Michael Webber, Executive Vice President
October 2024
IF RENTAL RATES ARE NOT DROPPING, WHAT IS CHANGING?
Much has been written about the soft, distressed commercial real estate market over the past few years with weak demand resulting in substantially lower occupancy in most markets and most buildings. An often-asked question with this weakened demand is “Why are prices (i.e., rental rates) not falling dramatically in response? Are office buildings not subject to the basic laws of supply and demand that other goods and services are?”.
The answer, as addressed in a previous article, is that rental rate is but one component of “price”, and rates are the last component to change. Building owners will hold onto their quoted rental rates as stabilized cash flow is the primary component used by lenders and investors to underwrite and value real estate property.
So what are the other components of price that show the market is reacting appropriately to market forces? The answer – lease concessions.
Lease concessions (buildout allowances, free rent periods, reduced cost amenities and flexibility options) have been around for decades. The changes in reaction to market forces are apparent in the changes in structure and timing, as well as the overall dollar values.
FREE RENT
Free Rent, or rental abatement, has been around for decades as an incentive for tenants to lease space. Historically, free rent has been strictly at the beginning of the lease term in most cases. While the amount of abatement varies by market, in many US markets the historical norm has been one month of free rent for each year of the lease term. This has usually been “outside the term”, meaning that for a five-year lease term there would be five months of free rent before the payment period begins. In other words, a five-year term becomes a five year, five month term with the first five months rent free.
In recent years there has been a gradual change in many building owners’ approach in an attempt to both increase incentives and yet preserve the face rental rates. Among these changes:
Increased levels of free rent beyond the historical norms (i.e., more than the one month per year prevalent in many markets).
Spreading of rent abatement over a period of years, perhaps with one or two months per year over most if not all of the lease term. This gimmickry allows an owner to preserve the quoted rental rate in form, but the substance is in reality discounting the rate by offering abatement in each year. In some leases, a landlord will insert a provision whereby they can “buy back” the free rent and restore the full rental rate by paying the tenant cash.
Introduction of “beneficial occupancy”. Beneficial occupancy is basically free rent before the agreed free rent period begins. With this mechanism, a tenant is allowed to occupy the premises for a period of months rent free before the official commencement of the lease term.
TENANT IMPROVEMENT ALLOWANCES
Tenant improvement allowances, the funds supplied by landlords for construction of tenant spaces, have been growing as an incentive in response to the softened real estate markets. For those landlords financially able to provide such allowances, the levels have increased by some 30% or more in most cases for the same lease term and rental structure. Unfortunately, construction costs have been increasing as well, so tenants are not necessarily realizing as much of a net improvement in their economic benefit.
An added benefit has been the loosening of restrictions on the use of allowances. In prior years, landlords placed significant restrictions on the use of allowances, often insisting on the full amount of the allowance being spent on physical improvements to the space. In a renewal transaction or one where existing conditions did not require significant work, the lease provisions often provided that any improvement dollars that did not go into construction were forfeited by the tenant and retained by the landlord. In the current environment, the use of the improvement allowance has loosened to the point where not only can it be used for furniture, equipment and various soft costs, but any remainder can be utilized by the tenant as additional rent credit (i.e., more free rent).
BUILDING AMENITIES
Throughout the past decade or so, beginning well before the pandemic had a negative impact on the office market, there has been an expansion of tenant amenities offered in office buildings. This is especially true in downtown markets, where there seems to have been a rush to install tenant lounges, rooftop decks, fitness facilities and a host of other amenities to buildings in an effort to lure tenants to an upgraded experience. In fact, some of these attractions have become so commonplace that they are no longer a distinguishing factor but rather a necessity in order to compete.
For tenants, there is an opportunity to capitalize on the competition and negotiate free or reduced cost exclusive use of the facilities. Specifically, these benefits can include:
Free and preferred scheduling of building conference facilities.
Free or reduced cost use of building fitness centers.
Reserved and reduced cost parking.
Free use of rooftop decks and lounges for company events, client entertainment.
In addition, landlords have shown a willingness to be more liberal with perks formerly reserved only for anchor tenants such as exterior building signage.
FLEXIBILITY OPTIONS
The competitive leasing environment has impacted landlords’ willingness to provide more flexibility in leases. Although the concepts are nothing new, tenants can drive negotiations to achieve more flexibility to deal with future business uncertainty through:
Shorter lease terms – While not an option all landlords can or will offer, many showed a willingness during and shortly after the pandemic to accept shorter lease terms in order to land or retain tenants. This has continued to a limited degree.
Expansion rights – Due to the large amount of vacant space, landlords have been able to increasingly offer both rights of first refusal and fixed expansion rights. Tenants are frequently able to negotiate a fixed pre-negotiated option to add adjacent vacant space for an extended period after the commencement of the initial lease term.
Termination options – Always a difficult provision for both landlords and lenders to accept, we are seeing more of a willingness to offer termination rights even on lease terms that are shorter than five years. There is generally a significant financial penalty involved with a termination option, but it provides tenants with an escape if their office needs change dramatically during the lease term.
It’s important to take all factors of “price” into account when negotiating an office lease and not exclusively focus on rental rates. Tenants can benefit significantly, economically and otherwise, by exploiting the market in other areas.