Do you use the Net Effective Rate to compare lease proposals?
Many users of ProCalc suggest that their client consider the Net Effective Rate per Annum of the lease.
But how many of them can describe what ProCalc‘s Net Effective Rate actually represents? “It just equalizes everything”, right? Uhm, something like that, but there are some pretty strong assumptions going on in the background which are important to understand. Let’s take a look:
First, it calculates the Net Present Value of the Lease (in Excel formula format):
= NPV ( discount_rate/12, month_1, month_2, month_3…..)
Then, it uses this NPV and amortizes it over the term of the lease at a selected interest rate, similar to calculating a mortgage payment:
= PMT ( interest_rate/12, lease_term_in_months, NPV, 0, 1) * 12
This calculation is equivalent to the tenant borrowing enough money on day 1 of the lease in order to pay their entire lease obligation. Who does that? Doing all these extra steps just overcomplicates and dilutes the practicality of the financial analysis and comparison for most commercial tenants.
There is a simpler way: just compare leases on the basis of the NPV divided by the total lease term. This accomplishes 3 things:
1. Most importantly, it keeps the comparison easy enough to understand and explain to just about anyone.
2. The Net Present Value “equalizes” the cash flows in such a way that it recognizes that money today is worth more than money tomorrow.
For instance, what is better? Free rent in the first 6 months of the lease, or the last 6 months of the lease? Of course getting free rent in the first 6 months of the lease is better than the last, and the Net Present Value recognizes just that.
Note! Many lease analysis templates discount cash flows on an annual basis (namely CCIM’s). This means the calculation assumes rent is paid once a year! This is both inaccurate and misleading. Be sure your lease analysis tool uses monthly cash flows in order to calculate the NPV of every lease.
3. Dividing by the Total Lease Term provides the ability to compare proposals with different lengths.
All other things equal, the Net Present Value of a 5 year lease is going to be lower than that of a 7 year lease. By dividing the Net Present Value by the lease term it allows tenants to compare costs on an annualized basis.
Think of it this way: while the total financial commitment of a 5 year lease will most likely be lower than a 7 year lease, at the end of that 5 years, the tenant will still have the need for space (assuming they are still in business). While a short term lease provides more flexibility, it does not allow the tenant to altogether avoid the a need for a place to do business. At the end of 5 years, that tenant will have to make another financial commitment. With a 7 year lease, it locks in what that financial commitment is for a longer period of time. Understanding this, always remember that just because the NPV is higher on a longer term lease, doesn’t mean it is necessarily more expensive.
Dividing by the lease term equalizes the additional 2 years of costs associated with the 7 years lease so that it can then be compared to the 5 year lease more effectively.
What’s the moral of the story? Keep it simple: stick to comparing leases using the NPV / Lease Term.
P.S. For leases that vary in square footage, simply use the NPV / Lease Term / Square Feet.
P.S.S. LeaseMatrix calculates all of these metrics for you, automatically: