Best Leveraging for the Transitioning Market
Gabe Marans March 9, 2016, 9:15 a.m.
The New York City commercial office market is in the middle of a transition. For many years we’ve been riding the landlord’s wave. But that’s beginning to change.
And there is an established transition pattern that allows a careful observer to understand the context of the market cycle and gain substantial leverage in a landlord-versus-tenant negotiation.
In general, there are four transition stages as the market moves from landlord-centric to tenant-friendly (even if figuring out the exact stage you are currently in is a brain twister).
Rents level out. Once the demand and supply of real estate reaches equilibrium, the taking price plateaus and ceases its upward climb. This stage is rarely cause for alarm as the market is functioning in a healthy manner. Nevertheless, it presents a potential complication since new purchasers of real estate typically assume pro formas at higher future rents. For those with poor acquisition timing, this stage is the beginning of a tumultuous road.
Concessions increase. When leasing activity starts slowing, the tide begins to shift more prominently in the tenant’s favor, and landlords search for ways to incentivize deal making. However, landlords remain incredibly sensitive to rental adjustments, so they instead focus on increasing the concession package. Free rent periods begin to creep up and landlords show an increased willingness to finance larger tenant improvement allowances and/or build spaces to a higher standard than they would otherwise consider. From a tenant advocacy standpoint, it should be noted that different landlords have different pain points; real estate investment trusts typically have a mandate to achieve high face rents but benefit from limited cash flow concerns and so are more likely to engage in dramatic concession package increases. Low-leveraged, long- term owners may not be as flexible at this stage. Pivoting back to our current market, tenants were able to negotiate slightly higher concession packages during 2015 compared with previous years, according to Savills Studley research.
Rents begin to drop. While the market continues to lose traction, landlords recognize that concession increases alone won’t spur transactions and realize that they must begin to reduce asking rents. In the absence of a catastrophic event, this stage generally rolls out slowly as landlords attempt to avoid a systemic shock to the system. Sublet availability is also a critical factor in how quickly rents plummet—as more sublet space hits the market it continues to undercut the ability of landlords to take an unwavering stand on rental rates. Due to New York City’s size and submarket composition, this stage may be initially limited to portions of the market before spreading to the rest of the ecosystem. For instance, due to the troubles afflicting the hedge fund world, certain Plaza District landlords may act decisively by lowering rents to attract tenants, while Lower Manhattan and the New Jersey waterfront continue to thrive thanks to a flight to low-cost but quality alternatives fueled by attractive incentive programs. In today’s Midtown Class A market, asking rents have showed some early signs of moderate decline, falling from an average of just over $90 per square foot in the third quarter of 2015 to $87.44 per square foot at year’s end.
Landlords get creative. At this point in the cycle, landlords are nervous and eager to both attract and retain valued tenants. They recognize that generous concession packages and lower rents aren’t enough to close a deal. Tenants with good advisers have the ability to secure highly favorable lease provisions that are materially beneficial to the tenant. For instance, if in a landlord market, the threshold to secure exterior signage rights is a 100,000-square-foot lease, by the time the market hits this stage that same landlord might be willing to consider the same signage rights for a 50,000-square-foot tenant. Landlords are also far more amenable to flexible expansion, contraction and termination rights as well as sublease and assignment provisions. One item that may become more stringent, however, is the security deposit—depending on the financial strength of all parties.
Tenants currently in the market are facing very encouraging tail winds. The ability to recognize this market-driven leverage is crucial as it may allow for a significant negotiating advantage from the perspective of the tenant. Landlords may be growing increasingly nervous, though those who choose to adopt flexible negotiating strategies will be able to dull the impact of a slowdown in the leasing environment