Since the cost of office space is second only to salaries on the typical firm’s balance sheet, it’s a given that minimizing rent could materially benefit the bottom line. However, unlike salaries and other fixed costs, minimizing office rent poses a unique challenge because facilities costs are beholden to an ever-fluctuating real estate market. Whereas most fixed costs can be easily modified to fit changing market realities, a firm’s lease contract does not generally provide a mechanism for market readjustment. What recourse do you have?
The current economic downturn has drastically changed the commercial real estate landscape. In most major metropolitan markets, effective rents have dropped between 25 and 30 percent from their peak in the first quarter of 2008. This seems to put firms with leases that were “locked in” during the real estate run-up at a tangible competitive disadvantage. However, there are ways to renegotiate an above-market lease and capture some of the cost savings associated with the current commercial real estate downturn. So, while firms with two or more years of remaining lease term frequently believe their negotiating leverage with their landlords to be limited, this is not always the case.
A Brief Primer on Commercial Real Estate Finance (And Why It Matters)
During the recent economic boom, it was a maxim that credit was cheap. Because of the ubiquity of cheap credit, for nearly a decade high-rise office buildings were traded at a dizzying pace. Commercial landlords profited by “projecting” future rents, assuming that their tenants would bear increases that sometimes amounted to 20 percent or more per annum. Lenders eagerly bought in to these assumptions, and provided financing for building purchases based almost solely on these projected rents—projections that bore little resemblance to what tenants could (and would) pay.
For landlords, this meant that it often made more sense to let space go vacant than to lease it. As long as credit was available to finance someone else’s purchase of a building based on projected rents, landlords could have a partially vacant building with a few tenants paying top rents and the ability “on paper” to lease the vacant space at those same high numbers—this rather than follow the traditional model of maintaining tenants and paying down serviceable debt with rental income. While they lost immediate rent money, they gained far more in increased building value. The net effect was that during the run-up, rents skyrocketed, and many landlords became disinclined to service their existing tenants.
However, now that cheap credit is no longer available, and purchase and sale activity in the office sector is nearly dead, a more traditional landlord-tenant relationship has emerged. The new maxim in commercial real estate is that “occupancy is king.” Landlords actually have to service the debt that encumbers their property, and the only way to do this is to maximize the number of dollars each asset produces, even if that means abandoning their past rent projections.
Generally, two things can help the distressed landlord finance short-term debt: cash and additional lease term. And both are factors you can use to create leverage with landlords. The cash represented by your rent payments will obviously help the landlord meet its immediate debt obligations, while your additional lease term makes a building appear more stable to investors, which makes refinance or sale easier. But to get better terms, your firm must convince the landlord that its long-term tenancy is more important than the immediate benefit of the spread between what the firm is currently paying and what the market will pay. Here are pointers on how to proceed.
Step One: Put Together a Long-Term Plan
Before negotiating additional lease term, you must first grasp the size and scope of space that your firm can reasonably expect to occupy once your existing lease expires. Work with your broker, architect and business advisors to ensure you are adequately preparing for any growth that may occur in the upcoming lease term, while not obligating the firm to space that will not be necessary in the extended lease term.
Step Two: Create Leverage with Your Current Landlord
Once you know how much space you can expect to occupy, you then set about creating the leverage necessary to convince the landlord to lower its existing rent obligation. This can be done in two ways. You can create a credible risk of default in the event that current rent is not lowered, or you can convince the landlord that another building owner will allow the firm to move early and will assume the existing obligation in exchange for a long-term commitment.
In either case, engage a real estate broker to assist in the leverage creation process. A broker can help make the risk of default more credible by helping the firm negotiate on less expensive or smaller space within the submarket while making the landlord aware of this activity. With the recent rash of law firm collapses, landlords are particularly sensitive to this risk. The broker can also help locate landlords within the firm’s submarket that may be amenable to assuming an existing obligation in order to gain your firm’s tenancy.
Then work with your broker and real estate counsel to evaluate your existing lease. Firms frequently find that when their lease is audited in detail, there may be termination rights or the existence of landlord default clauses of which they were not aware. The existence of an out is obviously very useful leverage in convincing a landlord to renegotiate existing obligations.
Step Three: Negotiate with Competing Landlords
Assuming no credible termination rights exist, go to the market and actively negotiate with competing landlords for relocation terms. Obviously, if you have 10 or more years remaining on your lease, few landlords will consider assuming the existing obligation. However, firms are frequently surprised by the willingness of landlords in a competitive market to eat an attractive tenant’s existing obligation and steal a rent-paying target from a competitor.
Also of note for law firms: In addition to taking advantage of lower rental rates, relocation can help solve issues associated with the accumulation of excess space, which many firms now face as a result of the economic downturn.
Once relocation space is found and negotiated, your next step is to go back to your current landlord and request a restructure of your above-market obligation. During the market survey process, firms frequently determine that it actually makes more sense to move early into new space. It is in the landlord’s best interest to pay keen attention to a firm’s demands at this juncture.
Luke Raimondo is an attorney and commercial real estate broker. As Managing Director of Travers Realty’s San Francisco office, he represents law firms nationwide on facilities issues.