Ahhhhh. The age old question “What is the Net Effective Rate of a deal?” Ask 100 commercial real estate professionals to define the Net Effective Rate and you will get 100 different definitions. How can this be? There is only one Net Effective Rate of each deal yet most people are not sure of how to define it and how it is calculated. If you negotiate transactions for a living, it is critical that you understand the Net Effective Rate. The purpose of this blog is to once and for all quantify what the Net Effective Rate of a commercial real estate leasing transaction is and explain it in a user-friendly, easy to read, plain English format that everybody (including you) will be able to understand.
Equally as important as knowing what the Net Effective Rate is, you must also know what it isn’t. There are other lease analysis programs out there that will tell you the “Average Present Value” is the Net Effective Rate of the deal. Nothing could be further from the truth or more incorrect. At the end of this blog I will explain why the “Average Present Value” is a complete contradiction of terms and should never be used when analyzing and comparing transactions.
I realize that this blog is a bit long but because this is such a critically important topic to so many people I wanted to be able to really explain the Net Effective Rate in detail. Think of this blog as more of a white paper than a blog. You may want to go back and re-read sections of this blog multiple times. You can use your calculator to test the numbers in the examples I give. You are welcome to call me if you are having issues understanding the concepts in this blog or calculating the same numbers as I have. If you negotiate deals for a living, you MUST, MUST, MUST understand everything in this blog. Your job depends on it. I hope you enjoy and learn.
NET EFFECTIVE RENT DEFINITION:
The ProCalc Net Effective Rate (NER) is the single amount that you can pay in every year of the lease, as an equal level payment, that (and here is the important part) WILL YIELD THE EXACT SAME PRESENT VALUE AS WHAT YOUR CASH FLOW IS SHOWING.
A typical cash flow will include a bunch of different costs. Some costs will be recurring (Base Rent, Operating/CAM, Taxes, Utilities, Parking etc.) and some will be one-time costs (Moving Fees, Architectural Fees, F & F, LHI etc.). The recurring costs can either increase or stay the same throughout the term. If they increase, they might increase on different dates (i.e. Operating increases every January, Taxes increase every July) and can also increase at different rates (i.e. Operating increases at 3% per annum, Taxes increase at 2% per annum). The ProCalc Net Effective Rate takes all of this into account and tells you the one amount that you can pay in every year of this lease that would yield the exact same present value.
Lets say you create a 5 year cash flow for 10,000 rentable SF using an 8% discount rate. Lets assume the PV of this cash flow is $1,000,000. Your rentable SF Net Effective Rate would be $24.17 per year. The calculation for the $24.17 appears just below in red. Right now I want to make sure you all understand what the NER represents. If you created another cash flow for the same 5 year term, 10,000 rentable SF, 8% discount rate and put nothing in that cash flow except $24.17 of base rent in every year, the present value would be the exact same $1,000,000 as your original cash flow. The Net Effective Rate is the amount you can pay in every year of the lease, as an equal level payment, that will yield the exact same present value.
The Net Effective Rate can be expressed in 3 ways:
-An annual aggregate dollar amount
-An annual rentable SF amount
-An annual usable SF amount
NET EFFECTIVE RATE CALCULATION:
You take the Present value of the cash flow and amortize it over the term of the lease using the same discount rate that was used to calculate the Present Value.
So in the example above we had:
|Discount Rate||= 8%|
|Term||= 5 Years (60 Months)|
|Rentable Area||= 10,000 SF|
|Present Value||= $1,000,000|
If you amortize $1,000,000 over 60 months assuming a beginning of month payment at 8% you will get:
|Monthly Payment||= $20,142|
|Annual Payment||= $241,705 (Monthly Payment x 12)|
|Divided By 10,000 SF||= $24.17 per sq ft|
So now you understand how the $24.17 Net Effective Rate above was calculated.
IMPORTANT – ProCalc calculates all time value calculations on a true monthly basis assuming a beginning of month payment because rent is due at the beginning of the month. For those of you that will try to check my calculations on your HP12C (or other financial calculator) you must have your calculator set to BEGINNING of period and you must enter the MONTHLY variables (Interest rate /12, term in number of months – not years). If you are set to END of period or if you enter annual variables you will NOT get the same results as I have in this example.
COSTS TO INCLUDE IN THE NER CALCULATION:
To successfully compare different deals, you must include in the NER calculation ALL costs to get into, occupy and get out of a piece of space. This means not just Base Rent but also Operating, CAM, Taxes, Parking, Utilities, F & F, LHI, Cancellation Penalties, Moving Costs etc. and any other costs incurred by being in this space.
IMPORTANT – The Net Effective Rental Rate works for both tenants and Landlords. When calculating the Net Effective Rate for landlords you must add up all the income the landlord will receive (i.e. Base Rent, Operating, Taxes etc.), subtract all the expenses the landlord will incur (i.e. commissions, TI, Tax & Op costs etc.) and calculate the present value of the Net Income. In this example I will use the ProCalc Tenant Rep Program to demonstrate the Net Effective Rate but the ProCalc Landlord Program has the same functionality from the landlord’s perspective.
A picture is worth a thousand words so let’s look at an example.
Below is a ProCalc cash flow for a:
-5 year transaction (9/1/2014 – 8/31/2019)
-5,000 Rentable SF / 4,175 Usable SF
-8% discount rate.
This cash flow has lots of costs with different increase dates, different increase rates and a few up front costs etc.
The Total Rent of this deal is: $1,015,334
The Present Value is: $837,114
To calculate the Net Effective Rental Rate you take the Present Value ($837,114) and amortize it over 60 months at 8% and you get:
$16,861 – Net Effective Rate Per Month @ 8.00%
$202,335 — Net Effective Rate Per Annum @ 8.00% (Monthly amount * 12)
You can now divide this amount by the rentable area (5,000 SF) and the usable area (4,175 SF) and get the following totals.
$40.47 — RSF – Net Effective Rate Per Annum @ 8.00%
$48.46 — USF – Net Effective Rate Per Annum @ 8.00%
The equivalent keystrokes on an HP12C Calculator would be as follows:
IMPORTANT – Press the blue G key, then press the number 7 key to make sure you are set to BEGINNING of period. You should see the word “Begin” in the display of your HP12C calculator.
837114, PV, 8, G, I, 60, N, PMT
Your calculator will now show 16,861. This is the monthly NER. Multiply this by 12 and you will get 202,335 which is the annual aggregate NER (aggregate meaning NOT a per sq ft amount).
What this means is that you can pay any of the following:
|$1,015,334||Over 60 months (all different payments based on the cash flow)|
|$837,114||Today (The Present Value)|
|$202,335||A year for 5 years (The NER per annum)|
|$40.47||Per rentable SF in every year (NER per annum / 5,000 RSF)|
|$48.46||Per usable SF in every year (NER per annum / 4,175 USF)|
If you created 5 different cash flows based on the 5 scenarios above, they would all yield the exact same present value of $837,114.
Let’s put this theory to the test.
The Cash flow below is the same 5 year term, 5,000 SF, 8% discount rate and the only expense in this cash flow is Base Rent at $40.47 per rentable SF in each year (The NER per rentable SF from above).
Notice the Present Value of both cash flows is the EXACT same at $837,114. If you were a tenant presenting both of these cash flows to a landlord, they would see that on a present value basis both deals are exactly the same. You now have two different ways of structuring the exact same deal.
EXTREMELY IMPORTANT – The ProCalc NER takes complicated cash flows with multiple expenses that are increasing on different dates and at different rates and brings the whole deal down to one single number per annum. The Annual Net Effective Rate is the amount you can pay in every year of the lease as an equal level payment and the present value will be the exact same.
EXTREMELY IMPORTANT – If you had calculated the Average Present Value of the deal above it would have been $33.48 per sq ft / per year ($837,114 PV divided by 5 years divided by 5.000 sq ft). If you performed the same test above by creating another cash flow with nothing but $33.48 of base rent in every year, the present value of that cash flow would have obviously been much lower than the present value of the cash flow at $40.47. The $33.48 (Average Present Value) does not get you to the same present value as $40.47. There is absolutely no correlation between the original deal and a deal at $33.48 per sq ft per year. More on the Average Present Value at the end of this blog.
COMPARING DEALS OF DIFFERENT LENGTH TERMS:
The ProCalc Net Effective Rental Rate also allows you to compare deals of different length terms. Suppose you need to compare a 5 year deal and a 10 year deal. You cannot use the Total Rent or the Present Value to compare them because obviously the 10 year deal will be more expensive than the 5 year deal. Since the Net Effective Rate Per Annum is a per annum amount, it shows you what you are effectively paying in every year of the lease regardless of length of term.
Remember the calculation for the Net Effective Rate is the PV amortized back over the term of the lease. So we would calculate the Present Value of both the 5 year and 10 year deal then one gets amortized over 10 years and the other over 5 years. That is the equalizing factor. The Net Effective Rate Per Annum tells you what you are effectively paying in every “YEAR” of the lease taking into account the time value of money. So you can compare 3 year, 5 year, 10 year, 15 year, 20 year deals side by side. The ProCalc Net Effective Rate is the ONLY metric that allows you to compare deals of different length terms. The Average Present Value does NOT take into account the time value of money.
WHY LANDLORDS LOVE THIS NET EFFECTIVE RATE PER ANNUM CALCULATION:
Pretend you are a landlord. You own a 300,000 SF multi-tenant office building. You have tenants ranging from 1,500 SF to 50,000 SF in the building. One day you are negotiating a 4,000 SF deal for 5 years, the next day you are negotiating a 15,000 SF deal for 10 years, the next day you are negotiating a 25,000 SF deal for 15 years. How can you tell how all these deals stack up against each other? You cannot use the Total Rent or the Present Value because they are all different sizes and all different length terms. The ProCalc RSF Net Effective Rate Per Annum brings every deal, regardless of length of term or size, down to one PSF number per annum. You know that in your building every deal should be a minimum $25.00 PSF Net Effective Rate no matter how big it is or how long the term is. When you analyze any deal, you go right to the RSF Net Effective Rate and you can see where this deal is in relation to all the other deals you have done in this building.
WHY THE AVERAGE PRESENT VALUE IS INCORRECT:
Other lease analysis programs out there are touting that they have a different calculation for the Net Effective Rate. They want you to believe the “Average Present Value” is the Net Effective Rate and that is what you should use to compare deals.
The calculation for the Average Present Value is the Present Value divided by the number of months in the lease, then multiply it by 12 to get the annual amount. Do not be fooled. THIS IS NOT THE NET EFFECTIVE RATE. Here’s why;
Finance 101 – Averages are non-legitimate financial calculations because they do not take into account the time value of money. In addition, you never, ever, ever take a time value calculation (the present value) and average it out over a term. It completely wipes out the purpose of the present value calculation.
Let me explain this to you all very simply by using role playing. You are the landlord and I am the tenant. We have come to terms on a 5 year deal and the totals are as follows:
|The total cost is||$1,000,000|
|The present value is||$750,000 (8% discount rate)|
|The NER per year is||$181,279 (PV amortized over 60 months at 8%)|
|The NER per month is||$15,106.59 per month|
Scenario #1) What we are saying is that if I paid you 60 different monthly payments all totaling up to $1,000,000 as outlined in a cash flow, you the landlord would accept that. This is a true statement and everybody should agree with it.
Scenario #2) Assuming we both agreed on the 8% discount rate, I (the tenant) could pay you (the landlord) $750,000 today (the present value) and you would allow me to occupy the space at no additional cost for the next 5 years. This is a true statement and everybody should agree with it.
Scenario 3) Now suppose I (the tenant) said to you (the landlord) I do not have $750,000 to give you today. How about we take the $750,000 and divide it by 5 years and I will pay you every year $150,000 (The Average Present Value)? Would you (the landlord) accept this deal?
I hope you all emphatically said NO WAY! Here is why. We just said in scenario 1, if the tenant pays the landlord over 60 months they have to pay $1,000,000. The tenant can only pay $750,000 if they pay the entire amount today. You cannot take the present value of $750,000 and spread it out over the 60 month term. That is completely defeating the purpose of calculating the PV. There is only one present. Today is the present. If you pay $750,000 today you can occupy the space at no additional cost for the next 5 years. If you are going to pay the landlord out over 5 years you must pay $1,000,000.
IMPORTANT – The Average Present Value is the equivalent of the landlord giving the tenant an interest free loan of $750,000 for 5 years. Allow me to explain.
You (the landlord) have this asset (the 5,000 SF of space) that in today’s dollars (the PV) is worth $750,000. When I (the tenant) tell you that I do not have $750,000 to give you today, could you please spread it out over 5 years and let me pay you the Average PV each year, that is the equivalent of the tenant borrowing $750,000 today and paying the landlord back over 5 years with 0% interest. You (the landlord) would of course tell me you cannot do that but here is an alternative.
You (the landlord) could say to me (The tenant) I have this asset (the 5,000 sf of space) which in today’s dollars is worth $750,000 (The PV). I (the landlord) will loan you (the tenant) $750,000 today for a 5 year term at an 8% interest rate. So we will amortize $750,000 over 5 years at 8% and you will pay me every month the exact same amount ($15,106.59 per month or $181,279 per annum – monthly amount x 12). Think of it as a mortgage for your lease. If you purchased a house today for $750,000 and you took a 5 year mortgage at 8% your payments would be:
-$181,279 per year
-$15,106.59 per month
If I asked you how much does this house cost you a year you would tell me $181,279 per year.
EXTREMELY IMPORTANT SUMMARY – If you take the PV of every lease and amortize back over the term of the lease using the same discount rate that was used to calculate the PV, you will have the Net Effective Rate Per Annum of the deal. The Net Effective Rate Per Annum is the equal level amount that you can pay in every year of the lease that will yield the exact same PV taking into account the time value of money. The average PV will have absolutely no relation to the original deal.
The Average Present Value is NOT the net effective rental rate of the deal. Do not be fooled by imitations. If you want to be an “AVERAGE” broker, use the Average Present Value. If you want to up your negotiating skills and be a financial genius use the ProCalc Net Effective Rate. You will elevate your status in the eyes of your client as well as the people sitting across from you at the negotiation table.
ProCalc, Inc. opened it’s doors back in April 1992. Over the last 22 years ProCalc has literally written the book on analyzing and comparing leasing and purchasing scenarios. Regardless of whether you are analyzing deals from the tenant, landlord, sublessor or purchasing (lease vs. buy) perspectives ProCalc has a program for you. ProCalc does pre tax, post tax, GAAP & P & L analysis. In the near future we will also be capitalizing leases once FASB and the IASB agree on how it will be done. We currently have over 2,500 companies using our software worldwide. Over the last 22 years we have fielded close to 1,000,000 tech support calls from all over the world. This is experience that you cannot get with any other lease analysis program or lease administration database (Checkout ProLease).
I hope you have found this article educational and enlightening. If you have any questions, comments or criticisms or would like to discuss the Net Effective Rate in greater detail, or see a demo of either our ProCalc or ProLease software please feel free to contact me. Thanks a bunch for taking the time to stop by our site.