Costly Tenant Leasing Mistakes Can Be Avoided

The Power of Leverage and Competition When Entering the Market

Timing Considerations

There's an old broker's saying that it is never too early to start looking for space. While this may have a nice ring to it, it is probably not all that accurate. The truth is, there is a definite window of time to position a tenant optimally to sign a lease (whether to renew or relocate). The window has closed when there is insufficient time to commit to the longest lead time alternative. The opening of the window is a bit more difficult to determine, and depends largely on market conditions.

Stated simply, the ideal time to enter a market is early enough to ensure that all options can be considered (for some tenants, this means a sufficient time for a new building) but close enough to lease expiration as to be an attractive candidate to the prospect buildings. In the current market, for a typical office lease (10,000 ' 30,000 rentable square feet), the ideal time is approximately 12-18 months in advance of a lease expiration date ' or, if a build-to-suit is being considered, two years.

In addition to leaving sufficient time for your longest lead-time alternative, it is important to leave a “float” period ' or time to break a deal and go with a different alternative ' should the deal begin to fall apart during negotiations or deal terms begin to erode. We have shown our clients a relatively simple graph to illustrate leverage in landlord-tenant negotiations, and the one thing that is clear is that the leverage shifts completely from the tenant to the landlord as soon as the time to make a different choice is gone.

Landlords can be very adept at giving vague responses up until that shift in leverage ' at which point the word “no” seems to be used a lot more frequently. Consequently, a law firm or other commercial tenant should not wait too long to make a deal. The question still remains: when is it too early to enter the market? For an anticipated move to a new location, a tenant has to keep in mind that building owners are, by nature, optimists. The deal to fill the building is always, “just around the bend.” Accordingly, even if a building has a vacancy that is perfect for your firm or company, the landlord is not going to hold it open if it believes that it will forego other opportunities while waiting for your lease to expire. If a renewal is the likely outcome, starting too early can telegraph a reticence to move which, if understood and appreciated as such by your landlord, decreases its interest in providing an aggressive renewal proposal. Conversely, if the stay-put landlord has no reason to expect a renewal, it has a greater incentive to propose its most competitive pricing.

Having examined leverage, the next step is to analyze competition, or how leverage is used to optimize lease terms.

Market Forces: Competition in Leasing

Your lease is scheduled to expire in three years and your landlord approaches you with a ten-year renewal. He shares rental rates published for other spaces in your building and offers a deal starting at $1 per square foot below these rates. There are several factors to consider before signing on the dotted line.

Virtually every aspect of a commercial lease transaction is negotiable. As with any negotiable transaction, one can assume that the first offer made is not necessarily the best offer to be had. The key to a winning negotiating strategy is to identify a number of viable building alternatives with suitable availabilities that are deliverable on-time.

Having alternatives serves two important purposes. First, it forces the landlords whose buildings are under consideration to compete for the tenant's deal. As negotiations progress, quoted occupancy costs will be driven down and tenant concessions improved. Eventually, competition will force the best deal to emerge from the pack. Deals cannot be evaluated in a vacuum. By comparing alternatives, tenants can evaluate the relative merits of each and assess at what price point each alternative could become their first choice.

The other benefit to a well-run competitive process is that it will help bring to light other potential costs of occupancy that might not have been apparent from the initial offers (such as common area expense and tax pass-throughs, required base building-upgrades and fit-out costs). This improved transparency will provide the tenant's broker with valuable information needed to compare the deals being offered properly and ultimately allow the tenant to make a more informed decision.

The bottom line is, if a tenant is negotiating with just one landlord, that landlord has the advantage, as it is operating in a virtual monopoly. With proper timing and competition, a tenant should be able to drive down the rent, but beware' it is not always about the cheapest rent.

Occupancy Costs: It's Not Always the Rent

Assume there are two buildings with the required vacancy. Your broker advises you to engage an architect to do test fits of the spaces. Why should you incur the time and expense of hiring an architect when one of the spaces has a lower rent along with new carpet and a fresh coat of paint? When you are in the market to lease commercial office space, accepting the proposal with the lowest dollar per square foot rent does not necessarily mean you are getting the best deal.

To analyze the expenses associated with an offer properly, one must look at overall occupancy costs, for which there are three main drivers:

• Rental Rates;
• Square Footage; and
• Fit-Out Costs.

In order to understand the full financial impact of all of the occupancy cost variables, it is advisable to engage an experienced architect. A good architect analyzes a building's space and helps determine how a tenant's personnel fits into it most efficiently. Also, the architect can help determine the costs of needed tenant fit-out as well as any building system upgrades. To better understand how a tenant's broker can use the information provided by an architect, we will examine the impact of two of the occupancy cost drivers; rent and square footage.

For this example, assume the tenant is considering two different buildings. Building 1 is offering space at $25 per square foot per year, while Building 2 is offering space at $23 per square foot per year. At first blush, it appears as though Building 2 would be a good deal because the rental rate is lower than that in Building 1. However, assume that the architect analyzes the space in each of these two buildings and determines that the tenant will need 25,000 square feet to fit into Building 1 properly, but will need more space ' 30,000 square feet ' in order to fit into Building 2. Thus, the occupancy cost for Building 1 will be $625,000 ($25 x 25,000 sq. ft.) and for Building 2, it will be $690,000 ($23 x 30,000 sq. ft.). Even though the base rental rate for Building 2 is lower, it will actually cost the tenant $65,000 per year more than Building 1.

As shown above, the information provided by an architect can be critical in helping the tenant and its broker analyze the quality of each deal offered. Moreover, the results of its analysis will provide the tenant with valuable leverage to negotiate a better offer for each prospect building.

Takeaways

• It is essential to manage the timing of lease negotiations to avoid shifting leverage from the tenant to the landlord.
• Alternatives are key to successful negotiations.
• The lowest rent is NOT always the best deal.

The conclusion of this article will discuss construction costs and turnkey solutions.

Douglas E. Simon is a Senior Associate at Tactix Real Estate Advisors, where he focuses on law firm real estate leasing. He can be contacted at [email protected]. Formerly a partner at Dechert, Richard Bendit joined Tactix in 2006. He can be contacted at [email protected].

By Douglas E. Simon and
Richard A. Bendit

For today's law firms (and their clients), leasing commercial real estate is rife with opportunities for failure. Even when tenants manage to navigate the issues of rent and space configuration successfully, mismanaged construction costs can easily turn a good deal bad. Furthermore, because a typical law firm or company goes through the leasing process only once every five, seven or 10 years, it is quite common to encounter costly problems or pitfalls.

Moreover, since real estate costs typically rank very high on a commercial tenant's list of individual expenses (second only to payroll), these mistakes can significantly impact a tenant's profitability. With this as background, it is extremely constructive to review some of the big mistakes that can be avoided by proper planning and guidance. This two-part article will provide a list that is by no means exhaustive, but an awareness of these problems, will help start the search on the right track.

The Power of Leverage and Competition When Entering the Market

Timing Considerations

There's an old broker's saying that it is never too early to start looking for space. While this may have a nice ring to it, it is probably not all that accurate. The truth is, there is a definite window of time to position a tenant optimally to sign a lease (whether to renew or relocate). The window has closed when there is insufficient time to commit to the longest lead time alternative. The opening of the window is a bit more difficult to determine, and depends largely on market conditions.

Stated simply, the ideal time to enter a market is early enough to ensure that all options can be considered (for some tenants, this means a sufficient time for a new building) but close enough to lease expiration as to be an attractive candidate to the prospect buildings. In the current market, for a typical office lease (10,000 ' 30,000 rentable square feet), the ideal time is approximately 12-18 months in advance of a lease expiration date ' or, if a build-to-suit is being considered, two years.

In addition to leaving sufficient time for your longest lead-time alternative, it is important to leave a “float” period ' or time to break a deal and go with a different alternative ' should the deal begin to fall apart during negotiations or deal terms begin to erode. We have shown our clients a relatively simple graph to illustrate leverage in landlord-tenant negotiations, and the one thing that is clear is that the leverage shifts completely from the tenant to the landlord as soon as the time to make a different choice is gone.

Landlords can be very adept at giving vague responses up until that shift in leverage ' at which point the word “no” seems to be used a lot more frequently. Consequently, a law firm or other commercial tenant should not wait too long to make a deal. The question still remains: when is it too early to enter the market? For an anticipated move to a new location, a tenant has to keep in mind that building owners are, by nature, optimists. The deal to fill the building is always, “just around the bend.” Accordingly, even if a building has a vacancy that is perfect for your firm or company, the landlord is not going to hold it open if it believes that it will forego other opportunities while waiting for your lease to expire. If a renewal is the likely outcome, starting too early can telegraph a reticence to move which, if understood and appreciated as such by your landlord, decreases its interest in providing an aggressive renewal proposal. Conversely, if the stay-put landlord has no reason to expect a renewal, it has a greater incentive to propose its most competitive pricing.

Having examined leverage, the next step is to analyze competition, or how leverage is used to optimize lease terms.

Market Forces: Competition in Leasing

Your lease is scheduled to expire in three years and your landlord approaches you with a ten-year renewal. He shares rental rates published for other spaces in your building and offers a deal starting at $1 per square foot below these rates. There are several factors to consider before signing on the dotted line.

Virtually every aspect of a commercial lease transaction is negotiable. As with any negotiable transaction, one can assume that the first offer made is not necessarily the best offer to be had. The key to a winning negotiating strategy is to identify a number of viable building alternatives with suitable availabilities that are deliverable on-time.

Having alternatives serves two important purposes. First, it forces the landlords whose buildings are under consideration to compete for the tenant's deal. As negotiations progress, quoted occupancy costs will be driven down and tenant concessions improved. Eventually, competition will force the best deal to emerge from the pack. Deals cannot be evaluated in a vacuum. By comparing alternatives, tenants can evaluate the relative merits of each and assess at what price point each alternative could become their first choice.

The other benefit to a well-run competitive process is that it will help bring to light other potential costs of occupancy that might not have been apparent from the initial offers (such as common area expense and tax pass-throughs, required base building-upgrades and fit-out costs). This improved transparency will provide the tenant's broker with valuable information needed to compare the deals being offered properly and ultimately allow the tenant to make a more informed decision.

The bottom line is, if a tenant is negotiating with just one landlord, that landlord has the advantage, as it is operating in a virtual monopoly. With proper timing and competition, a tenant should be able to drive down the rent, but beware' it is not always about the cheapest rent.

Occupancy Costs: It's Not Always the Rent

Assume there are two buildings with the required vacancy. Your broker advises you to engage an architect to do test fits of the spaces. Why should you incur the time and expense of hiring an architect when one of the spaces has a lower rent along with new carpet and a fresh coat of paint? When you are in the market to lease commercial office space, accepting the proposal with the lowest dollar per square foot rent does not necessarily mean you are getting the best deal.

To analyze the expenses associated with an offer properly, one must look at overall occupancy costs, for which there are three main drivers:

• Rental Rates;
• Square Footage; and
• Fit-Out Costs.

In order to understand the full financial impact of all of the occupancy cost variables, it is advisable to engage an experienced architect. A good architect analyzes a building's space and helps determine how a tenant's personnel fits into it most efficiently. Also, the architect can help determine the costs of needed tenant fit-out as well as any building system upgrades. To better understand how a tenant's broker can use the information provided by an architect, we will examine the impact of two of the occupancy cost drivers; rent and square footage.

For this example, assume the tenant is considering two different buildings. Building 1 is offering space at $25 per square foot per year, while Building 2 is offering space at $23 per square foot per year. At first blush, it appears as though Building 2 would be a good deal because the rental rate is lower than that in Building 1. However, assume that the architect analyzes the space in each of these two buildings and determines that the tenant will need 25,000 square feet to fit into Building 1 properly, but will need more space ' 30,000 square feet ' in order to fit into Building 2. Thus, the occupancy cost for Building 1 will be $625,000 ($25 x 25,000 sq. ft.) and for Building 2, it will be $690,000 ($23 x 30,000 sq. ft.). Even though the base rental rate for Building 2 is lower, it will actually cost the tenant $65,000 per year more than Building 1.

As shown above, the information provided by an architect can be critical in helping the tenant and its broker analyze the quality of each deal offered. Moreover, the results of its analysis will provide the tenant with valuable leverage to negotiate a better offer for each prospect building.

Takeaways

• It is essential to manage the timing of lease negotiations to avoid shifting leverage from the tenant to the landlord.
• Alternatives are key to successful negotiations.
• The lowest rent is NOT always the best deal.

The conclusion of this article will discuss construction costs and turnkey solutions.

Douglas E. Simon is a Senior Associate at Tactix Real Estate Advisors, where he focuses on law firm real estate leasing. He can be contacted at [email protected]. Formerly a partner at Dechert, Richard Bendit joined Tactix in 2006. He can be contacted at [email protected].