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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Cap Rates vs. Discount Rates: What’s the Difference?

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As discussed in my article, What’s a Cap Rate?, a capitalization rate is the unleveraged return generated by an income producing property; meaning if an investor bought a property all-cash (no financing) the cap rate would reflect the ratio of the property’s net operating income (NOI) to the purchase price. For example, if a property’s NOI is $100,000 and is purchased for $1,000,000 the cap rate would be 10%. Cap rates are used to calculate an asset’s value using the direct capitalization method in which the property’s net operating income is divided by the cap rate.

Cap rates are constantly changing because they are determined by the interaction of the capital market and space market, which are also in constant flux. Cap rates vary by market, asset type, asset class, etc. and reflect the demand for and risk associated with an asset. Market cap rates can be calculated through an analysis of recent sales comps but are still relatively subjective as they indicate how much an investor is willing to pay for a dollar of NOI.

Discount rates are similar to cap rates because they too are used to calculate value using a property’s net operating income; however, discount rates are applied to future income streams while cap rates are applied to a property’s current NOI. This is an important distinction because additional risk must be factored into the rate of return to account for potential changes to the property’s income. Therefore, a discount rate can be defined as the current market cap rate plus a risk premium. Like the direct capitalization method, a discounted cash flow analysis calculates an asset’s value by dividing future net income streams by the discount rate. Using the previous example, an investor may apply an additional 2% risk premium to the 10% market cap rate for a discount rate of 12% thus lowering the price they are willing to pay for the same asset to $833,333.33 ($100,000 ÷ 12%).

While market cap rates do reflect elements of risk, discount rates provide a more comprehensive approach to property valuation and are particularly useful when calculating the value of multi-tenant properties and multiple income streams. Every tenant’s risk profile is different and leases expire at different times. The discounted cash flow model allows investors to apply individual discount rates to specific income streams to account for the opportunity cost associated with each. The discounted income streams are then added together to calculate the price an investor is willing to pay for an asset which reflects their confidence in each income stream and risk tolerance.

Downtown DC Submarkets Q3 2019

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When you’re at the top, the only way to go is down. The East End, CBD, and West End are considered the DC metro area’s premier office submarkets; however, millions of square feet of new supply added to nearly 13,000,000 SF of vacant space along with competition from emerging submarkets like NoMa and Southwest have caused fundamentals to suffer, a trend that may continue for the foreseeable future.

East End

  • RBA: 53,024,189 SF
  • Vacancy Rate: 14.4%
  • 12 Month Net Absorption: (117,000 SF)
  • Average Asking Rent: $57.22
  • 12 Month Rent Growth: 0.1%

The East End is the largest and most expensive submarket in the DC metro area with over 53,000,000 SF of inventory and an average rental rate of $57.22/SF; however, competition from emerging submarkets with lower rents and increases in supply have resulted in negative absorption, rising vacancy rates, and anemic rent growth. Developers have been demolishing older office properties and building trophy assets in their place; delivering over 1,600,000 SF in the past 12 months. This led to a 2.9% increase in the vacancy rate in the past year. In addition to the new supply, more than 10,000,000 SF of older supply remains vacant. Interestingly, a large portion of this inventory consists of 4-Star properties built before 2000. The 14.4% vacancy rate is 1.5% higher than the metro average. This disparity is dwarfed by the difference between the East End’s availability rate compared to the metro average: 21.3% to 17.1%. The forecast for East End fundamentals is grim as traditional tenants (corporate law firms) continue to downsize while others look at other submarkets like NoMa and Southwest that provide the same quality product at more affordable rents.

Central Business District (CBD)

  • RBA: 45,135,622 SF
  • Vacancy Rate: 10.9%
  • 12 Month Net Absorption: (433,000 SF)
  • Average Asking Rent: $54.07
  • 12 Month Rent Growth: -0.3%

The CBD submarket is 2nd only to the East End in terms of total inventory, asset value, and average rents at over 45,000,000 SF, $22.2 billion, and $54.07/SF respectively. Unfortunately, the submarket is also experiencing similar trends and the associated pains. Like the East End, developers are repositioning older assets and flooding the submarket with new supply. Over 360,000 SF has delivered in the past 12 months with an additional 600,000 SF delivering by year’s end. This new glut of supply has resulted in over 433,000 SF of net absorption over the past 4 quarters; leading to a 0.9% increase in the submarkets vacancy rate and a 0.3% drop in rents. Fundamentals should continue to suffer as another 557,000 SF is scheduled to deliver in 2020.

West End

  • RBA: 4,822,739 SF
  • Vacancy Rate: 8.1%
  • 12 Month Net Absorption: (49,800 SF)
  • Average Asking Rent: $51.18
  • 12 Month Rent Growth: -0.8%

The West End submarket may be included in the Downtown DC submarket cluster along with the East End and CBD and is similar in that it has some of the highest rents in the metro area, but at only 4,822,739 SF of total inventory it only 9% and 10.7% the size respectively. The office inventory in the West End is old with average age of 59 years (median 41 years); however, due to limited developable sites and the associated construction costs there are no new projects under construction or proposed. While the lack of new supply has kept vacancy rates below the metro average, the submarket’s aging inventory and high rents have led to a flight-to-quality and more affordable submarkets; resulting in a 1% increase in the submarket’s vacancy rate in the past year and an associated 0.8% decrease in rents. The West End is also a “big footprint” submarket with approximately 40% of tenants occupying more than 10,000 SF; making it especially vulnerable to move-outs. The outlook for the West End is grim as traditional tenants (government, law firms, and consulting companies) continue to downsize and others relocate to emerging submarkets.

The “Once Per Year” Exception

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Commercial leases are full of “dos” and “don’ts” along with penalties for doing any of the “don’ts”” and/or not doing any of the “dos.” The good news is that there are also typically grace periods before the associated fees, interest, etc. apply. These penalties can range from nominal fees to the landlord terminating the tenant’s right to possession of the premises and accelerating the remaining rental payments. Grace periods can also range from a couple days to a relatively indefinite amount of time under the condition that the tenant is diligently pursuing a cure to the default in question.

While most numbers are relatively arbitrary there are generally accepted/reasonable standards that limit grace periods and penalties. For example, some landlords may provide a tenant up to 5 business days after written notice for nonpayment of rent before it is considered an event of default while others may only provide 3 days with no written notice. Both could be considered “reasonable” but most would agree that 30 days is not. Another example, and the focus of this article, is the interest and/or late fees incurred for the nonpayment of base rent or additional rent. While the interest is generally capped at the highest non-usurious rate allowed by law, the additional rate above the Prime Rate and fee amounts can vary based on the tenant’s negotiating leverage, market conditions, etc.

When it comes to penalties, tenants can try and extend the grace period and/or limit the fee/interest charged, but this could raise some red flags in the landlord’s eyes. Grace periods are already a concession on the part of the landlord and the penalties are in place to compel the tenant to abide by the terms of the lease. If a tenant is pushing back on what could already be considered “reasonable” terms and/or “nibbling” at relatively arbitrary numbers it can give the impression that they intend to pay late or are concerned with their ability to pay rent on time and are trying to mitigate their damages.

The solution I recommend is to accept the existing fee/interest amount but request an exception once per calendar year. This shows that the tenant understands the burden their violation will/can have on the landlord and acknowledges their fault by means of compensating the landlord based on the landlord’s own calculation of their damages. It also allows for honest mistakes/oversights that could arise because the tenant is on vacation, overlooks a notice/invoice from the landlord, etc. without having to incur costly penalties. Default provisions for nonpayment of rent would still apply, but the “once per calendar year” exception can be an effective, efficient, and mutually acceptable solution for both parties.

Assignment vs. Subletting: What’s the Difference?

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According to the Bureau of Labor Statistics, 20% of small businesses fail in their first year, 30% fail in their second year, 50% fail after five years, and 70% of small business owners fail in their 10th year in business. Yikes! Despite these grim statistics, commercial leases are generally a minimum of 5 years and contain severe, default penalties. In some cases, landlords will require the tenant to personally guarantee the lease, effectively using the tenant’s personal assets, i.e. home, as collateral to secure the lease.

Most tenants understand the implications of defaulting on their lease and enter into the agreement, eyes-open, and with every intention of abiding by the terms and conditions. The road to hell (and default) are paved with good intentions. Economic downturns, lost contracts/clients, sequestration, etc. can disrupt even the best laid plans; leaving tenants struggling or unable to meet their monetary obligations under their lease. In such cases, tenants’ most powerful tool/strategy to avoid default is to sublease or assign their lease.

Most, if not all, commercial leases contain Assignment and Sublease provisions and while the specific language and conditions can vary there are general, shared principles. Subletting and assigning are similar in that they both involve a transfer of the tenant’s right or interest in the lease that allow another (3rd) party to occupy the leased premises. Under the terms of most lease agreements the original tenant will remain responsible for the terms of the lease in the case of either a sublease or an assignment. This means that the landlord can proceed against the tenant in the case of a default by the subtenant or assignee; including but not limited to, rental payments, damage to the leased premises, etc. As a result, it is in both the tenant and landlord’s interest to carefully vet the proposed subtenant or assignee.

If subleases and assignments are similar in that they essentially allow the tenant to “rent out” their space to a 3rd party, what’s the difference?

Under a sublease, the tenant is either (sub)leasing a portion of the leased premises for the remainder of the lease term, all of the leased premises for a portion of the lease term, or a portion of the leased premises for a portion of the lease term. Subleases do not necessarily indicate financial hardship on behalf of the tenant or a likelihood of default. In fact, in some cases, companies may choose to lease more space than needed upon the lease commencement date in order to reserve the space for future growth. This is more common with large companies, i.e. Google, that can afford the lease payments but may seek to reduce expenses by subleasing the unused space. Another situation in which a tenant may request to sublease their space is in the case of a downsizing, consolidation, etc. where the they no longer need their entire space but do not want to move and can offset their rental obligations by renting the unused portion to another party.

Under a lease assignment, the tenant transfers all of its rights and responsibilities under the lease to the assignee along with its right to occupy the entire leased premises for the remainder of the lease term. A lease assignment is a much more serious request on behalf of the tenant than a request to sublease the space. While not always the case, a request to assign the lease may indicate that the tenant is unable or unwilling to continue to make lease payments and is likely to default on its lease then or at some point in the future. As stated earlier, most leases require the original tenant to remain liable for the lease (payments, responsibilities, etc.); however, with lease assignments the landlord may release the tenant and enter into a direct relationship with the assignee. The landlord’s decision will be based on a number of factors, most notably the financial strength of the assignee and the difference between the contract rent and market rents. Assignments are not necessarily indicative of financial trouble and can simply be the result of tenants relocating or consolidating; resulting in them no longer needing the leased premises.

Recapture & Profit-Sharing Provisions

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Most commercial leases contain Assignment and Subletting provisions which allow the tenant to (sub)lease a portion of or the entire leased premises to another party, known as an assignee or subtenant/sublessee. In most (if not all) cases, landlords must consent to the sublease or assignment. Language governing that consent can range from “in landlord’s sole discretion” to “not to be unreasonably withheld, conditioned, or delayed.” In addition to required consent, two of the most important rights available to landlords under the Assignment and Subletting section of the lease are Recapture provisions and Profit-Sharing provisions. They allow landlords to maintain control of the space/property and mitigate the impact of below market lease rates thereby allowing them to maximize the resale value of their asset.

Recapture provisions allow the landlord to terminate the lease and retake possession of the leased premises. There are a number of “triggers” that allow the landlord to exercise their right, including but not limited to, events of default, failure to maintain a certain gross sales revenue (in cases of percentage rent), etc. but in this case we’re focused on the instance in which the tenant requests the right to sublet or assign the lease.

Profit-Sharing provisions require the tenant to share any net profits from subleasing or assigning the leased premises. Generally, it’s 50/50 and the key term is “net” profits, which means that the tenant’s expenses in procuring a(n) subtenant/assignee, i.e. brokerage commissions, free rent, improvement allowances, and other considerations are subtracted from the gross rental value.

There are multiple issues for the landlord to consider when determining which right to exercise. Certainly the recapture right provides greater control over the space, but profit-sharing may be preferable in certain cases. The goal is maximizing value and/by minimizing risk.

Who secures the lease? Who’s the tenant? Who’s the proposed subtenant/assignee? Does the tenant have a personal guaranty? How much time is left on the lease? Is this an assignment or a sublet? What’s the difference? Why is the tenant seeking to sublease or assign the lease? What is the opportunity cost of releasing the premises? These considerations are intermarried but form models for decision-making.

The landlord’s primary goal is to collect (at least) the contract rent from the lease. The stronger party financially is the one with the greatest likelihood of doing so. If Google leased more space than it needed initially and requests the right to sublet a portion of their space, the landlord will prefer to share in the net profits from a sublease rather than recapture the space, regardless of the difference between the market rent and contract rent. In many cases though, landlords will need to consider the financials of two relatively similar parties. Generally, the minimum requirement for consent to a sublet/assignment is that the proposed subtenant/assignee have a financial net worth/strength equal to the tenant at the time of lease commencement. In cases where two parties are comparable financially the difference between market rents and the contract rent will govern the landlord’s decision.

Related to the landlord’s primary goal of collecting rent is the risk of default. The reason behind the tenant’s request to sublease or assign the leased premises is another key factor that landlords must consider. In the previous case, there is little to no risk involved. Large companies like Google will sometimes lease more space than they need at the time in order to extract maximum concessions from the landlord, take advantage of economies of scale, and ensure room for future growth. In such cases, companies may choose to sublet their space until they need it. Conversely, many (if not most) requests to sublease or assign the lease are the result of lost contracts, decreased revenue, declining profits, etc. and can foreshadow default. If market rents are higher than the contract rent in such cases the landlord should choose to recapture the space.

The opportunity cost associated with recapturing/releasing the space takes into account the previous two considerations and the difference between the contract rent and market rents, as well as market concessions. Depending on the condition of the space, the tenant’s proposed improvements and the associated costs, and current market tenant improvement allowances, the landlord may choose to simply take 50% of the net profits from the sublease/assignment.

Another closely related and crucial element is the time remaining on the lease term and whether the tenant is seeking to sublease or assign the lease. If there is not much time left on the lease, i.e. less than one year, the landlord may choose to recapture the space to secure a long(er)-term tenant when market rents exceed the contract rent. In the case of a sublease for a portion of the space for a portion of the lease term, the landlord may choose to simply share in the profits under the presumption that the original tenant will reoccupy the subleased space within the lease term. If a tenant is requesting to assign the lease the landlord will carefully consider the reason behind the request when making its decision.

The guiding principle for landlords/owners is to maintain control over their property by providing themselves with the most options/rights to manage changes in the market or their tenant’s financial condition. A property’s net operating income (NOI) sets the benchmark upon which it will be valued, but the risk associated with that income determines the capitalization rate to be applied, which ultimately establishes the property’s market value. The higher the NOI  and the lower the risk/cap rate the greater the value.

Montgomery County Submarkets Q3 2019

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Bethesda/Chevy Chase

  • RBA: 12,312,159 SF
  • Vacancy Rate: 12.1%
  • 12 Month Net Absorption: 16,500 SF
  • Average Asking Rent: $39.39
  • 12 Month Rent Growth: (1.2%)

Pre-leasing and new construction are the main themes of the Bethesda/Chevy Chase submarket. JGB Smith delivered 4747 Bethesda Ave in August 2019. This 5-Star office building was 80% leased prior to this and, in addition to serving as JBG’s new headquarters, will host Booz Allen Hamilton (65,000 SF), Host Hotels & Resorts (55,000 SF), and Orano (22,000 SF). Carr Properties will deliver another 361,000 SF, 5-Star Building at 7272 Wilson Ave in August 2020, which was already 60% leased in Q1 2019 with tenants such as ProShares (55,000 SF), Fox 5 (60,000 SF), and Enviva Partners (80,000 SF). Another 1,300,000 SF is under construction of which nearly 1,000,000 SF will be occupied by Marriott International, Inc. that is moving its corporate headquarters to 7750 Wisconsin Ave, set to deliver in January 2022.

Interestingly rent growth was negative this quarter, but this mostly the result of negative net absorption in the submarket’s 3-Star and 1 & 2-Star properties. Rent growth was actually positive for 4 & 5-Star properties (1.3%) and should continue to rise as new, trophy office space comes on the market. The strong demand evidenced by strong pre-leasing and new construction should continue but it will likely be marked by a flight to quality and an increasing disparity between average rents for 4 & 5-Star properties and 1, 2, and 3-Star properties.

North Bethesda/Potomac

  • RBA: 11,240,588 SF
  • Vacancy Rate: 15.1%
  • 12 Month Net Absorption: 74,000 SF
  • Average Asking Rent: $30.33
  • 12 Month Rent Growth: 1.3%

The woes of the North Bethesda/Potomac submarket can be attributed to large scale, government agency relocations and consolidations. The submarket has struggled to fill blocks of space vacated by the FDA, National Institute of Allergy and Infectious Diseases, and the National Cancer Institute. Vacancy levels hit 20.5 in Q2 2015 but have been gradually declining since and are at their lowest in over 5 years. Just as things were starting to look up, Marriott, the submarket’s largest tenant, will be vacating approximately 800,000 SF when it moves into its new headquarters at 7750 Wisconsin Ave (Bethesda/Chevy Chase submarket) in January 2022. This move will have a devastating impact to the submarket’s fundamentals; causing the vacancy rate to skyrocket and pushing rents down. The one bright spot and a bit of sweet revenge was ABT Associates relocation from the Bethesda/Chevy Chase submarket to 6130 Executive Blvd in Q1 of this year. The 130,000 SF lease deal had a notable impact on the submarket’s vacancy rate, but with new construction in neighboring, Bethesda/Chevy Chase, the North Bethesda/Potomac will be hard pressed to compete with demand with its aging inventory and lack of access to public transportation.

Rockville

  • RBA: 10,835,109 SF
  • Vacancy Rate: 10.8%
  • 12 Month Net Absorption: 62,000 SF
  • Average Asking Rent: $30.18/SF
  • 12 Month Rent Growth: 2.8%

At first glance, Rockville’s fundamentals look strong. The vacancy rate is below the metro average, and the past 12 months saw approximately 62,000 SF of net absorption with a corresponding 2.8% growth in rents. Despite these positive metrics the submarket has still not recovered from the Great Recession and is particularly vulnerable to large-scale, move-outs from government tenants. The submarket’s demand is driven by government agencies and the federal contractors that want to be close to them. Combined they account for over 40% of the office space in Rockville. Relocations by government tenants, such as the National Institutes of Health vacating 115,000 SF last year, have an oversized impact on a submarket such as Rockville because government-related businesses that support such agencies will seek to relocate as well to be in close proximity. Still Rockville is a Biotech hub with the U.S. Department of Health and Human Services occupying nearly 1,200,000 SF. If it can maintain this reputation is should be able to continue to attract companies in this rapidly growing field.

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