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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