Commercial Space Guide: Getting more from your lease

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During the past 12 years, the U.S. economy has suffered through two traumatic recessions, one made worse by the Sept. 11 terrorist attacks and another caused by a near financial meltdown.

Tellingly, the Madison commercial office market recovered much faster after two hijacked commercial jets crashed into the World Trade Center than it has since the financial crisis of 2008-09.

In Madison, office vacancy peaked at 17.3% in 2009, and four years later, the fact that it’s still around 14%, even after dropping nearly 200 basis points between 2011 and 2012, might give tenants the impression that landlords are still willing to deal on lease provisions. The extent to which they are in a deal-making mood actually depends on their individual situations.

The supply-and-demand principle certainly applies to commercial office markets. If there’s enough demand and little supply, a landlord is going to give less; if there is little demand and ample supply, a landlord is more willing to negotiate.

At the height of the 2008-09 recession, office landlords were very willing to make lease concessions to hold onto tenants and the lease income they generated. It was more of a tenant’s market back then, as the state of the economy created an imbalance in their favor. 

While tenants were not in the kind of commanding position where they could take a “my-way-or-the-highway” stance, they had enough leverage to renegotiate various aspects of their leases — especially if their businesses were challenged in that frightening economic environment.

Four years into a gradual economic recovery, there are varying opinions about whether those days are long gone. The economy has improved to the point where the Greater Madison office market, now with an overall vacancy rate of 13.8%, is approaching equilibrium (about 10% to 12% vacancy), but some believe it’s still more of a tenant’s market. 

As part of this, IB’s 2013 Commercial Space Guide, we got a landlord’s perspective on the office market from Chris Caulum, senior real estate associate at Oakbrook Corp., which tracks the Madison office market. For the tenant’s perspective, we spoke to Annette Gelbach, one of three principals with Key Commercial Real Estate.

In addition to the ebb and flow of the office market, IB presents its annual listing of commercial properties for lease, courtesy of Property Drive, LLC, beginning on Page 30.

Mad market

The process of assessing whether an office market favors tenants or landlords is rather nuanced. If broken down by office classification, Caulum believes that Class A space, those modern, multi-floor buildings of 30,000 sq. ft. or more, is at equilibrium or slightly tilted to landlords; with Class B and C buildings, it’s still a tenant’s market. 

There are certain submarkets — Oakbrook breaks up the Madison market into downtown, near west, far west, south, and east — where Class A tenants have multiple good options, depending on company size and geographic preference. Larger employers are having a difficult time finding enough existing space, and so build-to-suit becomes an attractive option.

According to Caulum, the far west submarket, which includes Middleton, has tightened up more quickly than any submarket, meaning there is less available space, which favors landlords. Downtown, on the Capitol Square, it’s extremely tight. A block or two off the Square, there are a lot of options, which favors tenants (the downtown market extends six to eight blocks from the Square). 

The smaller near west submarket, which is basically the area near Hilldale Shopping Center and includes University Research Park, is fairly tight. In this submarket, vacancy has dropped the most since 2008, from 19.4% that year to 12.9% in 2012.

In the south submarket, which includes Fitchburg, vacancy has fallen steadily since the recession, but the market still has not fully recovered from the departure of Epic Systems, now the area’s largest employer. 

In the east submarket, the Class A buildings in the American Center and High Crossing are “pretty full,” but the market’s Class A- and B+ buildings lag behind. “That is where you are seeing competition and really a tenant’s market,” Caulum said. 

In terms of submarket variance, vacancy ranges from 11.9% in the far west to 16.4% downtown, and the range is more “packed together” than a few years ago.

However, a submarket’s overall vacancy doesn’t tell tenants everything they need to know. Caulum noted that a submarket as a whole can have landlord-friendly vacancy of 5%, but if the niche area that fits a particular tenant has a vacancy rate of 20%, the tenant will be in a commanding position to negotiate good terms.

On this point, there is more agreement between our experts, for while Gelbach doesn’t believe Madison has the same intense tenant’s market of 2009, she sees more of a tenant’s market overall and believes it depends on a lot of variables, including the landlord.

Whether one is looking for new space or seeking to renegotiate an existing lease, the telltale signs of a tenant’s market not only include a willingness to make concessions but also a high degree of creativity and aggressiveness among landlords who want to make deals. Given the varying conditions in various submarkets, not every landlord is in a weak position, but others have little choice.

”It’s not the tenant’s market it was a few years ago, but it’s still tilted toward tenants,” Gelbach stated. “The submarkets really make a difference on where the available space is, and the type of space it is.”

Gelbach has a slightly different take on the submarkets. “Areas like the far west side and far east side still have ample space in the office market, which would lean toward a tenant’s market,” she said. “If you’re looking for Class A downtown on the Square, it seems pretty even in that there are not a lot of options, so it depends on what’s available on the market. If I was to evaluate the Madison area in a general sense, it would still be tilted slightly toward a tenant’s market.”

Re: Negotiations

According to Caulum, in office negotiations everything hinges on how much remodeling must done, the term of the lease, and the credit of the tenant. “That will never change,” he said. “The landlord views those three things through a different prism based on what kind of market you are in, who your competition is, and how badly you need to rent that space.”

While each landlord is different, there is usually flexibility on the base rate. Some want to maximize that base rate and don’t mind concessions; others offer lower rents with no concessions. “It’s the landlords with the longer-term perspective who are more willing to drop their rental rate rather than do concessions,” Caulum said.

Even in a tenant’s market, renters must offer a win-win and consider extending the lease in exchange for concessions. The more astute landlords understand their tenants’ business models, and the tenant seeking concessions has to make the business case, such as citing a significant decline in revenues or personnel in order to get reductions in their square footage and costs, technology improvements, free or reduced-cost building signage, or perhaps transition from a triple-net structure to a gross-lease structure.

For some building owners, the base monthly lease rate is non-negotiable because they must keep that rate at a certain level due to financing requirements, or to get a higher capitalized property value. However, they might be more willing to deal on build-out allowances and other incentives.

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Now that the market has recovered somewhat, there is less pressure from banks, and Caulum believes tenants are less likely to find a highly accommodating landlord. “You’ve heard of the term blend and extend?” Caulum asked. “The blend-and-extend period is pretty much over. There were many clients on both the landlord and tenant side that did blend and extends, and there was a time and place for them.”

For landlords who still are willing to deal, their appetite for negotiation depends on their outlook. Those who want to hold onto property for an extended period will view things differently than a landlord who wants to unload property. “To own long term, they probably are willing to lock tenants up for a longer time period and give them some concessions now, as long as the bank can see the value in doing that and will approve it,” Caulum said.

A landlord in trouble with the bank typically is capital-constrained. For these landlords, when a tenant is willing to renew for three or five years without improvements, rent concessions have got to be pretty attractive, Caulum stated. ”Then you’re thinking, ‘I don’t want this to be on the market and have to spend $100,000 [on improvements] for the next tenant, so I’ll take a hit on rent now but I’ll still be able to keep current with my lender.’”

At Their Mercy?

Whether you’re renegotiating your current lease or looking for new space, Gelbach said the tenant’s approach should involve ample due diligence in order to conduct an informed negotiation. Otherwise, tenants are at the mercy of the landlord.

“You really have to do yourself the favor of looking at the market and looking at your options if your lease is up in a year to find out what is out there,” she said. “So even if you are inclined to stay where you are, that knowledge can provide some leverage.”

As Caulum suggested, part of that due diligence is knowing your own landlord, especially whether he or she is inclined to be flexible on the base lease and not so much on concessions, or the other way around. With enough market knowledge, tenants can make landlords compete against each other.

Some self-scouting also is part of the calculation, starting with your lease criteria in terms of square feet, geographic parameters, and budget.

Gelbach advises tenants to look at their lease as a “total package” that includes apples-to-apples comparisons of base rent, tenant improvements, the term of the lease, triple net costs, rental escalators (annual percentage rent increases), useable (actual) square footage of your office space versus rentable square footage (the square footage that you use, plus a percentage of the common areas), and free rent.

“Take all that information and bring it down to your annual occupancy costs,” she explained. “If you are signing a three-year lease or a five-year lease, you are looking at those total occupancy costs.”

Tenants should start their due diligence with about one year left on their lease. The larger the tenant, the more time is required. If a tenant has an option to renew, the tenant usually has to give the landlord six months’ notice about their intentions. In that case, the tenant will want to start the market homework well before that point. “Nine months to a year, depending on the size of the tenant,” Gelbach said. “I’d probably push it out to a year, just to get the process going. I don’t think you can start too early, except when the spaces that might be coming available are not on the market yet.” 

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Class Distinction

For tenants on the hunt for new space, IB asked Oakbrook Corp.’s Chris Caulum to explain the basic differences between the various commercial office classifications — A, B, and C. As one can imagine, there is no single distinction —the differences are based on a combination of things.

Class A

Class A buildings tend to be multistory and in excess of 30,000 sq. ft. They have more amenities than Class B buildings, they are made of better materials, and they come with higher asking rents. Amenities include underground parking, nicer lobbies (including a two-story atrium), and common area amenities like conference, break, and fitness rooms. “By definition, you really can’t have a Class A building that is single story, or one that is under 30,000 sq. ft.,” Caulum said. “After that, it gets more subjective.”

Class B

These structures are a little smaller and a little older than Class As. Some Class Bs have functional issues, and tenants can’t quite get as high a drop-ceiling height. “There are a lot of little things that add up to Class B landlords not being able to compete as well for the best tenants,” Caulum indicated.

Class C

Class C buildings are smaller, older, and sometimes consist of a wood frame rather than concrete and steel. It’s not unusual for Class Cs to have significant functional issues such as a lack of elevators or other deficiencies that make them inaccessible under the Americans With Disabilities Act guidelines. They also tend to be in one-off, singular locations rather than in true office or business parks.

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Triple Net vs. Gross Rates

In order to do the necessary number crunching and calculate annual occupancy costs, tenants should know terms such as triple net. Under a triple net structure, tenants pay their pro rata portion of the building’s operating expenses, which are variable. With a gross structure, a tenant knows the monthly charge, regardless of the level of taxes, insurance premiums, and utility costs.

Some tenants believe that a gross lease is always better because they know what the fixed costs are going to be. While that might be true for some, the flip side is that when taxes stay the same due to stagnant real estate values, usually during a recession, landlords get more competitive on snowplowing, lawn mowing, and janitorial services.

“What we saw in our management portfolio is when people negotiated these vendor contracts, often we could hold triple net expenses fairly flat or with slight increases,” Caulum said. “So if you have a triple net structured lease, you have benefit of that. With a gross lease, you might be going up 3% no matter what.”

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