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Rent – What’s the Right Number?

We often get calls at Meridian inquiring about appropriate rent amounts. Setting a rent amount is particularly difficult in a related party situation. There are taxation, valuation and cost issues to think through prior to settling in on a number. Before we delve into these issues, let’s deal with leases between outside, unrelated parties.

With unrelated parties, rent is simply a game of what the market will bear. If you are leasing a facility, you typically want top dollar. If you’re renting, you want it cheap! In these situations, we see lots of traditional fixed dollar leases plus a few creative profit and volume driven variable leases.

With fixed dollar leases, the most common way to set an appropriate rent is to take the market value of the property and then amortize that value over 20 years at today’s 10% interest. For instance, a $1.5 million dollar site would initially lease for $6,315 per month triple net.

This base rent would then be pegged to an escalation index over the life of the lease.

A creative way to structure this same lease on a start-up site would be with a lower base, let’s say $5,000 plus a volume increment, perhaps a penny per gallon. To be at market, the station would need to do 131,500 gallons per month. Above that, the owner enjoys a very nice incremental rent. At 300,000 gallons, he earns $8,000 per month!

On related entities, the bare minimum rent should cover all loan costs and depreciation to avoid a loss at the real estate holding company level. However, operating entity rents are often driven by CPA tax advice, which typically means artificially high rents. Paying exorbitant rents can work great lowering taxes as long as the operating entity remains profitable. It’s when that that entity is put up for sale, however, that trouble begins.

Because most buyers price based on cash flow, an operating entity that has been paying very high rents will be priced low unless a seller can prove that the rents paid were artificially high. The seller is then in Catch 22. To argue for lower rents, he has to show that the property is only worth “X” and therefore, rent should have been much lower. However, he has just admitted a diminished real estate value. While he’s justifying additional bottom-line profit to show increased cash flow, he’s lowering the property’s capital value.

To avoid this dilemma, any leased entity that has a chance of subsequently being sold within the next three years should balance tax reduction with value maximization. If you’re not sure about your intentions with a leased property and want to play it safe, set your rents based upon market, which again is a 20- year amortization of your property’s current value using a current interest rate which today is approximately 10%. As long as this rent amount covers your loan payments and depreciation costs, you can’t go too wrong.

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