How do you measure commercial lease profitability with IRR?

1 What is NPV and how to calculate it

To calculate the IRR, you need to first calculate the NPV of the lease. The NPV is the difference between the present value of all cash inflows and outflows from the lease, discounted at a certain rate. The cash inflows are the rent payments that you receive or pay, and the cash outflows are the costs that you incur or save, such as maintenance, taxes, utilities, and tenant improvements. To calculate the present value of each cash flow, you need to use a discount rate, which is the minimum rate of return that you require or expect from the lease. You can use a formula, a spreadsheet, or an online calculator to find the NPV of the lease.

2 What is IRR and how to calculate it

The IRR is the discount rate that makes the NPV of the lease equal to zero. This means that the IRR is the break-even point of the lease, where you neither gain nor lose money from it. The higher the IRR, the more profitable the lease is. To calculate the IRR, you need to use a trial and error method, where you try different discount rates until you find the one that makes the NPV zero. You can also use a spreadsheet or an online calculator that has an IRR function to find the IRR of the lease.

3 What are the advantages of using IRR

Using IRR to measure the profitability of a commercial lease has some advantages. First, it allows you to compare different leases with different terms, such as rent, duration, and expenses, and see which one offers the best return. Second, it takes into account the time value of money, which means that it reflects the fact that a dollar today is worth more than a dollar in the future. Third, it considers both the cash inflows and outflows from the lease, which gives you a more comprehensive picture of the lease's performance.

4 What are the limitations of using IRR

Using IRR to measure the profitability of a commercial lease also has some limitations. First, it assumes that all cash flows from the lease are reinvested at the same rate as the IRR, which may not be realistic or feasible. Second, it may not exist or be unique for some leases, especially those that have negative or irregular cash flows. Third, it may not reflect the risk or uncertainty of the lease, which may vary depending on the market conditions, the tenant's creditworthiness, and the landlord's obligations.

5 How to improve the IRR of a commercial lease

If you want to improve the IRR of a commercial lease, you need to either increase the cash inflows or decrease the cash outflows from the lease. For example, you can negotiate a higher rent, a longer term, or a rent escalation clause to increase the cash inflows. Alternatively, you can negotiate a lower maintenance, tax, or utility expense, or a tenant improvement allowance to decrease the cash outflows. You can also try to reduce the vacancy rate, the turnover rate, or the collection risk of the lease to improve the cash flow stability and reliability.

6 How to use IRR as a negotiation tool

If you are a landlord or a tenant, you can use IRR as a negotiation tool to achieve your desired lease terms. For example, if you are a landlord, you can show the tenant how the IRR of the lease changes with different rent levels, lease durations, or expense allocations, and persuade them to accept the terms that are favorable to you. If you are a tenant, you can show the landlord how the IRR of the lease changes with different tenant improvement allowances, rent abatements, or renewal options, and persuade them to offer you the terms that are favorable to you. You can also use IRR to compare different lease proposals and choose the one that maximizes your return.

7 Here’s what else to consider

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