Leasing: The Engine That Can Turbo Charge Your Revenue
Why your leasing strategy is so important to increasing the value of your real estate investment
Welcome to another edition of Real Estate Investing Explained.
We are well underway on our current series: Executing Your Business Plan. So far we have covered:
Today we transition to leasing.
The most common way to add value is to physically upgrade the look and functionality of your investment and then execute your leasing strategy to increase revenue, which will drive up the value of your property.
Physical Upgrade + Leasing = Value Increase
Physical transformation first.
Leasing strategy second.
It doesn’t always work this way, but it is the most typical.
Sometimes the market rents increase (or decrease) regardless of what you do to the property.
Sometimes you will get lucky and find a property where the rents are below market and can be increased without doing anything. The previous owner may have not paid attention to market rents or had a different strategy.
Over the next set of newsletters we will get into all things leasing including:
Leasing strategies.
Analyzing lease comparables.
The leasing process and the role of brokers.
Negotiating a letter of intent (LOI) and a lease.
Leasing is not something that will fit into a single newsletter. It is much more complex.
But don’t worry! I will guide you through it.
Today we will cover:
Differences between commercial and residential leasing.
What to expect in the leasing process.
Defining your leasing strategy.
Leasing is one of the most interesting and dynamic aspects of the business. It is where all your hard work manifests into value.
Let’s dig in.
Differences Between Commercial and Residential Leasing
When it comes to leasing, there are some key differences between commercial and residential.
As a reminder, commercial refers to industrial, retail, and office. Residential refers to apartments and 1-4 unit residential.
Let’s start with the similarities.
Everyone wants tenants to lease their space. This is where revenue comes from.
These tenants should be able to pay the rent, not beat up the space, and be a “good neighbor” to the other tenants.
All tenants have a lease that details the rent, term (aka lease duration), and other “rules” of occupancy.
Proactive owners actively market their space and may be willing to offer incentives such as free rent.
That being said, they are fundamentally different in key ways.
Negotiating Rent: residential is covered by federal fair housing law to protect against discrimination. Every tenant needs to be offered the same terms. Therefore, rent is never negotiable. Commercial rents are actively negotiated in conjunction with free rent and tenant improvements. Commercial leasing is all about negotiations.
Tenant Improvements (TI’s): think of TI’s as a custom remodel of the suite for a specific tenant. This doesn’t happen in residential but is very common in commercial.
Leasing Broker Involvement: leasing brokers play an active role in most commercial leases. They are on the front line of the negotiations. Leasing for residential is typically done by someone on the property manager’s team.
To oversimplify, adding value to residential is about making the improvements and watching your hard work pay off as the rents increase.
Commercial is a two stage approach of making the improvements and then actively marketing and negotiating to get the right tenants in at the best combination of rents, TI’s, and tenant credit.
It is an oversimplification to highlight the differences.
As you read the rest of the discussion on leasing, keep these differences in mind to recognize which are going to be applicable to you as you pick your asset class (commercial or residential).
Let’s continue to the leasing process.
What to Expect in the Leasing Process
Despite the differences between commercial and residential, leasing does follow a fairly standard process. Here are the steps:
Understand the market and how your property fits into it.
Define your leasing strategy.
Assemble your leasing team: leasing broker and/or property manager.
Market and screen potential tenants.
Negotiations: letters of intent and leases.
Delivering the space for occupancy.
A simple process, but not always an easy one to execute. Much of this will depend on your leasing strategy, which is where we will focus on next.
Defining Your Leasing Strategy
Your leasing strategy should be part of your overall strategy beyond just leasing. We discussed this in The Risk-Return Spectrum: Choosing Your Real Estate Investment Strategy. There are three main strategies:
Core/Turnkey: low risk, low return. You buy a property that is well leased and maintained. There is minimal work to do.
Light Rehab: medium risk, medium return. There is some work to do, but it is mainly cosmetic (paint, carpet, clean up).
Value Add: high risk, high return. There is a lot of work to do. The property might even be vacant. You will be repositioning it and taking on a lot of risk for superior returns.
If you are buying core deals, you are unlikely to take an active role in leasing because there won’t be much to do. It is either a commercial property leased long term or a residential property with high ongoing occupancy and rents due to the location and construction quality.
Light Rehab and Value Add deals will require a more hands on approach. You will need to think about questions such as:
How aggressive do you want to be in your rent?
How important is maximum rent vs. occupancy?
How long can you last with low or no occupancy relative to your other expenses?
What is your budget for customizing the suite for the right tenant?
How important is the tenant’s credit and financial strength?
What is the condition of the economy and where are you in the real estate market cycle?
These are important questions that you need to really think about.
Talk with your partner and team. Ask for the advice from people you trust. Talk with your leasing broker.
The answers to these question should not be set in stone. They should be revisited regularly, particularly when circumstances change.
In your first year of ownership you may be full of confidence and enthusiasm. If things don’t go well, you could find yourself wishing you had done the lease you passed on 12 months ago.
Welcome to the dynamic world of real estate investing!
Time and changing circumstances change your perspective, adding to or reducing your confidence and tolerance for risk.
This is normal and to be expected.
But we are just scratching the surface of leasing.
This newsletter was just the teaser.
Next week we will dive deeper into the details with a discussion on how to analyze the market and the critical importance of understanding lease comparables (aka lease comps).
This is where things get interesting and the experienced operators start to distinguish themselves.
As always, I will share my knowledge and experience so that you can turbo charge your learning curve.
Stay tuned for next week.
This is going to be fun!