Construction requires lease provisions to line up

A question that occasionally comes up is what is the right rent for a building to be built and leased to a company. On its face this looks like it would be fairly straightforward to figure out. But a number of the provisions of the lease need to be considered to determine not just the lease rate but if all the elements of the lease line up so construction is feasible.

What is the cost to build? What is the market rate for the space? What financing is possible? What lease rate is necessary to provide the developer its desired rate of return and support the financing?

Take this example. Assume the building is going to be a generic 10,000-square-foot office building in a good location. It will be leased to a financially strong company for 10 years. The cost to build is $275 a square foot, or $2.75 million.

Say the bank will finance 70 percent of the construction cost, or $1.925 million, with 6.5 percent interest on a 25-year term. This financing produces a monthly payment of $12,998 and an annual payment of $155,973. The developer will provide the balance of the required cash, $825,000.

The bank's financing will depend on an appraisal of the value of the proposed building. The bank will commit to the loan only if the appraisal is equal to, or greater than, the cost of construction.

The bank will require the lease income to be bigger than the mortgage payment. This will provide a margin of safety on its loan and is called the "debt coverage ratio." Assume this debt coverage ratio is 30 percent. In this example, the bank will require the annual lease income to be $202,765 ($155,973 x 1.30).

Because the lease is going to be net, where the tenant pays the building's operating costs, taxes and insurance, this payment could be the rental amount. The developer would collect the annual rent of $202,765 and pay the mortgage and keep the remaining money as its return on the cash it put into building the building.

In this example, that cash return would be $46,792 a year, ($202,765 minus $155,973). But that is a return of only 5.7 percent, a low return. The developer will not take the risk for such a low return.

Let's say the developer wants a 12 percent return on the cash it puts into the building, which would be $99,000. The lease rate would be the mortgage payment plus the developer's return and total $254,973, or $2.12 a month per square foot.

Remember this is a net lease so, in addition to the rent, the tenant has to pay the building operating costs, taxes and insurance. If those are about $10 a square foot a year, it means an additional 83 cents a square foot a month. This makes the tenant's total lease cost $2.96 a square foot a month.

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Construction requires lease provisions to line up