Report: keep lease terms simple.

Over the last 15 to 20 years, there has been a significant change in the ownership of better quality office buildings from developer/owners to institutions, resulting in considerable change to owners' investment objectives and perception of risk, but very little change in the way buildings are leased. The recently released Yarmouth Report published by The Yarmouth Group suggests that a change in the structuring of the financial terms of office leases would not only be advantageous to today's institutional owners but would also provide additional flexibility and potential economic benefit to tenants.

Until recent years, offices were typically built and owned by private developers who financed the cost of construction through long-term permanent loans from banks and insurance companies. The objectives of these owners were to minimize equity investment, maximize cash flow and minimize tax payments. These owners were not averse to taking risks; they were typically speculators who developed buildings for profit with low levels of cash/equity. The focus of their dealings was their own self interest.

The advent of institutional investment in real estate during the late 1970's, either directly or indirectly, has changed the owners' investment objectives and perspective. Institutions typically represent third party money for which they have a fiduciary responsibility. They are therefore more averse to risk. They tend to seek stable, median returns rather than the volatile, potentially higher returns that motivate the developer/owner. Institutions, which in the United States are often tax-exempt, have historically sought to place investment capital in the market through outright property ownership rather than utilizing leverage, particularly to the extent of an individual developer/owner.

The typical current office lease form was established in the era when developer/owners negotiated directly with tenants. Many of the terms reflect a desire by tenants to protect themselves from what they perceive to be the self-serving interest of their landlords. Many of the practices encapsulated in these terms reflect the desire of developer/owners to have flexibility in accounting for certain aspects of income and expenditure in order to minimize tax liabilities and maximize cash flow.

Today's conventional wisdom, due to market conditions in which the tenant is deemed to be all powerful, is that it would not be possible to change the lease terms. This argument would bear more weight if prospective changes in lease terms were economically detrimental to the tenant. However, the Yarmouth Report suggests that the underlying financial lease terms need to be adapted so that their economic worth to an institutional investor can be more readily quantified and analyzed on a standardized basis. In the process, certain benefits can result for tenants. Inevitably, such a process will take time and careful education, and will probably require institutional owners to act collectively.

According to the Yarmouth Report, an example of a prospective change relates to the method of quoting rental rates. Traditionally, rent has been quoted inclusive of operating expenses, otherwise known as the "gross rent". As market conditions deteriorated, increasing amounts of free rent, tenant improvements and other inducements were granted to maintain the quoted level of gross rent. At the same time, as gross rents stabilized or declined, operating expenses and, particularly, real estate taxes continued to increase. It has thus become extremely difficult to measure the true rental value of office accommodation and, therefore, its underlying value to an owner. Institutional owners need to have a clear understanding of the investment return provided by a lease to the base building investment. This concept is encapsulated in the Landlord Net Effective Rent (NER) which reduces all payments and receipts of a lease transaction to a single annual annuity payment.

As increasing reliance is placed upon NER for lease analysis and valuation, institutional owners should consider offering space on an "as is" basis at the NER, according to the report, and then offer to pay whatever costs the tenant desires to be paid to occupy the space -- provided these are amortized over the term of the lease. The Yarmouth Group says this could be extremely beneficial to the tenant, who will be able to select between quality tenant improvements or more modest rental payments. The tenant also could be absolved of the increasing problem of dealing with dramatically changing rental payments (due to the effects of free-rent periods) throughout the term of the lease.