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Tenant lease concessions.

Assessments of commercial leasing markets throughout the United States reveal substantial vacancy levels, estimated at an average of 16 percent in urban centers and over 20 percent in suburban areas.

How are property managers responding to the surplus of space, greater competition, lack of real growth, and the general downturn in the real estate market? In several ways. First, managers are participating more actively in negotiations and entering them earlier on in the proposal stage. Second, more creatively structured leases are being developed to attract and retain tenants. Finally, the property manager is taking a much more proactive stance to accommodate and retain tenants.

Early considerations

As with any negotiating process, there are two goals to be met when structuring a lease arrangement: meeting the objectives of the manager while accommodating those of the tenant.

What are the objectives of managers? What do they look for in tenants? This, of course, varies as much among properties as among managers. Generally, one should look for matches in the following categories:

* The tenant's image.

* The tenant's credit quality.

* The tenant's desired use of space (back office or high profile).

* The lease term versus the lease rollover sc edule of the building.

* Tenant concessions that can be met by the manager that cannot be met by the competition.

* The economics of the transaction, including rights and obligations of the manager.

Tenants have a corresponding itinerary of concerns when selecting a manager, such as the following:

* What is the manager's reputation in the market?

* What is the manager's credit quality? Will necessary capital improvements be delayed due to weak financial status? Will services be cut off? Is the property overleveraged? Will the tenant have a new manager in six months?

* What is the quality of the physical building as well as the other tenants' spaces? Will the property provide the proper image?

* Will the property have the space necessary or helpful for the tenant's future expansion needs?

* What amenities are necessary or helpful for the tenant's business that this property may offer over its competition?

* What are some of the economics of the transaction including rights and obligations of the tenants?

If the fundamentals of the real estate, location, image, amenities, efficiencies, and/or qualities of the landlord do not satisfy the tenant's requirements, it is difficult for the concession package to overcome these shortcomings.

Control the lease transaction

Investors exercise control over the negotiations of a transaction through the use of concession packages. The asset manager exerts control over the negotiations of a lease by developing concession packages that satisfy annual business plans for each investment. In these business plans, the objectives for the particular properties are identified within the client's portfolio. Explicit leasing goals and the preferred deal structure are delineated.

Certainly, concessions offered are to a great degree dictated by the marketplace. A knowledge of the marketplace, however, positions an investor on a stronger footing to tailor the lease structure to meet his or her own objectives.

Investment managers can utilize a lease expiration schedule to assess the property's leasing exposure over the next 10 or more years. The future leasing exposure in conjunction with the existing vacancy determines how aggressive the manager wishes to get in the coming year. Additionally, it helps develop a game plan for early renewal of certain tenants, or buyouts of existing leases. With properties requiring extensive capital work, such as sprinklerization or asbestos removal, planning lease expirations is a particularly difficult process.

Categories of concessions

For purposes of clarifying how institutional landlord view specific con concessions, I have categorized more common lease concessions.

The first category is "up-front economic concessions." These are easily quantifiable concessions that get factored into the straight calculation of net effective rent. Free rent is an example. While some might not always agree on the exact value of these concessions, or what exactly net effective rent should be, everyone is generally comfortable with the process of evaluating these variables. At least both sides are dealing with essentially the same knowledge and the same common denominator--dollars.

For purposes of explanation, I have labeled the second category "flexibility concessions." By this group I am referring to variables whose value is more difficult to assess. The two parties negotiating the transaction may place different values on the concession. For example, an option to expand can be much more attractive to the tenant than to the manager.

A tenant may request an expansion option in year five of the lease for the next contiguous floor in a building. The tenant may not have immediate plans to expand, but is simply looking for flexibility. In this case, the value of the option may be very small to this tenant.

Assume, however, that the option space is currently occupied by a tenant whose lease expires two years before the new tenant's option to expand on that floor becomes effective. In all likelihood, the manager is looking at two years of costly downtime because he or she may view the likelihood of a short-term lease as small and feel obligated to deliver the space to the new tenant.

In this situation, an asset manager might counter the request for an option to expand by offering a first right of refusal. Should this offer be rejected by the prospective tenant, the investment manager might agree to the option but negotiate a two-year window in which he or she must deliver the space, in order to protect the investment.

There is no appropriate generic term for the third category of concessions, so I have labelled them "other." A common concern shared by most of the concessions in this category is their potential impact on other existing tenants and future leasing efforts. An example of this type of concession would be building signage.

As with flexibility concessions, other concessions often represent different intrinsic values to each of the parties negotiating a transaction. Obviously, the size of the transaction determines, to some degree, the bargaining position of each party. Assuming the investment advisor's portfolio is large and diversified, it is possible to negotiate multiple locations as well as multiple uses such as office and warehouse space with institutional investors.

Up-front concessions

* Free-rent concessions. These concessions are the most common concessions offered to tenants. One or two months of free rent is generally viewed as a cost of doing business as that is the time it would take to locate and negotiate with another tenant, even in strong markets.

As a long-term holder, managers do not generally have a problem meeting the normal market concession of free rent. However, they will not back load the deal so much that the rents for the last few years are significantly above what would be projected for the market rates at the time.

Some differential is acceptable, however, because it gives landlords an opportunity to discuss an extension that would amortize the current over-market rate over a longer period, which should be attractive to the tenant.

* Tenant improvements. Over-standard tenant improvements are viewed as investments in the future to some degree because they make it more difficult for competitors to attract current tenants when their leases expire. The level of tenant satisfaction is generally higher when a space is well appointed. Some upgrades are reusable, and it is certainly more justifiable for a tenant to spend hard construction dollars than to pay moving expenses.

* Base rent step-ups. Ignoring any significant time-value-of-money exposure, managers generally attempt to institute some form of escalation over the term, be it tied to CPI or to fixed steps in the contract. From the investor's perspective, it is preferable to see income increasing over time. In most instances, it also keeps the tenant tuned in to market rates so there is no sticker shock upon renewal of the lease.

* Operating cost pass-throughs. Pass-through provisions are treated very sensitively and are viewed as the manager's downside protection. Under a gross lease, the objective of the manager and tenant coincide more closely than the tenant often realizes.

When managers analyze their properties, they compare the tenant's total cost of occupancy (base rent plus pass-throughs) to market rental rates. Assuming equilibrium where the costs of occupancy equal market base rent, the lower the amount the tenant is paying for expense escalations, the more the manager is able to recognize on the bottom line.

Both manager and tenant have an interest in running the property as efficiently as possible. The lease should provide proper incentives for capital expenditures that save operating costs. Amortization of energy management systems or costs related to appeal of real estate taxes are commonly discussed.

* Lease buyouts. The institutional manager has certain objectives to meet when a lease buyout is necessary. First, assuming strong creditworthiness, often the manager would prefer that the original tenant stay on the lease. The manager's sole obligation in this case is simply to reimburse the tenant for rent. Second, to mitigate his or her costs, the manager wants to control the re-leasing procedure. This is a time consuming and inherently risky process. These objectives are not non-negotiable issues, but a manager would need to be highly motivated to undertake a direct assignment of a lease.

Flexibility concessions

Managers have a difficult time setting a fixed price renewal option past the 10th year of the lease. From the manager's perspective, a fixed option may impair the saleability of the project. Buyers may take a discount if they perceive the option price to be below market, whether or not the tenant knows if it will exercise the option.

The tenant, of course, is free to renegotiate the price if it is over market. Therefore, it is a no-win situation from the manager's perspective. Investment managers try to set prices tied to market rates with some discount. Additionally, long-notice provisions give some comfort to the manager.

Expansion and contraction options tend to create problems with respect to down time and stacking plans. In some cases, however, contraction options can be useful in phasing out a major tenant and spreading the re-leasing risk.

Other concessions

As previously mentioned, the common concern with most concessions is their effect on existing or future leasing efforts. Signage or building identity is often an issue with major tenants. The manager, at a minimum, must approve signage. In the long run, it is to the tenant's benefit to know that the manager has a consistent signage policy.

Prohibited concessions

Institutional managers cannot commit to any concessions that negatively affect the future sale or financing of the project or to concessions that may create long-term contingent liabilities. For example, a manager cannot allow a tenant the right to offset base rent against disputed charges or damages. This creates a level of uncertainty in cash flows that most lenders will not tolerate.

In buildings that contain asbestos, managers are reluctant to grant indemnities to the tenant for possible claims made against the tenant in the normal use of the space. In fact, managers should request indemnification from the tenant should it or its employees, contractors, and so forth, not comply with the hazardous material policy of the building. This is a relatively new issue raised in lease discussions and one that will receive greater attention in coming years.

Francis J. Decker, Jr. is vice president and director of investment management of the Real Estate Shop at Chase Investors Management Corporation, where he engages in a variety of supervising, management, and portfolio analysis activities. He is a certified public accountant and member of the American Institute of CPAs, the Massachusetts Society of CPAs, the Urban Land Institute, and the Pension Real Estate Association.

Chase Investors, a New York-based global investment management firm, has more than $33 billion in assets under management. Its Real Estate Shop manages over $5 billion.
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Author:Decker, Francis J., Jr.
Publication:Journal of Property Management
Date:Jan 1, 1991
Words:1960
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