Question

An owner of an office building (“Lessor”) is currently negotiating a six-year lease with a financial services company (“Lessee”) for 15,000 rentable square feet of space.

Lessee’s offer: The financial services company would like a base rent of $21 per square foot per year with step-ups of $2 per square foot per year beginning the second year. Downtown Covina Office Building owner would provide full service under the lease terms.

Building owner’s counter-offer: The owner of the office building believes that the $21 lease is too low and is trying to offer a counter-offer which includes a base rent of $26 per square foot per year with the same step-ups. Under this counter-offer the office building owner would also provide the financial services company with immediate $80,000 move-in allowance and immediate $20,000 in tenant improvements (TIs), as well as offer the last year of the lease at 50% discount.

1. Assuming that the office building owner believes that his required rate of return on investment should be 14 percent per year, is the counter-offer a better proposal for the building owner? What about for financial services company? Show and explain all calculations.
2. Financial services company’s counter-counter-offer: The company informs the office building owner that it has 1 year remaining on its existing 13,000-square-foot lease in an older building at $26 per square foot per year. The financial services company is therefore proposing a counter-counter-offer: it is willing to pay the office building owner $27 per square foot per year with the step-ups (same as above) on the new lease, but is demanding that the office building owner “buy out” the old lease in lieu of the moving allowance and TIs. Should the office building owner agree to this lease buyout counter-counter-offer, or insist on the lease at $26 per square foot per year with the step-ups, move-in allowance and Tis, and discounted last year of the lease? In other words, which one of the two is better for the building owner? Show and explain all calculations.

Answer 1

For this type of problem, we first need to find out our Net present values for each scenario. Please note that our rate of return as provided in question is the Internal rate of return of leasing company which is 14 Percent per year.

The formula to calculate discount factor for each year is.

Discount Factor = 1/ (1+(R/100))ⁿ

Where N is the year for which discounting is done and R being the discount rate.

We are showing calculations done in excel for simplicity.

Answer for Point A: The counter offer made by the building owner is best option for him as it is resulting in the Highest NPV for him, which is $1541103.73 which is more than the Lessee's offer which is resulting in NPV of $1472462.03.

For point B, consider the following calculations.

Taking counter-counter offer of Lessee is resulting in NPV of $1484442.11, which is still less than $1541103.73. Thus Owner of Building should stay with his offer of base rent of $26 per square foot per year with the same step-ups with $80,000 move-in allowance and immediate $20,000 in tenant improvements (TIs), as well as offer the last year of the lease at 50% discount.

P.S. Please do provide your valuable feedback.