commercial lease, it goes far beyond the base rent amount agreed upon in a lease. As a tenant, net effective rent includes additional charges in your lease. These costs are common with commercial leases, which are often triple net (NNN) leases, but can include other things you owe your landlord. Most commercial leases are triple net, which means you pay a portion of costs to upkeep common maintenance areas, utilities, and other operating expenses associated with the leased area of the property. Your base rental rate plus these additional costs make up your gross monthly rental payment. Net effective rent as it pertains to you as a tenant also includes rental concessions; your gross monthly rent and additional concessions equal your net effective rent.
Many factors impact a property owner's cash flow, in turn, impacting net effective rent, some of which were mentioned above. It might be overwhelming to think about each thing that could impact NER. Here is an in depth look at the most important factors to consider when negotiating a lease with your landlord:
Your base rental rate in a commercial lease is the amount you pay your landlord for property use. It is typically calculated as a fixed square dollar per foot price multiplied by the square footage of the space you are leasing. Some people refer to the base rental rate as "net rent," or but this can be confusing when talking about net effective rent. The base rental rate is positive cash flow to your landlord. Most commercial leases in the United States are triple net leases, which mean you pay some of the ongoing operating expenses for the property. These are not included in the base rental rate.
A rent-free period is a defined and agreed upon gap of time where you don't pay rent prior to your lease or at the start of the lease. Rent-free periods might relieve the tenant of only the base rent or of gross rent, including all operating expenses. The type of rent-free period negotiated in a lease depends on the market and situation. Although rent-free periods are not that common in commercial real estate, they can occur when a new tenant has to build out a space. The landlord might allow a one or two-month rent-free period to complete the work. Regardless of the type of rent-free period, this is negative cash flow to the landlord, which will negatively impact net effective rent. As a tenant, you should also be concerned what happens to this type of concession if you default. For example, if your rent is late one time, do you owe your landlord rent for the free period? If so, do you owe it all at once, or is it amortized throughout the remainder of your lease?
Property owners sometimes offer special incentives to attract long-term tenants in their commercial real estate properties. One common incentive, which leads to negative cash flow, is the tenant improvement allowance. This is the amount of money a landlord spends to allow a new tenant to redesign, renovate, or build out the office space, so it is functional for the business. The amount a landlord is willing to spend for a tenant improvement allowance hinges on the commercial rental market in a particular area. Keep in mind that your landlord can specifically allocate allowances to a variety of things including planning, engineering, moving, painting, fixtures, furniture, electrical wiring, HVAC repair or installation, and much more.
When tenant improvement allowances are negotiated and put into commercial leases, they are usually designated as a turn key build-out or a stated dollar amount.
When property owners want to lease out commercial space, they often enlist the help of a real estate agent. Once a successful lease is negotiated and the deal is closed, an agent typically gets paid a percentage value of the lease. Landlords typically pay this commission, another cost which negatively impact their cash flow and net effective rent.
The discount rate applied to a landlord's cash flows can impact net effective rent. It is an annual rate used to discount the projected dollar value of a property so it is equivalent to today's dollar value. The result of applying the discount is the Net Present Value. Perhaps more simply put, Net Present Value is the current value of a future amount of money or cash flows which have been assigned a specific rate of return. Future cash flows are discounted at the discount rate. The higher the discount rate, the lower the present value of future cash flows. As previously mentioned, this is the figure used to calculate net effective rent. These calculations can be complicated, but it's likely your leasing agent has a software program that will spit out the numbers you need to see how the discount rate impacts any lease you might sign.
In other words, the discount rate is the interest rate the landlord charges you. For example, a $20 per square foot tenant improvement allowance will typically add $5.00 per square foot per year to your base rent on a 5 year term. This is calculated by amortizing the $20 per square foot over 5 years at 10%.
Property owners use net effective rent to compare their investments. The underlying numbers provide insights which reveal if and how much a landlord will negotiate a lease, especially in comparison to the market and their other commercial real estate investments. Now that you have a broad understanding of the underlying economics of a lease and how it relates to net effective rent, you need to understand how to use this information as a tool to negotiate a better lease. You don't want to leave money lying on the table.
Here are two examples of specific areas you can negotiate for in your commercial lease. These items coincide with factors affecting cash flow and net effective rent, but they should be more clear as we put them in context. Also, keep in mind that many of these items are linked. If you compromise on one point, it should be for the purpose of getting something else on another item.
In real estate, three types of net leases exist: single, double, and triple net leases. A net lease means the tenant pays some other expense on top of a base rent amount. Single net leases are virtually non-existent in commercial real estate and only require the tenant to pay property taxes on top of their monthly rent. Double net and triple net leases are the most common, but they come with different risk and requirements. When you consider the risks and requirements of your lease, you will find the type of lease matters as much, if not more than your monthly base rent.
Above we outlined a handful of transaction costs as factors affecting net effective rent. Each one of these areas is a point of negotiation in a commercial lease, but keep in mind the extent to which your potential landlord will negotiate these points depends on the size of your business, your creditworthiness, the market, and the timing of the negotiations.
In order to have success in negotiating a commercial lease, it is important to have a level playing field with the landlord, and the first step is to understand the jargon and terminology that the landlord uses. The net effective rent is the true dollar amount (on a per square foot basis) that the landlord puts into their pocket in a deal.
The net effective rent is the base rent, minus the amortized costs such as broker fees, tenant improvement allowances, free rent and landlord’s work. This dollar amount represents an “as-is” base rent – as if the landlord rented you the space without the costs previously mentioned.