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Reviewing Leases on Income Producing Properties

When acquiring an investment property, a thorough review of lease agreements is required to determine the appropriate valuation of the property.  The value of the investment property is directly linked to the amount of rental income, the term, the quality of the tenants, the enforceability of the lease, and any issues that may interfere with the landlord’s ability to collect rent.

Quality of the Tenant
Assessing the stability of the tenant is a critical consideration. In the commercial context, large shopping malls and plazas typically have a number of store-fronts with a diversified tenant base, where the rental income is split between a number of units. In such a case, where one tenant’s lease expires and does not renew, or where one business shuts down, the overall impact on the profitability and value of the property will ideally be negligible. However, where an Anchor Tenant occupies a large portion of the property square foot, the success or failure of this particular tenant has large implications on the value of the property. If the Anchor Tenant does not renew its lease at expiry or the business ultimately fails, large amounts of square footage can be left vacant and difficult to fill with new occupants. This is more common as e-commerce is reducing the square footage commanded by traditional bricks-and-mortar retailers.

Duration of Term
A purchaser of an investment property has to understand the terms of the leases and any options to extend or renew the lease terms. The lease terms are key considerations in determining the length and extent of the rental income stream. The terms of potential lease renewals should be considered and the rental basis (i.e., whether fair market rent at the time of renewal or inflation-adjusted escalators or other means of determining the rent at the renewal period).  If the intention is to develop the property, long lease terms (without demolition clauses) will have an impact on a purchaser’s ability to do so. Specific consideration must be given to demolition clauses to understand the basis this can be done and the notice or time frame required to be given to the tenant.

Use & Exclusivity
Commercial leases will specify the permitted uses of the premises.  Use provisions restrict the tenant’s flexibility in its operations and ensure that a landlord stays onside other leases which restrict what the landlord can and cannot permit at the property. This is particularly relevant in medical office properties where tenants request that direct competitors cannot operate in certain proximity around their practice. All restrictive covenants in the lease should be identified to ensure existing and prospective tenants are in compliance.

Tenant Inducements
For new tenants, landlords will often grant rent-free periods or grant allowances to improve the property for tenants permitted use.