Is base rent going to drop dramatically?

Everyone in commercial real estate, brokers, ownership, lawyers and tenants are wrestling with this question. In order for ownership to reduce the base rent on their buildings to the extent that some in the industry feel is necessary, 20 - 30%, they would need to re-negotiate the terms on the underlying mortgage of the property. When an entity goes to buy a commercial building the commercial mortgage is underwritten based on existing leases and what the buyer and lender think the buyer can lease the vacant space. Then they subtract the operating costs for the building and property taxes. This gives them the Net Operating Income (NOI). To determine how much a buyer can borrow, the lender and buyer will negotiate a cap rate and the Loan to Value (LTV) ratio. These are determined by the risk factors and operating history of the buyer. The buyer will want a lower cap rate and a higher LTV and conversely the lender will want a higher cap rate and lower LTV So, if a building borrowed $100 million at $42 per square foot and they want to drop that by 25% they would now be able to borrow $75 million and they would need to write a check for $25 million to pay off the old loan. It is also worth mentioning that virtually all commercial loans are interest only loans and they usually have a seven to ten year term. Meaning unlike a home mortgage you are not paying down the principle. Also, building owners either pay off the old loan with a new loan or with the proceeds of the sale of the building. Hence the relatively short term of the loan.

The moral of the debt part of this story is well capitalized owners will be better equipped to weather this storm / renegotiate the terms of their mortgages.

Another obstacle to a building's ownership reducing the base rent to this extent is the underlying costs to operate a building. Ownership's base operating costs can range as low as $22 to as high as $40 per square foot. The higher end of the scale usually involves buildings with a ground lease. The two elements of Ownership's costs are operating costs and property taxes. So, in order to be profitable a building's ownership would need to cover these costs.

In conclusion, I think that landlords will likely lower rent slightly from what they were asking prior to the crisis and offer richer tenant incentive packages and thus delivering for their tenant a discounted effective rent in the range of what some are talking about (20 - 30%).

By maintaining base rent they do not have to go through the exercise of renegotiating the debt on the building. Also, by reducing base rent by say five to ten percent, they will maintain the valuation of their building.

Finally, it is harder to grow the price per foot, because of the long term nature of most commercial leases and it is easier to offer more free rent, tenant improvement allowance and in the short term discounted rent that is amortized over the term of the lease and unwind these incentives when the lease is up for renewal.

If you would like to learn how this applies to your specific situation then call or email me to set up a call or Zoom to discuss.

Michael Adler - 917-721-6437 - [email protected]