How to Calculate a Property’s Net Effective Rent: A Beneficial Approach for Tenants and Landlords in the Mexican Market

The term "net effective rent" is commonly used in the commercial real estate market. This concept represents the actual lease cost tenants pay monthly or annually throughout the entire duration of their lease contract after deducting concessions, discounts, or incentives agreed upon with the landlord.

There are several reasons why landlords make deductions to their tenants' rents. For instance, during the first six months of 2020, when the impact of the coronavirus pandemic slowed down office demand in Mexico, the average market price in the sector decreased by 7%, according to data from SiiLA Market Analytics. However, concessions, discounts, or incentives also occur during non-recession periods.

In Mexico, laws such as the Mexico City’s Civil Code stipulate deductions beyond contractual agreements. This Mexican regulation (articles 2412 to 2434) establishes that the landlord must make rent reductions for property defects, fortuitous events, or force majeure that prevent its use. Likewise, the law indicates that, in some instances, landlords must pay for property improvements and even make deductions and refunds in favor of the tenants.

Calculating the net effective rent benefits landlords and tenants in the commercial real estate market. For tenants, knowing the actual cost of rent provides financial transparency and certainty in planning their expenses. For landlords, it allows them to adjust the market price to ensure that the rent covers costs and offers an adequate return.

So, how is the net effective rent calculated?

The net effective rent is calculated by dividing the difference between the gross rent and the deductions or incentives by the total duration of the lease contract. The formula is as follows: Net Effective Rent = (Gross Rent - Deductions) / Contract Duration.

It is worth noting that a) the gross rent is the rental value stipulated in a lease contract for a certain period without considering concessions, deductions, or incentives; b) concessions, deductions, or incentives include any benefit that the landlord grants to the tenant, such as rent-free periods, subsidies for property improvements, allowances for construction expenses, among others; c) the lease contract duration is the total time covered by the legal agreement, including any rent-free period; and d) the net effective rent is the actual lease cost after deducting the value of concessions, deductions, and incentives.

Example:

Suppose we want to rent a commercial space in Mexico City's Polanco neighborhood, and the closing price we obtained is equal to the average market price in the region for the second quarter of 2023, which is $26 per square meter per month, according to SiiLA. The space we want to rent is 10,000 square meters. If we sign a 10-year contract, the landlord offers us a reduced price of $23 per square meter per month for the first two years of the lease, as well as two rent-free months to facilitate the installation of our company.

In this example, the gross rent of the commercial space we want is $26 per square meter per month for a 10,000-square-meters area that we will rent for ten years. To calculate the gross rent, we will pay during the contract's duration, we need to multiply the market price per square meter by the area we rent by 12 months and the contract's duration. Thus, we have $26 * 10,000 * 12 * 10 = $31,200,000. This means that over ten years, we will pay a gross rent of $31.2 million for a space in Polanco, equivalent to a $260,000 monthly rent.

However, to calculate the net effective rent, we need to subtract the value of the concessions, discounts, or incentives agreed upon with the landlord from the gross rent. First, the offer includes paying $23 per square meter monthly for the first two years. This amount multiplied by 10,000 square meters, by 12 months, and by two years gives us $5,520,000, which is $720,000 less than what we would have to pay with the regular rate of $26. Additionally, there are two rent-free months. If we must pay $260,000 monthly, the two discounted months will reduce gross rent by $520,000.

As a result, we have total deductions of $1,240,000. To calculate the net effective rent with this data, we need to divide the difference between the gross rent and the concessions, deductions, or incentives by the total duration of the lease contract. The formula is as follows: Net Effective Rent = (Gross Rent - Deductions) / Contract Duration.

Applying the formula, we get ($31,200,000 - $1,240,000) / 10 = $2,996,000. This means we will pay almost three million dollars in net effective rent annually, or approximately $249,667 monthly, equivalent to nearly $25 per square meter. The amount corresponding to the net effective rent is 4% lower than the gross rent.

Now you know how to calculate the net effective rent! To explore and learn more concepts, check out SiiLA REsource or contact us at contacto@siila.com.mx.