How to Gain the Upper Hand When Renewing Your Lease

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In commercial leasing, renewal options are for the sole benefit of the tenant. They give the tenant the option to renew the lease of their existing space upon certain terms and conditions. From another perspective, they prevent the landlord from essentially kicking the tenant out at the expiration of the lease term and lease the space to another tenant. Typical terms and conditions that govern renewal options are the timeframe in which a tenant must notify the landlord of their election to exercise their renewal option and how the rental rate will be calculated for the renewal term.

Basically, tenants want the shortest timeframe possible and landlords want a longer (reasonable) timeframe. Shorter notification periods put landlords at a disadvantage because if a tenant chooses not to exercise its option the landlord must put the space back on the market. If the typical lease up time for a particular property type is 6 months and a tenant does not have to give notice until 3 months before the lease expires, the landlord could be looking at 3 months of vacancy and lost rental income. Generally, the longest timeframe is one year because neither party wants to risk changes in the market that might adversely affect the terms of the deal.

*I recommend 9 months. It gives the tenant the time to find another space, negotiate the deal, and build out the space within a comfortable but not excessive period. For landlords it allows them adequate time to market the space and thus minimize any vacancy periods.

The next, and perhaps most important detail, to negotiate is how the rent for the renewal period will be calculated. Landlords’ preferred language is “the greater of the then escalated rate or the then market rate” while tenants’ preferred language is just the opposite: “the lesser of the then escalated rate or then then market rate.” The compromise is thus typically “the then market rate.” This is often and rightly conditioned by such terminology as “for lease renewals, for similar tenants, and for comparable properties in the submarket in which the property is located.” Landlords will also try and add language that precludes free rent or improvement allowances from the negotiations. While tenants should certainly attempt to strike language such as this it is ultimately not as important as one may think. What is most important is “the then market rate” because market rates are influenced by other economic concessions such as free rent and improvement allowances (a good broker knows this and understands how to structure deals based on the net value of the lease).

Determinations of “market rate” can be quite different especially when two interested parties are involved. Would it surprise you to learn that tenants will typically have a lower estimation of the market rate than the landlord? In order to preemptively deal with a situation in which the tenant and landlord cannot agree on the “market rate,” it’s recommended to include a three-broker arbitration method as part of the renewal option. Without going into too much detail, basically the landlord’s broker provides their determination of market as does the tenant’s broker, they then agree to have an independent third party/broker review both and come up with their own determination of the market rate which is binding on both parties.

With all that out of the way, both parties must negotiate the best deal for themselves. Some people believe that there are certain tactics to use in negotiations that will yield the best results. That’s true to some extent but at the end of the day the real way to gain leverage in a negotiation is to have options. Telling the other side that you’ll walk away if they don’t agree to x, y, and z only works if you have another option. There’s nothing better to convince a landlord to agree to your terms than to show them the terms being offered by their competitor. The key to successful negotiations is leverage and the key to leverage is options.

The landlord knows that moving is costly and disruptive to a tenant’s business, employees, and/or customers. It’s not difficult to estimate these costs and if the landlord can negotiate terms that are equal to or lower than these costs for the tenant it makes sense for the tenant to renew in place. The landlord starts with this leverage. Tenants on the other hand know that landlords incur the risk of lost revenue from the space remaining vacant and capital expenditures for any improvement allowances, brokerage commissions, etc. in securing a new tenant. That’s their leverage.

How does a tenant then increase their leverage to incentivize the landlord to add another month of free rent or knock another $0.50 per square foot off the rate? They research and pursue other available options in the market and let the landlord know that they’re out in the market. Landlords are now no longer negotiating with the tenant, they’re having to negotiate with their competitors. There’s no better proof to support your assertion of “market” than to show what other landlords are willing to offer.

This presents an interesting dynamic. The tenant is most likely being offered more aggressive terms because the landlords offering them are competing to secure that tenant and there are higher costs to secure a new tenant than to keep an existing one. The current landlord knows this and can afford to lower the rental rate to be more competitive while saving the costs of large capital outlays such as tenant improvement allowances to customize the space for a new tenant. They just need to be forced to make the “right decision.” Their job to is to negotiate the best deal for them, not the tenant, and they will up until the point that they risk losing the tenant to another building.

For more information on this or representation services, please contact Ryan Rauner, CCIM at 703-943-7079 or Ryan@RealMarkets.com

Fairfax County’s Tier-2 Submarkets Q2 2019

My classification of Herndon, Fairfax Center, and Merrifield as Fairfax County’s 2nd Tier submarkets is more of a statement about the 800-pound gorillas, Tysons Corner and Reston, than it is about them. Tysons Corner is one of the largest office submarkets in the nation (30,100,719 SF) and is the business center of Northern Virginia. Reston, the nation’s first planned community, isn’t far behind with 20,414,245 SF and over 1.6 million under construction. Reston Town Center commands some of the highest rents in the entire Commonwealth and Dulles International Airport is just down the road. Taken together, these two giants consume most of the office demand in Northern Virginia.

Whether a matter of perception (Herndon), lack of direct access to Metro stations (Fairfax Center), or delayed development (Merrifield), these submarkets are often an afterthought for tenants when considering where to locate their business; however, with more than 16.5 million square feet of 4 & 5 Star properties between them, these submarkets offer both quality and value with average rents well below their tier-1 counterparts.

 

Herndon

  • RBA: 12,760,803 SF
  • Vacancy Rate: 16.8%
  • 12 Month Net Absorption: (253,000 SF)
  • Average Asking Rent: $30.76
  • 12 Month Rent Growth: 2.1%

Herndon is an interesting submarket because of the diversity of its sub-submarkets. From the one-level/flex-style office properties along Herndon Pkwy to the Class A (4 & 5 Star) properties along the Dulles Toll Road (Sunrise Valley Dr), Herndon has options for every type of tenant and budget. Historically, Herndon has suffered from a negative name perception with many tenants preferring a Reston address, but things are poised to change with the Silver Line Metro’s expansion.

With nearly 2 million square feet within ½ mile of the future Metro stations with more proposed, Herndon has the potential to become one of the hottest submarkets in the region. Fundamentals in the submarket are a bit of an anomaly. Absorption was strong in the 1st quarter of 2019, due mostly to smaller leases, but taken as a whole the past 3 years saw negative net absorption of 755,000 SF. Still rent growth in Herndon is among the strongest in the metro area; rivaling Tysons. Herndon’s 3 Star properties were the primary drivers behind the rent growth at 2.6% versus only 1% for 4 & 5 Star properties. Despite this, Herndon’s rents are below the metro average and the submarket presents a huge opportunity for tenants that want to lock in lower rates before the 2nd phase of the Silver Line delivers.

 

Fairfax Center

  • RBA: 7,614,250 SF
  • Vacancy Rate: 24%
  • 12 Month Net Absorption: 76,500 SF
  • Average Asking Rent: $29.40
  • 12 Month Rent Growth: 2.4%

Merrifield

  • RBA: 10,226,227 SF
  • Vacancy Rate: 14.1%
  • 12 Month Net Absorption: (21,000 SF)
  • Average Asking Rent: $32.04
  • 12 Month Rent Growth: 2.6%

Northern Virginia’s Town & City Submarkets Q2 2019

Northern Virginia’s Town & City submarkets are a microcosm of the larger DC metro area. They can be defined by town or city limits or by the commercial area within a more suburban submarket. Tysons Corner encompasses parts of Vienna and McLean at least as far as the post office is concerned, but these submarkets are unique to themselves with differing factors influencing supply, demand, and more. Whether it’s because of proximity to their home, the traditionally lower rental rates, or some other reason, for many of the tenants in these submarkets, being anywhere else is unthinkable.

Fairfax City

  • RBA: 5,108,175 SF
  • Vacancy Rate: 11.5%
  • 12 Month Net Absorption: 3,600 SF
  • Average Asking Rent: $24.76
  • 12 Month Rent Growth: 0.5%

The Fairfax County government and George Mason University are the major tenants and stabilizing forces in Fairfax City; however, Zeta Associates is the submarket’s largest tenant and occupies over 120,000 SF. Fairfax City is home to many small tenants such as doctors, banks, and financial advisors that cater to the surrounding suburban population. There are many small law firms as well due to the presence of the Fairfax County Courthouse being located in old/downtown Fairfax City. The median new lease in 2018 was only slightly north of 4,000 SF. Despite its lack of metro access, Fairfax City’s vacancy rate is below the metro average due mainly to its affordable rents (among the lowest in the metro area) and central location in Northern Virginia.

 

Oakton

  • RBA: 1,616,074 SF
  • Vacancy Rate: 17.1%
  • 12 Month Net Absorption: (25,100 SF)
  • Average Asking Rent: $27.21
  • 12 Month Rent Growth: 2.3%

Oakton has always been a bit of a mystery to me. The submarket is centrally and conveniently located; bordering the Fairfax City and Town of Vienna submarkets and with most of its inventory located at the intersection of 123 and I-66. The submarket is home to AT&T’s Government Solutions main office and about 335,000 SF of 4 & 5 Star properties. Despite this fact, there are no new deliveries in the foreseeable future and Oakton seems content to remain a sleepy submarket that is generally overlooked by major tenants.

 

McLean

  • RBA: 1,699,117 SF
  • Vacancy Rate: 11%
  • 12 Month Net Absorption: (72,100 SF)
  • Average Asking Rent: $31.84
  • 12 Month Rent Growth: 0.6%

McLean is interesting because it’s one of the oldest and most mature submarkets in Northern Virginia. I remember my father started in the banking business in McLean. This submarket is home to many diplomats, businessmen, members of Congress, and high-ranking government officials and is just across the Chain Bridge from Washington, DC. McLean is the 3rd wealthiest “city” in the country and without any new construction in years or deliveries in sight, this submarket has vacancy below and rates above the metro average.

City of Falls Church

  • RBA: 2,831,818 SF
  • Vacancy Rate: 13.3%
  • 12 Month Net Absorption: (104,000 SF)
  • Average Asking Rent: $25.42
  • 12 Month Rent Growth: 1.6%

Great Falls

  • RBA: 273,966 SF
  • Vacancy Rate: 6.9%
  • 12 Month Net Absorption: (6,500 SF)
  • Average Asking Rent: $25.56
  • 12 Month Rent Growth: 2.7%

Town of Vienna

  • RBA: 2,005,964 SF
  • Vacancy Rate: 9.1%
  • 12 Month Net Absorption: (43,200 SF)
  • Average Asking Rent: $28.42
  • 12 Month Rent Growth: 1.2%

Arlington’s (Previously) Tier-2 Submarkets: Crystal City & Pentagon City Q2 2019

Once considered tier-2 submarkets in Arlington, Crystal City and Pentagon City are primed to become the hottest areas in the region with Amazon’s announcement to locate its HQ2 in National Landing. Questions still remain as to what ancillary demand will result from the most significant corporate move in recent history.

 

Crystal City

Crystal City’s office market has historically been dominated by federal agencies and contractors, but Amazon has changed all that. The result is a complete reversal of the negative fundamentals that have plagued the submarket for years.

In Q2 2019 alone, Amazon signed 3 deals with JBG Smith totaling approximately 537,000 SF with plans to occupy later this year and early next. In addition to this, Amazon plans to purchase 2 sites at Pen Place and Metro Park for the location of their future headquarters. These sites have over 4 million SF of development potential. Amazon’s deal with Arlington County stipulates that it must occupy at least 6 million SF by 2024.

BRAC hit Crystal City hard. At the end of 2018 vacancies were above 17% with more than 2.1 million SF of vacant space; however, recent increases in defense spending may create additional demand. Northrup Grumman, Raytheon, and Lockheed Martin recently won a $4.1 billion ballistic missile defense contract and with its proximity to the Pentagon, Crystal City may benefit as a result.

The old and tired buildings of Crystal City are seeing a revitalization through conversions into residential uses or renovation to compete with 4 & 5 Star properties and attract new tenants that want to be close to Amazon. Apart from Amazon, one significant delivery is the 460,000 SF building planned for 701 E. Glebe Rd which will house the Institute for Defense Analysis. Even surrounding areas will benefit from Crystal City’s renaissance with JBG’s Potomac Yard development in the south and Amazon’s campus spilling over into neighboring Pentagon City.

As a result of all this, rents in Crystal City are posting quarterly gains with 2.4% growth over the past 12 months.

With the majority of the submarket being owned by a few players, namely JBG Smith, sales activity has been low; however, there has been a flurry of activity in the multi-family market.

Pentagon City

With only 1.6 million SF of office space, Pentagon City is a small submarket. The lack of inventory and no new deliveries have kept vacancies low, but a lack of demand has historically hurt rent growth with recorded losses every year since 2012. That being said, rents experienced their first meaningful growth in the last 12 months at 3.3%. This trend should continue as the Amazon factor takes effect. The most recent office delivery in Pentagon City was a 320,000 SF building in 2013, which was built for Boeing. Development in this submarket has been dominated by multi-family projects. While the only sale in the past 10 years was Boeing’s purchase of the 2 buildings previously mentioned, Pentagon City’s proximity to Amazon’s HQ2 should give investors cause to take a renewed look at opportunities here.

 

Rosslyn-Ballston Corridor Q2 2019

Ballston

Ballston is home to a wide variety of tenants, from government agencies to major public companies to small firms. Large scale move-outs have resulted in negative net absorption, rising vacancy, and anemic rent growth since 2012. Relocations by large government tenants such as the National Science Foundation and U.S. Fish and Wildlife Service have created stiff competition for big-block tenants with 7 properties having 50,000 sf or more available. Other large tenants have staggered lease expiration dates over the next decade, which should help the submarket recover. As is the case in many submarkets, 3-Star properties are disproportionately affected with a 34% vacancy rate in Ballston, alone. There is only one property under construction in Ballston, Shooshan Co’s Liberty Center which will be a mix of office, retail, and apartments. The lack of new construction has eased the rise of vacancy and resulting downward pressure on rental rates.

Ballston is 2nd only to Rosslyn in total square footage at over 8 million square feet. It currently has the highest vacancy rate in the submarket cluster at 24%. Even with positive net absorption of nearly 50,000 sf in the past 12 months, rents decreased by 3.6% for an average asking rate of $41.10/sf/yr.

Virginia Square

Virginia Square is the smallest submarket in the Rosslyn-Ballston Corridor with only 1.6 million square feet of inventory. Despite positive net absorption in the past 12 months of over 28,000 sf and a vacancy rate of only 11.4%, rent growth was negative at 2.5% resulting in an average asking rate of $37.68/sf/yr.

Clarendon/Courthouse

With 2 metro stops and a heavier concentration of residential and retail than Ballston or Rosslyn, the Clarendon/Courthouse submarket is more often thought of as a play rather than work area. Still, many government agencies and contractors call this submarket home and while large move-outs in 2015 increased vacancy rates and put downward pressure on rental rates, a strong economy in recent years has led to job growth and increased demand. As a result vacancy rates are now below the metro average.

There have been zero deliveries in the past 12 months with no new construction planned for the next 12 months. The last year saw 129,000 sf of negative net absorption with a resulting 2.7% decline in rental rates. Clarendon/Courthouse has nearly 6.3 million square feet of inventory and an average asking rate of $39.82/sf/yr.

Rosslyn

Rossyln is the largest submarket in the RB Corridor with over 10 million square feet of inventory. BRAC and sequestration contributed to massive net absorption in recent years, but Nestle’s decision to move its headquarters to the submarket brought 750 jobs and put a dent in the vacancy rate. There was a significant delivery in the past 12 months of 560,000 sf at Central Place; however, Gartner’s 315,000 sf lease nullified the impact on vacancy.

Rosslyn has the 2nd highest vacancy rate in the corridor at 21.8%. Despite positive net absorption in the past 12 months, rents saw a decrease of 2.7% and still struggle to find meaningful growth. With 577,000 sf set to deliver in the next 12 months the submarket is vulnerable to continued downward pressure on rates. At $43.78/sf/yr, average rates are the highest in the corridor but still well below those in the East End, CBD, or West End.

 

Unique Opportunities Presented by Class B & C Multi-Family Properties

 

I’ve discussed, in previous articles, the explosion in the Class A/trophy multi-family market and how unsound investment principles may contribute to a correction in the years to come, but in this case I will be discussing Class B and C assets. While a specifically defined and universally agreed upon set of criteria does not exist, Class B and C properties are generally older and, as a result, do not have many of the amenities offered by new, Class A apartments. They may also be less efficient from an operational standpoint due to the age of building systems and, thus, are able to achieve a lower NOI compared to the gross revenue they generate. Rents are more affordable in Class B and C properties; making them available to a greater number of potential renters. In this article, I will go through the defining characteristics of Class B and C properties and explain how these create unique investment opportunities that mitigate many of the risks faced by their Class A counterparts.

Because age is one of the defining characteristics of Class B and C multi-family properties, one of the benefits to these investment assets is that they already exist. You don’t have to build them and thus incur the costs associated with development, which is a combination of time, permits, construction costs, and vacancy. When an investor purchases an existing property they are purchasing something with inherent value (cost to build) and with the ability to generate income through rents. There are historical records of rental rates, operating expenses, etc. The buyer has access to data and understands what they’re buying. If they can buy the asset for the right price, they should have an asset that will cash flow indefinitely. It may be sexier to own a Class A apartment building, but what they lack in sex appeal, Class B and C assets make up for in consistency and security.

Lower rental rates are another appealing factor of Class B and C multi-family properties; not because generating less gross revenue is a good thing, but because it opens up the tenant base to a greater number of renters. Vacancy is a matter of choice. You can be 100% vacant if you want to charge $100,000/month for a 1-bedroom apartment or 0% vacant if you want to charge $100/month. More people can afford $1,200/month than $1,500/month. Interestingly, because more people can afford $1,200/month there is more competition which can lead to more sustainable, if moderate, annual increases versus rates that are already at a stretch for many renters. The difference in revenue between Class A and B options decreases when Class A landlords are having to offer a month of free rent per year (concessions) to attract tenants.

For Class C apartments that are considered “workforce” housing or that choose to participate in subsidized housing programs such as Section 8, landlords are essentially guaranteed tenants. Many blue-collar workers may not have the financial wherewithal to purchase a home but can make excellent tenants. Government programs guarantee or subsidize rents for low income individuals and, while the programs impose specific requirements on the landlord, they can be a consistent way of ensuring an investment’s performance while an area undergoes revitalization/gentrification.

Functional obsolescence is both a risk and opportunity associated with Class B and C multi-family properties. Simply due to age, these buildings may have outdated finishes, layouts, etc. The building systems may be old and less efficient; resulting in higher operating expenses and/or deferred maintenance. While considered a risk, it is this attribute of Class B and C properties that make them so appealing to investors.

Perhaps the most common trend in multi-family investment is the renovation and repositioning of these types of assets. The basic formula is to buy a Class B or C apartment building, renovate the units (and sometimes building systems), and raise the rents. The higher rents (hopefully coupled with reduced operating expenses) leads to increased NOI. Furthermore, because the new owner has improved the property they have also increased the desirability from a leasing standpoint and eliminated future costs/risk associated with deferred maintenance and renovations which decreases the market cap rate (increases the market value).

Here is an example to better explain these concepts. An investor purchases a 20-year old, 100-unit apartment building for $8,000,000 ($80,000/unit) at a 7.5% cap rate. The units rent for $1,000/month and operating expenses run about 50% of gross revenue, so that NOI equals $600,000/year. The new owner purchases the property with a plan to renovate the bathrooms and kitchens of each unit at $20,000/unit and spend $100,000 updating some of the building systems to increase the building’s efficiency. The result is that the owner is able to increase the rent to $1,200/month, lower operating expenses to 40% of the gross revenue, and sell the property the following year at a 6.5% cap rate. So, how much does the owner make?

Due to the increased rents and greater efficiency the owner was able to increase the NOI to $864,000 and by increasing the marketability/reducing the risk of the property and selling at a 6.5% cap rate the property is able to yield a sales price of $13,292,307.69 ($132,923.08/unit). Even after subtracting the costs of upgrading the units ($2,000,000) and building systems ($100,000) the owner nets $3,192,307.69 ($11,192,307.69 – $8,000,000). That’s a significant amount of money, and while this is a simplified and hypothetical example, it shows the opportunity presented by Class B and C multi-family assets.

Class B and C multi-family properties are subject to the same risks as other real estate investments. The old adage that “you make your money in real estate when you buy the property” is true, but unlike their Class A counterparts, these asset classes present an opportunity to increase return by adding value.

NoVA’s Tier-1 Submarkets: Tysons Corner & Reston, Q2 2019

When it comes to office leasing in Northern Virginia, there two submarkets that dominate in both demand and supply: Tysons Corner and Reston. Tysons Corner is the business center of NoVA and, despite horror stories about its traffic, Tysons Corner provides some of the best access to major highways and public transportation in the region. Reston is the nation’s first planned community and, as a result, is uniquely positioned for growth in ways that Tysons Corner is not. With a little help from Dulles International Airport, the submarket created its own epicenter in Reston Town Center, which boasts some of the highest rental rates in the region. At $9.5B and $6.5B respectively, Tysons Corner and Reston are the largest office submarkets in Virginia, and they’re only just getting started.

Tysons Corner

 

The four Silver-Line Metro stations were a game-changer for Tysons Corner. Access and proximity to mass transit increased development density and connected Tysons Corner to the region like never before. The submarket is now being heralded as America’s next great city, but the explosion of residential development has not yet translated into comparable increases in office demand.

After Capital One completed its new headquarters, now the tallest building in the region, the Meridian Group delivered the first office building of the new Boro project. This approximately 440,000 sf building experienced strong preleasing and was nearly 75% leased by Q1 2019. This quarter should see another boost in demand as Appian moves its 600 employees (with plans to hire 600 more) into 205,000 sf at the former USA Today building.

Vacancy levels in Tysons Corner bely the overall strength of the submarket. They are still in the upper teens and above prerecession levels, but this is mostly due to 3 Star properties. Questions remain as to what will become of this older product as the flight to quality is likely to continue. Rent growth is indicative of this phenomenon with gains equaling about 2.5% since last year. Rents in Tysons average about $35/sf with new properties commanding average rents of $47/sf. Still, Tysons Corner offers a more affordable option to companies that don’t necessarily need to be in close proximity to DC with rates that are about 25% less than Rosslyn and Ballston.

Tysons Corner has a pipeline of proposed properties that is staggering; however, only one is set to deliver this summer: the latest addition to the Boro project. The majority of development has been multi-family and has centered around the four metro stations, but if the economy continues to boom we should see some of the more than two-dozen office projects begin to break ground in the coming years.

Reston

 

Much like Tysons Corner, Reston has benefited from the introduction of the Silver-Line Metro, a trend that will continue when the 2nd phase delivers in 2020. The submarket’s diverse tenant makeup, relatively affordable rents, and proximity to Dulles International Airport have led to vacancy levels below the metro average and annual rent growth of nearly 2.5% over the past 4 years.

Measured growth is responsible for Reston’s steady decline in vacancy as only 300,000 sf delivered from 2014-2017. The largest and latest delivery was the 368,000 sf, 5 Star office building at the Wiehle Metro Station. While leasing at this property has been anemic thus far, Google will be leasing a large block of space which should prompt Comstock to move forward with its plans to build an additional 2 towers for a total of approximately 800,000 sf. Boston Properties is, by far, the largest landlord in the submarket and just signed a lease with Fannie Mae for about 850,000 sf at Reston Gateway, which hasn’t even broken ground yet.

Average rents in Reston are slightly over $32/sf. While low compared to the metro as a whole, they are higher than the rest of the Dulles Corridor and Reston Town Center consistently commands rents that are 20% higher than the rest of the submarket’s 4 and 5 Star properties. Continued office, retail, and residential development around the metro station(s) and Reston Town Center should cause rates to continue to rise.