To effectively a negotiate commercial real estate lease as a tenant, it's helpful to understand what the landlord at the other end of the table is thinking. If he's a long-term holder of the building, he may have a different leasing strategy than if he's planning to sell soon. Landlord priorities shift depending on how their portfolio is structured, how they manage their buildings, or even how they finance their buildings. Something as far removed from you as an adjustable-rate mortgage can have a significant impact on how your landlord structures your lease.
ARM Basics
Adjustable rate mortgages for commercial real estate are similar to residential ones. ARMs have a rate that is set by adding a spread to an index rate. For instance, your landlord's loan could be calculated by adding 300 basis points to the 30-day LIBOR, which is a popular index rate set in London. If LIBOR is 0.25%, your landlord's loan payment will be based on a 3.25% interest rate, but if LIBOR goes up to 2.75%, the rate will be 5.75%. Commercial ARMs can have floors - which are minimum rates; ceilings - which are rates over which the loan can't go; and limits on how much the loan can adjust in a given year. However they're structured, having an ARM means that when interest rates go up, your landlord's monthly payment eventually increases.
ARMs, Interest and Inflation
While it might seem like your landlord's commercial real estate mortgage is his problem, it's actually yours. He pays his mortgage with your rent, so your landlord is usually motivated to structure your lease to allow him to cover his mortgage. If he has a relatively low balance, or he's got a short-term loan, it might not be an issue. However, if your landlord has exposure to interest rate risk, he might want to structure a lease with you that helps to mitigate it.
Generally, interest and inflation move hand in hand. With this in mind, landlords with adjustable interest rates are likely to be very sensitive to inflation. Triple net commercial real estate lease structures, which shift the responsibility for paying the building's operating expenses to you, are a step in the right direction for inflation-sensitive landlords. However, if the landlord also faces the potential of increased loan payments, there are two ways that he can protect himself:
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Writing short leases with no options or with options that reset to fair market value. This way, he knows that he can increase your rent relatively soon if inflation hits.
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Tying rent escalators to the Consumer Price Index without caps.
Either of these structures are landlord-friendly and will help to ensure that your rent keeps pace with any increases in his loan payments. Whether or not you want to grant them is a business decision for you and your tenant representative.
Short-Term Ownership
When a commercial real estate landlord has an adjustable rate mortgage and doesn't seem to care about the risk that it poses, he could be planning to sell the building. Many ARMs give a couple of years of low interest rates, so they can be good short-term financing tools. If that's the case, you should be able to get a long-term lease, since he'll be focused on improving his rent roll. When you negotiate with a short-term owner, keep in mind that he may be willing to trade concessions for base rent since concessions are one-time expenses but base rent gets capitalized. An experienced commercial real estate broker can help you formulate a strategy to maximize your opportunity in these situations.
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