The master lease agreement structure utilizes two entities.
The lessor (landlord) entity is the owner of the historic property and incurs the qualified rehabilitation expenditures.
The other entity is the lessee (master tenant) entity. This entity will master lease the property from the landlord, lease the space, be it to residential or commercial tenants, and pay all property operating expenses.
Now, we must have an understanding of the two types of structures before we can discuss the relative advantages and disadvantages of a master lease agreement, and the lessor and the lessee each.
What Is A Master Lease Agreement
Master leases tend to be longer; usually, the master lease agreement is drawn for 10 to 15 years.
A short-term master lease agreement (1 to 5 years) is usually short especially if tenant improvement is being given. If the master lease agreement is less than 5 years, the TI allowance can be minimal.
Think of it this way: Base Rent of $15 PSF annually, plus $10 PSF of OpEx, equals a Full-Service Gross (FSG) Rate of $25.
Two Types Of Master Leasing
As the lessee, you are able to create cash flow without requiring the capital to actually acquire an asset. That income is taxed advantageously compared to that of a fee-based property manager.
Also, as the lessee, you are able to “Test Drive” a property so to speak, and determine if you want to pursue its acquisition in the future.
There is also the ability to develop a relationship with the owner and if you act with competence it can (and has) led to additional opportunities including but not limited to the acquisition of the property via “seller financing”.
Now, for the lessor, they often choose to master lease because they trust a competent investor over a few based real estate agents.
They can also choose to master lease in order to retain title to the property and the benefits that come with ownership but yield the “Thrill of Management” to another party thereby freeing up their time.
The TI (Tenant Improvement) Allowance
If the tenant is responsible for CapEx, that Base Rent will probably be a little lower to account for that.
It’s all about where the “risk” of the building is shifted on a risk continuum – more to the landlord or more to the tenant.
Savvy tenants who hire a tenant representative are able to do market research and see what the all-in FSG (Full Service Gross) rate is on average in that market for a similar quality and aged building.
If the building is old, they tend to be less efficient from a functional perspective and obtain a higher OpEx.
How’s The Master Lease Behaving In The Real World?
So, let’s say that you have two buildings with vacancies side by side, and with similar attributes: One has an annual OpEx of $8 PSF and the other is $10 PSF (per square foot).
The owner of the $10 PSF OpEx building will have to take a lower Base Rent, all things being equal, it means lower NOI (net operating income).
Now, the information isn’t always perfect and at the end of the day, it’s a negotiation between Landlord and Tenant.
Landlords will sometimes accept a lower base rent if they can get a slightly higher annual rental increase, and Vice versa.
What’s The Difference Between Master Lease and PM
Meaning, Why Should You Master Lease?
- No Vacancy Worries (That’s 5% of GSI (Gross Scheduled Income) saved right there)
- No unit turns. The Lessee is responsible for that
- Typically a Master Lease pushes small repairs onto the lessee
- Typically CapEx are split between Lessor and Lessee
- Savings on Lease up fees that a PM may charge
- Savings on Project Management fees that the PM may charge
- No calls about who to lease too
- No calls to authorize repairs
- Same management liability protection
- Landlords can take a portfolio approach to ownership
All for that landlords usually accept a lower monthly rate. But if they add in the true costs of operations with a PM, they most likely will make more.
Making As Much As Possible While Investing As Little As Possible
Generally, a master lease is multiple properties under 1 lease payment. If you’re just wanting to be able to sublet it out, that is possible as long as the owner is okay with it and your lease agreement reflects that subletting is allowed.
Some mortgage companies are pickier than others, but as long as they are “upgrading” in some manner, you can generally do whatever you want with the house after a minimum of 6months.
Some flat out don’t care as long as they are getting their money. So it’s very important to do your own research. Only speaking to your lender and CRE professional can be accountable for what you might be expecting in your own journey.
There are additional reasons for both parties but this should be enough to serve as a quick and dirty overview.