Optimizing commercial property, part two
In part two of this video series, learn three different lease options and find other strategies to increase the income generated by your commercial properties.
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Hi, I’m Aaron Huberty with Wells Fargo Business Real Estate Financing. In this second part of our Optimizing Commercial Property Videos, we’ll introduce strategies that real estate investors can implement to maximize profit, minimize risk and strengthen cash flow.
Let’s begin by focusing on your leases. It is important to work with a good real estate attorney to help craft your leases. The first step is to determine what you want in your lease. So ask yourself these two questions; are there reasonable escalation clauses in your leases for operating expenses? These are provisions included in the lease that ensure that increases in operating expenses are covered by the tenant. After all, if expenses increase, you want to be covered. Number two, how long a lease do you want to sign? In commercial real estate, a lease term of 10 to 15 years is quite normal. It protects the landlord from potential vacancy by preventing short term turnover. However, if there is opportunity for rent growth in your market you may not be able to take advantage of it.
The next step is to look at gross operating income. Remember, there are two ways to add value to your property, by increasing gross operating income or by decreasing operating expenses. Operating income is driven by rents and vacancy rates, to optimize the rent potential of your investment property, you should consider doing some simple upgrades to your property, paint work, landscaping, improving the sidewalks or your parking spaces. These are not very expensive renovations but they can add tremendous curb appeal and therefore increase your rents. If you have vacancies in your property, think about offering competitive leases, either on your rates or on the term. You can offer long term leases where you don’t get as much rent, or you can have short term leases where you can get substantial rent. Another way of reducing vacancies is to allow subletting.
Next, you need to manage your operating expenses. Once again, this starts with your leases because that’s where you identify how the operating expenses of the property will be managed and who will pay for them. In commercial real estate there are predominantly three different ways leases are written.
The first one is called a gross low-rent lease. This is where the tenant pays a base rent and the landlord covers for all of the operating expenses of the property, and then the rental income goes up every year based on some external loan indicator, like the consumer price index, which adjusts with inflation. The second is triple net lease. In this case the tenant pays a base rent and pays for all of the operating expenses of the property. This is great for the landlord because the operating expenses are covered. The third kind of lease, which is also very common, is called a full service lease. In this case the tenant pays a base rent and then there is an escalation clause that increases rents over time to offset the operating expenses. As operating expenses increase, the landlord is protected because it’s covered in the lease.
So there you have three ways to structure your leases. You need to determine what is the best way for you to protect your downside and manage operating expenses. After all, these directly impact the net operating income. As a commercial property owner, you can also increase your return by talking to a qualified tax accountant who can help you understand the IRS rules around depreciation and how it can reduce your tax bill. A good, knowledgeable tax accountant will be able to identify those tax breaks.
Here’s the bottom line, owners of commercial real estate property focus on the net operating income, and how they can add value to improve the rents in their property or decrease their vacancy rates. As always, look at your operating expenses actively and manage them aggressively. Make sure that you have accounted for an increase in operating expenses in your leases.
Thank you very much for joining us on this segment of Wells Fargo’s Business Insight Series. To learn more about how Wells Fargo Business Banking can help you, visit wellsfargo.com/biz. In the meantime we wish you continued success.
Get more information about Business Real Estate Financing here.