Leverage in Rental Rate Negotiations

 

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Clients/tenants are always asking “how negotiable” asking rents are. The answer is more nuanced than the question may suggest. In general, negotiations are based on leverage and the party with greater leverage controls the terms. There are both macroeconomic and microeconomic factors at play when establishing leverage. For the most part, landlords and tenants cannot control market cycles, fiscal/monetary policy, etc. that shape the state of the commercial space market and economy, as a whole, and they are instead forced to adapt and operate under existing market conditions. At the micro level though, there are factors that are within either party’s control that can improve or weaken their negotiating position. From the tenant’s position, leverage is directly related to their desirability (how bad the landlord wants them as a tenant). A landlord’s leverage is based on the status and performance of the subject property. In this article, I will discuss the macroeconomic and microeconomic factors that influence commercial real estate rental rate negotiations.

Macro

When it comes to factors that influence market conditions and thus, rent negotiations, it doesn’t get much more “macro” then the overall state of the economy. Generally speaking, a good economy will be characterized by decreased unemployment/increased hiring; resulting in the need for more commercial space. The increased demand and relatively static supply will lead to decreased vacancy rates with a corresponding increase in market rents. In a landlord’s market, where the demand for space exceeds the available supply, tenants must compete with one another just to satisfy their space needs. In such a market, there may be little to no room to negotiate a reduction in the rental rate. In a tenant’s market, landlords must compete for tenants; resulting in lower asking rates along with other concessions to attract tenants.

Property type and class also play a significant role in determining the negotiability of market rents. An interesting phenomenon in the DC metro office market over the past few years has been an increase in market rents despite historically high vacancy rates. While this may seem to violate the law of supply and demand, it can be understood and explained when analyzing absorption rates by asset class. In many DC office submarkets, new, 4 & 5-Star properties are driving demand and have vacancy rates below and rent growth above the submarket average. This flight to quality has led to stark differences between Class A, B, and C buildings within the same submarket; resulting in a demand vs. supply microcosm. Amazon’s influence has led to the strongest industrial market in years. In addition to it being a landlord’s market, even small incremental reductions in the asking rate, i.e. $0.25-$0.50/SF/yr, are amplified due to the relatively low base rates for industrial properties. For example, a $1.00/SF reduction in the asking rate for an office property whose asking rate is $30.00/SF equates to a 3.3% decrease while a $1.00/SF reduction for an industrial property with an asking rate of $10.00/SF is 10%. Retail is, by far, the most unique commercial property type. Rental rate negotiations and other economic concessions for retail spaces are more heavily influenced by the tenant’s profile (desirability) than in any other asset type. Finally, there is flex space, which is a combination of office and warehouse. The proportion of office to warehouse can vary from project to project and from space to space within each project; resulting in corresponding variations in asking rents. Flex rates are a blend of office and industrial rates as is their negotiability.

Micro

Within the space market paradigm, there are microeconomic factors that can either increase or decrease a tenant or landlord’s negotiating leverage. For tenants, the goal is to maximize their appeal to prospective landlords. For landlords, it is successful property and asset management.

Tenants

As stated previously, a business’/company’s desirability as a tenant plays the strong role in being able to negotiate the maximum amount of concessions from the landlord. Of the many factors that contribute to a tenant’s desirability and thus their leverage, square footage, financial strength, and lease term play the most significant roles. The larger a tenant’s square footage requirement the greater their leverage. While not a direct (proportional) relationship, landlords are generally willing to accept less rent on a per square foot basis the larger the space being leased. This is particularly true for retail space.

Landlords must analyze a tenant’s risk of default when determining the amount of any economic concessions. The more economically viable the tenant, the more desirable. Tenants’ financial strength is extremely important in landlord markets because they can be the deciding factor in which tenant the landlord chooses to lease to. Even in tenant markets, a tenant’s financial strength provides substantial leverage by reducing the likelihood of default and the associated costs, i.e. vacancy, commissions, improvement allowances, etc.; allowing the landlord the opportunity to share those savings with the tenant in the form of a reduced rental rate.

Lease term can also play a role in lease rate negotiations. In most cases, the longer the lease term the greater the tenant’s leverage. This is particularly relevant when coupled with a tenant’s financial strength because landlords’ main goal is to have their property leased for as long as possible (at or above the prevailing market rent). Landlords may be willing to reduce the base rental rate for a long-term lease with the expectation that annual escalations will bring the rate up to market over the term. Also, the longer the lease term the longer the period in which the landlord does not incur lease up costs. In rare cases, landlords may be willing to reduce their rental rate for short-term leases, i.e. 3 years, in order to secure a tenant in a competitive market. In this situation, the landlord can provide the tenant with a renewal option at the expiration of the term at the then market rate.

Finally, rental rate negotiations are influenced by the amount of any other economic concessions/considerations related to the deal, i.e. free rent, improvement allowances, etc. Free rent is foregone income while tenant improvement allowances are cash out-of-pocket. Landlords recoup these losses through rental payments. The more months of rental abatement and the larger the improvement allowance the longer the time required for the landlord to recover their costs and thus the less room for negotiation off the asking rate.

Landlords

Landlords are able to maximize the strength of the negotiating position through effective and efficient property and asset management. This begins from the point of acquisition and the price at and assumptions under which the subject property was purchased. When determining whether to purchase an investment property (and at what price), investors must make projections based on their analysis of current and future market conditions. They create proformas that guide deal structuring based on asking rates, lease terms, square footage, etc. Landlords that purchases assets based on conservative assumptions or at below market prices, i.e. bankruptcy/foreclosure sales, have room to negotiate on their rental rate while still maintaining an acceptable internal rate of return. During the holding period, landlords can position their property to be competitive within its asset type/class and submarket by investing in capital improvements to reduce operating costs and/or, in the case of amenities or renovations, increase asking rents. By making wise acquisition and management decisions, landlords strengthen their financial position, thereby increasing their leverage. They are able to negotiate on their asking rate, but not required to do so, and the lower the subject property’s vacancy the less inclined a landlord is to come off their asking rent.

On the flip side, landlords that overpay or do not effectively manage their property may have little to no control over their leasing rate. Landlords with high vacancy properties have little leverage and may be forced to agree to significant rate reductions simply to cover the costs of ownership and/or “stop the bleeding.” Landlords that do not maintain their property relative to their competitors risk functional obsolescence and the potential situation in which they cannot reduce their asking rate enough to attract tenants while generating an acceptable rate of return or, in dire circumstances, a positive net operating income.

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Loaded Cap Rates

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Every year, municipalities assess the market value of all real property within their jurisdiction for the purpose of collecting real estate taxes. Due to the vast number of properties, assessors conduct mass appraisals. Real property is divided into classes based on property type and further stratified based on its unique characteristics. Assessors then use the most appropriate valuation model and apply collected market value indicators to calculate value. Most commercial properties are income-producing and, therefore, the income capitalization approach is primarily used because it provides the most accurate and pertinent approximation of market value.

Because the purpose of the assessment process is to determine value for the purposes of taxation, assessors are left with a Catch-22 dilemma. The direct capitalization approach calculates value by dividing a property’s net operating income by the market cap rate. Net operating income is calculated by subtracting all costs of ownership from the property’s gross revenue; including real estate taxes. Real estate taxes are ad valorem taxes; meaning their amount is based on the value of a transaction or, for the purposes of this article, a property. This means that if assessors were to use the traditional direct capitalization approach they would have to subtract real estate taxes from the gross revenue to establish the net operating income in order to calculate the value which would determine the real estate taxes that would need to be subtracted from the gross revenue to calculate the net operating income to calculate value which would determine the real estate taxes… You get the point.

So, how do assessors escape this circular logic? Simple, by loading the cap rate used to establish value.

Loading the cap rate involves adding the municipality’s ad valorem tax rate to the market cap rate for a particular property (class, type, etc.). Assessors then remove real estate taxes from the property’s net operating income and divide that amount by the loaded cap rate to calculate the property’s market value. I’ve provided examples below (with actual real estate tax rates) to show how calculations using loaded cap rates arrive at the same valuation as when real estate taxes are included in a property’s net operating income and the “unloaded,” market cap rate is used.

Loaded Cap Rate Example

Rosslyn-Ballston Corridor Q4 2019

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Much like Washington DC’s downtown submarket cluster, the Rosslyn-Ballston Corridor is suffering from competition from emerging submarkets that offer newer, 4 & 5-Star properties with access to public transit and lower market rents. What was once home to Northern Virginia’s premier submarkets is now being assaulted on two fronts. The Silver Line provided suburban submarkets like Tysons Corner and Reston with access to public transit and increased densities, and Amazon’s announcement to locate its HQ2 just next door in Crystal City has left many tenants searching for reasons to be in the R-B Corridor.

Ballston

  • RBA: 8,037,415 SF
  • Vacancy Rate: 21.7%
  • 12 Month Net Absorption: 172,000 SF
  • Average Asking Rent: $41.92
  • 12 Month Rent Growth: 0.6%

At 21.7%, Ballston has the 2nd highest vacancy rate of all Northern Virginia submarkets behind only the I-395 Corridor. From an absorption standpoint, this can be attributed to the National Science Foundation relocating to Alexandria and vacating approximately 600,000 SF (almost 7.5% of the submarket’s total inventory); however, this is only part of the story. The true cause of Ballston’s woes is competition from emerging submarkets like Tysons Corner and Reston, which have lower market rents, access to public transit, and new 4 & 5-Star properties. Ballston is in trouble. With the 2nd highest rents (and vacancy) in Northern Virginia, Ballston has seen a steady decline in market rents over the past 2 years with its 4 & 5-Star properties particularly hard hit (3.7% decline last quarter). The problem is that there is simply no reason to be in Ballston anymore. The delivery of the Silver Line changed the game and Ballston may not be able to recover in the foreseeable future. After the National Science Foundation’s relocation, the building owner performed a $140,000,000 renovation. The property is currently is only 14% leased.

Virginia Square

  • RBA: 1,651,601 SF
  • Vacancy Rate: 14.2%
  • 12 Month Net Absorption: (35,500 SF)
  • Average Asking Rent: $38.25
  • 12 Month Rent Growth: 1.3%

Blink and you may miss it. The Virginia Square submarket lies between Ballston and Clarendon and has only 1,651,601 SF of total inventory. Even more than Ballston, there is simply no reason to be there, and this is reflected in the submarket’s fundamentals. The vacancy rate is slightly above the metro average at 14.2%; however, this is deceptive. The vacancy rate for 4 & 5-Star properties, which comprise over 71% of the submarket’s office space, is at 18.1%. Despite being one of the smallest submarkets in Northern Virginia, Virginia Square is one of the most expensive with market rents for 4 & 5-Star properties at $41.05/SF. With no projects under construction or even proposed, Virginia Square should continue to suffer from a lack of demand. Coupled with the oversized impact of any negative net absorption due to its diminutive inventory, Virginia Square should see continued downward pressure on rents and rising vacancy rates.

Clarendon/Courthouse

  • RBA: 6,295,624 SF
  • Vacancy Rate: 14.7%
  • 12 Month Net Absorption: (228,000 SF)
  • Average Asking Rent: $40.90
  • 12 Month Rent Growth: 0.6%

Clarendon/Courthouse is more a multi-family submarket than an office submarket. The only building built in the past 2 years, 2311 Wilson Blvd, is more than 90% leased but is also only 175,000 SF. Clarendon/Courthouse’s vacancy rate has jumped by 3.6% over the past 12 months and while this is in large part due to the renovation of (3-Star) 1650 Edgewood St, it represents only 139,000 SF of the total 228,000 SF of negative net absorption over that period. The 3-Star vacancy rate in Clarendon/Courthouse is only 10.5%; meaning its 4 & 5-Star inventory (17.9% vacancy) is largely responsible for the submarket’s elevated vacancy rate. At $40.90/SF ($43.44/SF for 4 & 5-Star properties), market rents in Clarendon/Courthouse are among the most expensive in the DC metro area and, with no new projects under construction to drive demand, the submarket should continue to see fundamentals suffer. In addition to its nearly 1,000,000 SF of vacant and available space, Clarendon/Courthouse must compete for demand with neighbors, Ballston and Rosslyn, and their nearly 4,000,000 SF of space along with emerging submarkets like Reston and Tysons, which offer the same access to public transit with lower market rents.

Rosslyn

  • RBA: 10,144,610 SF
  • Vacancy Rate: 18.5%
  • 12 Month Net Absorption: 928,000 SF
  • Average Asking Rent: $44.97
  • 12 Month Rent Growth: 0.7%

As strange as it may sound, Rosslyn is celebrating a vacancy rate below 20% for the first time since Q4 2013. The submarket delivered 504,000 SF of new inventory in the past 12 months but saw positive net absorption of 928,000 SF over the same period. This is encouraging news but may not be a true indicator of Rosslyn’s viability. Despite having the 3rd highest vacancy rate in Northern Virginia, Rosslyn has the highest market rents at $44.97/SF; $47.83/SF for 4 & 5-Star properties which comprise over 76% of the submarket’s inventory. This has led to negative rent growth in eight of the past 10 quarters. Rosslyn is in need of a makeover. Roughly 80% of its office inventory was built before 2000 (45% between 1960 and 1979). The most recent delivery was 1201 Wilson Blvd which completed in Q4 2019 and added 565,000 SF. Due to strong preleasing the property is currently over 92% leased. While this provides evidence of the demand for new product in Rosslyn, there are no projects under construction or proposed in the next 12 months. Arlington County created the Rosslyn Sector Plan to “set out policies on public spaces building height and form, access, affordable housing, bicycle and pedestrian amenities, and viewshed preservation” to transform the submarket. Unfortunately this will take many years and, with large GSA leases expiring in 2020 and 2021, the submarket may not respond in time to shifts in demand and competition from less expensive but equally accessible submarkets.

What’s a 1033 Exchange?

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Most people have a least heard of a 1031 Exchange, but if you ask them about a 1033 Exchange you’ll probably get a puzzled look follow by: “you mean a 1031 Exchange?” While less well known, 1033 Exchanges are another powerful tool included in the Internal Revenue Code (Section 1033 to be exact) that allows for the deferral of tax liabilities resulting from capital gains. The fundamental difference between Sections 1031 and 1033 of the IRC is the cause precipitating the exchange. In the case of a 1031 Exchange, an owner voluntarily sells a piece of real property and then chooses to reinvest the realized capital gains into another “like-kind” property, the operative word being “voluntarily.” A 1033 Exchange, therefore, provides an owner the ability to defer and reinvest any capital gains resulting from an “involuntary conversion,” such as theft, casualty (complete or partial destruction), or eminent domain. Capital gains, in this case, derive from condemnation or insurance proceeds.

1033 Exchanges have rules that are similar to those governing 1031 Exchanges. Like in a 1031 Exchange gains must be reinvested in another real property of equal or greater value within a specified period of time; however, because the conversation is compulsory or involuntary time frames are extended. The minimum time for owners to complete a 1033 Exchange is two years from the end of the tax year in which the gain is realized; however, special rules and/or appeals to the IRS can extend the time to three to four years. The type of conversion impacts the commencement of the replacement period as well. In cases of taking by eminent domain the clock starts on the earlier of: 1) the date the property was condemned/seized, 2) the date the property was subjected to “threat or imminence of condemnation or seizure,” or 3) the date of disposition under “threat or imminence of condemnation or seizure” (IRC Section 1033(a)). With regards to theft or destruction the time period begins on the date the incident occurred. Therefore, if gains are realized at any time in 2018 a 1033 Exchange must be completed by December 31, 2020.

IRC rules take into account the nature and impact of the involuntary conversion and make allowances accordingly. Because the government is placing the burden on the taxpayer in cases where property is taken by eminent domain, the replacement period is extended to three years for property held for productive use in a trade or business or for investment. Another consideration is made for personal residences that are destroyed in a federally declared disaster. In such cases, owners have four years to complete a 1033 Exchange.

Another important distinction is the replacement property standard. For 1031 Exchanges, the property must be “like-kind” as “defined” by the IRS. Defined is in quotations because there is formal definition. Properties are considered of “like-kind” is they are “of the same nature or character, even if they differ in grade or quality.” (IRS.gov). Again, because of the involuntary nature of the conversion, the IRC requires a different standard for 1033 Exchanges, which is both subtle and significant. Properties under a 1033 Exchange must be “similar or related in service or use” with the goal being to return the taxpayer to a substantially similar position prior to the involuntary conversion. The IRS applies a functional test to determine if the standard is met, which distinguishes between owner-users and investors. Replacement properties for owner-users must have similar physical characteristics and end uses while investors benefit from a more lenient standard, which is similar to the “like-kind” standard in 1031 Exchanges. This is because investment properties are income-generating and, therefore, “related in the service or use” refers to the collection of (passive) rental income.

Much like 1031 Exchanges, 1033 Exchanges provide taxpayers with a powerful tool to defer taxes associated with capital gains resulting from insurance or condemnation proceeds due to the theft, destruction, or taking (by eminent domain) of real property. Due to the voluntary versus involuntary nature of the conversions, there are significant differences in the rules governing each, notably the time periods for the exchange and standards for the replacement properties. There are other important distinctions that I will discuss in subsequent articles; including the use of funds, role of qualified intermediaries, replacement of equity with debt, etc. In the meantime, it is always recommended to consult a tax advisor/CPA when contemplating a 1033 Exchange.

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Northern Virginia’s Tier-1 Submarkets Q4 2019

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Tysons Corner

  • RBA: 30,259,633 SF
  • Vacancy Rate: 15.1%
  • 12 Month Net Absorption: 560,000 SF
  • Average Asking Rent: $35.88
  • 12 Month Rent Growth: 4.2%

Tysons Corner is behind only the East End and CBD in terms of asset value and total inventory and despite vacancy levels that are above the metro average, the submarket continues to post rent growth that far surpasses the 10-year average and which even rivals the submarkets surrounding Amazon’s HQ2. It has been nearly a decade since the Fairfax County Board of Supervisors adopted a new comprehensive plan for the area that led to a combination public infrastructure projects and private development that shows no signs of slowing down. The delivery of the Silver Line in 2014 transformed the suburban, commuter submarket; connecting it to the rest of the region and spurring a flurry of transit-oriented, mixed-use development that should continue to drive demand.

Tysons Corner’s vacancy rate and rent growth metrics seem contradictory but upon closer examination provide evidence of the real story going on in the submarket. The market rent in Tysons Corner is nearly $36.00/SF; however, this again only tells part of the story.  The submarket’s aging inventory is largely to blame. 3-Star properties, which comprise 1/3 of total inventory, have a vacancy rate of 16.7% and an average rent of $27.31/SF (1.6% higher and $8.57/SF lower than the submarket averages). On the other hand, 4 & 5-Star properties have an average rent of $40.52/SF with new projects commanding even higher rates. In fact, properties built since 2015 have average rents just shy of $50.00/SF. Development, both commercial and residential, will continue to focus around the submarket’s four metro stations as will demand; resulting in a type of “locational” obsolescence for a significant number of properties.

This flight-to-quality trend has mitigated supply-side pressure on submarket fundamentals. New developments like the Boro have experienced strong pre-leasing and despite 582,000 SF delivering in the past 12 months, vacancy levels decreased by 0.4%. There are no projects currently under construction, but Tysons’ proposed development pipeline is staggering. Of the more than two dozen projects, Clemente Development’s View at Tysons is of particular interest. The proposed 40-story, 600-foot tall, 3,000,000 SF office building will be located near the Spring Hill Metro station; an area that has not seen the same level of interest as its counterparts. Another sign of things to come is the assemblage of more than seven acres on Tyco Rd by the Georgelas Group, which is in addition to the 7,500,000 of developable square footage already assembled.

One final, notable piece of news is the Hanover Company’s purchase of 1500 Westbranch Dr with plans to develop up to 420 residential units with ground-level retail. This may be a sign of things to come as developers repurpose or redeveloper older, high-vacancy office properties into residential uses, and could be the solution to the submarket’s vacancy issues.

Reston

  • RBA: 20,669,006 SF
  • Vacancy Rate: 13.2%
  • 12 Month Net Absorption: (229,000 SF)
  • Average Asking Rent: $33.66
  • 12 Month Rent Growth: 0.3%

Like Tysons Corner, Reston’s future has been forever changed by the delivery of the Silver Line metro and similar trends are shaping submarket fundamentals. Demand, driven by proximity to public transit, and measured development have caused vacancy levels to fall below the submarket’s historical average. The most recent, notable delivery was Comstock Company’s 5-Star, 368,000 SF office building at Reston Metro station. Google signed a 164,000 SF lease there in the 2nd quarter of this year; prompting Comstock to break ground on phases two and three early this year. The two buildings will add an additional 446,000 SF to the site and are expected to deliver in mid-2020.

Boston Properties, the largest landlord in the submarket, continues to prosper with Fannie Mae taking 850,000 SF at Reston Gateway (under construction) and Leidos relocating its headquarters by consolidating into 287,000 SF at 17Fifty (delivering in 2020).

Rent growth in Reston since 2016 has been nearly 8%, but like Tysons Corner, this belies the true state of the submarket. The average rate for 4 & 5-Star properties is $38.00/SF; however, Reston Town Center commands rents more than 20% higher and Comstock’s Reston Station has rents in the $51.00-$52.00/SF range. New development, centering around existing and future metro stations, should continue to dominate demand. As a result, the submarket should continue to see a flight-to-quality and widening gap in fundamentals between 4 & 5-Star properties and 3 and 1 & 2-Star properties.

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Discounting to Account for Risk: Anchors, Franchises, & Mom-and-Pops

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When valuing a multi-tenant, income-producing property, a discounted cash flow analysis is the most appropriate valuation method because it accounts for an investor’s perceived risk associated with each income stream and calculates a value based on the required return to compensate for that risk. Risk factors range from macroeconomic to microeconomic issues; some of which can be mitigated or insured against while others are unpredictable and uncontrollable. By analyzing income streams independently, investors can focus on the factors most likely to affect that particular tenant/business and account for them by increasing their required return, thus lowering the present value of that income stream (reducing the amount they are willing to pay for it).

Discounted cash flow analyses are especially important when valuing multi-tenant retail properties. This is because of the importance of tenant mix within this asset class, which results in a variety of businesses/services, square footages, etc. In no other asset class will one find such a range in the terms and concessions in different tenants’ leases within the same project. To some extent, the terms offered to various tenants reflect the landlord’s risk assessment at the time of lease; however, investors purchasing these income streams must reassess the value based on current market conditions and risk factors.

For this article, I will discuss and analyze risk factors that are particularly relevant for 3 broad classifications of retail tenants: anchors, franchises, and mom-and-pops.

Anchors

Anchor tenants are typically major department/chain stores in a retail center whose presence draws customers thus providing smaller tenants with increased exposure/business. Anchor tenants generally occupy large blocks of space, but due to their importance (leverage) they are able to negotiate lower rental rates than other, smaller tenants. Still, because many retail leases contain percentage rent clauses, anchor tenants contribute to the landlord’s bottom line by increasing overall gross sales in the center. Much like their footprint and role in the vitality and viability of the center, anchor tenants’ income streams deserve an oversized risk analysis.

Investors must consider the likelihood and overall impact of the anchor tenant defaulting on their lease and/or vacating the center. This would not only include lost revenue from the anchor, itself, but also the lost revenue from percentage rent due to the reduction in gross sales. The cost and time required to replace the former anchor must also be calculated. If landlords do not replace the anchor quickly other tenants may default or choose to leave; creating a positive feedback loop that is anything but “positive.”

Franchises

Many of the “brand name” tenants that occupy retail centers are franchises that are locally owned and operated. Franchises make good tenants because they have proven business models and quality standards that are imposed and enforced at the corporate level. Franchises’ recognizability can contribute to a more positive perception of the center; resulting in increased patronage, gross sales, and leasing demand, which in turn can lead to higher rents. As a result, franchises are generally seen as less risky than independent businesses.

When analyzing franchise income streams investors should focus on the age, history, and current public perception of the individual franchise. There are relatively young/new franchises that are considered to be some of the most desirable tenants, i.e. Orange Theory; however, newer franchises may also be considered riskier because they do not have a track record over multiple market cycles. While the past is not necessarily an indication of the future, investors can and should look at a franchise’s performance over its history and during different economic cycles; paying special attention to the current relevance and perception of the product or service (think Blockbuster).

Another important factor to consider is the number of franchise locations, both nationally and locally (owned by the franchisee). The number of locations across the nation can provide insights into the viability, popularity, and strength of the franchise, in which case the more the better. When viewed from a local perspective, the number of locations requires a more skeptical analysis. Multiple locations owned by the same franchisee may indicate financial strength and success; however, it may also be a sign that the franchisee has spread themselves too thin and/or oversaturated the market thus making an otherwise attractive tenant a risk of default.

Perhaps the most important factor for an investor to consider is whether or not there is a corporate guaranty securing the lease. Personal guarantees are only as strong as the individual signing the guaranty and, if the business is in dire financial straits, one can expect this to extend to the guarantor. Corporate guarantees, on the other hand, are secured by the corporate franchise, which takes responsibility for the financial obligations of the lease in the case the franchisee defaults.

Mom-and-Pop

“Mom-and-pop” retail tenants are small, family-owned or independent businesses that present the greatest risk to investors due to competition from large retailers, e-commerce sites, and franchises which have the advantage of economies of scale, greater buying power, larger advertising budgets, etc. This is not to say that such businesses cannot be good tenants; however, they require the greatest scrutiny with particularly attention being paid to the number of years in business (in general and/or at their current location), financial strength (gross sales/net profits), and amount of local competition from similar businesses. If the tenant has been in business and profitable for many years (at the present location) with a history of on-time payments and provides a product or service that insulates them from corporate/franchise competition, they may be a relatively low risk. The upside for investors is that “mom-and-pop” tenants generally do not lease large blocks of space and thus re-leasing the premises is relatively easy and inexpensive.

Is Subleasing a Good Idea? No, Because…

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Is subleasing a good idea? The answer, like most others in commercial real estate, is “it depends.” This question is not from the point of view of the existing tenant who is seeking to transfer their lease rights/interests and possession of the premises to a 3rd party, known as the sublandlord/sublessor or assignor. Rather, it comes from the perspective of the 3rd party, known as a subtenant/sublessee or assignee. For tenants, sublease/assignment rights are one of the most important afforded to them in a commercial lease because they provide a means of “getting out of their lease” when it makes economic, strategic, or practical sense to do so. Tenants are not usually, truly released from their leasehold obligations but rather are able to rent the entire premises or a portion thereof to mitigate their monetary obligations. Therefore, subleasing is always a “good idea” for the tenant even if the situation necessitating it is not.

For the potential subtenant or assignee the situation is not as clear cut and a number of factors must be considered. Subleases can be a great option for some companies but can also be fraught with danger. Before deciding if subleasing makes sense it’s important to understand the pros and cons associated with this type of leasehold interest and the associated opportunities and liabilities.

Cons

No Tenant Improvement Allowance

Because many sublandlords are trying to lower their leasehold costs they are typically unwilling or unable to provide tenant improvement allowances (market or otherwise). As a result, subtenants must take the space “as-is” or pay for the cost of any improvements or changes to the premises. Depending on the remaining term and/or the subtenant’s own financial situation this may be undesirable or untenable.

Non-Market Deals

Subleases provide the opportunity for non-market deal terms that benefit subtenants such as below market rents and/or shorter (sub)lease terms; however, they can also exclude positive market terms such as rental abatement and tenant improvement allowances. There can be instances in which the economic value of typical, market terms for prime leases can exceed the savings offered by sublease options.

Landlord Approval Required

All subleases/assignments must be approved by the landlord. In most cases, the landlord’s approval “shall not be unreasonably withheld, conditioned, or delayed;” however, in other cases it may be withheld in the landlord’s sole discretion or conditioned so that finding a suitable subtenant or assignee is difficult. Furthermore, the timeframe within which the landlord must respond to a tenant’s request to sublease or assign their space can vary and for subtenants looking/needing to occupy quickly, delays could be costly and/or dire.

Landlord AND Sublandlord Approval Required

After the sublease or assignment has been agreed to by the landlord, all future requests on behalf of the subtenant are subject to the approval of both the landlord and sublandlord. This additional level of bureaucracy can result in minor inconveniences to real damages in cases of service interruptions, issues impacting the subtenant’s use of/access to the premises, etc.

Subject to Terms and Conditions of the Prime Lease

Sublease agreements are typically shorter/simpler than prime/commercial leases. This is because they are subordinate to the lease between the tenant/sublandlord and landlord; making many important terms and conditions non-negotiable. Subtenants are subject to the timeframes, remedies, etc. set forth in the prime lease and must rely on the sublandlord to advocate and make requests on their behalf.

Non-Transference of Rights

Many rights afforded to the sublandlord/tenant under the terms of the original lease do not transfer to the subtenant. It could be argued that rights such as renewal options or rights of first offer/refusal should not transfer to another party; however, the right to sub-sublet or assign the sublease is an important protection for subtenants or assignees especially depending on the length of the sublease term.

Sublandlord Default

The financial strength/situation of the sublandlord/assignor is an extremely important factor that subtenants must consider when determining whether to enter into a sublease agreement. Many requests to sublet/assign the lease result from financial hardships and/or mismanagement on behalf of the existing tenant. If the tenant/sublandlord defaults on their lease the subtenant is at risk of losing possession of the premises either by the landlord recapturing the space or requiring the subtenant pay the prevailing market rate for the property. Prospective subtenants should always request to see the sublandlord’s financials.

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Is Subleasing a Good Idea? Yes, Because…

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Is subleasing a good idea? The answer, like most others in commercial real estate, is “it depends.” This question is not from the point of view of the existing tenant who is seeking to transfer their lease rights/interests and possession of the premises to a 3rd party, known as the sublandlord/sublessor or assignor. Rather, it comes from the perspective of the 3rd party, known as a subtenant/sublessee or assignee. For tenants, sublease/assignment rights are one of the most important afforded to them in a commercial lease because they provide a means of “getting out of their lease” when it makes economic, strategic, or practical sense to do so. Tenants are not usually, truly released from their leasehold obligations but rather are able to rent the entire premises or a portion thereof to mitigate their monetary obligations. Therefore, subleasing is always a “good idea” for the tenant even if the situation necessitating it is not.

For the potential subtenant or assignee the situation is not as clear cut and a number of factors must be considered. Subleases can be a great option for some companies but can also be fraught with danger. Before deciding if subleasing makes sense it’s important to understand the pros and cons associated with this type of leasehold interest and the associated opportunities and liabilities.

Pros

Below Market Rental Rate

Sublandlords must compete with other available spaces in the market. Many subleases are the result of economic hardship on the part of the tenant/sublandlord and, as in all things, time is money. To increase the likelihood of securing a subtenant and decrease the time to do so, many subleases are offered at below market rates. When combined with the other limiting factors associated with sublease deals, this can lead to significant differences between the sublease rental rate and market rates for comparable properties. Subleases, therefore, can present the opportunity for companies to occupy space in prime locations and with amenities that might otherwise be outside their budget.

Shorter (than market) Term

Sublease terms are limited to the remaining term left on the sublandlord’s lease. This leads to the potential for shorter than typical, market (sub)lease terms (less than 3-5 years depending on asset class). This can be a huge benefit to companies that anticipate significant short-term growth and do not want to be locked into a long-term commitment and/or take space they do not need at the time or to others that have concerns about the future of their business or the economy and prefer to limit their exposure.

Furniture, Phones, etc.

Many sublease options are “turnkey;” meaning the space comes with furniture, phones, etc., which in most cases come at no cost to the subtenant. This can significantly lower the upfront costs associated with leasing commercial space.

Shared Common Areas/Amenities

In some cases, sublandlords are willing to “share” their space; providing subtenants with access to common areas within the leased premises such as conference rooms, kitchens, reception areas, workrooms, etc. Subtenants can thus (sub)lease and pay for less square footage while still enjoying the benefit of such amenities.

DC’s Emerging Submarkets Q4 2019

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Southwest

  • RBA: 12,422,074 SF
  • Vacancy Rate: 11.0%
  • 12 Month Net Absorption: 663,000 SF
  • Average Asking Rent: $50.94
  • 12 Month Rent Growth: 0.3%

The Southwest submarket offers brand-new, trophy space at a discount, which has created a shift in demand away from DC’s downtown submarkets. There is almost a direct, inverse relationship between the submarkets’ fundamentals. Both are delivering significant new supply which puts upward pressure on vacancy rates and suppresses rent growth; however, in Southwest demand has surpassed the increase in supply with 663,000 SF of positive absorption leading to a 3.9% decrease in vacancy over the past 12 months. The submarket’s 11% vacancy rate is the 2nd highest in DC, behind only the East End, but this is misleadingly high due to the 22% vacancy rate amongst 3-Star properties. Even this metric should see improvement with WMATA recently leasing nearly 150,000 SF of 3-Star space. The 2nd phase of the Wharf is underway and will deliver an additional half-mile and 1,250,000 SF of new development over the next 3 years, which will consist of a mix of office and multi-family with ground level retail; creating a work-live-play environment. Despite supply-side pressures, demand and strong preleasing should continue to put downward pressure on vacancy rates and upward pressure on rents.

NoMa

  • RBA: 11,573,181 SF
  • Vacancy Rate: 7.5%
  • 12 Month Net Absorption: 614,000 SF
  • Average Asking Rent: $51.30
  • 12 Month Rent Growth: 0.6%

Despite nearly 523,000 SF delivering in the past 12 months, the NoMa submarket saw a 1.2% decrease in vacancy and a 0.6% increase in rents resulting from 614,000 SF of positive absorption. Affordable rates compared to downtown DC and an abundant supply of green, 4 & 5-Star buildings have attracted federal tenants which have accounted for over 50% of the leasing since 2014. New supply is scheduled to deliver in the coming years but fundamentals should not suffer because one of the two buildings under construction is 100% preleased to the Department of Justice and the other is a build-to-suit for the FCC.

Capitol Riverfront

  • RBA: 4,170,351 SF
  • Vacancy Rate: 7.5%
  • 12 Month Net Absorption: 3,400 SF
  • Average Asking Rent: $50.57
  • 12 Month Rent Growth: 1.8%

Capitol Riverfront is a small submarket but despite its size it led the DC metro in rent growth in the first quarter of this year at 4% and has the highest occupancy levels of any submarket with average rents over $50/SF. Like NoMa and Southwest, Capitol Riverfront has affordable rents compared to the East End and CBD which has led to increased demand as evidence by strong preleasing. Recent development has been characterized by converting aging/vacant office properties to multi-family; however, the submarket should continue to evolve around Buzzard Point with the 2nd phase of The Yard which is proposed to deliver nearly 2,000,000 SF of office, 400,000 SF of retail, and more than 3,000 multi-family units. Capitol Riverfront’s fundamentals should remain strong for years to come due to the submarket’s metro accessibility, convenient location, and growing retail scene, which combined make it the perfect work-live-play environment.

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