The Importance of Net Effective Rent (NER)
June 30, 2020 | Tyler Staton
This article serves as an overview of Net Effective Rent (NER) and its importance for the commercial real estate industry, primarily for landlords and their brokers.
NER is a single number that can capture the financial impact of a commercial lease. Given that commercial leases have many different rental components, associated operating expenses, concessions, and other items, it is useful to be able to simplify the financial impact of a lease down to a single metric for analysis.
It is calculated by deducting operating costs and incentives from a lease's total base rent, and can be understood as a landlord’s true “take home” amount from a lease transaction. Generally, it is in the best interest of the landlord to achieve the highest possible NER, as this equates to more revenues and higher building values. It is vital for leasing professionals to have the ability to analyze the components of a deal and quantify the landlord’s NER.
Importance of net effective rent to commercial landlords
For commercial landlords, it is vital to attract new tenants and retain their existing ones at the best possible terms. Net effective rent can be used as a tool to help property owners negotiate a better lease. Here are the top 3 reasons why NER is important to commercial landlords:
1. Net effective rent helps commercial landlords in their leasing strategy and decision making.
NER can be used as a benchmark for new leases. Leasing teams can monitor this metric on a building level by aggregating the NERs of all the leases in that building. They can use this as a threshold that serves as a target for the minimum rental level that they would grant to a new tenant in that building. This helps to ensure that their building’s revenues continue to increase.
2. Negotiating on Net Effective Rent can help a landlord maintain a higher base rent.
By using the NER as the metric with which to negotiate a lease, landlords are able to offer incentives to a tenant while still maintaining a higher base rent. This can be beneficial for a landlord since rent escalations will still happen off of the higher base rent, and the base rent will be used as the starting point for a renewal negotiation. This could mean higher revenue for a landlord.
3. Net effective rent is a measurable way to compare normalized information.
a. For leasing teams and brokers - NER can be used to compare two offers side-by-side to understand which one would generate better returns, even if the two leases are structured very differently. An offer with a higher base rent could potentially bring in less revenue because of incentives. This fact could be missed by a leasing team if a NER analysis is not done, causing them to make a less than optimal deal.
b. For building owners - By using NER it is possible for building owners to compare the financial performance of buildings across different geographies. This can be done despite differences in local measurement standards, lease structures, and currencies. This allows an owner to have a single metric to use to better assess the value of their buildings in a multi-city or multi-country portfolio.
c. For the industry - Since NER is the true measurement of the value of leases, having an overview of the average NER at a market level would allow for an informative analysis of that market. This has traditionally been difficult as often only the headline rates of leases are made public.
How to calculate net effective rent
These following terms are necessary for calculating the net effective rent:
1. Base rent: the regular monthly rent
2. Term: refers to the length of the lease
3. Incentives: rent free months, tenant’s total cash allowance
4. Tenant improvements: the improvements a commercial landlord makes to the interior of the rental space in order to suit the preferences of the new tenant.
The simplest way to calculate the net effective rent is to calculate the total amount of base rent due over the term of the lease, including escalations, and deduct the total value of incentives. This value is then divided by the number of months in the lease term and then divided again by the area of the unit to get the NER of the per unit of area rented.
Sample of net effective rent calculation
Landlord A has listed a vacant 500 sq m unit and is asking $10 per sq m per month in base rent, but is also providing the first 3 months rent free to entice a tenant to sign a two-year lease. Given that, the tenant would pay $5,000 a month for just 21 of the 24 months of the term - this would amount to $105,000 in net effective rent over the lease term. When that is spread out over the full 24-month term, that yields a NER of $4,375 a month or $8.75 per sq m per month.
Contrast this with Landlord B who is also marketing a 500 sq m unit, but this one is listed for $9 per sq m per month with no incentives. Or Landlord C, who is charging $11 per sq m but is offering a Tenant Improvement Incentive of $25,000 to help with the fit-out. While Landlord A has a higher base rent than Landlord B, he is in fact taking home less revenue, and while his base rent is lower than Landlord C he is taking home more revenue.
*Will we be assuming there are no taxes, insurance or additional maintenance expenses.
The table shows how calculating the monthly per sq m NER is an effective way to get a single number to compare normalized information in order to understand the true value of a lease.
Glossary of Terms
Total rental amount from base rent (including escalations), government fees (taxes and insurances), service charge and other charges.
Value of revenue from base rent and any taxes and insurances.
Net Effective Rent
The base rent less all service charges, rental concessions, tenant improvements etc.
A charge from the landlord to the tenant to cover costs of operating and maintaining shared parts of the building.
Money paid to the tenant to offset costs of improving the space.
Duration of the lease period (Day, Month, Year).
The tenant is not responsible for paying their rent during the rent free period.
Fees the landlord will pay as part of concessions.
Minimum rental amount paid per unit of measure (sq m, sq ft) per period of time (monthly, quarterly, yearly)
Increases in the base rental amount of rental items at predetermined intervals during the term of the lease.