Never before has the office market so dramatically shifted in favor of tenants. To survive, landlords must adjust to this new economic reality. Over the past year some regions saw vacancy rates shoot up as much as 50%, and more dark space is on the way as leases renew and job losses continue.
The situation is so dire that landlords with Class-A spaces, such as the Willis Tower in Chicago and 666 Fifth Avenue in Manhattan, are unsure if they'll be able to lease vacant space in the next three years, much less renew leases.
Tenants, who for years watched rents soar, are suddenly in the driver's seat. They are demanding more from cash-starved owners with bloated vacancies.
While tenants are justified in wanting to recoup losses, a long-term solution requires changes in the way both sides approach transactions. Commercial real estate transactions are complex, and tenants have an obligation to be informed about the best way to structure the real estate facilities and services they need.
Tenants should communicate effectively with landlords and test competing deal structures for the best economic and operational fit. For owners and investors, there is an even greater challenge as the market shifts to favor tenants. To prosper, owners must make three fundamental changes in their approach to tenants:
Provide greater leasing flexibility — Owners have begun to offer one- and two-year leases in prime commercial buildings, a trend that was unheard of until recently. Consider prime space in Manhattan, where 10-year leases have been the norm for decades.
Kushner Cos., a major owner-manager in the Northeast, directed brokers to promote one- and two-year leases at 666 Fifth Avenue, a prime Class-A property that recently sold for $1.8 billion or $1,200 per sq. ft., the highest price per sq. ft. ever recorded. Another owner, the Paramount Group, is advertising two-year leases at 1633 Broadway near New York's Times Square.
Focus on greater transparency — Commercial leases have long been filled with arcane language regarding costs. While tenants are responsible for the terms they agree to and should retain expert advisors, even the most sophisticated space users face bills they don't understand. A tenant can routinely be billed for hundreds of thousands of dollars, with little more explanation than a few line items on a one-page annual statement.
Operating expenses sometimes contain costs for owners' pet art projects, political contributions, jewelry purchases and ski trips. Based on our firm's review of expense charges since the mid 1980s, more than 80% typically contain errors that favor the building owner. We helped one tenant recover $5 million in HVAC overcharges billed in a three-year period by a highly regarded institutional owner.
Owners must recognize that tenants now demand objective monitoring and control of all lease-related costs. This accountability even extends to landlords' own financial stability. In a San Francisco-area transaction that closed last spring, Crate & Barrel delayed its commitment to 1.2 million sq. ft. of distribution space until the owner provided assurances it could meet its debt obligations.
View tenants as primary constituents — During the economic boom, many owners operated in a heady world of high finance. Each building represented a beautiful stream of cash flow, and often tenants were regarded as necessary inconveniences, subordinate to whatever lender requirements a landlord accepted to secure a mortgage.
These arrangements often resulted in leases with excessive restrictions on tenants' rights, putting them at risk and sometimes limiting tenants' day-to-day operations. For example, a tenant could be prohibited from repairing a leaking roof, subleasing space or making alterations until a lender assessed the situation and responded.
In the new economy, owners and investors will need to strike a better balance between their capital needs and tenants' business operations. After all, it is the tenants' timely rental payments that generate all value in commercial real estate.
The building owners who will prosper in this changed environment will embrace greater transparency and put tenants before investors because tenants are their true capital source. The most successful landlords also will partner with tenants to infuse leases with the flexibility and transparency business requires in today's constantly changing world.
Marisa Manley is the president of New York-based Commercial Tenant Real Estate Representation Ltd. (CTRR). She can be reached at [email protected].