Expert: Jim Avancena, CPM - 10/12/2007

Question
Jim,

I am a licensed real estate salesperson in Texas. I am currently working for a dentist who would like to secure office space for a new practice. I have not worked on a commercial leasing deal before but am very interested in the field otherwise I would refer him to someone else. I am a personal friend of the doctor as well. I am trying to figure out cost for the doctor but struggling with some of the terms. We are going to lease 2,400 sq ft. I have been told that the rate is approx $1.28/sq ft and they are allowing $18/sq ft for "finish out" plus 4 for the triple net expenses for a total of $22/sq ft. It is a new construction building. How do I calculate these numbers to reflect the doctors monthly, yearly, and term expenses?

Answer
Jim-

You will learn a lot in this process!

First, 2,400 square feet for a dental office is very large. I assume there must be another dentist in your
friends practice?

As you likely know, the rental rate can be quoted in a monthly or annual per square foot rate, depending one the practice in the area where you are located.  I assume then that the $1.28/sf is a monthly rate per square foot; or $15.36/sf per year.  Is this correct?

You say they are allowing $18/sf for finish out.  There are many aspects of the matter of "finish out".  According to the landlord, are they saying they will give your friend up to $43,200 (2,400 x $18) toward the cost of having the office built and you can hire who ever you want to contract with to build his office by bidding the work out yourself?  Or does the landlord mean that he will build your friend's space out for him and then bill your friend for all of the cost of construction; but the landlord will deduct $43,200 from the total bill first? If this is what your landlord intends, be very careful that your landlord agrees to charge you only accepted market unit prices for the cost of the construction work, otherwise your landlord could inflate all of the charges for the construction work, and a job that should cost $35,000 dollars, will be billed to you for $55,000!  Be careful also that the lease does not include language that allows the landlord to "oversee" the construction operations in your new friends new suite and charge the dentist 10% or 15% construction management fee to watch over your contractors' work.   When you hire a contractor, get references on each contractors and only hire a contractor with a very organized, meticulous construction operator - don't always hire the lowest bidder, that may be where the more disorganized contractors are found.

You may want to ask your landlord to do the lease and build out of the office on a "TURNKEY" basis.  This is designed to limit your friends liability for overcharges in constructing his office.  Negotiate all the terms of a lease that also includes a provision for the landlord to prepare your friends offices according to construction plans that are attached as part of the lease agreement.
This will require that your landlord and your friend sit down with the landlords architect (at no cost or obligation to your friend) and work out all the layout of the interior offices and finishes to the dental office - everything - lights, carpet, tile, walls, doors, outlets, sinks, etc.   Then the landlord takes the detailed construction drawings and prices out how much all the work will cost him to build.  If the cost is $58,000 to build the office, either agree that your dentist friend will pay the landlord for all of the cost over the $18/sf "finish out" allowance; ($58,000 - $43,200 = $14,800 paid to the landlord), half at the time the lease is signed and half when the suite is completed, or often the landlord will simply finance the cost of the  $14,800 overage cost over the 5 or 10 year term of the lease like a loan (including a modest but fair charge like an interest fee, for financing the construction work,) and your friend will pay the landlord a separate fee each month to pay back the cost of the loan too.  They call this the TURNKEY basis because you friend the dentist simply signs his lease and the next thing he has to do is "turn the key in the lock of the door" to your suite when it is completed.   

If you can get the landlord to do the lease and construction work this way, you will know what all of the potential charges will be BEFORE your friend commits to signing the lease, and if the costs are too much, you don't sign the lease.

Otherwise your friend signs the lease, and your landlord has great control over how the construction work gets done and many actually use that leverage to charge tenants more than they should pay to get their construction work done.  

Not all landlord's will agree to the TURNKEY basis, but many will do things differently to enable them to get a long term - good credit - medical tenant to lease 2,400 sq. ft. in the project.

I am not sure I understand what is meant by "plus 4 for the triple net expenses..."  It could mean several things.
First, the landlord might be saying that he believes the total amount of the expenses to operate the new project will be about $4 dollars per square foot per year to pay for the combined costs of maintaining the parking lots, replacing lighting in the common areas or street lights, pay the taxes on the property, take care of the landscaping, etc. and the landlord wants your dentist friend to ALSO pay the landlord an additional $4.00/sf to pay for your clients share of those costs EACH YEAR  of the lease, and perhaps even more if those costs increase over the lease term.

Your landlord could also mean that the costs to maintain the property are estimated to be approximately $4.00/sf each year, and he wants your client to agree to pay for these maintenance fees as they increase above $4.00/sf. in future years.  So , if nest year the total maintenance costs total $5.00/sf, the landlord will bill your client for $1.00/sf for these maintenance charges.  The costs to operate and maintain a property may be called Operating Expenses or Common Area Maintenance ("CAM") charges.  So you will need to find out EXACTLY what the landlord means by paying for the "triple net expenses".  You lease should include a specific listing of the costs that the landlord considers are the costs that your friend will be required to reimburse each year.   One landlord a few years ago was found to be including the costs of a fully paid trip to La Costa for a week each year for his family and other friends as an annual management team meeting!  There should be a list that includes all the costs that will be included; re-stripping the parking lot, resurfacing the parking lot as needed, painting the benches in the common areas for the public, costs of grounds maintenance, property taxes, security charges for a security guard, etc.

You must read every single word of the lease the landlord wants your client to sign and be certain to note every word of the document that deals with costs your client has to pay.  Monthly rent is easy to calculate by simply multiplying the total monthly rent by the square footage
($1.28/sf x 2,400 sq.ft.) of the office and multiply that total by 12 to get the annual rent.   Be careful to identify any "ESCALATION" provisions in the lease that indicate that the annual rent shall be increased each year by a certain factor, such as 2%, or by 80% of the increase in the consumer price index, etc.  Be certain you understand exactly how these escalations function!

You may be able to make a very accurate estimate of how much you can expect expenses to increase each year by contacting officials that deal with each of the expenses that are involved.  For instance, you can call the real estate tax board for the area and ask someone knowledgeable in that office what you should expect for tax increases on the property for the nest few years, or try to find a local chapter of the Institute of Real Estate Management (IREM) and ask someone there to suggest how they would plan for the expenses to increase over the next few years on a new property like the one your friend may locate his practice in.  

I hope this is helpful.  You have asked me to address in few words what others have written volumes about over decades.

You may be lucky enough to help your with more detailed questions by calling the national IREM office in Chicago, of the BOMA office in New York or Washington DC.

Go get em' and good luck.

-Jim