In a Period of Stubbornly High Vacancies & Tight Financing, Tenancy Still the Trump Cards in Negotiations
While perhaps not a nationally significant or unusual deal by itself, U.S. Cellular's renewal this past month of an office lease in Madison, WI, succinctly depicts the current state of leasing.
U.S. Cellular agreed to extend its lease with affiliates of Wells Real Estate at the U.S. Cellular Building, a four-story, 102,000-rentable-square-foot office building. The Chicago-based carrier leases 73% of the building and owns a 45% equity interest in the property. The amendment extends the lease from April 2013 to December 2017. As part of the deal, the monthly base rent will decrease 11% from $87,668 to $77,830. In addition, U.S. Cellular is entitled to a four-month rental abatement.
Several things about this deal make it typical of other firms making lease renewal decisions in the current market. Landlords have a vested interest in holding onto quality paying tenants, or risk loss of income, more scrutiny from current and potential lenders, and face higher marketing costs to re-fill the space.
Tenants, too, have a vested interested in staying put. While in this case, the tenant is part owner, in other cases, tenants face a disruption in their business and significant relocation and operational costs if they leave a good location. But the market reality is that there are good deals to be had out there as vacancies remain stubbornly high and money for refinancing commercial properties remains hard to come by. As a result, tenants are clearly making the decision to at least shop around.
"In sectors like the office market, we're finding tenants taking the opportunity in a soft market to upgrade office image and pick-up additional amenities by moving from a Class B building to a Class A building, generally with minimal increases in their rent. The term you hear tossed around is 'flight to quality,' " said Ryan Walsh, principal of RadatzWalsh Inc. in Edina, MN.
"To compete with the market, landlords are offering up free rent to keep tenants, somewhere around one month per year of the lease, (net or gross) depending on the situation and other terms," Walsh said. "Also, improvement money is being spent to upgrade finishes and make spaces more functional on extensions. Usually $10 to $20/square foot for 3- to 5-year deals and some additional credits or rent reductions if the space can be used as is."
"It is all on a case-by-case basis," Walsh said, "but the savvy landlords factor in the costs of having the space sit vacant for a while, tenant improvements for new groups and other transactions costs. They generally come to the conclusion that it is in their best interest to work hard to keep a good tenant that they know pays rent on time."
While tenants enjoy the upper hand currently, CoStar's latest market outlook sees big changes ahead for U.S. office markets.
Nelson Taylor, owner/broker of William Raveis Chapman Enstone in Providence, RI, said tenants are also leveraging the market to cut a better deal for themselves.
"Many will approach their current landlords for lease/term reductions," Taylor said. "Tenants will approach me to give them comps to support their requests. More often than not, if their requests are reasonable, owners will agree to a reduction. If owners prove inflexible, tenants will move."
"Owners are much more flexible with 3- to 5-year leases. In my world of crossover commercial, most owners are reluctant to do anything over five years, though they will offer renewal options. At least 10% reductions in the overall lease costs," Taylor said.
While U.S. Cellular merely extended its current lease, CoStar is also seeing landlords offering concessions to tenants who renew -- even if they are downsizing. Case in point, AeroGrow International Inc. amended its lease with Pawnee Properties LLC in November 2011 for its headquarters at 6075 Longbow Drive in Boulder, CO. AeroGrow renewed its lease but reduced its square footage from 16,184 to 9,868. The landlord reduced the monthly base rent 23% to $9,046 ($0.92/square foot/month) from $19,261 ($1.19/square foot/month). The lease was extended 18 months to September 2014.
"My experience is that all my clients are reassessing their space needs, consolidating as necessary, removing redundancy and heavily incorporating hi tech where it can," said Guy Levingston, principal of Intermountain Commercial Real Estate in Boise, ID. "They will shop the market and present competitive bids back to landlord to see if the landlord will budge or meet the best deal. You call it landlord generosity; I call it "market rate" for 2012. I believe it is going to take some years for office market rental rates to climb back up to what was considered "normal" before the 2007 downturn."
Kevin Postal, president/broker of Atlantic Property Group in Port St. Lucie, FL, agreed, adding that such short-term concessions provide a way for the landlord to ride out the down market.
"Most landlords don't want to sign leases longer than three years at the lower rate hoping that there is light at the end of the tunnel for better returns on their investments," Postal said. "It is definitely a buyer's market, but landlords usually won't show their hand until it's absolutely necessary. I've seen reductions up to 30% in some office rents."
"Although most tenants prefer to stay in existing locations, they are also economy-minded these days," Postal said. "Of course, they want to seek out the best deal in the market. I am finding that tenants are willing to move as far as 15 to 25 miles in any direction if it means saving money."
Many tenants are also taking advantage of current conditions to expand at their current location while signing on for a lease extension.
REVA Medical Inc. did just that for its corporate headquarters at 5751 Copley Drive in San Diego. REVA more than doubled in size, expanding from 17,018 square feet to 37,470 square feet under a new deal with landlord ARI Commercial Properties that extends its lease through January 2018. Under the terms of the lease amendment, the annual base rent for the leased space increases over the term from $37,000/month (80 cents/square foot) to $60,000/month ($1.60/square foot) at the end of the lease. Up until the amendment, REVA Medical had been currently scheduled to pay $1.60/square foot per month.
"Many landlords have offered reduced rates to blend-and-extend for three to five additional years. I don't view this as landlords being generous but rather (they are) being strategic to lock-in longer lease terms, stagger expirations, and reduce capital expenditures," said Steve Rosetta, executive vice president | market leader, Cushman & Wakefield of San Diego.
"We are seeing tenants shop around for better terms and more flexibility versus renewing," Rosetta said. "In the end, a tenant may renew but they are all testing the market. Landlords may be reluctant to drop rates to keep a tenant initially but nearly all will reduce rates rather than loose a tenant to another building."
NetSuite Inc., which leases 79,589 square feet for its corporate headquarters at 2955 Campus Drive in San Mateo, CA, extended its lease in December for another seven years until August 2019. In 2010, NetSuite had already amended its original lease signed in 2008 to reduce its space to its current size. With the extension just signed, NetSuite will be paying $40.20/square foot per year in 2013. Under its original 2008 lease, NetSuite had been scheduled to pay $63.88/square foot per year this year. So by extending long term, NetSuite has cut its scheduled rent more than a third.
"At the beginning of a process, a [tenant] client may feel they will renew or give back space. However, after going through a real estate process it becomes quite clear what is financially and operationally more favorable," said Michael McKeever, senior vice president, UGL Services Los Angeles. "The smart landlords are offering concessions to maintain occupancy, so the tenant may renew but typically on much better terms than they originally thought. It's case by case. Some clients are reducing their rent by 20% and combined with space give back sometimes 40%+ reduction."
We asked other commercial real estate industry professionals what they are seeing in terms of office renewal negotiating conditions in their markets. The following are some of their comments.
Over the past 18 months, I have seen tenants continue to operate in their current location. Occasionally they have tested the market but they prefer to stay put and typically pay a little bit of a premium to do so. Of course this premium does not take into account the costs and the disruption associated with the move. I have not seen the rent reduction in renewals. I have seen landlords reduce the rent if the tenant expands within the asset and commits for an additional seven to five years. Over the past 12 months, I have seen very little downsizing. If anything, I have experienced the tenant expanding if space is available.
Todd Jones, Founder / Principal, Lone Star Realty Advisors, Irving, TX
[Tenants] are definitely shopping the market, but in most cases they are renewing their leases. It is expensive to move so if there is not a significant reason to leave their current building, most companies are staying. These companies are investigating the market and negotiating aggressive terms from landlords. Current landlords typically have the edge by being able to offer lower tenant improvement costs and still accommodate tenants. In addition, companies don't face expensive moving costs when they renew their leases and it is less disruptive to their business.
Bill Rothstein, Senior Vice President / Brokerage Services, Cushman & Wakefield NorthMarq, Minneapolis, MN
All tenants are shopping around for better terms. However, a smaller percentage actually ends up relocating. Relocation costs vary depending on a number of factors and often times it can be the determining factor. Additionally, better terms generally come with longer lease terms, from which the majority of tenants in Orange County currently shy away. It depends on the ownership entity, the debt structure, where the asset sits in the lifecycle of the fund and the portfolio strategy. In some cases, we've seen savings north of 25% to 30%, whether through straight rent reduction, free rent or some combination of the two. It also depends how much lease term is left and position relative to market.
Eric Antonini, Vice President, UGL Services Orange County
Buying Rather Than Renewing
More of my clients are looking for office space or land to purchase, seeing this down market as an opportunity to buy their own instead of continuing to lease from others. Activity is definitely up, with more work to do than I could have imagined.
Mark W Kidd,, President, M Kidd Properties Inc., Houston, TX
From my perspective, we are still seeing tenants actively looking to evaluate the office market alternatives in order to make an informed decision about leases expiring. Some tenants want to upgrade their office space to better buildings for office rents close to the same that they are currently paying. I am still seeing quite a few tenants that prefer to renew or short term extend leases in place to not incur the costs of moving. Lastly, I am seeing some smaller tenants 5,000 to 15,000 square feet looking to purchase buildings at reasonable prices to take advantage of low interest rates and opportunities to own.
Robert J. Donnelly, Jr., CCIM, Executive Director | Capital Markets Group, Cushman & Wakefield of New Jersey Inc., Morristown, NJ
Renewal Process Starting Well in Advance of Expiration
Our clients are making the effort to renew their lease well in advance of the renewal date. I think there are two business reasons: Taking uncertainty of real estate space out of the business climate; and locking in the cost of real estate in a down market for a predictable period of time. Property owners in general are resisting this effort and are holding the out to the last possible moment to renegotiate, running the risk of tenant alienation. To the extent lease terms includes an arbitration clause, this resistance includes resolving rent related issues by use of arbitration.
John Guillory, President, Northridge Group, Oakland, CA
Landlords Holding on Tight to Tenants
Landlords are still holding on tight to their tenants and are willing to be more aggressive on renewal lease terms. Landlords can't afford the downtime/loss of revenue; therefore, they are willing to reduce renewal rents. Because of the favorable renewal rates, tenants are signing up for additional square footage to lock in today's low rates. In most cases, there has been pent up demand for more space and coupled with the low renewal rates is driving the rollover expansion of space. Landlords are still providing free rent to maintain face rates. Free rent is applied to parking and storage space as well. The majority of landlords are still providing turnkey improvements instead of a fixed improvement amount. Overall, concessions haven't reduced but have remained fairly steady.
JR Pearce, Crown Acquisitions Inc., Laguna Niguel, CA
For a couple of years now, our percentage of transactions related to renegotiations and renewals has increased dramatically. The past two years, 75% of our transactions have been renegotiations and/or renewals. We have reduced tenants' rates as far as 18 months before expiration. In new leases, we are seeing one month free for each year of term. We usually are able to negotiate for at least that, maybe more. Most landlords are clinging to their TI dollars. But some healthy ones use TI dollars as needed especially to attract tenants, as corporations aren't able or wanting to use their capital for TI's.
Denis Mehigan, Principal, The Mehigan Co., San Francisco
A Tenant's Market Can Turn on Dime
The few firms that are growing are expanding and securing good lease rates and terms. However, most corporations have learned to do more with less and are leaving very little room for expansion. On renewals most are holding or taking less. With the lack of new construction and the improving fundamentals, many tenants could be surprised at how fast the office market can turn from a tenants' market to a landlords' market. We believe 2012 will continue to slow demand and gradual occupancy improvements. But after the elections, we believe because of pent up demand in 2013 there will be a rush of expansion and with the lack of new construction, we could see a strong landlord oriented market by as soon as 2014.
Michael Bull, President & Founder, Bull Realty Inc., Atlanta, GA
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