November 2017 — Rent is one of the key indicators of the property’s value. Many elements come into play when analyzing a market to determine the amount of rent to charge. Some of these factors include:
- Rent: the rent that competitive buildings are charging (creating a rent grid analysis is essential)
- Space: the supply of space, the market’s ability to absorb that space, and why you need to watch both the micromarket (your neighborhood, or sub-market) and macromarkets (the city or area as a whole)
- Economic cycles: the supply-and-demand cycles that affect the rental business (you need to watch these indicators to anticipate trends so you can price your rents competitively in the market)
In order to gain a full understanding of the interrelation among these factors, you will need to perform an in-depth market analysis. Fortunately, with the help of the Internet and many other research sources, performing this analysis will not be as limited and as time consuming as it once was.
The Importance of Rent
The three most important things about marketing and leasing commercial real estate are: (1) the rent, (2) the rent, and (3) the rent. Rent is everything when you are dealing with investment property. It is the critical element upon which you will base the analysis of your market, and it is one of the key indicators of the property’s value. One cannot overstate its importance.
As an example, consider the issue of building valuation. The following steps are three ways to value a property:
- Calculate the cost of the land and value of the improvements.
- Figure out the value of the property compared to the sales of similar, nearby properties.
- Take the rent minus expenses, from which are calculated a variety of financial indicators, such as return on investment, net operating income, and capitalization rate.
The rent you charge (the final dollar figure a tenant will pay, with operating expenses, tenant improvement allowances, escalation adjustments, and any other charges or concessions factored in), compared to the rent of competing buildings, will most likely also be the determining factor in whether or not you make a deal.
Analyzing the market is an exercise based in the past tense. Forecasting future rents based on past rents involves a certain amount of guessing.
You will be using old information to help set future rents. Since it is impossible to know the future, the rents you set are, by definition, speculative. Arriving at a rental rate is an art, not a science.
Your job is to make the best guess at the amount a tenant will be willing to pay for your space one, three, or eight months into the future. Of course, a lot can happen during that time to change even the best-crafted income forecasts, and rental rates are often moving targets fluctuating with economic cycles.
One of the most baffling questions to ask any real estate professional is how he or she determines what rent to charge a tenant. Try finding that answer in a real estate financing textbook and you may spend more time piecing together half answers of theory than hard answers from practical real estate management experience.
The short streetwise answer is: Charge as much as you can. Figuring how much rent to charge is not hard if you think of it in terms of meat and gravy. In simple terms, the rent has to cover the building’s mortgage(s), operating costs, and tenant fit out. This is the meat. The gravy is the percentage return on the investment after all the meat has been paid for. How much gravy you can get will depend on how much you ask for, as well as how much the market thinks the space you are leasing is worth.
How High Can You Go?
To figure out how much rent to charge, ask a real estate professional. The answer he or she gives will help establish a floor (bottom number) from which you can calculate rent for your particular building(s).
Transferring the meat and gravy analogy to rent, we can see why the answer to the question of how much to charge is as much as the market will bear. The market sets the limits. For example, if all the rents in your micromarket are around $17 a square foot, how can you ask—and why should a tenant pay—$20 a square foot?
The other side of the rent equation is, of course, the breakeven cost on the property. If the rent does not cover the expenses, the owner might have to foreclose on the property. But suppose your micromarket suddenly becomes popular for any one of a number of reasons, such as below-market rents, new development, or government subsidies. Your renewals, and comparative renewals, will not be going for $17, but for higher than that. So, how high can rent go? It can increase until there are no takers, and prices have to fall back to what tenants are willing to pay. This is known as market elasticity.
In setting rents, think of space as a commodity. Strip away the marketing hype from a building and what do you have left? You have a box of vacant space. Walk down the cereal aisle in a grocery store, and the same concept as selling space in office buildings is evident. The boxes of cereal may look different, but essentially they all contain some form of processed grain with or without sugar and flavorings (tenant improvements). Some are premium priced (Class A office space), and some are generic (Class C space). Yet their pricing cannot exceed certain market parameters for each class; otherwise, the consumer will not buy the product. And so it is with commercial real estate.
The exceptions—and there are always exceptions—occur when, for intangible reasons (such as a stock’s price being bid up beyond its worth), price becomes ridiculous, yet a certain segment of the market will pay it for some exclusive benefit perceived only to themselves.
Now that we have discussed how the elasticity of the market affects what you can charge for rent, you know why you need to learn the market before negotiating the rent.
Real estate professionals suggest not worrying too much about being off the mark a little. When a market is rising, it is okay to set the rental rate a little too high. Even if you lose a prospect, don’t worry. Since rental rates are increasing, the next prospect probably will accept your rate. In the process, setting the rate higher indirectly helps move the market toward the rate that you are asking. In a falling market, set the rental rate a little below what you think the market is. If you lose a prospect in these circumstances, you’ve good reason to worry, because the rent may have been too high. Since rental rates are falling, the next prospect is even less likely to accept your rate. If you do not get below the market rate, you run the risk of chasing it all the way down, one step behind the entire way.
As you build your research about the market, it is important to share it with the ownership. While the ownership may have one idea about what rents should be (usually as high as possible), your research may help provide a reality check.
This article is adapted from BOMI International’s Leasing and Marketing for Property Managers, part of the RPA designation program. More information regarding this course or BOMI International’s new High-Performance Sustainable Buildings credential (BOMI-HP™) is available by calling 1-800-235-2664. Visit BOMI International’s website, www.bomi.org.