Asking rent is the number on the flyer. Effective rent is what a lease actually pays you once you back out everything you gave to get it signed. Owners who track only the first are usually surprised by the second, and the surprise tends to arrive at refinance.
This is the second article in a series on how to read your own building. The first covered why NOI is not your cash flow.
The math
Effective rent is short to calculate and almost never calculated.
- Add up the total base rent the tenant will pay over the full term, including scheduled escalations.
- Subtract every month of free rent.
- Subtract the tenant-improvement allowance you are funding.
- Subtract the leasing commission.
- Divide by the number of months in the term, then by the square footage if you want a per-square-foot figure.
That is effective rent. Some owners also subtract a reserve for the cost of re-leasing at the end of the term; lenders sometimes do. The simple version above is enough to change how you read your rent roll.
A worked example
The figures are illustrative, not a lease we signed.
A 4,000-square-foot office suite, five-year term, asking rent of $28 per square foot per year with 3 percent annual escalations. To close the deal the owner gives four months free, a $40-per-square-foot improvement allowance, and pays a 6 percent commission on the total lease value.
- Total base rent over five years, with escalations: about $594,000
- Less four months free: about $37,000
- Less TI allowance at $40 per square foot: $160,000
- Less commission at 6 percent: about $35,600
- Net over the term: about $361,000
Divide by 60 months and 4,000 square feet, and the effective rent is roughly $18 per square foot per year against an asking rent of $28. The building's rent roll says $28. The lender's spreadsheet says $18.
The exact gap depends on the deal. In a soft market with a well-capitalised tenant and a big build-out, it widens; on a renewal with no TI, it nearly closes. The direction never changes: effective rent is always below asking, and the concessions are the reason.
Why this matters more than it looks
Three parties compute effective rent whether or not you do.
Your lender underwrites it. A refinance sized on asking rent will come back smaller than expected, and the conversation about why happens after you have already planned around the larger number.
Your appraiser uses it. Market rent in an appraisal is effective rent, and comparable leases are adjusted for concessions before they are compared to yours.
A buyer will run it on every lease in your rent roll during due diligence. A rent roll underwritten at asking is underwritten at a price nobody is paying, and the buyer's retrade will be exactly the size of the gap.
The renewal implication
Effective rent is also the number that makes renewals look different. A renewal with the existing tenant typically carries no TI, a smaller or no commission, and little or no free rent. A slightly lower face rent on a renewal is often a higher effective rent than a new lease at asking, before you even count the months the space would have sat dark. Owners who hold out for asking on a renewal are frequently trading a better deal for a worse one and calling it discipline.
What to do with this
Run the calculation on the last two leases you signed. Ten minutes each. If the gap surprises you, that is the number to carry into your next budget, your next lender conversation, and your next renewal negotiation.
Then look at your rent roll as two columns instead of one: what each lease says, and what each lease pays. The second column is your building.
About this series
Gain Property Group manages more than 600,000 square feet of office, retail, industrial and multifamily property across Hillsborough, Pinellas, Pasco, Polk, Manatee and Sarasota counties, including buildings we own ourselves. Once a quarter we publish what we are actually seeing across that portfolio in the Tampa Bay CRE Letter, including asking versus effective rent by asset type and county. It is free, and it is one email a quarter.
If you own commercial property in Tampa Bay and want your rent roll read the way a lender reads it, request a free management assessment. In writing, no obligation, whether or not you change managers.
This article is general information about commercial property operations. It is not investment, legal or tax advice.