Contradictions in Logic

These days, the resetting of capital stacks (the ownership structures for office buildings) is most often facilitated through selling the building.? The current market sale dynamic typically involves one set of financial partners (equity, lenders) taking big losses to permit a new set of investors and lenders to “reset” the capital stack on economic terms that provide a pathway to success (e.g., a productive investment).

In many cases, the assets being acquired have significant vacancy.? New owners have a couple of options when considering the best pathway to success.? The quality of the asset and the market value of the vacant space is a factor.? But much of the available space in the buildings which are now trading at steep discounts to their prior value is commodity space, meaning it is average in its appeal, it does not stand out as uniquely desirable.? The owner’s playbook calls for amenities as a first line of defense against irrelevance.? This is why we’re seeing so many building owners spend heavily on new amenities like high-end conferencing facilities and tenant lounge spaces.? Next, these new owners must decide what to do with vacant space.? In many cases, the prior financial partners (the broken capital stack) had no money to spend on tired, second or third generation spaces.? These spaces are not marketable in their current state, so at a minimum, new owners must plan to “white box” (demolish all existing improvements and bring the space to warm shell condition) available spaces.? But even in clean warm shell condition, office floors can be tough to lease when tenants are less committed to building new space and leasing for long terms.? Smart owners are closely monitoring tenant demand and speculatively building new office space in a variety of size increments.? These “spec spaces” are move-in ready.? This is a smart strategy as it addresses one of the big impediments to getting deals done today, the cost of tenant improvements.?

However, we’ve noticed an interesting contradiction in the market.? In some cases, the same landlord who is proceeding to build new spec spaces, spaces it will lease for shorter term (3-5 years), balks at the idea of building new space for a tenant on a 5-year term. This will present challenges as it’s quite possible one of the longer-term realities of post-pandemic office leasing will be occupiers’ insistence on greater flexibility (e.g., reduced term commitment).? The long-term office lease was always a bad fit for tenants whose business needs are constantly changing. ?Landlords building and leasing spec spaces for shorter term smartly recognize the tenant’s dilemma. ?Yet, in refusing to build new space for a tenant on a 5-year term, they seem to contradict ?themselves.?

It's true that current market rental economics (in most cases) don’t allow for net-positive outcomes (e.g., profitable) when underwritten over terms of less than 7 or 8 years.? It’s also valid for landlords to stop short of building highly unique office space, designed to meet the individualized needs of a given tenant over a short-term lease.? Ultimately, the solution may be for tenants seeking shorter-term leases on shell space to agree to design schemes which the landlord deems consistent with what it would otherwise build speculatively.?

Ask TenantSee Weekly

Our landlord is building new amenity spaces.? How do they allocate the cost of this space??

It’s increasingly common for landlords to spend heavily on amenities.? While these amenities may benefit tenants by enhancing the building experience, it’s important to understand how the cost can impact your lease. For starters, the extensive capital spending must be treated correctly in the lease.? Capital investments should be amortized over their useful life.? This will mitigate the tenant’s exposure to large increases in operating costs due to the distribution of capital expenses over short periods.? Further, the operating costs of amenity spaces must be fully understood.? We’re aware of some examples in the market in which landlords are passing through artificially lower operating costs in the early years of new amenity spaces, while the building is still being leased.? These landlords intend to pass through the total cost once the building is fully leased, creating the potential for large increases in operating costs which are not properly reflected in the base year.? Amenities can be a great addition to any building, but their cost must be fully understood by tenants.