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Leveraged Breakdowns

A Beginner’s Guide To Commercial Leases, Part One: Income

The terms and conditions within a commercial lease can make or break a deal. Analysts must fully understand each of these terms if they want to build practical and effective LBO models. The lingo used can initially be confusing, but with practice you’ll get the hang of it.

Private equity real estate returns for stabilized properties are derived from three basic concepts: income, expense, and time. This post will focus on some of the key terms that define income in commercial leases.

Base Rents

Commercial leases typically state income to the landlord in dollars per square foot. (often called the “Base Rental Rate” or “Base Rent”). Note, these leases always imply that the dollars per square foot is calculated on an annual basis. For example, a lease rate of $30 psf for a 5,000 sf space would equal $150,000 of Base Rent per year, or $12,500 per month.

The Base Rent is also set for a term: either the Initial Term (beginning with the commencement of the lease) or an Option Term. A ten year lease means it has an Initial Term of 10 years. If the tenant has options to extend the lease for five years, and can exercise this option three times, you would say the lease has three consecutive 5-year options.

Common Areas

Naturally, it isn’t always quite that simple. Things can get complicated when there is a shared space in the building, usually referred to in the lease as “Common Areas.” Depending on the landlord, the lease may include an allocation of common area space added to the actual occupied space covered by the lease, referred to as the “Common Area Factor.” Think of the center court at your local shopping mall, or the reception area on the first floor of a multi-story, multi-tenant office building. Common Areas may also include break rooms, restrooms, elevator shafts, and stairwells. In order to distinguish between the actual space occupied by the tenant and the amount of space covered by the lease, the adjectives “Rentable” (what the tenant pays rent for) and “Usable” (what the tenant actually occupies) are added. If 8% of the building’s total square footage is common area, an 8% Common Area Factor would be added. Assuming the 5,000 sf space mentioned earlier was Rentable Square Feet, then the Useable Square Feet would be 4,630 sf (5,000 / 1.08).


Generally speaking, the section of the lease that describes the rental rate and terms will also describe any escalators. Escalators are any clauses that increase the Base Rent, or add rent over and above the Base Rate. Some escalators are a percentage increase on a periodic basis (i.e., 2% increase annually; 15% increase every fifth year), while some are tied to an index such as the Consumer Price Index (i.e., 80% of the CPI increase for the prior five year period). Often these fixed or indexed increases are tied to options to extend. Many retail leases include a percentage rent clause where the landlord may receive additional rent if the tenant generates sales above an established threshold.

Final Thoughts

Building a real estate LBO model requires careful attention to the terms and conditions included in each lease. Private equity real estate returns are sensitive to rents, expenses, and time. Part Two will focus on expenses, particularly how expenses are allocated between the landlord and the tenant.

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