The Difficult Decisions facing Commercial Landlords

As a counterpoint to all the doom and gloom in the news, especially if you're a residential property owner anticipating a massive increase in your mortgage payments, I thought it might be a good time to take you behind the scenes into my own world as a commercial landlord.

As anyone who has commercial assets will know, we often face some difficult decisions!

Some background

We have some assets in our portfolio that we have owned for about 25 years. Our standard practice used to be that we would develop from scratch, a brand new commercial property and convince a great tenant to enter into a long lease. Leases today are not like they used to be: when I first started my career a typical lease ran from 25 to 35 years, nowadays you'll be lucky to see 15 years!

In the past we would sign a long lease on a new building and the tenant would pay us quarterly in advance for next quarter century - everyone was happy! Back then having a long lease on a commercial property was a bit like owning an ATM - regular cash paid out on a regular basis!

But what happens when you reach the end of the lease?

I'll give you an example - one of the buildings I look after has been in our portfolio for about 20+ years with the same well established tenant we signed the lease with way back when the building was new. They were given an excellent building and we built a great working relationship with them. However when they reached the end of their lease they decided to move on.

In a sense I can’t blame them – with so many newly built buildings out there, they could move straight from our last generation asset into a brand-spanking-new office building with all the bells and whistles. Of course we offered various incentives in an effort to persuade them to stay, but alas in this particular case, after so many years in business, their model had changed, they had different drivers motivating them to choose a specific location. So after 20+ years, they handed the building back to us.

What happens next?

When a commercial tenant hands the building back, typically a ‘Schedule of Dilapidations’ will have to be compiled – this is where our professional advisors go through the floor or building identifying things that require repair, refurbishment or replacement.

When then tenant signed their lease all those years ago, they took on the obligation to fully maintain all the plant & equipment and to return the building back to us in the same condition it had been given to them at the start of the lease - as you can imagine, after 25 years this can start to add up.

When the schedule of dilapidations is complete, we send it to them and after some negotiations it is typically settled by them agreeing a pay us a specific sum of money in lieu of the physical work. This sum can obviously vary, but it would not be usually for it to equate to 6-12 months’ of rent depending on its condition.

The first difficult decision

It is at the point when the first of your difficult decisions has to be made: what are you to do with the building? As the landlord you’ve just been handed a chunk of money, but what should you do with it?

Lets not forget, the tenant has now left the building, so you won’t have their rent coming in anymore, that final payment is going to have to last you until you sign up your next tenant. This is where your choices start to run out - do you save the money and try to rent what you have, or do you spend the money on bringing the building up to a newer standard?

There’s a lot you need to consider: What’s the current market cycle? What supply and demand issues does the market currently have? Are there a lot of tenants looking for space? What is your competition doing? What is your own situation? Do you have income coming from other assets that can help you bridge the gap?

If you have just this one asset, it puts you in a more difficult situation, because 100% of your income has just stopped. This is a really tough decision – if you do spend that money upgrading the building, will you secure a new tenant quickly, or is there a risk it sit there empty anyway? Do you instead hold onto the money and try to make do with what you have, perhaps in a somewhat shabby state - no doubt this will make it more difficult to rent (or the tenants will demand a discounted rent)?

This is why understanding the market cycle is so important. If there are hundreds of tenants out there looking for space, you might be able to find someone to take the building as is.

But if there are a lot of buildings available out there and only a handful of tenants, then the shoe is on the other foot. You will be up against other landlords offering attractive incentives to secure the tenants. This is when your decision not to smarten up the space comes back to bite you!

To refurb, or not to refurb?

So, do you refurbish the building? Of course, you will have to tidy it up a certain amount - this is where the money you got from the outgoing tenant will come in handy. But the problem is, rarely does the payment cover the full cost of these refurbishment works. You may need to inject more of your own capital in to make up the difference - the question is, do you have enough to cover this and continue to pay down any debt??

When you’re considering refurbishment, you also have to consider the age and condition of the building, as it can heavily influence the scope of the project. If the building is old it may require a comprehensive overhaul of the equipment and plant (boilers, aircon) and this can cost a lot of money. In my experience this usually costs more than the annual rent!

So what kind of return on investment are you looking for if you are expected to spend that kind of money? Alternately, what would the ROI look like if the building works are only small? What is you decide to forgo all the bells and whistles that new buildings are offering and just go with a paint job and some new carpeting - will it be enough to get you by?

We bring in our professional teams – property agents, engineers, architects, contractors – to advise on the cost and we end up with a lot of views and reports. Sometimes these views of one advisor will be the opposite and it contradiction of another - this is where it gets difficult: how do you make a final decision when you have so much information to process?

Regardless of the advice, only you can make the final decision, because ultimately it is you who is left with the completed building still left to rent.

Even though our building was handed back to us in a very presentable condition, when you lift the lid and look under the bonnet you realise the systems are quite old and need replacing, especially things like the mechanical and electrical services – the aircon, the elevator, the boiler, the lighting… the list goes on!

Changing things up

If you’ve had a large single tenant occupying the entire building up until now, you're also going to have to think about the configuration of the newly refurbished building. When a building is rented to one tenant it is configured a certain way, but if its rented to multiple tenants the layout can be quite different.

What if your advisors are telling you it will be easier to rent if its converted from a single tenant layout to one suitable for multiple tenants? This can be a very costly conversion, requiring electrical and mechanical systems to be split and duplicated.

Also for example, a large tenant may have a canteen and a large comms/server room. Perhaps they had a big boardroom alongside lots of smaller meeting rooms on a particular floor. But with multiple tenants taking a floor each you’re going to need to configure each floor differently: multiple kitchenettes will replace a single canteen and a server closet on each floor will replace the large server room.

You also need to consider your lobby as well - a large single occupier may have a receptionist, but when the building is split into separate floors the receptionist may disappear, replaced with a tenant directory mounted on the wall by the elevator?

These are all important decisions, but remember they are all speculative. Whether you decide to tear out the canteen or reconfigure the lobby, you are often making the decision with zero clarity as to who the ultimate occupier is going to be. Three tenants might sign up quicker than one, but will all the expenses of that conversion be worth it? And what if a single occupier comes along after you did all the work?!

No easy answers

The smartest thing you can do is develop a great network of connections into existing occupiers so that you stand a better chance to secure one of them as your next tenant before you start the work. That way you’re able to offer a bespoke service with the benefit of their input, what they’re prepared to pay, how they want it configured, and you'll be assured to know your new income stream is just around the corner. It also saved the tenant a lot of money too!

Obviously, this is much easier said than done because tenants aren't always willing to make decisions in a time frame that suits you.

At the end of the day, owning a commercial asset can be very rewarding, but it would be a critical error on your part to overlook the fact that you must maintain and reinvest in your asset – obsolescence is a huge risk these days, especially when you consider the constantly changing workplace environment, property technology and expectations around sustainability and climate action. Take advice when you can, pay close attention to market trends, and build your network so you can make informed decisions rather than being guided by your gut.

If you'd like to gain a better understand the real estate investment process, consider subscribing to my YouTube channel - Gavin J Gallagher on Real Estate.