Commercial leases are structured with a standard 36 to 60 month tenure having an escalation at the end of every 36 months and are generally B2B or C2B as the tenant is a company in most cases. Escalations typically range between 12-15% every 3 years and are meant to index the rent to inflation. Normally, the tenant invests significantly in interior fit-outs as offices are handed over in a bare shell form. In order to recover the costs, the tenure needs to be for a significant period.
Lock-in: Almost every commercial lease will have a lock-in. Lock-in periods are generally 2 to 3 years. During the lock-in period, a tenant cannot vacate the premises providing the landlord with a stability of rental income. Landlords, therefore, insist on a lock-in period in order to protect themselves from volatility in the lease.
Notice period: A standard notice period in a commercial lease ranges between 3 and 6 months for reasons similar to what we discussed above – longer lease-up times. 3-6 month notice periods give landlords an opportunity to find a new tenant without losing rent for longer periods of time.
Market Yield Vs In-place yield: This creates an important anomaly in the rent structure. Rents in the top cities in India have been growing at 10-12% per year, which is much higher than the contracted escalations of 12-15% every 3 years built into the leases. Over a 15-year lease period, the tenant will end up paying significantly lower rents compared to the market.
This restricts the value of the property as commercial Real Estate sells at a “yield” (also called cap rate), which is rent divided by price. In an under the rented building, the cap rate becomes much lower forcing the landlord to sell at a lower price.
At AGB Realtors, we pay a lot of attention to the market yield (yield at market rent) vs. the in-place yield (yield at current rent). A higher market rent yield tells us that there is upside potential in the investment if we can wait till the lease tenure is over or if the tenant decides to vacate mid-way. It also indicates safety, as a tenant is unlikely to leave if the market yield is higher. The reverse is true if the market yield is lower. In such a case we are wary, as the incentive for a tenant to leave is higher since he can switch to a new office building for lower rents. This happens if there is an oversupply in that particular market.