NNN long term lease, inflation factor?

[Stephanie Z.]

I need to learn to assess a sale and negotiate a commercial lease, as the owner/lessor. 

Can y'all tell me what you're seeing right NOW in the market for commercial (office) space leases regarding the annual increase rate?

Backstory: We own a business that we are considering selling. The deal will have several interdependent factors -- mainly, 1) the sales price of the business, 2) the RE sale price OR lease deal 3) the employment agreement for the key employee (my spouse) who would be required to work for a couple more years after the sale. 

So, it's not as simple as hiring a broker and negotiating a sales price and being done with it. This is more like buying a car with a big trade in AND financing it. For that, I'm used to negotiating only one thing at a time, but that's not possible here as the three parts all have to happen at the same time. We will be negotiating all three put together (and some smaller issues) to make the deal happen. (We will, of course, involve our CPA and attorney before signing any deals!!)

The buyer will offer to buy OR lease the property that the business sits on from us; this sort of buyer is generally happy to do either. I am leaning towards the NNN lease, with the fact that we would get a substantial, reliable monthly cash flow in rent to supplement our earned income and delay any need to dip into our assets to support our anticipated early, partial retirement.

We will likely be offered a NNN lease with 5 or 10 year initial term plus 2 or 3 five year options. The last time we considered selling was 5 years ago when inflation and interest rates were quite low. At that time, we were offered 2% annual increases and we were considering moving forward, negotiating for 3%. Things have changed a lot in the market since then, so I'm ISO a concept of what the norms are and what the ranges are. 4%? 5%? A tie to inflation rate?

How can leases take variable inflation into consideration? Are annual increases ever tied to inflation? If so, using what measure? And what exactly are the increases looking like right now? 

Thoughts? Thank you!!

[Joseph Gozlan]

I happen to be a commercial AND business broker so I understand the complexity you are facing. As you mentioned, there are multiple variables to the negotiations. 

Here are a few things to consider:

1) The biggest consideration should go to your biggest expense: TAXES! Selling a business will be taxed, selling the building will be taxed and becoming a W2 employee (for your husband) will have tax implications as well. So, the moving parts of the deal might be pulling in different directions as it comes to the taxes HOWEVER, the buyer might be flexible enough to move numbers from one pat to another realizing for them the total purchase price remains the same. 

2) You mentioned it's an office. The office buildings are in a world of hurt since COVID blew up in 2020 and I don't think we'll ever see them recover to the pre-COVID levels. 

3) Run the What-If scenarios for the sale vs. lease. If the buyer want's to move to a cheaper, place, fails to run the business, succeed to run and need a bigger place, etc. How does it look for you as a landlord? Can you find another tenant? How fast? Will you have to keep paying mortgage on the building while it's empty? Can you afford it?

To answer you specific question, there are leases that are set in a way where the increases are X% OR CPI the higher of the two thus hedging from inflation. That said, I've never seen them on NNN leases (which already hedge you from inflation) only in NN and modified gross leases where the landlord expect to be impacted by the rise in inflation.