In 2010, the commercial real estate market will all be about liquidity.
Today’s leasing environment is not for the faint-hearted. Tenants are holding the cards. Landlords are faced with cash constraints, and the added pressure to offer deep tenant incentives in the face of diminished income. It is the well-capitalized landlords who will live to see another day.
The deterioration of underlying market fundamentals has further exacerbated landlords’ problems. Owners who purchased properties between 2005 and 2007 with aggressive underwriting are finding the current leasing market extremely difficult to cover their profit margins.
Initially, many landlords were inclined to sit on vacant space and ride out the storm. Landlords wouldn’t collect rent during this time, but on the other hand they wouldn’t have to commit significant capital in the form of tenant improvement packages. Furthermore, landlords would be held into a low rent for an extended period of time. In the wake of the worst downturn in a generation, it became clear that the market was not expected to rebound quickly enough to ride out the storm.
With limited future growth prospect and diminished cash reserves, landlords will have tough choices to make next year. They will attempt to balance their limited capital and resources against increasing expenses and availabilities.
Tenants Rule
Cost sensitive tenants are actively seeking to limit capital expenses and reduce occupancy costs. They also understand the market is in their favor and are hunting for deals. Savvy tenants, such as Bank of New York Mellon and Sullivan & Worcester, have seized opportunities to take advantage of generous incentives and concessions to renew at their current locations.
This has essentially forced landlords to aggressively compete amongst themselves, bringing down their margins as they increasingly rely on lease concessions and rent reductions. The large number of sublease and available space options has added pressure to attract the limited number of active tenants.
Additional pressure is also added from landlords who are burdened with encumbered space. Often, these landlords offer extremely aggressive deals at the eleventh hour in an attempt to secure a tenant. If landlords want to compete in this leasing environment, they must be able to fund capital costs, leasing commissions and tenant improvements.
Landlords trying to stay afloat will make enticing offers to lure tenants to their properties. However, tenants must be cautious when dealing with their current or future landlord. Given the turbulence surrounding distressed owners, the best advice for tenants may be not to take the best bargain. Due to the increasing uncertainty of the landlord’s financial health, lower rents, numerous amenities, and generous concession packages may not last. Tenants, therefore, must do their homework.
What does all this mean?
Tenants should carefully research the landlord’s history and balance sheet. Landlords who are struggling financially are the first to scale down on amenities, improvements, and building services. Tenants have been protecting themselves by adding “self help” clauses to their leases such as Interruption of Business Services, and Subordination and Non-Disturbance Agreements. These force the landlord to ensure that current conditions identified in the lease will be upheld in the future.
The tenant must scrutinize the lender as well. In the event of default, tenants need to know who will keep the lights on. Subordination clauses will guarantee that the tenant’s lease will be upheld if ownership changes. These steps are time consuming but necessary.
Next year will be decisive for commercial real estate owners. Boston landlords will continue to struggle as weak tenant demand and increased concessions drive the market. Knowledgeable tenants who understand the financial health of the landlord will be protected. Well capitalized landlords will hold a distinct advantage and attract the highest quality tenants going forward.
