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The term "net effective rent" is commonly used in the commercial real estate market. This concept represents the actual lease cost tenants pay monthly or annually throughout the entire duration of their lease contract after deducting concessions, discounts, or incentives agreed upon with the landlord.
There are several reasons why landlords make deductions to their tenants' rents. For instance, when the impact of the Covid-19 pandemic reduced office demand worldwide, in Brazil, the average asking price dropped by almost 5%, and in Mexico, the average market price in the sector decreased by 7%, according to data from theSiiLA Market Analyticsplatform. However, concessions, discounts, or incentives can also occur during other periods, not just during recessions.
In Brazil, the Tenancy Law (Federal Law No. 8,245) regulates the rights and duties of tenants and landlords. The law stipulates cases in which the tenant must be compensated for expenses related to property improvements, among other important aspects.
Calculating the net effective rent brings benefits for both landlords and tenants in the commercial real estate market. For tenants, knowing the actual cost of rent provides financial transparency and security in planning their expenses. For landlords, it allows them to adjust the market price to ensure that the rent covers costs and offers an adequate return.
So, how do you calculate the net effective rent?
Thenet effective rentis calculated by dividing the difference between the gross rent and the deductions or incentives by the total duration of the lease contract. The formula is as follows: Net Effective Rent = (Gross Rent - Deductions) / Contract Duration.
It's worth noting that:
A) The gross rent is the rental value stipulated in a lease contract for a certain period without considering concessions, deductions, or incentives;
B) Concessions, deductions, or incentives include any benefit that the landlord grants to the tenant, such as rent-free periods, subsidies for property improvements, allowances for construction expenses, among others;
C) The lease contract duration is the total time covered by the legal agreement, including any rent-free period;
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D) The net effective rent is the actual lease cost after deducting the value of concessions, deductions, and incentives.
How to calculate?
Example: Imagine you want to rent a commercial space inFaria Lima, São Paulo, where the average asking price per square meter is R$198 and the desired office has 1,000 square meters. Considering a 5-year lease, where the landlord offers a reduced price of R$195 per square meter for the first two years, as well as 2 months of rent-free to facilitate the moving process for the new tenant.
In this example, the gross rent of the commercial space is R$198 per square meter per month for an area of 1,000 square meters that will be rented for five years. To calculate the gross rent that will be paid throughout the contract, we need to multiply the market price per square meter by the area to be rented, by 12 months, and by the contract's duration. For this example, we haveR$ 198 (price per m²) * 1,000 (area) * 12 (months) * 5 (years lease) = R$ 11,880,000.This means that over five years, we will pay a gross rent ofR$11.880million for a space in Faria Lima, equivalent to a monthly rent ofR$ 198,000or a year rent ofR$2,376 million.
However, to calculate the net effective rent, we need to subtract the value of the concessions, discounts, or incentives agreed upon with the landlord from the gross rent. First, the offer includes paying R$195 per square meter monthly for the first two years. This amount multiplied by 1,000 square meters, by 12 months, and by two years gives us R$ 4,680 million, which is R$72,000 less than what we would have to pay with the regular rate of R$198, that was giving us a total of R$ 4.752 million Additionally, there are two rent-free months. If we had to payR$198,00monthly, the two rent-free months would sum R$396,000.
As a result, we have total deductions of R$496,000 (396,000 per the 2 free rents, and R$ 72for the discount on the price per square meter for 2 years, or 24 months).To calculate the net effective rent with this data, we need to divide the difference between the gross rent and the concessions, deductions, or incentives by the total duration of the lease contract. The formula is as follows: Net Effective Rent = (Gross Rent - Deductions) / Contract Duration.
Applying the formula, we get (R$11,880,000 – R$ 468,000) / 5 = R$ 2,282,400 millions. This means we will pay R$5.8 million in net effective rent annually, or approximately R$190,200 per month.
Rent Adjustment and Contractual Renegotiations
The value calculated above is accurate for the initial year of the contract. However, in rental agreements within the Brazilian market, the gross rental amount will be subject to adjustments on each contract anniversary, based on a predetermined index. The most common indices in the Brazilian real estate market are IGP-M, IPCA, and SBI – the latter being anindex provided by SiiLAthat gauges return on capital, income return, and total return for commercial properties.
Another important aspect to consider is that Brazilian law allows for a potential renegotiation of the rental value between landlords and tenants starting from the third year of the contract. Consequently, the gross rental value might be changed, requiring a reevaluation of the Net Effective Rent.
The topics of negotiations and lease agreements for commercial properties take center stage in both modules offered by the SiiLA ACADEMY – the Office module and the Logistics module. For the September 2023 classes, industry experts will present this subject matter, taking on the role of guest lecturers. For the coming edition, students enrolled in the Logistics course will have the valuable opportunity to learn from Ricardo Betancourt, CEO of Colliers in Brazil – a distinguished multinational company known for its expertise in representing landlords and tenants, as well as offering appraisal and consultancy services.
