When a building changes hands – a trend all too familiar in Denver right now – it’s hard to understand exactly how it will affect you and your business as a tenant. That’s why we’re continuing our “Building Sale Basics” series with this next installment that breaks down how a building sale can potentially increase your cost exposure.
As commercial real estate continues to increase in value, buildings are selling at record prices. There are multiple factors that feed into this increased value, including a rise in land prices, construction costs and mostly assessed taxes. In our current market, many buyers are willing to pay a higher price tag because they know they can get a good return on their investment.
Here’s how: During the due diligence process of a building purchase, owners create a proforma, which is a set of calculations that projects the financial return that a proposed real estate project is likely to create. Proformas are typically used to determine cash flow for the investment and assess operational costs, including potential for capital improvements for the building. Along with other elements, this helps determine a price point any buyer is willing to pay for the property.
So, what does that mean for you?
When a new owner purchases a building at a high price, they typically find a way to pass that expense onto the tenants throughlease agreements, and specifically as it relates to the operational costs for the building. These expenses are passed through as triple net (NNN) expenses. That means in addition to your base rental rate (which might increase just due to the market), you are also responsible for covering NNN expenses, which are property taxes (largest contributor to the increases seen today), property insurance and common area maintenance. In short, you’re helping cover your proportionate share of the operating costs of the building.
In the past, the majority of office leases in the Denver market operated on a gross lease model, where the operating costs of a building were rolled into your rental rate year one and you paid a minimal passthrough each year thereafter based on actual expenses. Now, it’s more typical to see NNN leases that separate lease rates and operating costs. For example, two buildings in Lower Downtown might both be listed with a lease rate of $30/sf NNN. However, they could easily have different NNN expenses, meaning your all-in might be $41/sf for Building A vs $46/sf for Building B. We recommend working with a tenant rep broker who understands how to break it down so you’re never caught off-guard with respect to this additional operating cost exposure in a lease.
How to protect yourself against rising costs
While it might seem like you have zero power when your building sells to control these cost increases, there are a few steps you can take to protect you and your business.
- Leverage your size. If you are a large enough tenant, there is potential for you to cap the amount of NNN expenses you pay. You can negotiate this in your lease terms upfront typically.
- You can relocate. If your lease is nearly up (within 12-18 months), you can make the executive decision to move elsewhere and leverage the market in your favor. There are plenty of options in Denver that can meet your specific business needs like location, amenities and type of office space.
- Negotiate more tenant improvement (TI) dollars. Depending on where you are in your lease term, you might be able to get additional TI dollars through a lease restructure. Most owners want to pump a certain amount of capital into building improvements, and they might consider putting that into a tenant space like yours. Oftentimes, they require some sort of lease extension in return, but it’s all contingent on the value the new owner sees in you as a long-term tenant.
While rising operating costs are a concern for every business, remember you have choice in how you approach your commercial real estate decisions. If and when your building sells, reach out to a trusted broker who understands your options and will work in your best interest to mitigate your risk and explain all of your options.
Interested in learning more? Click here to read the first blog post in our Building Sale Basics series about Estoppel Certificates and what you should do with them.