Month: April 2020

One of the first and most critical steps to realizing a new development project is securing the land to build on.

In this case, there are only two options – buy it or lease it.

Though many developers frown upon the idea of renting a parcel of land to build on, it is an attractive alternative that comes with lots of possibilities. That’s why today we’re going to share with you what a ground lease is and what the pros and cons are to having one.

So, let’s get started!

What Is a Ground Lease?

A ground lease, also known as a land lease, is a lease agreement that allows you to rent a piece of undeveloped or developed land for a long period of time. This land your leasing can be used for development and commercial purposes.

In other words, a ground lease is an agreement that lets you lease the land you want to build your next commercial property on.

With a ground lease, the following happens:

• A landowner leases the land (rather than selling it) to a developer for anywhere between 35 and 99 years
• The developer (or tenant) pays rent to the landowner and retains the right to develop buildings and operate business ventures on the premises
• All responsibilities and associated costs related to the land, such as taxes, insurance, development permits, and maintenance fall onto the developer

When a developer signs a ground lease agreement, they do not own the land; they are only renting it. However, any structure or facility that the developer builds on the land is owned by the developer, not the landowner.

When the ground lease expires and is not renegotiated, the land, as well as any improvements created by the developer, reverts back to the landowner.

Ground leasing enables a developer to obtain a piece of land that’s too expensive to buy or is otherwise inaccessible and make something profitable out of it. For example, government properties are often too expensive for an investor to buy. That said, renting a piece of government property is much more doable.

In addition, a ground lease enables the landowner to benefit from the property they’re leasing to developers without having to sell it or make major investments to develop the site.

In the end, it’s a win-win situation for both the landowner and developer.

A Practical Example A Ground Lease

Large franchise chains like McDonald’s frequently operate using a ground lease. The land is usually purchased by the corporation and leased to the local franchise to develop the building, set up the operation, and run the business.

Every ground lease agreement contains specific terms and provisions for the usage of the land. In this case, the land is only provided for the development of a McDonald’s restaurant. The developer is bound by the lease agreement and cannot switch 10 years down the road and open a KFC joint.

Types of Ground Leases

A development project is rarely paid for in cash. In fact, there are different kinds of loans or mortgages available to finance the construction and/or improvement of the land. In order to grant the exorbitant amounts of money required to develop a commercial project, banks will require some collateral in the event the business defaults.

Should the business fail, there is a hierarchy of who gets to claim the assets to recoup their investment.

Top priority is usually either the bank providing the loan or the landowner. From here stem two basic types of ground leases – subordinated or unsubordinated.

Subordinated Ground Lease

With a subordinated ground lease, the landowner agrees to forfeit the top priority claim to the land should the developer default on the loan.

Banks are much more willing to finance a business venture if they’re guaranteed the right to claim first. As such, the landowner effectively pledges their land as collateral in the event the business goes bankrupt.

This means that a subordinated ground lease creates a significant risk for the landowner, which is usually compensated for by charging the developer a higher rent.

Unsubordinated Ground Lease

An unsubordinated ground lease gives the landowner the ability to claim their land back should a developer default – guaranteed.

This is a preferred option by many landowners who do not wish to incur the risk of losing their land.

However, it makes it difficult for the developer to secure the necessary funds for development, as banks are reluctant to approve a loan if not given top priority to claim should the loan go into default.

To offset this challenge and make it worthwhile for developers, unsubordinated ground leases typically come at a reduced rate and yield less profit for the landowner.

Ground Leasing vs Other Commercial Leases

Though still related to commercial real estate, ground leasing differs dramatically from other forms of commercial leasing.

Gross Leasing

Similar to renting an apartment, in a gross lease the investor (or tenant) pays the landowner an agreed rent amount to use the facilities for conducting their business. There is usually an already erected building such as an office space, grocery store, or workshop that the investor simply leases.

The investor assumes no other responsibility with a gross lease other than the scheduled rent payment. Taxes, permits, insurance, and other costs fall onto the landowner. However, the investor has very little freedom to modify or upgrade the facilities without prior consent.

Net Leasing

Net leases allow investors to assume some of the landowner’s responsibilities to varying degrees. Because of this, the investor has more freedom to improve and modify the facilities.

The exact structure of a net lease is up to the landowner and investor to negotiate and agree on.

A special kind of net lease, called a triple net lease, transfers most of the landowner’s costs and responsibilities to the investor, including construction cost, property taxes, insurance, and more. Since these are costs the investor is now responsible for, this type of lease usually comes with a lower base rent.

Absolute Net Lease

Absolute Net leases are similar to triple net leases but go a step farther by placing 100% of the responsibilities onto the Tenant’s shoulders.  This includes structural items such as the roof, exterior walls, and parking lot.

Advantages of Ground Leasing

Ground leasing is not the perfect solution for every real estate development project. However, it’s becoming increasingly popular in the United States and offers a number of advantages for both developers and landowners.

Pros of Ground Leasing for Investors

The biggest advantage for property investors using a ground lease is that they don’t have to buy the land to operate their business and make a profit. Acquiring the land for a development project can be the biggest hurdle holding an investor back from successfully running a business.

In fact, acquiring land involves massive upfront costs, and many times, the perfect site is just not accessible. For example, oftentimes the landowner doesn’t want to sell or the land may be public property that cannot be obtained or is uneconomical to do so.

Ground leasing helps you avoid upfront costs and frees up resources to be used on improvements instead. And to top it off, rent payments are tax deductible, which is always good news.

Pros of Ground Leasing for Landowners

Arguably, ground leasing is more advantageous to the landowner than the investor leasing the land.

The owner of the land retains ownership, and sometimes, a significant portion of control over how property is utilized. Depending on the case, the ground lease may include extensive documentation for the type of facilities built, the purpose of the business, and details on how business will be conducted.

Once the ground lease agreement is signed, the landowner can enforce the provisions found in the contract. Any changes to the development or use of the land must receive the land owner’s permission.

In addition, ground leasing is a great way to establish a passive income stream for landowners. This is because the owner of the land doesn’t need to invest in developing the real estate themselves. They just collect rent payments.

If a landowner were to sell their land, they would receive capital gains and owe a significant amount of taxes to the government. After all, rent payments are considered regular income and are subject to taxes. However, it can be financially advantageous to pay income taxes rather than capital gains taxes.

Finally, the owner of the land inherits all buildings, structures, and improvements at the end of the ground lease term. If the current ground lease is not extended or renewed, the investor must simply forfeit their immovable assets unless there is a clause in the ground lease that mandates the developer to demolish and remove all structures and return the land to its original stage when the lease is up.

Disadvantages of Ground Leasing

Like most things, there are disadvantages to ground leasing that both investors and landowners need to consider.

Cons of Ground Leasing for Investors

While investors pay for the right to develop and operate businesses on land with a ground lease, the project and design must first be negotiated with the landowner.

Of course, investors always seek the most lenient use provision so they can operate their business as they see fit.

However, sometimes that’s not possible and the ground lease may contain a specific schedule and timeline for the execution and development of the project. Investors who don’t uphold the schedule can face financial repercussions. These limitations are often hard to overcome and investors may face huge burdens to complete the project.

No matter how good your initial design is, in practice it’s often required to make changes and alterations. Depending on the use provisions, every significant change to the project must receive approval by the landowner, which can create points of friction and lead to lost time during the development process.

With a ground lease, the investor pays rent to the landowner. However, they also incur all other financial costs related to the land such as taxes, construction, improvements, permitting, insurance, and more. All of this can become very expensive over time.

Not to mention, in some cases long-term rent can prove to be more expensive than buying the land outright. Sure, sometimes that’s just not possible or economical to do. However, total cost must be taken into account before agreeing to a ground lease.

Cons of Ground Leasing for Land Owners

While not immediately obvious, there are a fair number of disadvantages to ground leasing for landowners.

To start, every development project faces the risk of not succeeding. Businesses fail for a million and one reasons. If the investor defaults, they usually cannot pay the rent they owe, meaning the landowner is out a lot of money.

If the business is bankrupt before even finishing construction, there is usually a long list of unpaid contractors which will begin litigation to recoup their money. This can affect the landowner and compromise their interest in the property.

The worst part is when a leasehold mortgage or another finance structure is involved. The relationships between the finance provider, the land tenant, and landowner become very complex, very fast.  If no protections are in place protecting the landowner, they may end up accountable for their investor’s business failure and lose the land.

In addition, though partially mitigated by the use of proper insurance, there is always some element of risk associated with incurring liability for injured third parties at the site or environmental damage caused by the investor. And while the landowner is not directly responsible for such injuries or damage, they may be held partially accountable.

Finally, landowners must carefully consider the rent structure of the ground lease. Since it encompasses decades, the market can and will change dramatically, rendering a fixed rent structure irrelevant within just a few years.

The rent structure must change just as the market does and account for inflation and the state of the market, so that the landowners always receive a fair rent for their property. There are even some ground leases that tie the rent rate to the performance of the business. So, if the business excels and becomes very profitable, the landowner also gets a proportionate share of that profit.

Wrapping Up

In the end, a ground lease is a complex, though highly advantageous solution for developers looking to start a commercial project without having to invest a ton of money upfront. Plus, the benefits awarded the landowner make leasing land for a long period of time a fairly easy process that allows both parties to win.

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It is estimated that there are 109 million people, or 36% of the population, currently renting in America. And this only accounts for residential properties. When it comes to commercial buildings, there are well over 5.5 million spanning the country. And you can bet a lot of them are being leased.

Needless to say, there is a lot of opportunity available for investors of all kinds to build a successful real estate business.

Investors in the market looking to expand their commercial building portfolios are always on the hunt for the best deals and the most profitability. However, determining whether a potential investment property is a good one or not takes some know-how.

If you’re an investor looking to build a bigger portfolio with properties that have a high ROI and tenants willing to pay premium prices, you’re going to need a quick way to vet, compare, and analyze potential listings. That’s why today we’re going to teach you about one of the best resources investors rely on to gauge the value and profitability of potential investment properties: gross rent multiplier – A.K.A. gross income multiplier (GIM).

What is Gross Rent Multiplier?

Gross rent multiplier (GRM) is a calculation used by real estate investors to determine the value and estimated profitability of a property before taking the plunge and buying.

Experienced investors always have a plate full of potential properties they’re considering when trying to build their portfolio. But prioritizing which ones to invest more time and resources into for analysis quickly becomes difficult, especially if the properties are not exactly comparable, as is often seen with commercial properties. That’s where calculating the gross rent multiplier comes in handy.

Why Gross Rent Multiplier is Important

It’s not enough to know that the gross rent multiplier is useful in determining the potential profitability of an investment property.

A successful investor will understand why calculating this value, as opposed to others, is so important, especially in the beginning stages of purchasing:

• Quickly and efficiently decide which properties are worth your time analyzing further
• Compare properties that are similar and determine which ones stand to generate the most annual revenue
• Buy the right property at the right time, regardless of the status of the housing market using gross rental income values in your calculation
• Avoid falling victim to the versatile housing market by using fair market value to determine potential annual rental income – use GRM instead
• Easily convince lenders of your ability to repay a loan upon approval
• Determine how the property’s condition and possible rent rate compare to the competition
• As a commercial investor, easily differentiate between very different properties and let the numbers guide your efforts
• GRM / GIM is a more pure metric compared to cap rate as there is less room for error by the Broker or Seller.

Of course, there is no magic formula that will guarantee what a potential investment property will yield the first year or any year thereafter. The point of calculating the gross rent multiplier is to quickly weed out properties you know will not be profitable and focus your attention on those you are seriously considering investing in.

How to Calculate Gross Rent Multiplier

Gross rent multiplier is a mathematical formula used to calculate an investment property’s potential rent income based on the ratio of the property’s fair value market (or purchase price) to the expected gross annual rent income.

In other words, to calculate the gross rent multiplier of any property, you have to have a value assigned to the property and know the amount of rent you can expect to collect each year from it.

You can get the GRM for an investment property using the following equation:

Market Value (or purchase price)/ Annual Gross Rental Income = Gross Rent Multiplier

Let’s say you want to purchase an investment property listed at $300,000 and you know the annual gross rental income is $30,000. Calculating the GRM would look like this:

$300,000/$30,000 = 10.0 GRM

Of course, this means nothing to you right now; it’s just a number. However, if you were to take a comparable property, also listed for $300,000, but with an expected annual gross rental income of only $25,000, you would now have a GRM of $300,000/$25,000 = 12.0 GRM.

Comparing the two example properties, you now realize that you stand to make much more money with the first property as opposed to the second based on the gross rent multiplier. In fact, the lower the gross rent multiplier, the higher the likelihood that the property will yield more profit.

Of course, the gross rent multiplier does not account for things like:

• Cost of vacancies
• Annual taxes
• HOA fees
• Insurance
• Maintenance and repairs
• Utilities you cover

Remember, GRM relies solely on the gross annual income. To really determine whether an investment property is worth your time and money, you’ll have to do more research.

Want to take a potential property’s GRM and estimate the market value?  Simply use this formula:

GRM x Annual Gross Rental Income = Approximately Value Market              

What a GRM is Not

Gross rent multiplier is an excellent tool for quickly comparing properties and gauging whether you should continue your research or not.

That said, GRM is not the end all calculation you should use to make an investment decision. Many other factors play into the profitability of a property that go far beyond the expected annual gross income.

In addition, the gross rent multiplier is not a calculation that should be used to determine the time it will take for you to pay off an investment property. Unfortunately, many investors are misinformed and are led to believe that if a property has a GRM of 10.0 that means it will take approximately 10 years to pay off the property in full and begin generating nothing but profit.

The problem with this thinking is that the gross rent multiplier does not take into account any other expenses related to a property that an investor will be in charge of. Not to mention, the gross rent income is an estimate, not a surefire number that will remain static over time. All of these things have the potential to play into how long it takes you to pay off your investment property and begin generating pure profit.

Want to get an idea how much the related costs of owning an investment property might be each year? Choose one of the following to get an idea:

• 1% of the purchase price of the property
• $1 per square foot of the property

Knowing this information and the GRM will give you a better idea how much profit you stand to gain from an investment property each year.

Wrapping Up

In the end, all real estate investments come with a certain level of risk, no matter which calculations you use to make a final purchasing decision. That said, the gross rent multiplier of a property is an excellent tool to have on hand for quickly vetting and comparing properties so you can focus your efforts on properties that are likely to generate you the kind of annual income you want.

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Floor area ratio (FAR) is the ratio of a building’s total floor area (zoning floor area) to the size of the piece of land upon which it is built.
Calculate the FLOOR AREA RATIO: Divide the GROSS FLOOR AREA by the BUILDABLE LAND AREA. The result is the Floor Area Ratio (FAR).
STEP BY STEP:
STEP 1.
Determine the total BUILDABLE LAND AREA, in terms of square feet, for the site. The buildable land area is that portion of a development site where construction can legally and reasonably occur – so public streets and rights-of way, wetlands and watercourses, and other constraints would not be included. Buildable Land Area (B) = (Parcel Width x Parcel Depth) – Square feet of undevelopable land (if applicable).
STEP 2.
Determine the FLOOR AREA of each story of the building. Calculate the area of each story (floor) of the building, typically measured between the exterior walls. Those portions of each story above the ground surface prior to any manipulation or grading are usually included in the calculation.
STEP 3.
Determine the GROSS FLOOR AREA of the Building. Gross floor area is the sum of the floor area of each story. Gross Floor Area (G) = Floor Area of 1st Story + Floor Area of 2nd Story… for all floors above the ground.

Understanding BOMA Standards – Measuring Commercial Real Estate

When renting an office space or other commercial real estate, it’s not always immediately obvious what you’re paying rent for. 

There are several types of commercial leases, each with their nuances about the rights and responsibilities of the tenants and landlords. Just as a quick overview, here are the most common types:

1. Net lease – This lease allocates building costs and responsibilities between the landlord and tenant. The most common type is the triple net lease, where the tenant pays all taxes, insurance and maintenance for the building, in addition to the monthly rent.
2. Gross lease – The landlord pays for all repairs, building taxes and insurance. The tenant is only responsible for paying rent, however, it is usually elevated to account for all these expenses.
3. Modified gross lease – These are commonly found in real life situations. Landlords keep some responsibilities, like paying the taxes, insurance, and major repairs (for example roof renovations). However, the tenant is responsible for maintenance and minor repairs, like painting and decorating.

Regardless of the lease type, rent is always calculated from the square footage of the leased floor area. As a tenant, you will always try to negotiate the best (lowest) rent price. However, it’s just as important to have a complete understanding of how this area is being measured.

• Do you measure from the outside wall or the inside wall? 
• Are support columns excluded from the area?
• Are electrical, mechanical and janitorial rooms excluded or included? Why? 
• What about the toilets and staircases? 

 

Depending on where you put the tape measure, you’ll get slightly different square footage. Multiply that by all the floors in the building and you get a wild discrepancy, that’s directly linked to your rent. 

There is no universal, legally defined method to measure a commercial building. However, there are the BOMA Standards. 

BOMA Standards

BOMA stands for Building Owners and Managers Association. Over 100 years ago, in 1915, BOMA created and published the first standard for measuring floor area in commercial real estate. In the last century, the standards have evolved parallel to the industry and BOMA has established itself as the global authority in building measurement. 

BOMA standards are not a regulatory requirement. They are entirely voluntary, however, they are recognized and trusted by the American National Standards Institute (ANSI). Therefore, the majority of commercial landlords, developers and lease contracts use them regardless. 

Today there exist several different BOMA standards for measuring various types of commercial property: 

1. Industrial
2. Gross Area
3. Multi-Unit Residential
4. Retail
5. Mixed-Use
6. Office

 

You can purchase the latest edition from the BOMA website. Each is designed in accordance with the specific needs of that industry as well as the specific architecture of the measured buildings. Below, we’ll take a look at the standards that are used for measuring an office building.

 

Measuring an industrial building using the BOMA Industrial Standard

In 2019, BOMA updated its Industrial Standard. 

The previous version, published in 2012, gave different recommendations for single-story, multiple-story, single-occupancy and multiple-occupancy buildings. The old standard furthermore defined two different methods for measuring buildings – the External Wall Method – Method A and the Drip Line Method – Method B, each of which contained multiple exclusions. This created considerable confusion for landlords and tenants who had to navigate complicated scenarios to pick out the most appropriate method for measuring a building. 

The new 2019 BOMA Industrial Standard combines all the best features from both deprecated methods and offers a single unified way to measure an industrial building.

The new method measures all areas used to conduct “Industrial activities” that are also covered by a permanent roof. The measured area is practically the same as when measured via Method B (Drip Line Method) from the old standard, as it measured the external footprint of the roof and anything within the perimeter was included. 

However, since Method A was more popular and commonly used for enclosed buildings with solid exterior walls, new areas are now included such as covered loading docks, therefore increasing the rentable area of the buildings. 

“Industrial Activities” are defined in such a way to allow more styles of buildings to be measured using the 2019 version of the standard, compared to previous versions, which offered limited support.

Measuring an office building using the BOMA Gross Area Standard

In 2018, BOMA updated it’s Gross Area Standard to define four new methods of measurement that replace the older definitions. The two most relevant for negotiating commercial leases are Gross Area 1 and 4. 

BOMA Gross Area 1 – Leasing Method

Gross Area 1 – Leasing Method replaces the deprecated Exterior Gross Area or EGA. 

Gross Area 1 defines all areas inside of the building, as measured from the outer edge of the external walls. The standard also accounts for areas that fall outside of the building, but are developed and provided to the tenant for their exclusive use. 

This method was specifically designed for cases when the entire building is leased by a single tenant. If both parties agree to use the method, much simpler measurements are needed to calculate the floor area of the building and therefore the rent price.

 

Gross Area 1 – Leasing Method sums up all following areas as measured from the outer edge of their exterior walls. Spaces are classified as follows: 

• Space Classification A: Floor Area, Parking Area, and Connectors
• Space Classification B: Balconies, Exclusive Use Covered Galleries, and Finished Rooftop Terraces
• Space Classification C: Unenclosed Occupant Circulation and Roofless Structured Parking

If you’re negotiating a lease based on the BOMA Gross Area 1 method, consider that many areas that are not usable for conducting business will be charged with rent – the area of the external walls, restrooms, corridors and hallways, maintenance areas, electrical and mechanical rooms, elevators, staircases, etc. Keep that in mind when negotiating the rent charge. 

BOMA Gross Area 4 – Construction Method

BOMA Gross Area 4 – Construction Method replaces the deprecated Construction Gross Area or CGA.

Gross Area 4 defines a larger area, that includes Gross Area 1, as well as any areas within the property that are not enclosed structures, but have a floor, or are covered under a roof or canopy. This measurement method gives a more complete look at the building in terms of construction and replacement costs. However, it is not typically used to calculate rent in commercial leases.

Gross Area 4 – Construction Method sums up all following areas as measured from the outer edge of their exterior walls. Spaces are classified as follows: 

 

• Space Classification A: Floor Area, Parking Area, and Connectors
• Space Classification B: Balconies, Exclusive Use Covered Galleries, and Finished Rooftop Terraces
• Space Classification C: Unenclosed Occupant Circulation and Roofless Structured Parking
• Space Classification D: Public Use Covered Galleries and Sheltered Area (Industrial)
• Space Classification E: Building Voids
• Space Classification F: Other Rooftop Areas, Unenclosed Connectors, Decks, and Plazas

Measuring an office building using the BOMA Office Standard

In order to understand how this standard works, we need to make two important definitions: Usable Area and Rentable Area

Usable Area

Usable area is the physical area that tenants can use to conduct their business. This is space to locate desks, working stations, furniture, equipment and personnel. The usable area is measured from one of three points:

• The office side of the common corridor wall 
• The inside of the external wall of the building 
• The middle of partition wall, separating two adjacent tenant spaces

The usable area does not include: restrooms, elevator shafts, fire escape stairwells, public corridors, janitor rooms, maintenance rooms and other functional areas that are not available for business purposes.

Many tenants will make the assumption they are paying only for the usable area and don’t need to care about all the deductions listed above. And they will be wrong. 

All these common areas are an integral part of the building. You can’t have a roof if there are no walls and you can’t run an office if there are no toilets, electricity or running water. The landlord has no choice but to pay for building and maintaining these areas, so the law gives them the right to include them in the rentable area. 

Rentable Area

Rentable area is all the interior space of the building, except for the elevator shafts and fire escape stairwells. 

The rentable area is measured from the:

• Inside surface of the exterior building wall
• Office side of walls of major penetration – stairs, elevators, escalators, flues, pipe shafts, and vertical ventilation ducts

Since the last update in 2017, the BOMA Office Standard now also lists balconies, terraces, and roof spaces as rentable space, because these amenities are highly desirable by office workers for resting.

The majority of commercial leases are structured based on the rentable area of a building and this creates the need to define one more parameter – load factor.

Load Factor

The load factor of a building is simply the percentage difference between the rentable and usable space. When the building is leased to a single, this calculation is very easy to make. If there are multiple tenants sharing the building, then the load factor is calculated based on their respective shares of rentable space. 

 

We have a separate guide about Understanding Core Factor, Loss Factor and Load Factor

 

BOMA Standards also use another metric, called the R/U Ratio. This the ratio of rentable space to usable space and you calculate it by dividing the former with the later. You get a number like 1.03 or 1.17. The higher this number is, the more rentable space is lost to common and service areas. So, as a tenant, it’s beneficial to look for a building with a lower R/U ratio.

Why should you care about building measurements

Tenants who are not aware of these building measurement standards could make the mistake of renting an inadequate space for their business, assuming that all rentable space is available for use, or paying much more than anticipated to rent the space they actually need. 

It’s critically important to discuss and verify with the landlord which building measurement method is used to define the area. Before signing the lease, it’s recommended to have the building measured by a professional surveyor to verify the numbers provided by your landlord. 

These extra steps will help you avoid confusion, disappointment and potential disputes with the landlord.

 

Many times brokers and sellers need to estimate the unit square footage and all they have is the total building square footage. So the question is how much to deduct for the exterior walls. The general rule of thumb is 4% of the total square footage.

Let’s say we have a structure that is 100′ x 100′ for a building totaling 10,000 square feet. A 12″ thick wall x 100 SF x 4 (assume there are 4 walls) equals 400 square feet of exterior wall which translates to 4% of the total square footage.

Understanding Core Factor, Loss Factor and Load Factor

In commercial real estate, you’ll commonly hear and see these terms: core factor, loss factor and load factor. Just what exactly are they and how do they influence the square footage you lease and your rental costs?
Core factor, loss factor and load factor are exactly the same thing. Different terminology is used throughout the industry, but they all mean the ratio between the rented and usable space in a commercial building.
Confused? The loss factor is just a percentage difference between two area measurements. However, to properly understand its significance to your business, we need to wind back a little bit and talk about floor area in commercial leasing.
If there’s something universally true about the commercial real estate industry, it’s that just like physics, space is relative. One of the most controversial aspects of the real estate industry is how to calculate the area or square footage of a building – often a simple rectangle.
Depending on who is measuring and why, you can get a different answer.

Who measures what?

If you’re a property developer, a landlord or an investor, you’re most certainly interested in the rentable square footage, otherwise known as the gross leasable area.
This is the entire footprint of the building, as measured from the outside walls. It includes all walls, lobbys, common halls, toilets, stairways, elevators, service areas, machinery rooms, utility rooms, and other facilities.
The property owner pays for the costs to develop, maintain, advertise and improve the entire building, so it’s only fair to have these shared areas included in the rentable space.
On the other hand, if you’re a commercial tenant, you only really care about the usable space in a building.
That’s the area enclosed between the internal walls of your rented space. This is where you place computer desks, shelves with merchandise, dinner tables, etc. And while you need walls, electricity and running water in the building, they’re not really your problem.
You’re interested in the area needed to set up your shop or office. However, your landlord may argue that toilets are usable space – after all your business is conducted by human beings. Store fronts and lobbies can also be considered usable space, since customers use these areas when they visit your business.
So the further we look into the details, the more complicated it is to answer which areas are what. In fact, even different regulators like BOMA and REBNY don’t entirely agree on how areas should be measured and which facilities are regarded as usable.
You can read more about floor areas in our article – Understanding Commercial Lease Floor Areas – Gross vs Net Leasable Area

How to calculate the loss factor

Okay, now that we know the difference between area measurements, calculating the loss factor is very easy. Let’s consider the following scenario:
We’ve got an office building, with an external footprint of 25,000 sq.ft. That’s the rentable space, otherwise known as gross leasable area.
The building is segmented into several office spaces with a total internal area of 20,000 sq.ft. That’s the usable space, otherwise known as net leasable area.
The remaining 5,000 sq.ft are occupied by walls, hallways, staircases, toilets, shared kitchens and a couple of smaller utility rooms. That’s the common space.
To find the loss factor for this building, you divide the total common space to the rentable space and convert that into a percentage.
5,000 sq.ft / 25,000 sq.ft * 100% = 20% Loss Factor
Why does the loss factor matter?
As the name implies, you use the loss factor to determine your losses.
If the property is advertised with 25,000 sq.ft of rentable space, then you’re losing 20% to common areas. If you imagined 25,000 sq.ft. of desks and computers, you’ll be very disappointed.
If the property is advertised with 20,000 sq.ft of usable space, and rent is calculated based on the area, then including the common areas will raise your rent by 25%. That’s probably a lot more than you budgeted for.
Calculating loss factor for multiple tenants
If multiple tenants share the same building, then the loss factor for each tenant is calculated based on their share of the total rentable space in the building.
For example, if you rent 1,000 sq.ft. worth of office space in the same building, then your share of the total usable space is 1/20 or 5%. That means you’re also responsible for 5% of the common areas, which is 250 additional square feet.
Your total rented space is adjusted to 1,250 sq.ft. and you’ll be asked to pay 25% more than you originally thought.
Obviously, the smaller the loss factor, the more efficiently you can pack your business in a given building, reducing your annual renting costs by tens of thousands of dollars.

Can you influence the loss factor?

So the loss factor mainly depends on two things – how well and efficient the architects designed the building and how the building is being measured.
The efficiency of the layout
Property developers and landlords are also interested in a lower loss factor, as it indicates they have efficiently used their money and resources to create usable space. By maximizing usable rented space, property owners guarantee their building is more cost effective for their tenants, making it more desirable.
One of the biggest factors is the overall building shape.
A rectangular footprint will yield the most usable space since most of our furniture and equipment is rectangular and easily organized into rows or columns.
A curved or circular building, while infinitely more interesting and attractive to visitors, will offer less usable space and make that space harder to fill with desks, shelves, machines, whatever your business needs.
Of course, the sheer amount of service areas, restrooms, straicases, elevators, lobbies and other common areas will also dictate how much of the building is actually usable to its tenants. In most commercial buildings, these features are built to code – there is a specific requirement for how many of each are needed depending on the size and purpose of the building.
However, optimizing their size, location and orientation can gain a few square feet here and there. Adding this up for an entire office building or a mall will yield a substantial benefit.
The measurements of the building
Again, the loss factor is a byproduct of the measurements already taken. Depending on who, how and why took those measurements, and what standard they used, the loss factor can vary.

Negotiating the loss factor

Can you negotiate the loss factor? You can certainly try.
When negotiating a commercial lease, it’s extremely important to agree early on how the leasable area is measured, which facilities are included, what the loss factor is and how much it actually costs you to lease your business space.
Not doing so in the beginning will almost surely lead to frustration, disputes and potential losses for either or both sides of the lease. That’s not good business.
Usually commercial rent is charged per square foot of space – for example $3 per sq.ft per month.
The first thing to ask is whether that’s the rentable area or usable area being charged. Usually, it’s the former. Then, request a breakdown of the rentable and usable space, as well as the loss factor.
If you perceive the loss factor too big, try negotiating the price based on the usable area.
It’s best to shop around and compare loss factors between multiple buildings to see which one is the most efficient for your business. Then, armed with this information, you can bargain with the owner of the building you actually like to bring the price down a fair amount.
Perhaps you can negotiate a smaller price, for a longer lease term, which will guarantee your landlord they have stable occupancy and return on their investment.
If lowering the rent or changing the loss factor is not an option, you can try reducing other costs such as building taxes, maintenance, landscaping, etc. Alternatively, you can demand certain improvements to the property which will benefit your business, helping you offset the rental cost.

What if you can’t bring the price down?

Sometimes, you’re just getting a good price.
Even if you think the loss factor is too high, there’s little you can actually do to force the price down.
However, you should still always investigate this matter in order to go into a commercial lease fully prepared and aware of the true benefits and drawbacks to the deal.