The Math Behind the Motivation

Occupiers often think pricing for office space is one dimensional.  Sure, they understand that different quality buildings and spaces translate to different prices.  But pricing is actually complex and dynamic, based on many variables, including specific owner motivations.  And motivations vary significantly from one owner to the next.
 
Consider the exact same quality of space in 2 comparable buildings having different owners.  On the surface, you might expect the owner’s rental objectives to be similar.  However, in practice, they can be drastically different.  Why?  Because owner motivations and the leverage narrative may be completely different.  How can they differ?  Start with the asset itself.  How much of the building is vacant or soon to be vacant?  What percentage of the leases roll in the near-term?  What is the owner’s cost basis?  Does the owner intend to hold the asset for the long term, or will they look to sell?  Is the asset evaluated on a stand alone basis, or is it part of a portfolio?  Is the owner a REIT?
 
It’s not uncommon to see a situation in which one owner is willing to transact for $65/sf; whereas the other won’t transact for anything less than $75/sf.  For the existing tenant, seeking to execute a discounted lease extension, the normal approach is to leverage the value it creates by de-risking the owner’s future.  Specifically, the extending tenant will often require less capital (tenant improvements) and will not expose the owner to a disruption in cash flow.  However, even when the cash flow from the discounted extension of the existing tenant is higher than that from a new deal at full market, the owner whom is focused on max valuation will go for the higher rent, riskier outcome.   This is because they’ll make more profit on the sale due to a higher asset value.  Commercial office buildings are valued based on the capitalization of net operating income.  A $10/sf swing in net operating income at a 5.5% cap rate is worth $181/sf in asset value.  If we’re evaluating a 20,000 sf space, that’s worth $3.6M.  Even if the owner has to spend $50/sf more in tenant improvements and the space sits vacant for 12 months, the value derived from a future sale is greater than the cost of acquiring the new deal, which is about $2.3M (the additional $50/sf in TI and the 12 months downtime).  Further, holding firm on rental value may have an aggregate effect on the values of other space in the asset.  So while the owner takes more risk and spends more up front, it comes out $1.3M ahead.  Now consider this same calculus over a 600,000 sf asset.