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Leased Property—Interesting Investment

When we write or talk about real estate “investments” it is usually with the idea of ownership of the property. When you own the investment property, the opportunities for profits and cash flow from it are thought of as rent paid by a tenant to the owner. The owner also has a potential profit that can come from the later gains when the property is sold.

Since the emphasis is on ownership, the average real estate investor might not think about the cash flow and potential profits from a property that is leased rather than owned. However, there are investors who specialize in making profits, sometimes big profits from properties that they do not own.

This cash flow from a lease can be extremely interesting. Often the lessee making a huge profit has a relatively small cash investment in the property.

If you were the lessee of a building and wanted to make a profit on a possible sublease of some of it, who would your “customer” be?

The Usual Lessee

Take the position of the person acquiring property for use in a trade or business. For this person, the fundamental advantage of leasing over purchasing is the fact that the entire amount expended for leasing is currently deductible. On the other hand, if the property were owned, the owner would not be able to deduct any part of the purchase price. His entire cost would have to be capitalized, and could only be recovered through depreciation of the cost of the improvements over their life. The remainder would only be recovered on the disposition of the property.

The Estate for Years

A lease is defined as a contract between the owner of the land or building (landlord or lessor) and a tenant (lessee) in which the lessee agrees to pay a stipulated sum (rent) for the use and enjoyment of the property for a specified period of time. This is, for the lessee, very much like an ownership, and is also called an estate for years.

A lease is a complicated legal contract and it should not be entered into by either the lessor or lessee without professional assistance. All leases are different and so we cannot cover all of the possible combinations of items in a lease in this publication.

We can cover just the elements that can result from negotiating leases and subleases for profit.

The Original Lease

The original lessee may lease a property for a certain specified monthly rental amount. This lease is with the owner of the property.

As an example, what if a commercial building is leased for $10,000.00 a month? If the lessee could sub-lease the same property to another renter-user for a rent of $11,300.00 per month, then the original lessee would have a cash flow of $1,300.00 from this situation that is often called a “sandwich” lease. The original lessee is “sandwiched” between the owner and the user of the property.

This original lessee still pays the original specified monthly rental of $10,000.00 to the owner, but since he is collecting $11,300.00 from the sub-lessee under a separate contract, the difference of $1,300.00 is a monthly profit for him.

The Right to Sublease

As we pointed out, you need professional assistance to prepare the lease. If a “sandwich” situation is contemplated, a provision giving the tenant the right to sublease space is an absolute necessity in the lease agreement.

It is customary, in landlord prepared “form” leases, to preclude assignment and subletting. The ideal position for an active landlord who intends to provide competent continuing management to his real estate is to maintain this clause intact throughout the lease negotiation and thereby provide himself complete control of all assignments and sublettings, since none can be accomplished without his prior approval.

The usual original reason for the lessee to place the provision to sublet into the contract is the question about the future amount of space that the original tenant will need. If a tenant believes that he will need less space in the future, a sublease clause can be provided to solve the problem. The owner will usually agree in this situation, since the alternate provision might be for a cancellation of the lease.

A good counter-offer from the owner in this situation might be a “right of approval” of a sub-tenant. There might be other things that the owner wants into the lease regarding the use, etc., of a sub-lease tenant. All must be negotiated.

The Profits

• Our example of the commercial space leased for $10,000.00 and sub-let for $11,300 showed a $1,300 a month cash flow.
• One speculator, when looking through an area for a commercial property, noticed a well-located house with an owner’s “for rent” sign. He inquired and leased the house for his own use. A few months later, he moved from the property, but was able to sub-lease the house for a $500 a month profit.

(Note:  This is getting into a dangerous area. The original lessee would probably be liable for any damages to the home. Take care!)

• A retail store operator leased a 30,000 square foot retail location, knowing that it was too large for him. By negotiating for the entire space, he was able to get an excellent price per square foot — a wholesale price based on his financial strength and ability to lease the large space.

The retailer used 15,000 square feet, as originally planned. The balance of 15,000 square feet was remodeled (by the retailer at his expense) and sub-leased to a number of smaller retail operators, who paid a premium price for their store area.

The original lessee ended up with enough income from the sub-leased space to pay all of the rent on the building. He had negotiated a situation where he had free rent for himself in an excellent downtown location.

• One lessee leased a commercial building that had been used entirely by the offices of an insurance company as a regional location. By taking the entire building, he was able to work out the same rental rate that the insurance company had paid – also on the entire property

With very little in changes, the lessee then leased each room or suite of the building separately to various professionals — attorneys, insurance agents, real estate agents, etc. His cash flow from the “sandwich” lease situation amounted to a profit of $13,000.00 per month — for leasing and managing a property that was not owned, and in which he had little cash investment.

Making these profits may take a little ingenuity on the part of the lessee. He may have the imagination to see the uses of a property that the owner does not, or would not have the time to do himself.