How the Capital Markets and Current Drop in Property Values Can Work to a Tenant's Advantage

The lack of sales comparables in the market right now makes it difficult to determine exactly how much value deterioration there has been, but it is safe to assume that values are down close to 40% off the peak for many markets around the country. It is easy to see how values have changed so dramatically when you look at some of the variables that have changed over the past twenty-four (24) months. The most often used benchmark of value has been the capitalization rate (cap rate) at which a property trades. Cap rates are essentially the net operating income (NOI) divided by the purchase price. Market cap rates have moved upward 150-250 basis points in most instances. Combine such upward movement with a 10%-15% reduction in rent rates, and the effect is a decrease in a property's value by 20% or more. Of course that doesn't take into account the deterioration in the debt markets, where loan to value ratios have dipped from 75% or 80% to 55% or 60% with interest rates expected to rise in the coming months. In combination, the result can be dramatic (a 28% decrease in value) as indicated in Chart 1 below.

As mentioned earlier, for some landlords this change in value can be largely academic. There are certainly, well-capitalized institutional landlords who did not put aggressive debt on a property and are invested for the long term. These landlords will endeavor to make market deals in order to keep their properties well-leased and cash flow positive. Numerous other owners used as much leverage as possible to purchase properties as they were relying on the consistent decline of cap rates to create value and a belief that rental rates would continue to increase as well. These owners had more of a trading mentality, and typically they will lose control of their properties at some point to a lender or other participant in the capital stack (the numerous levels of debt on the property).

Asset-Level Decisions

The reality is that most owners fall somewhere in between, and even well-capitalized owners have an asset-level decision to make when they are going to make a major investment in their property in the form of concessions and improvements required to attract or retain a tenant. See Chart 2, page 4. For example, assume that a landlord is contemplating renewing a tenant that is currently paying $70 per square foot in a property that costs $20 per square foot to operate, leaving a $50 net rent. Under the “Old Math” (or Old Market Rules) a landlord would have the value of its asset pegged somewhere around a 6.0% cap rate or $833 per square foot. Even a conservative owner would have been able to get a loan for about $583 per square foot at those rental levels. Assume now for the sake of argument that net rents are down $10 per square foot for the asset in question at the time of renewal, and the cap rate has increased 150 bps to 7.5%. That would put the implied value of the property at $533 per square foot, which would be less than the original loan. At that point, the owner needs to make a decision. Is it worthwhile to: 1) put additional equity into the property; 2) give the keys back to the lender; or 3) negotiate a reduced loan balance with the existing lender? That may not be a simple decision, and while the owner is contemplating its strategy, the tenant may relocate, thus reducing the value of the property even further.

Opportunities and Pitfalls

This dynamic creates both opportunities as well as potential pitfalls for a tenant that is looking to take advantage of the current market to reduce occupancy costs for the long term. Never before has it been so important to understand an owner's goals as it pertains to a specific asset in order to drive leverage for the tenant. Before the market meltdown, tenant leverage was created in a very linear fashion: The tenant broker made a careful study of the market and literally created an auction for the tenant by leveraging one landlord against another while being very conscious of the needs of their client. While that element has certainly not changed, the process has become multi-dimensional and now potentially involves first mortgage lenders, mezzanine lenders and special servicers (that are calling the shots because they represent a group of lenders that own the debt as part of a large pool) and requires a deep knowledge of the owner's ability and willingness to supply more equity to any given property.

In some cases, the owner is not motivated by the capital stack at the property to make an aggressive market deal because an aggressive deal will trigger a default on the mortgage. In other cases, given the rental income from tenants in place, the owner has cash flow from the property, but the asset has so much debt that the lender will not fund any concessions to make new deals or restructure existing leases. Given that the owner no longer has any equity in the asset (a re-appraisal will confirm that the asset is worth less than the debt); the owner likewise has no incentive to fund the necessary concessions to get a market deal done. Therefore, owners do not respond in a market fashion to lease proposals from tenants. A tenant needs to understand these situations, and in those cases may need to engage someone other than the existing owner, or may need to assist the owner in negotiating with the lender. In other cases, a tenant may be able to create more leverage for itself by funding tenant improvements directly, thus saving an owner from using equity it may not even have to make a deal. In that event, the tenant needs to have a clear understanding of what the market value for that equity is, and make sure that the benefit inures to the tenant for the long term in the form of lower rental rates, free rent or even a preferred equity stake in the property.

The multi-dimensional nature of the current commercial real estate climate makes it difficult for tenants to get answers and make decisions in a timely manner. Real estate options may be lost due to timing alone; a tenant has to make a decision to relocate by X date or it cannot design and build out its space in time without holding over. Holding over is often costly and may subject the tenant to eviction and consequential and punitive damages under the lease.

Tenants today often think (given the press) that there are plenty of concessions available in the market for a new or restructured lease deal. However, if your tenant is dealing with an owner without the ability to fund such concessions, the tenant may not be able to garner anything much beyond a lower rental rate. Moreover, even if your client merely wants to expand its space, which we do see, there may be no owner/special servicer/landlord entity to make decisions where the owner is in financial distress. In these situations, the tenant must either wait for a new owner or equity infusion to take place before it acts or have to relocate to meet its business needs. The issues owners are facing actually hurt net absorption numbers because demand may be there but tenants are unable to act for the reasons described above.

Tenants with space leased in an asset that is part of a portfolio have often felt the brunt of the commercial market collapse the most. For example, in a number of cases across the country, a decrease in the value of assets in a portfolio coupled with the fact that the portfolio was highly leveraged, have caused an owner to be unable to function normally. The owner/asset manager/listing brokers cannot make any forward commitments until the owner/lenders/equity investors: 1) restructure the debt; 2) garner a new infusion of equity; 3) enter into a combination of 1) and 2) above in a form of pre-packaged bankruptcy; or 4) there is a partial liquidation and/or reorganization of the portfolio. Even if the property in which the tenant leases space is not leveraged at the property level, corporate debt that is in default can stall a tenant's desire to make a real estate decision for many months.

Conclusion

Clearly, there are many paths that a tenant/landlord negotiation can take in the current market. Tenants must understand not only their own goals and objectives but also those of the owner and its lenders and equity investors in order to negotiate to the tenant's advantage.

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John Kevill is the Managing Director, Capital Market, Jones Lang LaSalle, Washington, DC. Elizabeth Cooper is Managing Director, Brokerage, also in the firm's Washington, DC, office.

It is definitely a tenant's market, but the tenant needs to be aware of the “point of no return” for the landlord.

It is well documented that the current economic malaise has its roots in real estate. The residential real estate crash gets a tremendous amount of airtime from the mainstream media, but the commercial sector has been decimated as well. Because of the fact that in many cases office properties are under lease to viable tenants that are paying higher “old economy” rents and owners have capital structures in place that reflect the heady times as well, in most cases the decrease in values has done nothing more than affect the book value of properties. Absent a major capital event at the asset level in the form of a new lease being signed at today's rents, required major capital improvement, or a loan maturity, the decrease in value only shows up on paper. That will change with time, however, and tenants need to be acutely aware of how their tenancy will affect the value of a property and how to properly leverage their existing or contemplated occupancy.

Value Deterioration

The lack of sales comparables in the market right now makes it difficult to determine exactly how much value deterioration there has been, but it is safe to assume that values are down close to 40% off the peak for many markets around the country. It is easy to see how values have changed so dramatically when you look at some of the variables that have changed over the past twenty-four (24) months. The most often used benchmark of value has been the capitalization rate (cap rate) at which a property trades. Cap rates are essentially the net operating income (NOI) divided by the purchase price. Market cap rates have moved upward 150-250 basis points in most instances. Combine such upward movement with a 10%-15% reduction in rent rates, and the effect is a decrease in a property's value by 20% or more. Of course that doesn't take into account the deterioration in the debt markets, where loan to value ratios have dipped from 75% or 80% to 55% or 60% with interest rates expected to rise in the coming months. In combination, the result can be dramatic (a 28% decrease in value) as indicated in Chart 1 below.

As mentioned earlier, for some landlords this change in value can be largely academic. There are certainly, well-capitalized institutional landlords who did not put aggressive debt on a property and are invested for the long term. These landlords will endeavor to make market deals in order to keep their properties well-leased and cash flow positive. Numerous other owners used as much leverage as possible to purchase properties as they were relying on the consistent decline of cap rates to create value and a belief that rental rates would continue to increase as well. These owners had more of a trading mentality, and typically they will lose control of their properties at some point to a lender or other participant in the capital stack (the numerous levels of debt on the property).

Asset-Level Decisions

The reality is that most owners fall somewhere in between, and even well-capitalized owners have an asset-level decision to make when they are going to make a major investment in their property in the form of concessions and improvements required to attract or retain a tenant. See Chart 2, page 4. For example, assume that a landlord is contemplating renewing a tenant that is currently paying $70 per square foot in a property that costs $20 per square foot to operate, leaving a $50 net rent. Under the “Old Math” (or Old Market Rules) a landlord would have the value of its asset pegged somewhere around a 6.0% cap rate or $833 per square foot. Even a conservative owner would have been able to get a loan for about $583 per square foot at those rental levels. Assume now for the sake of argument that net rents are down $10 per square foot for the asset in question at the time of renewal, and the cap rate has increased 150 bps to 7.5%. That would put the implied value of the property at $533 per square foot, which would be less than the original loan. At that point, the owner needs to make a decision. Is it worthwhile to: 1) put additional equity into the property; 2) give the keys back to the lender; or 3) negotiate a reduced loan balance with the existing lender? That may not be a simple decision, and while the owner is contemplating its strategy, the tenant may relocate, thus reducing the value of the property even further.

Opportunities and Pitfalls

This dynamic creates both opportunities as well as potential pitfalls for a tenant that is looking to take advantage of the current market to reduce occupancy costs for the long term. Never before has it been so important to understand an owner's goals as it pertains to a specific asset in order to drive leverage for the tenant. Before the market meltdown, tenant leverage was created in a very linear fashion: The tenant broker made a careful study of the market and literally created an auction for the tenant by leveraging one landlord against another while being very conscious of the needs of their client. While that element has certainly not changed, the process has become multi-dimensional and now potentially involves first mortgage lenders, mezzanine lenders and special servicers (that are calling the shots because they represent a group of lenders that own the debt as part of a large pool) and requires a deep knowledge of the owner's ability and willingness to supply more equity to any given property.

In some cases, the owner is not motivated by the capital stack at the property to make an aggressive market deal because an aggressive deal will trigger a default on the mortgage. In other cases, given the rental income from tenants in place, the owner has cash flow from the property, but the asset has so much debt that the lender will not fund any concessions to make new deals or restructure existing leases. Given that the owner no longer has any equity in the asset (a re-appraisal will confirm that the asset is worth less than the debt); the owner likewise has no incentive to fund the necessary concessions to get a market deal done. Therefore, owners do not respond in a market fashion to lease proposals from tenants. A tenant needs to understand these situations, and in those cases may need to engage someone other than the existing owner, or may need to assist the owner in negotiating with the lender. In other cases, a tenant may be able to create more leverage for itself by funding tenant improvements directly, thus saving an owner from using equity it may not even have to make a deal. In that event, the tenant needs to have a clear understanding of what the market value for that equity is, and make sure that the benefit inures to the tenant for the long term in the form of lower rental rates, free rent or even a preferred equity stake in the property.

The multi-dimensional nature of the current commercial real estate climate makes it difficult for tenants to get answers and make decisions in a timely manner. Real estate options may be lost due to timing alone; a tenant has to make a decision to relocate by X date or it cannot design and build out its space in time without holding over. Holding over is often costly and may subject the tenant to eviction and consequential and punitive damages under the lease.

Tenants today often think (given the press) that there are plenty of concessions available in the market for a new or restructured lease deal. However, if your tenant is dealing with an owner without the ability to fund such concessions, the tenant may not be able to garner anything much beyond a lower rental rate. Moreover, even if your client merely wants to expand its space, which we do see, there may be no owner/special servicer/landlord entity to make decisions where the owner is in financial distress. In these situations, the tenant must either wait for a new owner or equity infusion to take place before it acts or have to relocate to meet its business needs. The issues owners are facing actually hurt net absorption numbers because demand may be there but tenants are unable to act for the reasons described above.

Tenants with space leased in an asset that is part of a portfolio have often felt the brunt of the commercial market collapse the most. For example, in a number of cases across the country, a decrease in the value of assets in a portfolio coupled with the fact that the portfolio was highly leveraged, have caused an owner to be unable to function normally. The owner/asset manager/listing brokers cannot make any forward commitments until the owner/lenders/equity investors: 1) restructure the debt; 2) garner a new infusion of equity; 3) enter into a combination of 1) and 2) above in a form of pre-packaged bankruptcy; or 4) there is a partial liquidation and/or reorganization of the portfolio. Even if the property in which the tenant leases space is not leveraged at the property level, corporate debt that is in default can stall a tenant's desire to make a real estate decision for many months.

Conclusion

Clearly, there are many paths that a tenant/landlord negotiation can take in the current market. Tenants must understand not only their own goals and objectives but also those of the owner and its lenders and equity investors in order to negotiate to the tenant's advantage.

[IMGCAP(1)]

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John Kevill is the Managing Director, Capital Market, Jones Lang LaSalle, Washington, DC. Elizabeth Cooper is Managing Director, Brokerage, also in the firm's Washington, DC, office.