What's the Rate?

If you look at the quarterly market reports provided by all major real estate service firms (Cushman & Wakefield, included), you will find that rent data is typically expressed in terms of “Asking Rents”.? Reports will cite the trend in Average Asking Rents by submarket, or by building class.? This is a somewhat misleading indicator.? Why?? Because it does not reflect the rent after negotiations, which often includes reductions in rate from the Asking Rate and potentially significant landlord-funded concessions.? In other words, Asking Rents reflect what landlords are asking, not what they’re getting.

Even if market reports cited the actual rental rates tenants have contracted to pay in leases (“Face Rates”) they wouldn’t accurately reflect the true value of the space in the market. These values are only reflected in “Net Effective Rates”, rates derived after deducting the value of landlord-funded concessions from the Face Rent.? Net Effective Rate is a much better proxy for market value.

Why so much complexity?? It’s because a key chapter in the modern landlord playbook calls for the financial engineering of higher Face Rates.? ?This is because assets are valued by capitalizing net operating income (“NOI”) which is a byproduct of Face Rate.? The higher the Face Rate, the higher the NOI, the higher the value.?

Here’s an example of how this might play out in a proper market-based negotiation.? Tenant tours a space with broker and decides to include it on a short list of sites with which to negotiate.? Landlord’s initial proposal indicates a $70/sf starting rent with 3% annual increases over a lease term of 8-years, with 3 months of free rent and $50/sf in landlord-funded tenant improvements.? The Average Net Effective Rent (before deducting operating expenses and taxes) for the proposed transaction is $69.41/sf (assuming a straight-line amortization of the $50/sf tenant improvement allowance).? This, despite an average Face Rent of $77.81.? In other words, there is already an $8.40/sf gap between the Average Face Rate and the Average Net Effective Rate associated with the landlord’s initial offer.? Now, let’s say the market value of the space is an Average Net Effective Rent of $55/sf.? The question becomes how can the tenant get full market value while the landlord still preserves its minimum Face Rent requirement?? The answer lies in the concessions.?? For sake of this example, imagine the landlord must preserve a Face Rate of $65/sf.? To meet the market value and secure the tenancy, the landlord must enhance the concessions.? To do so, it might double the amount of the tenant improvement allowance from $50/sf to $100/sf, drop the Face Rate to $65/sf, and increase the free rent from 3 months to 7.? This yields an Average Net Effective Rate of $55/sf, in line with market.

Data is everywhere today.? But do you have the right data, and/or, do you know what to do with it?? The role of a great tenant advisor it to help identify the right data, correctly interpret its meaning, and use it to develop a strategy that ensures its tenant client achieves maximum market value. ?????

Ask TenantSee Weekly

This week’s question:? We are thinking about exercising the renewal option in our lease since we like our space and it seems like the easiest way forward.? Are there any downsides??

Yes!!!? An important question!? Glad you’re asking now, before exercising the option.? Most renewal options should not be exercised as they result in a worse outcome for the tenant.? Many renewal options are tied to fair market value, but the definition of fair market value can vary wildly from one lease to the next.? The quality of outcome in exercising a renewal is, in fact, directly correlated to the quality of the option language as it was negotiated in the lease document.? We’ve seen instances in which fair market value is correlated with assets that are not comparable to the tenant’s building, assets which are materially better and therefore command much higher rent.? We’ve seen instances in which fair market value is limited to deals the same landlord has done in its building, a construct which totally disables the value of the broader market.? Most importantly, exercising the renewal mitigates a tenant’s leverage when the market is soft (as it is currently).? Landlords want you to exercise because it almost always results in a better outcome for them.? The only times a renewal should be exercised include when it is at a fixed value which is demonstrably lower than the tenant would otherwise expect to pay for comparable space (rare) or when the market is very tight and there is a threat the tenant’s space could be leased to another tenant from within the building or the outside market (e.g., as a defensive measure).? So, in your case, while we’d need to see your lease, we’d be willing to bet you’re better off not exercising.? Instead, take the time to survey the market and negotiate with other landlords, in addition to with your existing landlord.? This is not as easy as signing a piece of paper, but it will enable you to save significantly on the cost of your next lease.