THE MARKET IS WEAK - WHY ARE RENTAL RATES NOT PLUMMETING?

The COVID-19 pandemic has had a profound effect on how America, and indeed the world, does business. The forced experiment in a partial or full work-from-home approach has demonstrated to a lot of office users that a different, perhaps smaller, office footprint may be needed long term. The resulting impact on demand for office space has been dramatic. In Chicago’s CBD alone for example, the amount of sublease space available has swelled to levels never before seen. Compounding the vacancy problem, recent and pending deliveries of new buildings are increasing the overall supply of space just as demand has dropped precipitously.

In spite of the surge in vacancy rates, both direct and via subleases, the effect on the most visible component of price has been minimal. Quoted rental rates have barely moved. In the overall Chicago office market, the amount of vacant space increased by over 10.1% for the fourth quarter of 2020 compared to the fourth quarter of 2019. At the same time, however, quoted rental rates only declined by .2%. Isolating Class A downtown Chicago office space for the same periods, vacancies increased by 11.6% while quoted rental rates fell by only 0.4%.

Why is this?  Basic supply and demand economics tell us that prices will naturally fall when supply increases and demand decreases to establish a new point of equilibrium.  Yet that does not seem to be occurring, at least not yet.  The key reasons can be summarized as follows:

• The “price” of office space is comprised of many more factors than rental rate alone.

• The prolonged effect on cash flow given the long term nature of office leases.

• The significant impact that even small changes in rental rate have on building valuation.

• Lender and investor influences.

Pricing Office Space

The most visible aspect of office space pricing, and the one that gets the most focus, is rental rate.  Historically in office market downturns rental rates are the last component to move.  Before rental rates are reduced, building owners are much more likely to sweeten a lease economically through extended free rent periods, increased improvement allowances, and reduced rate or free perquisites like parking or fitness center memberships.

In other words, the “price” of office space has multiple components.  With little or no downward movement in rental rates, that doesn’t mean the down market has not responded through other aspects of price.  Tenant improvement allowances and free rent periods have increased rather significantly, in many cases by 20 to 25% or more.

Cash Flow Impact

While many may view it as wishful thinking, real estate owners want to believe that this downturn is temporary in nature.  Office leases, however, are typically long term.  Consequently, there’s a reluctance to respond to the market with an approach that will have a long term impact for what they hope is a short term issue.  If office demand returns to where it was in late 2019 some time in the next year or two, building owners don’t want to be saddled with lower rental rates, and thus lower effective financial returns, for several years.

Building Valuation

Commercial real estate is largely valued through the use of a “cap rate”, which is essentially an interest or discount rate as adjusted for risk, duration of the secured cash flow, quality of the asset and a few other factors.  Put simply, the value of a building is primarily based on its cash flow divided by a cap rate.  For example, a building with a cash flow of $1,000,000 that is assigned a cap rate of 6% would indicate a building value of approximately $16.7 million.

For a building owner concerned about preserving or increasing the building valuation, either with a near term goal of selling or refinancing the asset, it is much less costly to fund additional concessions than it is to reduce the rental rate.  To illustrate, let’s compare the cost of funding a $10.00 extra tenant improvement allowance on a 10,000 sf lease with the cost in reduced building valuation of dropping the rental rate by $1.00 per year in a ten year lease.

Funding additional $10.00 in improvement allowance:

• $10 times 10,000 SF = $100,000

Effect on building value of reduced rental rate (assumed 6% cap rate):

• $1.00 divided by 6% times 10,000 sf = $166,667

In either case, the nominal cost in cash flow is $10.00, but when viewed through this lens the reduced rental rate is much more costly to the building owner than funding an extra $10.00 up front.  Extending this concept to an entire building, perhaps with an even lower cap rate, the impact is significantly magnified.

Lender / Investor Influences

When equity or debt is raised for the purchase or refinancing of a building, a good portion of the underwriting is based not just on existing leases but on expectations for future rents as well.  Many mortgage loan documents establish minimum economic terms for new leases based on this underwriting.  Lease terms that deviate from these parameters often require lender approval.  In times of decreasing demand and/or increasing supply, not only does a building owner have to alter expectations – the lender does as well.

While equity investors are less likely to have formal rights in this regard, the optics of reducing rental rates below those that were projected at the time of the investment make building owners reluctant to lower them.  Other, less visible means (i.e., abatements, improvement allowances, etc.) are easier to use as a reaction to a softening market.

Implications for Tenants

If the duration of the supply / demand imbalance persists long enough, the market will inevitably begin to affect rental rates more directly.  This will be in addition to the other aspects of “price” that have already been adjusted.  When this in fact occurs is difficult to predict, as landlords are likely to hold out as long as they collectively can for the reasons cited in this article.

In the meantime, it makes sense for tenants in the marketplace to aggressively pursue the growing lease concessions that are being offered now.  Periods of free rent and increased improvement allowances (some or all of which may be convertible to additional free rent) should be the primary areas of focus, as well as cost free or reduced cost amenities.

With tenants’ increased negotiating leverage, many landlords may be more willing to grant non-economic concessions.  These include expansion, contraction, termination and renewal options, as well as prominent signage or naming rights, exclusive use restrictions and parking preferences.