In commercial real estate, there are generally considered to be four asset types: office, retail, industrial, and land; however, there are subtypes or specializations within each that have their own unique characteristics. One example is flex space. Flex properties are unique because they are a combination of office and warehouse; not to be confused with one-story office or industrial with a small office component. Another example, and the subject of this article is medical space. While traditionally falling under the office category, the desire for visibility and “walk-ins” have led to an increase in the number of doctors and dentists locating their practices in retail spaces. There are specific features of medical space that differentiate it from typical office use and impact its appeal from a landlord/investor perspective.

There are many different medical specialties, but the most important characteristic of medical space that distinguishes it from general office space, from a commercial real estate perspective, is how the space is used. Normal office space is for the use of the tenant and its employees with the occasional visitor or guest. Medical space, on the other hand, is used by the tenant, its employees, and patients. This is significant because of the increased traffic and resulting wear and tear on the building’s common areas. Furthermore, tenants (and their employees) of a building have an interest in taking reasonable care of the common spaces (particularly bathrooms) because they work there and use the facilities every day. Patients and visitors do not*. They may visit the building once or twice per year and, therefore, care little with how they leave it (testing centers are particularly notorious in this regard). Depending on the size of the practice, number of practices within a particularly building, and the number of daily patients, landlords may incur significant costs by having to renovate the common areas to maintain the building’s quality and with greater frequency than its nonmedical counterparts. This causes many landlords, particularly of Class A buildings, to institute a policy of no medical tenants in their building.

*Many medical offices have bathrooms within their space for the use of their employees and patients, and while this may be their decision based on the nature of their practice it may also be a requirement of the landlord to minimize wear and tear and disturbance of other tenants.

A distinction does need to be made between both single-tenant (individual condo) and multi-tenant properties and then again between office and retail space. As mentioned, the wear and tear on building common areas is the main reason that medical use is seen as undesirable. This issue is magnified in multi-tenant office buildings where common areas are shared, and particularly in multi-story buildings in which the medical tenant occupies space on any floor above the first. For single-tenant office properties (usually smaller) where a medical tenant occupies the entire building, this issue is mitigated to the point of elimination. In these situations, the tenant’s use is factored into the deal, mostly likely through a triple net rental structure where the tenant is responsible for paying for maintenance, repairs, and replacements of common areas and building systems. This leads to the subject of medical use in retail space. Most retail spaces are self-contained units with their own entrance and building systems. The common areas are relegated to the parking lot, sidewalks, etc. and retail landlords account for and want as much traffic as possible. Like single-tenant office properties, they mitigate their exposure to the externalities of medical space through a triple net rent structure.

Apart from this adverse aspect, medical tenants are some of the most desirable from both a landlord and investor perspective for two main reasons: 1) they sign long-term leases and 2) they are considered to be among the most stable/least risky businesses from a financial standpoint. Due to the significant capital investment required to build out medical space, doctors and dentists prefer 10-year (plus) leases with renewal options, typically two 5-year terms for a total of twenty years. This gives them a longer period over which to amortize their costs. Medical practices also benefit from the sense of familiarity and permanence that remaining in the same location instills and which also allows them to add to their patient base over the years. In addition to the capital cost of moving and constructing a new office, medical tenants also risk lost revenue from attrition.

Healthcare spending now accounts for nearly 1/5 of our gross domestic product and, as more states implement Medicaid expansion and baby boomers continue to retire, we can expect that number to rise (healthcare spending on average nearly doubles after the age of 64). Medical practices have always been seen as stable businesses though. Doctors and dentists have specialized skills that are always in demand. Just like you can’t fix your own car (anymore), you don’t want to perform surgery on yourself and, unlike automotive problems, serious health issues are not something you want to put off addressing. Even in 2008 and 2009, when the economy and lending ground to a halt, banks were still lending to doctors and dentists and, today the rates offered to medical practices/practitioners are among the most aggressive out there (even to the point of 0% down and rates around 4% or lower). This provides a vital insight into how medical practices/tenants are viewed from an investment standpoint. The process by which landlords evaluate tenants is similar to the underwriting process for financial institutions. Instead of lending money, the landlord is lending the tenant use of their space and, thereby, foregoing income from other potential tenants. The more stable the tenant, the greater the likelihood the landlord will receive the agreed upon income stream over the lease term, and the less risky an investment the more an investor is willing to pay for it. Landlords are investing in their tenants and thus are willing to make greater economic concessions to secure them as a tenant because they are confident that they will make that money back over the term of the lease and/or based on a sale of the property.

Another element of medical space that contributes to its security from an investor/landlord perspective is the large capital investment made to construct the premises and the resulting infrastructure value. Medical build outs have never been inexpensive but with rising labor and construction costs they can reach $150+/SF. Depending on the rental rate and tenant’s financials, landlords may be willing to contribute a sizable tenant improvement allowance, but one that is still unlikely to account for even half of the required capital. Tenants that invest their own money in a space have an interest in that space; increasing the likelihood of remaining/renewing in place and decreasing the likelihood of default. In the off chance a medical tenant defaults, vacates, or relocates, the landlord is left with an extremely marketable space with valuable infrastructure (and potentially equipment). Most medical practices have similar layouts (waiting room and check-in/check-out area, exam rooms with sinks, etc.) that can easily be reused by other specialties (doctors and dentists). Medical tenants can save hundreds of thousands on build out; allowing them to deploy capital elsewhere. As a result, landlords may also be able to charge a premium for medical space thus increasing the property’s net operating income and market value.

As discussed in previous articles, cap rates provide an estimate of property’s value based on its net operating income. They are expressed as a percent because they reflect the rate of return (based on an all cash purchase) that an investor is willing to accept for the year-one income stream. Market cap rates are calculated by analyzing sales comps based on property type, class, size, etc., but acquisitions are truly made based on the discount rate an investor places on the property’s future cash flows. Discount rates include a risk premium which can either increase or decrease the acquisition cap rate thereby lowering or raising the price, respectively. Secure investments require a much lower return (think Treasury bonds). While there are many factors involved in a risk assessment, the probability of tenant default and length of lease term are among the most important. If a tenant defaults the landlord must incur legal fees, lease-up costs (brokerage commissions, improvement allowances, etc.), and vacancy losses. Similarly, assuming the tenant does not default, the remaining lease term, better expressed as the remaining future cash flows, is the only income stream that the purchaser can rely on with relative certainty; being unable to predict future market conditions (vacancy rates, rental rates, etc.). The tenant may renew but it may also be the case that the owner is required to find another tenant, thereby incurring the aforementioned transaction costs and vacancy losses. Medical tenants minimize these risks through all the reasons mentioned and ask a result, landlords/owners are able to sell their leasehold interests at a premium; increasing the sales price relative to an equal but considerably riskier rental income stream.

• RBA: 10,196,000 SF
• Vacancy Rate: 15.6%
• 12 Month Net Absorption: (96,900 SF)
• Average Asking Rent: $32.71
• 12 Month Rent Growth: 3.2%

Merrifield, along with Herndon and Fairfax Center, have historically been considered 2^nd tier office submarkets in Fairfax County; however, changing demand trends have resulted in a growing disparity not only between premier and secondary submarkets but also within this 2^nd tier. Employers and developers are increasingly catering to the millennial generation, which constitute a greater percentage of the employment base every day and value convenience and experiences; leading to the emergence and dominance of the mixed-use development. A combination of preference and lack of affordability in the DC metro housing market has given rise to a more urban generation, many of which do not own automobiles. In order to be able to recruit and retain top talent, employers are moving to metro accessible submarkets. Within these submarkets, 4 & 5-Star properties are absorbing the lion’s share of demand, particularly newly built assets. As a result, developers are focused on metro assessible submarkets due to the increased density levels and higher rents, which can offset rising construction and labor costs.

Merrifield, while technically metro accessible, has less than 10% of its office inventory within walking distance (0.5 miles) of its one metro station, Dunn Loring. On top of that, only 16.5% of its 4 & 5-Star properties (4 of 26) are metro accessible; even less considering the fact that 2675 Prosperity Ave is 100% occupied by U.S. Citizenship and Immigration Services. Most development in the submarket over the past decade, particularly around the Dunn Loring metro, has been multi-family, mixed-use. While considered the submarket’s crown jewel, the Mosaic District is not metro accessible and has only one office property totaling a meager 97,191 SF and which is 100% leased by CustomInk. Over half of the submarket’s 4 & 5-Star inventory (51.6%) is located within the Fairview Park office campus and, of that, nearly a quarter (2,426,213 SF) is available for lease. Of the remaining 4 & 5-Star properties, 8115 Gatehouse Rd (209,423 SF) is owned and occupied by Fairfax County Public Schools; 8110 Gatehouse Rd (214,075 SF) is owned and occupied by Inova Health Systems; and 3023 Hamaker Ct, 8501 Arlington Blvd, & 8505 Arlington Blvd (288,423 SF total) are medical buildings. That leaves only 8260, 8270, & 8280 Willow Oaks Corporate Dr (596,802 SF total) which, like the Fairview Park Dr properties are not metro accessible. *Costar has 2751 Prosperity Ave (93,893 SF) erroneously listed as a 4-Star property.

The submarket’s vacancy rate has been improving since it nearly doubled (12.1% to 23.1%) in Q2 2015 when Exxon Mobil vacated its 117-acre campus and approximately 1,200,000 SF. Positive net absorption from 2016-2018 brought vacancy levels back down. Inova Health Systems is mostly responsible for the rebound in the submarket’s fundamentals. It purchased the former Exxon Mobil site in 2015 across from its flagship hospital. The Fairfax County Board of Supervisors approved updates to Inova’s plans in September 2019 to allow more academic and research space along with complementary housing, retail, and hotels. Initial plans were scaled back from 15,000,000 SF to 5,000,000, and while this seems like a dramatic reduction it is still on par with Amazon’s HQ2 plans in National Landing. The University of Virginia and Inova will each occupy approximately 2,000,000 SF; leaving an additional 1,000,000 SF for commercial use. Officials expect the center to establish Fairfax County as a health sciences innovation hub, thereby helping to grow and diversity the economy.

General Dynamics added to the 1,000,000 SF of positive net absorption in 2017 when it leased the entire building at 3170 Fairview Park Dr (143,000 SF) and BAE Systems just relocated its headquarters from Rossyln to 2941 Fairview Park (133,000 SF). Most leasing is from smaller tenants though and owners and investors are hoping that Inova will have its own “Amazon effect;” acting as the submarket’s main demand driver.

Despite this, rent growth has been strong; averaging 3.2% over the past 12 months. This is exclusively attributable to the submarket’s 4 & 5-Star properties which saw a 5.62% increase in rents versus a 0.17% drop in 3-Star rents. This is consistent with the “flight-to-quality” trend across the DC metro area. At $36.64/SF, Merrifield’s 4 & 5-Star rents may be lower than Tysons Corner and Reston but they are higher than Herndon ($36.02/SF). Two of the metro stations in the 2^nd phase of the Silver Line will be located in the Herndon submarket, immediately connecting it with the entire DC metro region via public transportation. With twice the number of metro stations and millions more square feet in existing and proposed inventory, Herndon will emerge as the next premier submarkets in Northern Virginia; leaving Merrifield in the dust.

Due to no supply-side pressure, landlords may be able to maintain rents in the short-term, but with an aging inventory and competition from more urban, metro accessible submarkets the long-term outlook isn’t promising. Net absorption for 2019 is currently at negative 96,900 SF and the submarket’s vacancy rate jumped by a staggering 2.3% from last quarter. Submarket sales also provide evidence of Merrifield’s decline, which averaged around $60,000,000 over the past 5 years but are just over half that for the year ($36,500,000). This may all be temporary, but it is more likely that Merrifield’s failure to evolve as an office submarket prior to the delivery of the Silver Line in 2014 will likely doom it to an existence as a secondary submarket for the foreseeable future.

This is the time of year when we reflect on all the things in our life for which we are grateful. Over my nearly 12 years as a commercial real estate broker, I’ve had the opportunity to work with many different clients in various industries and across every property type and asset class; from first-timers to established companies to seasoned investors. For the most part, I’ve been fortunate to work with good clients and even better people. Some have become dear friends. I’ve attended clients’ weddings and been adopted as a member of their company “family.” It’s a blessing to work with/for people you like. To those clients, I want to extend my sincere thanks for placing your trust in me and allowing me to represent you. It is a pleasure and an honor.

On the flip side, bad clients are the worst. Instead of enjoying working with/for them, you tolerate them. Simple interactions have the ability to cast a shadow over your entire day and leave you feeling exhausted. At this point in my career, I’m able to choose who I want to work with/for and have the experience to identify (potential) bad clients. The most important take-away from my experience with bad clients is that they remind me how blessed I am to work with good clients and makes me appreciate them even more.

The difference between a “good” client and a “bad” client can best be understood by their juxtaposition, and it’s not about money. It’s about the relationship. Here are some important distinctions that separate good clients from bad clients.

Ask questions vs. question you

Some of the best clients are the most inquisitive. Their questions stem from a desire to understand and learn so that they can take a more active and engaged role in the process. Bad clients question you. Their questions stem from both a lack of trust and lack of knowledge and their purpose is more to test their broker’s knowledge rather than understand the logic/factors behind the issue(s).

Example:

• Good client: “What is the current market escalation rate and what factors influence it?”
• Bad client: “I read somewhere that 2% escalations are market now. You proposed 2.5%, why?”

Treat broker as an advisor vs. an order taker

Good clients appreciate the important role that commercial real estate plays in the health and wealth of their company and thus regard their broker as trusted advisor and partner. There are many decisions and factors that have serious impacts on how a company operates, grows, etc.; including but not limited to: whether to lease or purchase, how much space to take, how long of a lease term to sign, etc. Commercial real estate brokers help their clients develop a strategic plan and have the knowledge and expertise to negotiate and structure deals based on their client’s short-term and long-term goals. Bad clients treat their brokers as order takers. Bad clients do not respect their broker’s experience or market knowledge and want to do things their way regardless of the potential consequences.

Example 1

Due to the fact that the space is in shell condition, estimates for the turnkey build out came in north of $70/SF. The landlord requires a 7-year term over which to amortize the costs. The client is only comfortable signing a 6-year lease agreement.

• Good client: “What can we do? We’d prefer not to have to come out-of-pocket for the build out”
• Bad client: “We’re not signing a 7-year lease. Tell the landlord we’ll do a 6-year or we’re walking.”

With bad clients it’s their way or the highway. Their arrogance and self-centeredness blinds them to the possibility that there may be alternative ways to accomplish their goals. This example was taken from a real transaction with a good client. We structured the deal so that they had the right to terminate the lease after 6 years by paying the unamortized transaction costs. The terms protected the landlord’s capital investment and got my clients what they needed based on their risk tolerance.

Example 2

Broker is representing a tenant and receives a letter of intent (proposal) from the landlord, which they review, edit via track changes, and presents the proposed counter to the client. The broker explains that, based on their experience, the terms they recommend countering with are consistent with current market conditions in that particular submarket for that particular asset class/property type and similar tenants based on their financial strength, length of lease term, etc.

• Good client: “Thank you. Would you please explain x, y, and z? Would it be possible to ask for 1 more month of rental abatement or should we ask for another $0.50/SF off of the rental rate?”
• Bad client: “I know another company that leased space in this submarket and got “x” more months of free rent and were at $”y”/SF. Counter with those terms and see what they say.”

Bad clients don’t realize or care about the potential negative impacts of “lowballing” or presenting unrealistic/one-side terms. It denotes either a lack of respect or lack of knowledge (oftentimes both) and can result in the other party terminating negotiations and refusing to deal with the offending party. It is also a waste of time; another indication of a fundamental lack of respect.

Working with/through broker vs. looking for ways to cut them out

This is an issue of loyalty and basic respect. In theory, one works with an experienced, commercial real estate broker because their market knowledge and expertise along with their understanding of the client’s needs will result in the best deal possible; one that extracts maximum concessions both monetary and non-monetary and protects the client’s interests. Bad clients (erroneously) believe the savings from not having to pay the broker’s commission (even if the other party is responsible for paying commissions) will result in a better deal for them and thus will look for ways to cut their broker out of the deal. Bad clients do not understand or appreciate the value an experienced broker provides or that commissions are factored into landlord proformas. Economic concessions in leasing are market-driven not commission driven.

Example 1

A broker has an active agency agreement with a client that is looking to lease or purchase an office property. The client identifies a potential option not presented by their broker.

• Good client: “I was doing some of my own research and came across a property that I think could work well for us. I’ll send you the address. Please reach out to them and get some more information.”
• Bad client: Calls landlord or seller directly “Can I get a better deal if you don’t have to pay my broker a commission?”

Example 2

Broker negotiated a renewal right in their client’s lease agreement. The landlord reaches out to the tenant with a proposal to renew the lease.

• Good client: Sends proposal to their broker and notifies the landlord to negotiate through their broker.
• Bad client: Tells the landlord that they will not be using a broker if they agree to lower the rental rate.

Bad clients are short-sighted and ignorant. They do not know how to gain leverage in renewal negotiations nor what concessions are available to them based on market conditions, which are different from initial leasing concessions. Brokers protect their clients’ interests by staying up-to-date on market conditions; thereby ensuring they are able to negotiate from a position of strength and extract the maximum amount of concessions.

Realistic expectations vs. unrealistic expectations

Realistic expectations denote an underlying respect for the broker as a professional and person. Good clients are respectful of a broker’s time; understanding that sufficient notice and time must be given to compile data, schedule tours, review contracts, etc. Good brokers strive to provide the highest level of service possible. Good clients appreciate that “possible” falls within the context of agreed upon timeframes and the fact that the broker has other clients and responsibilities. Bad clients, like bad people, are selfish and only care about themselves. It’s their world and everyone else is living in it. In their eyes, brokers exist to do their bidding and should be at the beck and call. These very people are, themselves, often unresponsive.

Example

• Good client: “I’ll send you a list of dates/times that we’re available next week for a tour. Please confirm which work for you.”
• Bad client: “I’m only available tomorrow at 2pm tomorrow to see the properties. Let me know where to meet you.”

Fairfax Center

• RBA: 7,796,6925 SF
• Vacancy Rate: 22.2%
• 12 Month Net Absorption: 13,200 SF
• Average Asking Rent: $30.29
• 12 Month Rent Growth: 3.3%

The Fairfax Center submarket is mainly comprised of the areas known as Fair Oaks and Fair Lakes (and coincidently is where I was raised and currently live). The area is centrally located with convenient access to Route 50, I-66, Route 29, and the Fairfax County Parkway; making nearly every destination within Northern Virginia less than a 30-minute drive. Fair Oaks Mall, Fair Lakes Shopping Center, Fairfax Corner, and Fairfax Towne Center offer over 3,000,000 SF of retail amenities and the submarket is also home to Fair Oaks Hospital and medical campus. Despite these positive features, Fairfax Center has suffered over the past decade due to BRAC, sequestration, and move-outs by large, government contractors. Emerging trends in office leasing are likely to contribute to these woes due to the submarket’s lack of access to public transit.

At 22.2%, Fairfax Center’s vacancy rate is 9.4% higher than the DC metro average, but it is actually down from its peak of 24.3% in 2017. The downturn started in 2007 when, over the next 4 years, the submarket experienced 849,200 SF of negative net absorption (approximately 11% of total inventory) the result of sequestration and a shift towards small business in federal contracting, which caused anchor tenants like Northrop Grumman and ManTech to vacate large blocks of space. Just as the submarket was starting to recover in 2011, posting 4-straight years of positive absorption, SRA International vacated 290,000 SF at the end of 2015 due to its merger with CSC.

Fairfax Center’s availability rate paints an even bleaker picture of the current state of the submarket and its possible future. 4 & 5-Star properties comprise 57% of the submarket’s inventory and while the vacancy rate is 18.8% the availability rate is 25.2%. Similarly, 3-Star properties, which comprise over 40% of total inventory, have a vacancy rate of 28% with a whopping 32.7% availability rate (nearly 1/3). Combined the submarket has over 2,100,000 SF available (28% of total inventory).

The submarket’s “recovery” is being driven by smaller tenants with the average lease being less than 10,000 SF; however, it is unlikely that small-tenant leasing will be able to make a significant impact on submarket fundamentals in the near future. Furthermore, the submarket is still vulnerable to large-scale move-outs. CGI occupies over 200,000 SF at 12601 Fair Lakes Cir and their lease is set to expire in February 2021. General Dynamics signed a short-term renewal of the entire 185,581 SF at 12450 Fair Lakes Cir in 2018; indicating that it is likely to reduce its footprint over the coming years.

Despite this all, rent growth over the past 12 months was 3.3%. This can mostly be attributed to the submarket’s 4 & 5-Star properties, which was over 4.5%. This can be attributed to a number of factors, one of which is rising construction costs. Many spec suites and build-to-suits today can cost more than $70/SF. This has caused many landlords to increase their minimum lease terms and/or increase rental rates to either increase the amortization period or reimbursement timeframe. In addition, some owners are repositioning older assets; updating common areas and adding building amenities such as fitness facilities, tenant lounges, etc. so that they might compete with similar assets in Reston and Tysons Corner. This can involve huge capital outlays, which are reflected in the property’s asking rate.

Another factor contributing to the oxymoronic rent growth figures, is likely competition amongst tenants for small blocks of space. Fairfax Center has 12 buildings that have at least 25,000 SF of contiguous space available. Landlords are likely still holding out hope that they will be able to lease these blocks to full-floor tenants so that they do not have to incur the costs of multi-tenanting the floors. To “multi-tenant” a floor, landlords must create a common area corridor that provides ingress and egress to all tenants on the floor (per code) as well as access to bathrooms. Landlords with underperforming assets may be unwilling or unable to incur the significant, up-front expense to demise their spaces to adapt to the submarket’s changing tenant profile.

The “good” news for Fairfax Center is that there has been little to no supply-side pressure to exacerbate the submarket’s vacancy issues. Only 2 buildings have been built since 2008: Inova’s medical office building on Fair Oaks Hospital’s campus and the Apple Federal Credit Union building at Fairfax Corner. The only proposed project is the Peterson Companies’ 2^nd phase of Fairfax Corner; however, this is indefinitely on-hold due to weak preleasing activity.

Fairfax Corner is a perfect example of the impact of public transit amidst changing workforce demographics and demand trends. As baby boomers continue to require and millennials make up an increasing percentage of the employment base, access to metro is becoming a requirement. Some millennials in Arlington and DC do not own cars, limiting them to metro-accessible employment centers. Employers that do not locate their business in such submarkets risk greatly reducing the talent pool from which they’re able to draw. Even though Fairfax Center is more affordable than submarkets like Reston and Tysons Corner, asking rents will likely need to decrease further to compete for tenant demand to compensate for its lack of access to public transit. Unfortunately, this drop in asking rates is more likely to be the result of (continued) elevated and/or increased vacancy rather than a proactive strategy by submarket owners.

In this article, I will explain and apply commercial real estate concepts; using a real-world situation. Through this example, I will demonstrate the critical importance of working with an experienced, commercial real estate broker (especially) when negotiating the terms of a lease agreement. There are many considerations beyond basic economics that impact and govern the tenant/landlord relationship. If your lease is less than 20 pages, you’re doing it wrong (unless you like paying attorneys’ fees). There’s a saying that goes something like, “if it were not for attorneys, the world would not need attorneys.” A simple lease is a weak lease. An agreement that dictates the relationship between two unrelated parties for a period of multiple years benefits neither party if the terms are left ambiguous and open to interpretation. Ambiguity only benefits attorneys because they charge by the hour. By working with a commercial real estate broker (not agent) and particularly a CCIM, you will have access to market data and deal-structuring expertise that will allow you to negotiate effectively and “Call a Tenant’s Bluff.”

In this scenario, my client is the owner of a commercial property that is currently leased to a tenant with less than 6 months left on a 3-year lease. The tenant has a 5-year renewal option at the then market rate; however, it is capped at 106% of the rent in the final year of the lease term. The owner would like to sell the property and will likely realize a higher sales price if it were sold as an investment property (leased) versus vacant. My client sent me the following (paraphrased) message relating a conversation with the existing tenant:

I spoke with the tenant and they are on the fence and are weighing the decision to 1) stay in place and purchase the building, themselves; 2) renew the lease, but for 3 years not 5 years; or 3) move to another building in the same submarket at a far lower rate with 6 months of free rent and a moving & tenant improvement allowance. The tenant suggested I meet with their broker to discuss terms.

My response:

I would like to address the points we discussed over the phone and included in your email and will send a separate email with my recommendation moving forward.

Tenant weighing decision to stay in place and purchase the building

Most renewal options include a timeframe, expressed in months from the lease termination date, by which the tenant must notify the landlord of its intention to renew. Unfortunately, your lease with the existing tenant does not, which allows them to weigh their decision and keep you in limbo. If they are weighing their decision to stay, I would not put much “weight” in their claim that they are considering purchasing the building. If they truly wanted to stay then buying the building would make sense; however, it should be at the market price for the property as the cost of ownership would significantly decrease their costs of occupancy.

Renew for 3 years (not 5 years)

I would not recommend agreeing to anything less than a 5-year lease. When discounting cash flows, investors must apply a cap rate plus a risk premium to the income stream to ascertain its value. Sales data can be used to determine the market rate for a particular asset type, class, etc. but, at the end of the day, the cap rate is a reflection of what each individual investor is willing to pay for each dollar of net operating income. Because there are multiple years of income the investor must also apply a risk premium to the cap rate to account for the potential loss of that income. Discount rates consider a number of risk factors, including but not limited to: length of lease term, single tenant vs. multi-tenant, size of space, cost of reletting space, difficulty in reletting the space, etc. Based on the fact that our property is a 10,000 SF (actual square footage redacted for confidentiality), single-tenant space, most investors would place a significant risk premium on a 3-year lease from an existing tenant because it strongly indicates that they do not intend to stay long-term. Below is a (relatively) hypothetical example of how the risk associated with a 3-year lease could impact the sales price.

5-Year Lease

• 10,000 SF x $12.00/NNN = $120,000/year net operating income
• $120,000/year ÷ 6.5% (hypothetical market cap rate) = $1,846,153.85 Sales Price

3-Year Lease (with added risk premium)

• 10,000 SF x $12.00/NNN = $120,000/year net operating income
• $120,000/year ÷ 7% (discount rate) = $1,714,285.71 Sales Price

As you can see, a 3-year lease has the potential to lower the investment value of your property by over $131,868.14.

Tenant moving to another building in the same submarket at a far lower rate with 6 months of free rent and a moving & tenant improvement allowance

I would recommend asking for the address of this supposed location. There are so many contradictions within this assertion that I almost don’t know where to start.

Far lower rate

I ran a search for flex spaces in our submarket from 7,500-12,500 SF and have attached a report showing the available options. In addition, I’ve attached an analytics report on all flex properties within our submarket; showing the average market rent to be $13.46/SF ($12.74/SF for available space). The maximum rent we can charge the existing tenant based on our current lease is $12.50/NNN. If they are looking at another submarket then it’s not “nearby” and is not comparable. If they’re looking at straight warehouse/industrial space they can expect to pay a lower rent but not “far lower.” In addition, if the rent is “far lower” that would be because the space is not built out; meaning there is no (significant) showroom/office portion of the space. If there was the landlord would adjust their rental rate accordingly. I originally used a square footage range of 7,500-12,500 SF but after expanding it to 15,000 SF, identified one property to which they may be referring. The space is 14,419 SF (over 30% larger than our space) and they are asking $9.32/NNN. The space is 60% office and has 3 docks. I spoke with the listing broker and they have not seen demand for that much office and are thus pricing it closer to a straight industrial property. For a tenant with good credit that is willing to sign a 5 to 7-year deal they would be in the $7-$10/SF range in terms of a tenant improvement allowance. At their asking rate the annual rent would be $134,385.08 ($14,385.08 more per year than our property at $12.00/NNN).

6 months free

This amount of rental abatement is not market for industrial spaces. Because flex space is a combination of office and warehouse a tenant may expect a slight increase in the number of months of rental abatement but that would be based on the length of the lease term, proportion of office to warehouse, rental rate, etc. A landlord may be willing to provide 6 months free for a 10-year term but not likely for a 5-year and certainly not for a 3-year.

Moving & tenant improvement allowance

How much? Allowances are based on a number of factors; including but not limited to, length of lease term, rental rate, landlord’s pro forma, etc. If they’re paying a “far lower rate” there’s a high likelihood that there will be “far lower” money the landlord is willing to provide for either a moving or improvement allowance. As mentioned previously, if they are truly being offered a “far lower rate” this would likely be because the property is more warehouse than flex and would require a significant build out to make it comparable to your property.

In summation, based on these points along with the list of current, available options I do not believe this to be an accurate claim. They may be able to find a space that has two of the three, if they are willing to sign a longer-term lease, but not all three and not in this submarket.

Not explicitly addressed in my response but a telling an important point is that the tenant suggested that my client speak with their commercial broker; clearly so that they could receive unbiased advice. After all, this is the impartial party whose appraisal of the leasing market is founded on objective data and not on the fact that they only get paid a commission if the tenant moves or if they’re able to convince my client to pay them if they can convince their own client, the tenant, to renew. Just like landlords (can) take advantage of unrepresented tenants’ lack of experience, expertise, and market knowledge the reverse is also true. My client was unrepresented when they originally negotiated the lease with their tenant; resulting in a renewal option without a notice period and in which the rental rate was capped. They also agreed to a 3-year lease term, which is not long enough for it to be a viable investment sale and is too long for the property to be considered by an owner-user. Commercial real estate decisions should not be made in isolation, but rather should be part of a greater strategy based on the client’s goals and plans. Good commercial real estate brokers, particularly CCIMs, have the analytical tools to help clients formulate said plan and the expertise to structure deals in accordance with it.

Herndon

• RBA: 12,815,207 SF
• Vacancy Rate: 15.7%
• 12 Month Net Absorption: 307,000 SF
• Average Asking Rent: $31.83
• 12 Month Rent Growth: 2.8%

Herndon is one of the most exciting submarkets in the DC metro, quietly nestled in the shadow of neighboring juggernaut Reston; however, with the delivery of the 2nd phase of the Silver Line in 2020, Herndon is poised for explosive growth. Historically, Herndon has suffered from an “address stigma,” which is more relative (compared to Reston) than objective. Herndon has over 7,600,000 SF of 4 & 5-Star properties many with prominent visibility along the Dulles Toll Rd and Route-28. Rates for these properties increased by a whopping $1.00/SF (2.86%) from last quarter ($35.02/SF to $36.02/SF) and average rents increased by $0.63/SF (2.02%). Even 3-Star properties saw a $0.20/SF increased from last quarter ($25.73/SF to $25.93/SF). On top of that, Herndon’s metro accessible properties command rates higher than the average market rate for both Reston and Tysons Corner. That’s not all.

Herndon has been plagued by high vacancy since Q1 2016 when the submarket saw a 3.7% jump in the rate in one quarter from 12.5% to 16.2%. Vacancy peaked at 18.7% in Q2 2017 and then fell to 14.5% just 3 quarters later (Q1 2018). Just when things were looking up, vacancy again skyrocketed by 3.7% in 2018; ending the year at 18.2%. The submarket’s rollercoaster ride is the result of large-scale move-outs, the most recent being Time Warner Cable vacating 13820 Sunrise Valley Dr in 2018 when it was acquired by Charter Communications. Herndon has endured stormy weather for nearly 4 years; however, recent and significant leasing activity (including at 13820 Sunrise Valley Dr) has brought vacancy back down to 15.7% and should indicate an end to Herndon’s vacancy woes. Projections have rates dropping to 12.1% in the next 12 months likely due to the delivery of the 2nd phase of the Silver Line.

Amazon may have chosen National Landing as the site for its HQ2, but its subsidiary Amazon Web Services (also known as Vadata) is quietly making Herndon its unofficial headquarters in the DC metro. On October 4, 2019, AWS purchased 13600 EDS Dr for $54,000,000. The 400,000 SF office building sits on 57.05 acres along Route 28 (the property was assessed at $80,676,490). The company established One Dulles Tower (13200 Woodland Park Rd) as its east coast hub in 2017 when it leased the entire building (403,622 SF). Remember 13820 Sunrise Valley Dr that contributed to the spike in the submarket’s vacancy rate? AWS leased the entire building (268,240 SF) in May of this year.

The reason for all this is Herndon’s strategic location. The submarket provides access to two major north-south and east-west transportation nodes: Route 28 and the Dulles Toll Rd, respectively. Herndon is situated between two of the largest industrial submarkets in the area: Route 28 North and South. Tech giants like AWS are continually building and leasing more data center space and neighboring Loudoun County and the area known as Data Center Alley is home to the largest concentration of data centers in the world. In addition, Amazon’s disruption of the retail industry has directly benefited the industrial market by increasing the need for storage and distribution space as well as last-mile delivery. Herndon’s proximity to over 47,200,000 SF of industrial inventory and Dulles International Airport along with its inventory of 4 & 5-Star properties make it an ideal choice for Amazon and others.

With the opening of Herndon’s two metro stations (Herndon Station and Innovation Station) next year, the submarket will be immediately connected to Dulles International Airport and the greater DC region by public transit. Reston and Tysons Corner have already begun syphoning demand from closer-in submarkets (Rosslyn-Ballston Corridor) since phase-1 of the Silver Line delivered because of their relative affordability and new supply of trophy, 4 & 5-Star properties. Herndon has similar quality product and is even more affordable.

Considering these recent developments, it should come as no surprise that Herndon led all Virginia submarkets in sales over the last year with almost $1,000,000,000 deployed over the past 3 years. Despite this, Herndon’s average market cap rate (6.3%) is still above the metro and its average sales price per square foot is below that of Reston and Tysons Corner. As a result, Herndon presents a rare opportunity for investors to “buy low” in a submarket in the early stages of a complete transformation. There are more than two dozen projects proposed and in April 2019 the Town of Herndon approved Penzance Properties’ first mixed-use redevelopment at 555 Herndon Pkwy. This project, located right at the new Herndon Metro Station, will include a high-rise office building and two high-rise residential towers. This is just the beginning for Herndon. The combined forces of the Amazon effect, AWS’ growing office and data center needs, and a regional shift in employment growth into the cyber-security, IT, and high-tech fields could see Herndon join the ranks of Reston and Tysons Corner as one of Northern Virginia’s premier office submarkets.

No one wants to pay more for something than it’s worth; however, determining what something is worth isn’t always straightforward. The difference between market value and investment value can sometimes blur the lines when appraising or assessing real estate, especially for owner-occupied properties. Market value is defined as a property’s likely sales price in an arm’s length transaction (in a competitive and open market) between a buyer and seller, both acting knowledgeably, prudently, and without compulsion. Investment value is unique to each buyer and, as a matter of perspective, it can include tangible and intangible considerations. As a result, when a buyer is purchasing real property for their own use a subjective element is introduced into an otherwise objective (valuation) process.

There are three main valuation methods used to appraise/assess a property’s value: 1) cost approach, 2) direct capitalization approach, and 3) sales comparison approach. The cost approach is primarily used for insurance purposes because only the value of the improvements are insurable. This method calculates the cost to build an equivalent property (minus depreciation) and then adds the value of the land. The direct capitalization approach is used for income-producing properties and calculates value by “capitalizing” (dividing) a property’s net operating income by the appropriate (cap) rate. Cap rates, expressed as a percent, reflect the return an investor is willing to accept for each dollar of NOI based on an all-cash purchase. For example, an investor that is willing to accept a 10% return would be willing to pay $1,000,000 for a property with a net operating income of $100,000 ($100,000 ÷ 10% = $1,000,000). Market cap rates vary based on property type, age, etc. and are calculated through analyses of recent market sales of income producing properties.

The sales comparison approach compares recently sold properties with similar characteristics to the property being valued, including location (within the same building, project, neighborhood, submarket, market, etc.). Price adjustments are made for differences between the sales comps and subject property to determine a value that is consistent with recent market activity (typically within 6 months). This method is most commonly used to value residential properties, both because of the large number of sales (sample size) and due to the fact that owners enjoy beneficial occupancy of the property (not income-producing). Because owner-occupied commercial real estate also provides beneficial occupancy rather than rental income, the sales comparison approach is also commonly used valuation analyses for such acquisitions.

The biggest problem in using the sales comparison approach to value commercial real estate is the issue of sample size. The number of residential properties exceeds that of all commercial properties (office, retail, flex, and industrial combined) by many orders of magnitude. Leasing makes up the overwhelming majority of commercial transactions and, as a result, there may be few, if any, sales to use as a basis of comparison. This is evident in assessed values that remain the same year after year. Assessors use the direct capitalization (income) approach to assess income-producing real estate, but generally use the sales comparison approach when valuing owner-occupied commercial properties. When there are no comparable sales in the year of assessment or other data to support an increase or decrease in a property’s assessed value remains the same. Because assessors often value properties at an assessment-to-sales ratio (ASR) below 100%, many (brokers and laymen, alike) believe that a property’s assessed value reflects the lowest end of the spectrum in terms of market value. As alluded to earlier, this is not necessarily the case and as certain properties, property types, etc. age and become functionally obsolete, the reverse may be true. A lack of comparable sales may indicate that there is no market for a particular property (type) and is likely evidence of a decline in value and in a property (type) being over-assessed.

As the title of this article suggests, there is a way to use the direct capitalization approach to value for owner-occupied properties. As mentioned previously, most residential transactions involve the purchase and sale of real estate, while leasing dominates commercial real estate. As a result, leasing comps are nearly as numerous, on a proportionate basis, in commercial real estate as sales comps are in residential. In order to use the direct capitalization method to calculate the market value of an owner-occupied commercial property, one must perform a hypothetical investment analysis of the subject property using actual market data, rates, etc.; treating it as if it were being purchased as an income-producing property.

Market Analysis

Prospective buyers and/or brokers must first conduct a search for comparable properties that are available for lease. Search parameters such as square footage (range), building age (range), location, etc. should be as narrow as possible. The resulting (short) list of properties should produce an accurate market rent (range) for the property. Rents quoted in triple net terms allow for a quick and easy calculation of net operating income (rental rate x square footage = NOI). Full-service gross leases present more of a challenge and require all costs of ownership (real estate taxes, operating expenses, utilities, cleaning, & insurance) be added together and subtracted from the rental rate on a per square foot basis. The resulting number is the triple net equivalent rent which can then be multiplied by the square footage to calculate the property’s net operating income.

After calculating the subject property’s potential net operating income, more market research and analysis is required to determine the appropriate market cap rate to apply to the income stream. There are a number of sources which provide cap rate information based on submarket, property type, etc.; however, as before, the narrower the focus the more accurate the resulting valuation. Assessors will add basis points to cap rates based on age, vacancy, etc. thereby lowering the value relative to NOI. For example, if the market cap rate for industrial properties in a particular submarket is 7% with average vacancy rate at the time of sale of 50%, a property that is 0% vacant may justify a 0.5% reduction in the cap rate while a property that is 100% vacant may require a 0.5% increase to account for risk. For a property with an NOI of $100,000 the resulting difference in value would be $205,128.21 = ($100,000 ÷ 6.5%) – ($100,000 ÷ 7.5%). Relevant/current data coupled with market knowledge and experience will produce the best, most accurate estimates of value.

Case Study

Ryan Rauner is interested in purchasing 123 Industrial Ave and plans to occupy and use the 25,000 SF property for his storage and distribution business. Due to a lack of comparable sales in the surrounding area, Ryan is having trouble determining how much he should pay for the property. After researching leasing rates for comparable properties within the same submarket, he determines that the market rent is about $10.00-$11.00/NNN; resulting in a potential net operating income of $250,000-$275,000. The current market cap rate for industrial properties in the subject submarket is 7%; however, the submarket’s vacancy rate is slightly about the market average. Ryan knows that investors would likely require a higher rate of return to account for the risk associated with the property’s vacancy and thus adds 1 basis point to the cap rate as a risk premium. He then capitalizes the potential NOI by 8% for a resulting valuation of $3,125,000-$3,437,500.

Fairfax City

• RBA: 5,054,602 SF
• Vacancy Rate: 10.9%
• 12 Month Net Absorption: 24,000 SF
• Average Asking Rent: $24.72
• 12 Month Rent Growth: (0.2%)

At slightly over 5,000,000 SF, Fairfax City is 1.78, 2.55, and 2.96 times larger than the McLean, Vienna, and Falls Church submarkets respectively. The vast majority of the submarket is comprised of 3-Star and 1 & 2-Star properties (98%) and the average market rate of $24.72/SF reflects as much. The submarket’s vacancy rate of 10.9% is well below the metro average but this is the result of zero supply side pressure. There have been no significant deliveries since 2007, before the Great Recession, and there are no projects under construction and none proposed in the next 12 months. Low demand is the biggest threat to Fairfax City’s fundamentals. The office inventory is old with an average and median age of 1978 and 1982 respectively and small with an average and median size of 22,872 SF and 13,096 SF respectively). Combined with a lack of metro access the submarket will continue to struggle to attract large tenants. This risk is reflected in the recent sales of WillowWood Plaza I & II (10300 & 10306 Eaton Pl) and WillowWood Plaza III & IV (10302-10304 Eaton Pl), arguably the submarket’s nicest and best located buildings. Buildings I & II sold in June 2018 for $22,300,000 ($91/SF) and were about 50% vacant at the time of sale. Buildings III & IV sold in December 2018 for $32,000,000 ($115/SF) and were 0% and 50.1% vacant at the time of sale respectively. The submarket’s largest tenant, Zeta Associates, occupies the entire building at 10302 Eaton Pl (Building III). Despite having an occupancy level approximately 25% higher, this portfolio sale was only able to achieve a $24/SF higher sales price.

City of Falls Church

• RBA: 2,831,871 SF
• Vacancy Rate: 12.4%
• 12 Month Net Absorption: (25,400 SF)
• Average Asking Rent: $25.46
• 12 Month Rent Growth: 1.4%

Negative net absorption of 25,400 SF led to a 0.9% increase in the submarket’s vacancy rate over the past 12 months. Oddly, this was accompanied by a 1.4% increase in market rents. Even more strange was that this increase came largely from 4 & 5-Star properties ($30.10/SF average rent), which have a vacancy rate of 21.5%. Despite only comprising 17.5% of total office inventory, 4 & 5-Star metrics are heavily influencing the submarket’s fundamentals. Combined, 3-Star and 1 & 2-Star properties have an average market rent of $24.48/SF and vacancy rate of 10.5% versus the submarket’s $25.46/SF and 12.4%. Vacancy rates should remain low due to zero supply side pressure. There are no properties under construction or proposed in the next 12 months. The average & median age of the office inventory is 1962 & 1965 and the average & median size is 14,749 SF & 5,560 SF respectively. As a result of demand trends, Falls Church would benefit from new product, particularly in proximity to the submarket’s lone metro station (East Falls Church). The most significant recent sale was of 6400 & 6402 Arlington Blvd in February 2019. The 410,197 SF project was 26.76% vacant at the time of sale and sold for $38,119,000 ($92.93/SF); reflecting the value-add nature of the sale.

McLean

• RBA: 1,708,579 SF
• Vacancy Rate: 11.2%
• 12 Month Net Absorption: (40,800 SF)
• Average Asking Rent: $31.18
• 12 Month Rent Growth: (0.5%)

McLean was once the central business district of Fairfax County; however, this title was usurped by neighboring Tysons Corner. The submarket’s fundamentals provide a telling picture of the state of office demand in McLean and the greater DC metro, as a whole. Negative net absorption of 40,800 SF led to a 2.4% increase in the submarket’s vacancy rate and a 0.5% drop in market rents, which despite having no 4 & 5-Star properties average $31.18/SF. At $32.82/SF and $28.93/SF, McLean has the highest 3-Star and 1 & 2-Star rents in Fairfax County. With an aging inventory (average/median age of 1977/1980) and no access to metro, McLean’s fundamentals should continue to suffer. The submarket’s one saving grace, zero supply-side pressure, is also the main contributing factor to its lack of demand.  There are no properties under construction or proposed in the next 12 months and with high rents relative to asset quality and demand trends favoring newer product with proximity to metro, tenants will likely look to Tysons Corner for their office needs. Despite this Fairfax County’s Department of Tax Administration considers McLean to be one of the County’s premier submarkets, along with Tysons Corner and Reston. As a result, commercial properties received a 0.5% reduction in their market cap rate; leading to an increase in assessed values even if a property’s net operating income remained the same. The recent sale of 1420 Beverly Rd may cause assessors to reevaluate the submarket’s status. The 46,000 SF building, built in 1985, sold in November 2018 for $12,700,000 ($276/SF) at a 7% cap rate and was fully leased at the time of sale. Another significant sale occurred in December of 2018 when 1313 Dolley Madison Blvd (53,051 SF) sold for $13,000,000 ($245/SF). The property was 13.8% vacant at the time of sale with the most recent lease signed in September 2018 at $32.00/SF full-service.

Town of Vienna

• RBA: 1,984,657 SF
• Vacancy Rate: 7.3%
• 12 Month Net Absorption: (8,200 SF)
• Average Asking Rent: $28.86
• 12 Month Rent Growth: 2.0%

Vienna’s total office inventory is fairly, evenly divided between 4 & 5-Star, 3-Star, and 1 & 2-Star properties (634,390 SF, 595,033 SF, and 755,234 SF respectively) as are the rents for each property class with an average of $4.46/SF between them. Despite a 7.3% vacancy rate which decreased by 0.5% over the past 12 months and is nearly half the metro average along with 2% rent growth over the same period, Vienna’s fundamentals are misleading. The true Vienna submarket is located within 2 blocks of Maple Ave (Rt-123) and is comprised solely of 3-Star and 1 & 2-Star properties with an average rent and vacancy rate of $26.64/SF and 10.4% versus the submarket’s $28.86/SF and 7.3%. Vienna’s inventory is old and small, with an average and median age of 43 years (built in 1976) and average and median size of 18,901 SF and 7,200 SF respectively. A total of 3 buildings comprise the submarket’s 634,390 SF of 4 & 5-Star office inventory. One of the three is 1007 Electric Ave, a build-to-suit, headquarters expansion for Navy Federal Credit Union that delivered in 2017 and increased the submarket’s 4 & 5-Star inventory by 37%. This property borders Tysons Corner. The other two, 9300 & 9302 Lee Hwy, are located by the Dunn Loring Metro and I-66’s Nutley St exit and border the Fairfax City submarket. Full building leases for both properties expire in 2022, which could have a tremendous impact on the submarket’s vacancy rate if they remain unleased. That being said, the properties’ proximity to metro coupled with the submarket’s most significant, recent sale may alleviate such concerns. In December 2018, the 41,224 SF 2-Star office building located at 9401 Lee Hwy sold for $9,300,000 ($226/SF) despite its age (built in 1973). This property is even closer to the Fairfax City submarket, notably the new mixed-use development, Scout on the Circle, which will have 83,200 SF of retail space and 400 apartments and was likely purchased as a redevelopment play.

“Regular Business Hours” is a term used in full-service gross (primarily office) leases and refer to the days and times that a property is open/accessible to the public and during which building services are provided at maximum levels. They are based on and consistent with how and when most office users/businesses operate. In most commercial leases, regular business hours are 8:00am-6:00pm, Monday through Friday, and 9:00am-1:00pm on Saturdays with federally recognized holidays exempted. Office tenants still have access to the property 24 hours a day, 7 days a week, 365 days out of the year; however, some building services may be unavailable or reduced to minimum levels outside regular business hours in order to reduce expenses. Examples of services that may be unavailable at such times can include but are not limited to property management, mail service, access to fitness or conferencing facilities, etc. Elevator service will always be available but may be reduced to one lift during off-hours.

Regular business hours are generally not subject to negotiation, particularly in multi-tenant office buildings where provisions that govern management of the entire property require consistency. For tenants that consistently operate outside regular business hours, there may be the option to have the leased premises separately submetered; however, this may be inefficient, ineffective, or prohibitive from a cost standpoint. Full-building tenants might request changes/extensions to the building’s regular business hours based on their hours of operation; however, this must be done during the proposal/letter of intent stage of negotiations because of the potential impact on operating expenses. Any resulting increase or decrease would need to be factored into the other economic terms of the deal. For the landlord this means increasing the base rent, lowering the amount of rental abatement (if any), and/or lowering the improvement allowance (if any). For tenants it means extracting additional economic concessions equivalent to the landlord’s savings.

The primary purpose of regular business hours is to provide the landlord with a framework to accurately estimate operating expenses and thus their projected rate of return. The primary building service affected by regular business hours is HVAC (heating, ventilation, and air conditioning). Lease language may vary, but landlords are required to maintain comfortable temperature levels during regular business hours (comparable to other office buildings) as part of a tenant’s right to quiet enjoyment. Utilities such as electricity and water are always fully available, but heating and cooling levels are modified during off-hours to lower energy consumption. Landlords do not turn off the heat in the winter or air conditioning in the summer outside regular business hours, but rather lower the minimum temperature and increase the maximum temperature respectively. For example, the HVAC system in an office building may have the temperature/heat set at 70° during regular business hours and at 65° after hours.  Tenants may request the landlord to extend HVAC service beyond regular business hours by providing advance notice and paying the landlord’s hourly rate for such service, which is subject to change. Depending on the tenant’s square footage, this may not be a viable or cost-effective long-term solution.

Most office leases are full-service gross and include all costs of ownership within the base rental rate. Real estate taxes are based on the assessed value of the property and determined by the applicable municipality’s tax rate and are thus outside the landlord’s control. Operating expenses, on the other hand, which include utilities and HVAC present the opportunity for cost savings through efficient management and/or investment in capital improvements such as energy efficient systems. Because the difference between the base rental rate and the costs of ownership equals the landlord’s net profit and landlords are constrained by market rents, they have an interest in minimizing their controllable expenses in order to maximize their profit. Landlords are able to charge tenants for increases in expenses after the first lease year (base year), but acquisitions are based on a property’s projected net operating income and without a consistent, set schedule acting as a control against which to measure expenses (energy consumption), landlord proformas would be unreliable and their rates of returns unpredictable. Furthermore, the predictability of energy consumption and the associated costs provide landlords with a benchmark against which to measure and identify usage that exceeds normal office use on a per square foot basis. Most leases contain provisions that allow landlords to submeter a tenant’s space, at the tenant’s expense, and require them to make payments directly to the utility provider in cases of excessive use.

Finally, regular business hours also provide the landlord with means to predict and limit wear and tear on a building’s common areas. Tenants may have 24/7, 365-access to their building and space, but visitors and guests do not. Regular business hours restrict access for non-tenants and discourage excessive usage by building tenants by limiting building services and decreasing energy consumption, particularly with regards to HVAC levels; thereby prolonging the life of building systems and finishes and reducing the frequency of and need for repairs, replacements, and capital improvements.

HVAC stands for heating, ventilation and air conditioning (HVAC) and refers to the different systems, machines and technologies used to provide heating and cooling in and for commercial properties. The party responsible for a property’s HVAC system (tenant vs. landlord) is intrinsically linked to the tenant’s use, and the lease structure, full-service gross vs. triple net, which defines those responsibilities is a byproduct of that use. The vast majority of office leases, especially multi-floor office buildings with internal common areas/amenities, are structured as full-service gross leases where all costs of ownership (NNNs – real estate taxes, operating expenses/CAM, insurance) and occupancy (utilities and cleaning) are included in the base rent. Landlords are responsible for HVAC maintenance, repairs, and replacement along with maintaining a comfortable temperature levels. Landlords are willing to assume this responsibility because office tenants, regardless of their business, have little difference in their consumption of building resources/utilities. Therefore, landlords can estimate and include these costs in their proforma and accurately calculate their net revenue. In addition, landlords can “pass through” any increases in those costs over the initial year of tenancy to the tenant and most leases also contain provisions allowing the landlord to submeter a tenant’s space and charge them directly for utilities if it is determined that their use exceeds normal office use.

Retail, flex, and industrial properties, on the other hand, are structured as triple net leases. In addition to the base rent, tenants must pay their proportionate share of real estate taxes, operating expenses/CAM, and insurance along with utilities and cleaning for the leased premises. Particularly with respect to utilities, this is because of the uniqueness of each tenant’s use and their consumption needs to support their business operations. The same industrial project may have as tenants both a granite fabricator and a storage & distribution center. The granite fabricator will use significantly more water and power than the storage & distribution center; making an accurate allocation of utility charges an administrative nightmare. Of all commercial property types, retail projects contain the most diverse mix of tenants and uses, which presents the same challenge. Flex properties are a mix of office and warehouse; however, the proportion of office and warehouse can differ from project to project and even within spaces within the same project. Even for tenants within the same industry, the amount of office versus warehouse (conditioned vs. unconditioned space) will directly impact their consumption of utilities. For this reason, landlords treat each space/tenant as a self-contained unit and as such each will have their own HVAC unit(s)/system of which they are at least partially responsible.

In a typical (landlord-sided) lease, the tenant is responsible for maintenance, repair, AND replacement of the HVAC unit(s)/system. The HVAC system is and remains the property of the landlord even after the tenant’s occupancy/lease has ended. As a result, tenants may inherit an HVAC system along with any preexisting issues and/or deferred maintenance. Tenants should always inspect and/or request information on the existing HVAC unit(s) prior to signing the lease agreement. While HVAC responsibilities in triple net leases generally fall on the tenant, like most things in life and commercial real estate, they are subject to negotiation.

Maintenance

In nearly all cases, tenants are responsible for maintenance of the HVAC unit(s) servicing the leased premises. Lease agreements generally require tenants to contract with a licensed HVAC contractor to perform regular system maintenance (quarterly or biannually). The landlord may require the tenant to provide copies of the maintenance reports detailing the condition of unit. HVAC maintenance contracts include:

• Inspecting and Changing Filters
• Visual Inspection of the Entire System
• Cleaning and Removing Debris
• Checking the Condensate Drain
• Checking the Thermostat Settings
• Checking the Electrical Connections and Voltage
• Lubricating Moving Parts
• Inspecting Exhaust Outlets
• Checking Fuel Lines and Connections
• Checking the Refrigerant Levels

Repair

Despite regular maintenance, the HVAC unit(s) servicing the leased premises may require repairs over the term of the lease. Depending on the issue and/or age of the unit, repairs can be costly. As a result, tenants may request the landlord be responsible for repairs, especially if the unit is old and nearing the end of its useful life thus increasing the likelihood repairs will be needed. At the very least, tenants can negotiate a cap on repairs with the amount tied to the age/condition of the unit along with the tenant’s negotiating leverage. Tenants can also request that any existing warranties be transferred to tenant or request the landlord warranty the unit(s), themselves. Regardless, any damage caused by tenant or required repairs resulting from tenant’s negligence or actions will be the sole responsibility of the tenant.

Replacement

Due to the cost associated with replacing an HVAC unit/system, landlords want to place the responsibility on the tenant and vice versa with the age and condition of the existing unit(s) playing the primary role in the negotiations. The fact that the HVAC system is/remains the property of the landlord, the issue of replacement is a particularly contentious one for tenants. If a tenant is inheriting a unit at the end or nearing the end of its useful life, they should either request the landlord install new units prior to occupancy or require the landlord be responsible for replacements during the initial lease term. If the landlord is unwilling to agree to such terms and the tenant is responsible for replacement of the existing HVAC system, the tenant should request any warranties be transferred and that the landlord covenant that the system servicing the leased premises is in good, working order at the time of lease commencement. A case can be made that with regular maintenance and repairs as needed, a system in good, working order should not require replacement over the initial lease term or other agreed upon time period (for longer lease terms, i.e. 10 years). Landlords may be willing to warrant the unit for a reasonable period, i.e. 5 years, after which the tenant would be responsible for replacing the unit as required. Another solution to mitigate the tenant’s cost to replace the HVAC system (especially towards the end of the lease term) is to negotiate a proration of the cost of the new unit over its useful life. For example, if the cost of a new, $6,000 unit has a useful life of 15 years the tenant’s costs would be limited to $400/year of term remaining.

The Tax Cuts and Jobs Act of 2018 will likely have a huge impact on how both landlords and tenants approach the issue of HVAC replacement. Prior to its passage, HVAC replacement was viewed as a capital expense and thus subject to depreciation over a 39-year period. The new/current tax law treats replacement of an HVAC system (up to $2,500,000) as a business expense that may be deducted that same year (capped at $1,000,000/year). The value and timeliness of this change cannot be understated, as R22 (Freon), the industry standard refrigerant for many years, will be completely phased out by January 1, 2020.