The 2008 financial crisis sent ripples throughout the world economy and the effects of the changes in individual and institutional behavior can still be felt today. There has been a steady decline in homeownership since that time (after a peak in 2004). Millennials, riddled with student loan debt and traumatized by the worst economic crisis since the Great Depression, both prefer and, to some extent, are forced to rent. This has led to a booming multi-family market across the nation with seemingly no end in sight to development in major urban areas and downward pressure on market cap rates; prime conditions for a bubble. No one saw an end to the booming housing market in the early to middle 2000s or if they did, it did not stop the majority of people from continuing to engage in the same behavior that led to the largest market correction in living memory.

Multi-family refers to apartment buildings of 4 or more units where Fair Housing laws apply. The amount of properties in this asset class pales in comparison to the number of single-family homes in the country and thus a correction does not have the ability to impact the economy to the same level; however, unsound investment principles do have their consequences. In this article, I will explain what is going on in the multi-family investment market and how the assumptions upon which investment decisions are being made are likely to lead to a correction.

One of the great things about multi-family properties is that everybody needs a place to live. Technology has created disruption in traditional commercial real estate asset classes. Companies are taking less office space, allowing employees to telework, opting for open/collaborative layouts, etc.; making office properties less attractive as an investment class. Vacant office properties trade for less than they’re “worth” and fully leased properties trade for more. I put “worth” in quotations because market value is what an asset sells for in the open market in an arm’s length transaction. What this means is that there is a significant impact on the value of a property/asset class based on the perceived risk associated with it.

Amazon’s impact on the retail market has been significant. Because products can be purchased online and delivered, many product-based retailers are having trouble competing with their online counterparts due to the added cost of leasing retail space. This has increased the prevalence and desirability of more service/experience-based tenants. Big box stores are at particular risk because of the lack of potential tenants that could/would re-lease such a large amount of space. The one benefactor has been industrial assets, as companies like Amazon require storage and distribution centers for their products, and due to the exponential growth of digital information, data centers are increasing in number, need, and desirability as a stable tenant/business.

As two of the most commonly traded asset classes struggled to adapt to life in the 21st century, investors saw multi-family properties as solid and safe investments with the potential for significant appreciation. Many people lost their homes as a result of the housing crash. The damage to their credit and net worth forced many to become renters. For millennials graduating with tens of thousands of dollars of student loan debt, renting was not only a necessity due to financial reasons but was also a choice brought about by a lack of faith in the housing market and the desire to be in more urban, work-live-play environments. As a result, investors and developers rushed to satisfy the demand of America’s largest generation.

Multi-family assets are classified as A (trophy), B, and C properties. I will touch on B & C class apartments in another article, but it is the newly-built, class A properties that are the focus of this discussion because they are the most susceptible to a potential crash. As millennials graduated college and moved to job centers in primary markets, developers hastened to increase supply of high-rise, hundred-unit plus apartment buildings with each seeking to outdo the other by providing the newest and most fashionable amenities. Even though these projects costs hundreds of millions of dollars, developers had no problem financing such projects, as investors needed to “park” their money somewhere and multi-family was seen as a safe investment.  This was intensified by Fannie Mae and Freddie Mac offering low interest, non-recourse multi-family loan products. Sound familiar?

This isn’t necessarily bad, at least initially, but as demand increased, it continued to put downward pressure on cap rates. Without going into cap rates in greater detail, the basic principle of supply and demand applies. Development takes time and often fails to keep up with demand. As a result, prices exploded. Multi-family properties in Washington, DC have been trading below a 5% cap rate. A five percent return is not necessarily bad if the investment is considered safe; however, that 5% is based on an all cash purchase. How many investors have hundreds of millions to put toward a single purchase? Some do. As I mentioned, investors need to park their money somewhere, but with the rates being offered by Fannie and Freddie, many investors chose to finance the investment thereby taking advantage of the effects of positive leverage to increase their return.

Real estate investors make decisions based on projections that are unique to each project. These projections address the four questions posed by the cash flow model: how much money goes into the investment (purchase price), when to buy, when to sell (holding period), and how much money comes out of the investment (sales price and after-tax sales proceeds). Some investors choose to buy and hold, but many base projections on holding periods of 5 years. This is because most commercial loan terms are 5-years at which point the property can be refinanced or sold.  This has created a virtual game of hot potato where the last investor to hold the property gets burned.

Decreasing cap rates means that the return on each dollar of NOI goes down. The spread between the all cash return (cap rate) and the interest rate (cost of financing) creates positive leverage; allowing investors to increase their return above the cap rate. As that spread narrows due to rising interest rates, the actual return these properties generate decreases. If interest rates increase to the point where they exceed the all cash return, financing becomes undesirable. This will eliminate investors that cannot afford to purchase assets in cash thus eliminating a substantial portion of demand for such assets thereby decreasing their value. Interest rates have been kept artificially low for over a decade and have only one way to go… up. Interest rate risk is one of the greatest dangers affecting the multi-family market.

Another risk facing the class-A multi-family market is oversupply. As stated previously, supply cannot keep up with demand in real time. The development process can take multiple years during which time demand may have waned and/or supply may have caught up with or overtaken demand. This is what we’re seeing in DC and its surrounding submarkets. Deliveries of thousands of units each year has led to a concession war between owners. Tenants can move from one apartment building to the next an enjoy 1-2 months of free rent as landlords compete for occupancy. This has also caused stagnation in rental rates. Many owners based their projections on annual rental escalations; leading to an increase in NOI over the holding period. If rents remain relatively flat the NOI for the property in the year of disposition will be below projections and without a decrease in market cap rates to increase the value, owners may not be able to achieve the return that they based their acquisition decision on.

Here is an example that will put these concepts in practice. A 100-unit apartment building was built in 2010 and sold fully-leased to an investor in 2015 at a 6% cap rate for $18,000,000. The units lease for $1,500/month and the NOI for the building was $1,080,000. The new owner was able to achieve financing at 4.5% and projected that rents would increase by 3% per year over the 5-year holding period resulting in an NOI of $1,215,549.51. Because of increasing demand this owner was able to sell the property in 2015 at a 5.25% cap rate for a sales price of $23,153,324.09 and netting a healthy profit as a result. The new owner was able to obtain financing at a slightly higher interest rate of 4.75% and based their investment decision on a 5-year holding period with the same annual rental increases of 3%. They also project that cap rates will continue to decrease and that they will be able to sell in 5 years at a 4.75% cap rate for another healthy profit.

Fast forward to 2020. Due to increased supply, rental rates remained relatively flat over the holding period leading to an anemic increase in NOI to only $1,227,705.01. On top of that interest rates increased to 5.75%; increasing the cost of money. When money is more expensive, there are fewer buyers and the remaining buyers cannot afford to pay as much for the same asset. As a result, cap rates saw a slight increase to 5.5%. What does this mean for the owner?

Based on their initial projections the owners expected to sell the property at the end of the holding period for $28,802,351.32; however, market conditions will result in an actual sales price of $22,321,909.27 and a loss. Because interest rates are higher than the unleveraged return of the property the owner will be unable to refinance without contributing additional capital to the investment. While some large, institutional investors can weather such a storm it becomes increasingly difficult as deal size and interest rates increase and (rates of) returns and rents decrease (or remain flat).

Millennials will eventually grow up and while increased interest rates will make home ownership less affordable (and renting more prevalent as a result), it’s naïve to think that this generation’s preferences will not change. Nearly 60% of homes in the country are owned by people over the age of 50. As baby boomers pass away there will not only be a huge transfer of wealth but also of supply. Home prices should decrease as a result; finally making homes relatively affordable.

Everyone wants to make hay when the sun is shining, but the decision making regarding multi-family acquisitions is decreasingly defensible based on fundamental investment principles. As investors are willing to pay less and less for the NOI a property produces, they are opening themselves up to interest rate risk, supply risk, etc. They are leaving less and less room for error if anything adversely impacts their projections. Just like we saw in the years leading up to the housing crash, we will continue to see this game of musical chairs continue until the music stops and just like then the best thing to have is cash so you can benefit from the poor and irresponsible decisions of others.

 

When it comes to traditional commercial real estate (office and retail), Northeast and Southeast Washington, DC are underwhelming to say the least. Decades of high crime rates coupled with their predominantly lower income demographic have kept developers and investors from investing in these submarkets. Things are changing in the region and Amazon’s announcement to locate its HQ2 in Crystal City (National Landing) will only accelerate the changes already taking place across the district.

Northeast and Southeast’s office markets are tiny in comparison to those of Northwest and Southwest with only 3,000,000 sf of total space and, of that, only 75,000 sf of office space considered to be 4 or 5 Star (all in Southeast). There have been no new deliveries in the past year and only slightly over 50,000 sf are scheduled to deliver in the next year. Combined the submarkets saw negative net absorption last year of about 30,000 sf along with slight declines in rent growth.

The retail market is only slightly larger/better at around 5,700,000 sf with moderate, positive net absorption of about 72,000 sf last year. Still rent growth was negative in both submarkets. Northeast is benefiting from the wave of redevelopment and gentrification from surrounding areas, with over 92,000 sf of new inventory delivering last year with an additional 28,000 sf planned for this year compared to zero for Southeast.

There is a decent sized industrial market in Northeast compared to the rest of the District. At slightly over 9,000,000 sf this submarket contains large areas of space that will eventually be redeveloped. Sales prices seem to defy logic here with an average of $227 per square foot and are indicative of investors’ expectations for the area’s continued gentrification and associated rises in property values across the board.

We may see drastic changes in these submarkets over the next decade though as investors continue to look for “affordable” opportunities in DC. Due to historical issues making these areas “undesirable” they will be the last to undergo gentrification. This is happening currently through residential flips and multi-family investment. Anacostia, particularly, should see exponential growth due to its location along the waterfront and proximity to National Landing (Amazon). The Brightwood/Fort Totten submarket is already seeing steady rent growth and an increase in investment.

With metro access, proximity to the Wharf and National Landing, and being the last “affordable” areas in Washington, DC, Northeast and Southeast should see huge growth in the years to come. These traditionally undesirable areas of the District have the potential to produce astronomical returns to anyone willing to incur some short-term risk. When you have the opportunity to buy in the path of (re)development when prices are low, you take it. You need only hold the property until the time comes when it makes sense to (re)develop it yourself or sell. You make money in real estate when you buy it and Northeast and Southeast Washington, DC are an opportunity unlike any other in the region.

For detailed information on market data, leasing, etc. please contact Ryan Rauner at Ryan@RealMarkets.com or 703.943.7079.

If you’re an executive at a company that leases commercial space, you’ve probably received a call (remove “probably” and add “constantly”) from a myriad of commercial real estate brokers who tell you that they can save you money and/or that your current broker isn’t… doesn’t… can’t… etc. Basically, they’ll say just about anything and everything to get their foot in the door. I know that all my best relationships/decisions, both professional and personal, started with a cold call (enter sarcasm). One of the most common tactics used by commercial brokers is offering to review your pass-through payments.

In full service (office) leases, all costs of ownership (operating expenses/CAM, real estate taxes, & insurance) are included in your base rental rate. The first year of your lease is called your base year. If those costs increase over the lease term the landlord will pass those expenses through to you, the tenant. For example, company A signs a lease on March 1, 2019 for 5 years with a base rental rate of $25 per square foot. The costs of ownership in that year are estimated to be $10 per square foot ($15 per square foot profit to the landlord). In year 2 the costs of ownership increased to $10.25 per square foot. Therefore, the landlord would charge the tenant an extra $0.25 per square foot in addition to the annual rental escalation.

What these cold-calling brokers are offering to do is essentially audit the landlord’s books to see if they overstated the costs of ownership and have overcharged you.

I’m not saying that landlords don’t make mistakes, but I would say it’s uncommon. Landlords have an interest in keeping the costs of ownership low.  Sure, they can pass through the charges to tenants if they increase but this makes them less competitive and attractive in the marketplace. If Landlord A has costs of ownership of $10 per square foot and Landlord B is at $8 per square foot, Landlord B can offer an asking rate of $25 for a profit of $17 per square foot while Landlord A will have to charge $27 per square foot for the same return. All things being equal, which building would you choose? In addition, if one landlord has costs of ownership that increase year after year, their tenants would be less inclined to renew; choosing to relocate to a building in which their costs of occupancy are lower and/or more stable.

The idea that a landlord would intentionally overstate expenses and overcharge tenants is even less likely. There are certainly unscrupulous players out there, but they’re quickly exposed. Landlords don’t want the reputation of being charlatans.

If the landlord does mistakenly or intentionally overstate the costs of ownership, the amount is most likely negligible (on a per square foot basis). The exposure increases directly based on the amount of square feet you occupy ($0.25 per square foot is only $250 at 1,000 SF vs. $25,000 at 100,000 SF). That’s not to say that you shouldn’t do everything you can to save money. You shouldn’t pay a penny more than you owe and if your pass-throughs increase, it’s not unreasonable to request a copy of the landlord’s books to inspect them. I’m a firm believer in the principle of the matter but one needs to perform a cost benefit analysis. Would you spend $500 to save $250 or even $500?

So, are these brokers really flying in to save the day? No. They’re really just trying to get their foot in the door and are likely more interested in making themselves money than saving you money.

This is all a moot point if you/your broker did not negotiate an audit right provision in your lease. For more information on audit rights, check out my article Lease Audit Rights or contact me at Ryan@RealMarkets.com.

It’s good to be a landlord. Regardless of the rent structure (full service, triple net, etc.) the costs of ownership are always passed through to the tenant. Each year within a prescribed timeframe, landlords will present tenants with their determination of the costs of ownership (operating expenses/CAM, real estate taxes, insurance, etc.) for that year which tenants are required to pay as additional rent. In full service leases, the costs of ownership are included under the base rental rate with tenants being responsible for any increases in those costs over the term of the lease. Tenants generally don’t benefit from any decreases in those costs (again it’s good to be a landlord). In triple net leases, tenants simply pay the costs separately and directly to the landlord and/or taxing authority.

So, what if you think the landlord has overcharged you? What’s your recourse? Simply put: nothing… unless you or your broker were able to negotiate audit rights into your lease. Audit rights allow tenants to perform a comprehensive analysis of the landlord’s books and records to ensure that the amount charged is accurate. Landlords do not always agree to audit rights. Like all concessions/negotiations they are a matter of leverage. The more leverage the tenant has based on size, financial strength, etc. the more inclined the landlord is to agree to the concession.

Audit right language varies from lease to lease but contain similar points that should be understood:

Election to Audit Timeframe

Most audit provisions will start with something like, “The statement of Operating Expenses delivered by Landlord shall be conclusive and binding upon Tenant unless, within X days after receipt thereof, Tenant shall give Landlord notice that Tenant disputes the correctness of said statement…” Landlord’s will try to minimize the amount of time that a tenant has to audit their books and tenant’s have an interest to have that timeframe as long as possible. What’s important is to understand how long you have to dispute the charges. There may also be language detailing the amount of time in which the landlord must provide access to its records.

Tenant Must Pay Amount First

In almost every case, tenants will be required to pay the amount owed in the statement regardless of whether they elect to exercise their audit right. If the audit determines that the tenant was overcharged then the overpayment will be credited towards their next payment of rent.

Location/Times

Terms will dictate when and where the tenant can audit the landlord’s books. An example would be “Landlord shall permit Tenant’s accountants, consultants, and/or employees to examine Landlord’s books and records, during regular business hours at Landlord’s place of business.”

Tenant’s Choice of Auditor

The tenant’s choice of auditor may require landlord’s consent. As with any case in which landlord’s consent is required, always ensure that consent shall not be unreasonably withheld, conditioned, or delayed. Landlords may require the auditor be independent of tenant’s business.

Non-contingency basis

Landlord’s will usually require that the auditor’s compensation be on a non-contingency basis. This reduces the likelihood of frivolous audits. Tenants are unlikely to spend money on an audit unless the amount they believe they will save as a result exceeds the cost of the audit. As a result audit rights become more important as square footage (and the potential impact of an overstatement) increases.

Who Pays

Some audit provisions contain language such as “if determined by an independent accountant that Landlord’s statement of Operating Expenses was incorrect… and the amount of the overstatement was more than X percent, Landlord shall pay for the cost of the audit.” The amount of the percent is a negotiation in which the landlord wants it to be as high as possible and the tenant as low as possible. This amount can also help a tenant determine if an audit makes economic sense based on the costs of the audit and likelihood that they were, in fact, overcharged and by the agreed upon amount.

Confidentiality

Finally, most audit provisions will require the tenant to keep the results of the audit confidential. Landlord’s don’t want every tenant coming to them demanding a refund based on one tenant’s audit and, more specifically, the exercise of one tenant’s rights as landlords to not agree to audit provisions for every tenant.

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So, what if a landlord refuses to grant you audit rights? What do you do? How do you protect yourself? Perhaps the best course of action is to request operating expense statements for the past few years prior to leasing from a particular landlord. While the past is not necessarily an indicator of the future, it can give you an idea of trends and/or how efficiently the landlord operates their building. Another option is to carefully review the lease language regarding what is included under operating expenses as well as how certain costs are treated, specifically large capital expenditures such as repaving the parking lot, replacing/repairing the building roof, renovation of the common areas, etc. Landlords may not be willing to modify their language but understanding a landlord’s accounting practices can help you estimate your potential exposure.

As always, it’s recommended to employ the services of an experienced commercial real estate broker when leasing commercial space. For more information regarding representation services, please contact me at Ryan@RealMarkets.com or 703-943-7079.

Georgetown is home to lobbyists and politicians, high-end shops and restaurants, and to the University that shares its name. Georgetown is one of Washington, DC’s oldest and most prestigious neighborhoods with waterfront real estate. Despite all this, Georgetown has struggled in recent years to adapt to changing trends and competition from other submarkets in DC.

Lack of metro access combined with excessively high retail rates have led to negative net absorption over the past 3 years, this despite no supply-side pressure. Historic preservation groups make it extremely difficult to build in Georgetown evidenced by the fact that there has not been a new delivery here since 2006 nor are there any scheduled for the next 2 years. The majority of Georgetown’s office inventory is within a quarter mile of the intersection of Wisconsin and M, is roughly 4,100 square feet, and was built in the early 1900s.

Rents in Georgetown are among the highest in the DC metro area at around $50 per square foot but finally saw an end to their roughly 3% annual growth from 2014-2017 and were negative in 2018. This trend may continue as landlords attempt to backfill recent vacancies.

For detailed information on the Georgetown submarket please contact Ryan Rauner, CCIM at Ryan@RealMarkets.com.

 

When leasing commercial space companies must decide on the length of lease term. This decision is influenced by a number of factors, including but not limited to, growth projections, continuity of operations, build out needs, economic conditions, etc. Market conditions, outside the tenant’s control can also have an impact. For example, retail landlords generally require minimum 5-year leases and during the early years of the Great Recession landlords were willing to agree to nearly any length of lease term (sometimes as short as 1 year) just to get their spaces leased.

In this series I will be discussing the most common/traditional lease terms: 3-year, 5-year, and 10-year, but will also touch on less conventional terms shorter than 3 years, between 5 and 10 years, and longer than 10 years. I will touch on the Who (generally prefers which), What (you can expect in concessions as a result), and Why (tenants may choose one over another).

Less than 3 years

Most landlords are not willing to agree to lease terms of less than 3 years. Only in rare cases and/or dire economic conditions might a landlord choose to do so. Options for shorter than 3-year lease terms primarily take the form of subleases. Subleases can be great opportunities for tenants looking for shorter term leases as they are often offered below market rates for comparable properties and can also include furniture.

Between 5 and 10 years

The main reason for a lease term between 5 and 10 years is that the landlord requires a longer term over which to amortize the costs of the tenant’s improvements/allowance. As construction costs rise so too will the prevalence of 6 and 7-year leases. Another reason for an “in-between” lease term may be due to the need for space being tied to a contract, franchise agreement, etc. The lease term is then made coterminous with the factor which necessitates the requirement for the commercial space.

Longer than 10 years

Similar to terms less than 3 years, most landlords will not agree to terms in excess of 10 years. They may not want to encumber their space for that long and/or want the opportunity to reset the rent at the then market rate at the end of the term. Renewal options are used as ways to provide tenants with the security of knowing that they will still have the ability to keep their space and allows the opportunity to increase the rent if the tenant’s rental rate at the end of the lease term is below market (landlords’ preferred language is “the greater of market or the then escalated rate”). Ground leases are the exception and can be as long as 99 yeas depending on the municipality in which the property is located. Generally ground leases need to be from 50-99 years for a new development to make sense.

***Did you know Tysons Corner is on a ground lease?***

It’s always recommended to seek the advice and services of an experienced commercial real estate broker when leasing commercial space. For more more information on representation, please contact me at Ryan@RealMarkets.com

 

When Phase 1 of the Silver Line was finally approved, we learned that the Tysons Corner metro stations would not have parking. Who cares though?

I don’t plan on riding the metro. It’s dirty, crowded, and unreliable. Daily parking and rides during rush hour add up. Unless you live in walking distance to a station you also have to drive, find parking, walk to the station, wait for the train, endure multiple stops, then walk to your place of business. Basically, it takes longer to get to work and is more expensive to ride the metro than it is to drive. So yeah, no thanks.

Guess what though, you may not have a choice.

Every commercial property has a parking ratio. They vary depending on use and building square footage but minimal requirements are dictated by the County. Typically office buildings in Fairfax County are required to have a minimum 3 parking spaces per 1,000 square feet, but with the metro that’s all changing. Based on proximity to mass transit (metro) developers can request an increase in density or FAR (floor to area ratio), which means they can build a more building on less land. They can also request a reduction in their parking ratio, which means fewer parking spaces.

*Many buildings in Arlington have less than 2 spaces per 1,000 square feet.

In addition, depending on their proximity to the metro, existing buildings may now be forced to adopt permitted parking to prevent metro riders from parking in their building’s parking lot and taking away spaces from paying tenants. Commercial real estate broker or not, we all know that you can fit more than 3 people in 1,000 square feet. So why wasn’t parking an issue before? A few reasons…

One, because it was free and unreserved; unreserved being key. When you reserve parking only those for whom it’s reserved can park there. You park there you get towed. We’ve all been frustrated driving around a parking garage passing empty space after empty space looking for one that’s not marked “Reserved.” Another reason is that many buildings aren’t 100% leased so naturally there would be excess parking and even if a building were 100% occupied some people may be on vacation, home sick, on the road, or simply didn’t come to work leaving enough parking for tenants and visitors.

Those days are now over.

So what does that mean? It means that all of us that don’t want to give up our cars and suffer the metro daily are out of luck. Well, some of us are out of luck. See, when you permit parking you can’t provide more permits than you have parking spaces. A landlord with a 3 parking spaces per 1,000 square feet parking ratio can’t give a tenant 5 parking permits (spaces). The math doesn’t work. And when you have 5 people and only 3 parking spaces you get 2 people riding the metro. So where do you fall in the hierarchy of your company? Are you parking permit worthy?

While there is over 20 million square feet of office vacancy in Fairfax County the only 2 markets most companies want to be in are Reston and Tysons Corner. Naturally that’s leading to rising rental rates in these markets. It’s basic supply and demand and the rules of supply and demand don’t stop there. You start with free and unreserved parking then you get permitted parking and then… you got it! Paid parking.

Because of the metro, tenants may eventually have to factor parking costs into their monthly budgets. Parking charges will most certainly not be as high as say Arlington, at least not initially, but depending on the amount of space and people you have the amount may not be negligible. And, come on, it’s Tysons Corner. I’ve been parking here for free, forever. I already get irritated having to pay for parking at Towers Crescent or Tysons Blvd, and now I may have to worry about that on Greensboro Dr and Spring Hill Rd? Give me a break.

People will try and make the case that Tysons is becoming a work, live, play environment and to a certain extent that’s true or at least becoming true. But how long do we have to wait for that day and what do we do in the mean time?

Executives will need to analyze where they’re drawing their workforce from and factor that into their decision on where to lease space. If you’re millennial heavy this may not be a problem. Companies will want to locate their offices in close proximity to the metro as a way of attracting a more urban, tech savvy employee base.

If you have a more traditional employee base that loves their cars though you’ll want to stay away from buildings within walking distance to the metro that will be forced to permit their parking. Many of these buildings will have shuttles running rides to and from the metro during regular business hours, which may still allow them to attract metro riders.

Finally, when in lease discussions you can try and negotiate free parking for the initial lease term and any renewal terms (less likely). This landlord concession, like all others, will be directly to your company’s square footage footprint; the more you take the more you get. However, when it comes to paid parking landlords oftentimes will outsource management of the parking facilities to 3^rd party companies, which means it’s out of their hands.

The point is times are changing and Tysons Corner will experience the associated growing pains. One day Tysons Corner will resemble Arlington. It will be walkable. At least that’s the plan. In the meantime though, load up on hand sanitizer and buy some good books because you may be spending a lot more time on the Silver Line than you’d thought.

 

When leasing commercial space companies must decide on the length of lease term. This decision is influenced by a number of factors, including but not limited to, growth projections, continuity of operations, build out needs, economic conditions, etc. Market conditions, outside the tenant’s control can also have an impact. For example, retail landlords generally require minimum 5-year leases and during the early years of the Great Recession landlords were willing to agree to nearly any length of lease term (sometimes as short as 1 year) just to get their spaces leased.

In this series I will be discussing the most common/traditional lease terms: 3-year, 5-year, and 10-year, but will also touch on less conventional terms shorter than 3 years, between 5 and 10 years, and longer than 10 years. I will touch on the What (you can expect in concessions as a result), Who (generally prefers which), and Why (tenants may choose one over another).

10-Year Lease

Why?

There are a number of reasons that tenants may prefer a 10-year lease. One is continuity of operations. If a tenant’s use requires customers or patients to visit their space they have an interest in those customers and patients knowing where they are located; fearing that they may lose some of those customers/patients if they were to change locations. Similarly, if a location is highly desirable a tenant may want to “lock it in” for as long as possible so that the landlord cannot lease the space to a competitor or other business. In the same vein, if tenants have the opportunity to lease space in a tenant’s market, categorized by high vacancies (high supply/low demand) which puts downward pressure on rental rates, they may want to “lock in” that rate in hopes of paying below market rates for the duration of the lease term. Finally, depending on the extent of the tenant’s build out needs/costs, they may need a longer lease term over which the costs of their improvements/allowance can be amortized.

Who?

Doctors and dentists almost exclusively sign 10-year leases (if purchasing is not an option). Retail users are also prime candidates for 10-year leases due to the importance that their location within both a submarket and retail project impact their success.

What?

Ten year leases are long enough to amortize the costs of most build outs. Interestingly though, improvement allowances seem to be affected by the law of diminishing returns. If a 5-year lease gets a tenant a $50/sf improvement allowance a 10-year lease will not likely result in a $100/sf improvement allowance. There is a dollar per square foot amount, different for each landlord, market, etc. over which landlords are not willing to go. They want to know that a tenant has some “skin in the game” to reduce the risk of default. Landlords may provide other economic concessions such as free rent as an incentive for tenants to sign up for a 10-year lease term as opposed to cash.

It’s always recommended to seek the advice and services of an experienced commercial real estate broker when leasing commercial space. For more more information on representation, please contact me at Ryan@RealMarkets.com

 

When leasing commercial space companies must decide on the length of lease term. This decision is influenced by a number of factors, including but not limited to, growth projections, continuity of operations, build out needs, economic conditions, etc. Market conditions, outside the tenant’s control can also have an impact. For example, retail landlords generally require minimum 5-year leases and during the early years of the Great Recession landlords were willing to agree to nearly any length of lease term (sometimes as short as 1 year) just to get their spaces leased.

In this series I will be discussing the most common/traditional lease terms: 3-year, 5-year, and 10-year, but will also touch on less conventional terms shorter than 3 years, between 5 and 10 years, and longer than 10 years. I will touch on the What (you can expect in concessions as a result), Who (generally prefers which), and Why (tenants may choose one over another).

5-Year Lease

Why?

Five year leases are the most common lease terms and, in many cases, the reason is simply because it’s the default lease term. Many landlords require a minimum 5-year lease term (retail particularly). In addition, 5 years is both short enough and long enough for companies to forecast and make accurate projections. Finally, if a company wants or needs to modify/customize their space a 5-year lease generally provides enough term over which improvement allowances can be amortized.

Who?

Most (established) businesses lease commercial space for 5 years. As previously mentioned, retail tenants are generally required to enter into a minimum 5-year lease.

What?

Depending on the asset class, nature of the tenant’s business, and extent of the build out (and finishes), a 5-year lease can get you a brand new, turnkey space. This applies mostly to office space where layouts/office configurations are relatively uniform, reusable by subsequent tenants, etc. Due to the uniqueness of retail and industrial tenants’ uses and associated infrastructure and build out needs the amount of money in the deal may or may not be sufficient to cover the cost of their improvements. Retail rates are relatively high compared to office and industrial rents in the same market, which in theory would afford a higher improvement allowance, but because each retail tenant’s business has proprietary specs their build outs are generally more expensive. Industrial spaces are generally leased in larger square footage blocks with a relatively small portion of the space actually being built out. Thus the impact of the improvement allowance is magnified. For example, an industrial tenant that leases 20,000 sf at $10 per square foot (triple net) and receives a (meager) $5/sf tenant improvement allowance has $100,000 to spend towards build out. If they only require a 2,000 sf showroom/office space that improvement allowance actually equates to $50/sf ($100,000/2,000 sf).

It’s always recommended to seek the advice and services of an experienced commercial real estate broker when leasing commercial space. For more more information on representation, please contact me at Ryan@RealMarkets.com

 

When leasing commercial space, companies must decide on the length of the lease term. This decision is influenced by a number of factors, including but not limited to, growth projections, continuity of operations, build out needs, economic conditions, etc. Market conditions, outside the tenant’s control can also have an impact. Retail landlords, for instance, generally require minimum 5-year leases. Another example was during the early years of the Great Recession when landlords were willing to agree to nearly any length of lease term (sometimes as short as 1 year) just to get their spaces leased.

In this series I will be discussing the most common/traditional lease terms: 3-year, 5-year, and 10-year, but will also touch on less conventional terms shorter than 3 years, between 5 and 10 years, and longer than 10 years. I will touch on the Who (generally prefers which), What (you can expect in concessions as a result), and Why (tenants may choose one over another).

3-Year Lease

Why?

Perhaps the most common reason tenants may prefer a 3-year lease is flexibility. Three years is a relatively short time in business. Tenants may want the ability to move to another building or submarket. In uncertain economic times, many businesses may not want to lock themselves into a “long” term obligation and be on the hook for rental payments if the business fails. Another reason may be time. If a tenant needs to lease space quickly for whatever reason, i.e. their current lease is expiring, and they did not give themselves enough time to thoroughly evaluate their options, negotiate the most advantageous terms, etc. they may want to minimize the amount of time they are in a less than optimal space. Three year leases are generally the shortest lease term that landlords will allow.

Who?

Many new businesses or start-ups find 3-year leases appealing. They are still testing out their concept and may not have tools, data, etc. to make accurate projections for growth, revenue, etc. They don’t want to bite off more than they can chew; making a 3-year lease an easily digestible lease term.

What?

Landlords amortize the costs of tenant improvement allowances over the term of the lease and 3 years is simply not long enough for landlords to be able to offer much money and still offer competitive market rates. Concessions can range from paint and carpet (flooring) and some minor demo to nothing. This is another reason why 3-year options are a preferred choice of tenants that are in a hurry. The build out process requires architectural drawings, permits, construction, etc. which can take months. Paint and carpet do not require permits and can thus be done “over the weekend;” allowing tenants to move in quickly.

It’s always recommended to seek the advice and services of an experienced commercial real estate broker when leasing commercial space. For more more information on representation, please contact me at Ryan@RealMarkets.com