Vacancy is a reflection of a property’s rental rate. The vacancy for any space goes to zero at a certain price or 100% at another. Would you lease 100,000 SF for $1,000/month? Would you lease 1,000 SF for $100,000/month? The intersection between the demand and supply curves for space in a particularly market, asset class, etc. determines market rents and occupancy levels.
Historically high vacancy rates are one of the many legacies of the Great Recession (for more information on the impacts of the Great Recession see my article The Great Recession’s Impact on the Office Market). Oversupply and functional obsolescence have led to a flight to quality, with many owners/landlords of Class B and C properties experiencing the lion’s share of the market’s vacancy. Spaces may sit on the market for months or even years with seemingly no end in sight.
In some cases, this is due to the unwillingness or inability of owners/landlords to lower their asking rates. Old school/long-term owners may have paid off the asset years ago and, therefore, do not necessarily need the rental income. They have their price and stick to it. Others may have purchased the property at a price based on certain assumptions. If those projections were wrong at the time or have since become outdated they may not be able to lower their rates without incurring a loss. Older (Class B & C) buildings are generally less efficient than their newer/Class A counterparts. The higher operating expenses thus compress the profit margin when netted against market rental rates.
For the rest of owners/landlords the answer is simple: lower your rental rate until you lease up your space/property. This is only one part of the answer posed by this article. The operative word is “effectively.” Certainly some money is better than none but no one wants to leave money on the table.
One of the problems with Class B & C properties is that their spaces/suites and common areas are old and tired; having suffered decades of wear and tear. In order to be more attractive to tenants these assets must undergo renovation. After renovation comes repositioning (higher rents). Many owners may be unwilling or unable to spend the money to renovate their property on a speculative basis, which makes sense. They also may not have the financial ability to provide market tenant improvement allowances depending on the size of the tenant. So, how do they get from point A to point B?
As touched on in my article, Losing Money to Make Money, landlords/owners must assess when to make short term sacrifices for long term gains. The first step is lower a property’s asking rate until, despite the property’s shortcomings, it is able to attract quality tenants (make them an offer they can’t refuse). The next step is to structure the deal in a way that minimizes the out-of-pocket costs for the owner; such as providing tenants with rental abatement in lieu of tenant improvement dollars. Similar to the concept of positive financial leverage increasing an investment’s return, if the owner can use someone else’s (the tenant’s) funds to improve their own property they will be increasing the value of their asset without incurring a dollar for dollar expense. In fact, the lack of rental income due to rental abatement decreases the owner’s taxable income and, depending on how their business is structured, can allow them to have those losses offset taxable income elsewhere.
The final step is to negotiate the shortest lease term possible while providing a renewal option for the tenant at the then market rate. Landlords understand the costs associated with moving. Unless a tenant/company has grown and requires more space (or contracted and requires less) they are likely to stay in the same space/building. When it comes time for the tenant to exercise their renewal right, the landlord is in possession of a more marketable and desirable space and one in which the tenant has made a financial investment. The landlord can, therefore, reasonably demand a higher (market) rate from their existing tenant or go to market in a significantly improved position.
For more information on listings or representation services, please contact Ryan Rauner at 703-943-7079 or Ryan@RealMarkets.com.