In the world of commercial real estate or CRE investment, lease structuring is critical when it comes to sustaining a high-yield portfolio. Poor lease structuring can slowly create havoc on your returns and this means that you could stand to lose where others might easily gain because of inefficiencies in your lease terms. Let’s take a closer look at how poor lease structuring leads to portfolio drag.
Exactly What is Portfolio Drag?
When you experience portfolio drag, this means that your portfolio is underachieving its potential. Your portfolio might be affected by underperforming assets. You might also be slow to realize inefficiencies with the management of those CRE assets as well as hidden costs that quietly eat away at your returns. If you are experiencing portfolio drag you might take a closer look at your lease structure for any properties that are yielding less than expected returns or are not reaching or exceeding anticipated benchmarks.
The Consequences of Poor Commercial Lease Structuring
1. Pay Attention to Your Long-Term Lease Details
Yes, a long-term lease adds stability to your portfolio and is often great for securing a return on your CRE investment. However, that added stability may not maximize your net operating income, NOI, for the long run and we recommend to not be overly generous with the terms. As COVID taught everyone in the business, CRE leasing trends can quickly become volatile or reactionary and that could create a drag if your lease structuring doesn’t allow for periodic or routine adjustments. The inability to repurpose your structure can have a quick and unexpected effect on your portfolio.
2. Lease Structuring Without an Eye on the Overall Market
In addition to being wary of long-term leases as a potential honeypot, you’ll want to consider how a poorly structured lease could slowly erode your returns if you’re not “market-aware” over the long term. Specifically, you should always consider escalation clauses in your commercial lease structuring. This will allow you to adjust according to slow-building inflation or cost-of-living issues. If you fail to account for trends in the CRE market, you could be left with an underperforming asset.
3. Pay Attention to Renewal and Termination Strategies
There are a variety of reasons as to why you might need to vacate a tenant or a tenant might need to terminate a lease. Be sure to account for these reasons in your lease structuring so that you and your tenants are aware of your collective rights. Also, when it comes to a lease renewal, poor lease structuring might present wording that is ambiguous or ineffective. Obviously, you will want to sustain a happy tenant so be sure that your renewal terms are fair and easily understood. Don’t be afraid to follow up with a friendly call so that both you and your tenant know exactly what to expect if a renewal is pursued.
4. Maintenance and Repair Clauses
Every CRE owner understands that maintenance and repairs make up a significant portion of operating expenses (OpEx). Lease structuring that does not account for OpEx can lead to tenant disputes as well as additional budget-breaking expenses. When a landlord presents vague lease terms in this regard, it can erode trust and escalate disputes that could otherwise reach an amicable resolution. Make sure that your commercial lease structuring properly specifies what a tenant should expect when it comes to building maintenance and infrastructure repair.
The Escalating Effect of Poorly Structured Lease
Poor lease structures often create a slow, compounding effect. The issues may go unnoticed or can be easily ignored in the early stages, but like with mold or a bug infestation, these problems must be addressed or they will surface real challenges for you, your tenants and the property itself.
Examples of these effects can surface as a result of changing market conditions over the years or as your assets age. If you are not properly prepared with a well-structured lease, you might soon realize how these effects can evolve into unexpected expenses for your portfolio. Over time, this can present a lose-lose situation as an owner or investor will be forced to consider injecting additional capital into an asset or simply accepting lower-than-expected returns or even negative NOI.
How to Avoid Poor Commercial Lease Structuring
There are a number of ways in which you can negate the potential for portfolio drag. Let’s consider how a well-crafted commercial lease structure can allow for a stronger, more fluid and more profitable occupancy.
- Incorporate rent reviews in your lease structuring. An escalation clause helps you and the tenant to understand how economic shifts might affect rent agreements when it comes to renewals. This should not come as a surprise to a worthy tenant so be sure to follow through in this regard.
- Do your due diligence in screening tenants before signing. Conduct thorough background checks as well as any financial guarantees. Protect yourself against any tenant-related risks by assuring swift recourse in your commercial lease structure.
- Be sure to provide clear and agreeable renewal and termination options. This is where both you and the tenant will benefit from a firm but fair arrangement. The goal is to retain a desirable tenant so make sure the lessee clearly understands and appreciates the processes involved when it comes to negotiating a renewal agreement.
- It’s imperative that your lessee is explicitly aware of maintenance obligations upfront. Poor lease structuring could create very real tension if these expectations are not properly put to the page. Regular inspections and an active management approach are key to maintaining tenant relations and keeping unexpected costs at bay.
If you’re looking for a groundbreaking lease management solution that can help you keep your NOI in the black, you’re in the right place. We encourage you to test drive our industry-leading lease management software which can help you eliminate long and short-term portfolio drag. Let Quarem show you the way to a more practical and profitable lease structuring system.
