The Restructure
What may not be readily apparent to some occupiers is the extent to which the San Francisco office market presents an opportunity to restructure leases. What does it mean to “restructure” a lease, you may ask. Well, it can mean a lot of different things, but in this case we’re talking about negotiating new terms ahead of an expiration such that the tenant receives immediate benefit. For example, say a lease has 3 years remaining at rents that are significantly above market and the tenant requires improvements to modify the space. If the tenant is willing to commit to the building for a term extension beyond the existing expiration, depending on the circumstances at the asset level, there may be an opportunity to recast the lease. The trade for the landlord is one of near term pain for long term gain. The trade for the tenant is one of near term gain for (potentially) less future gain. In a perfect world scenario, timing would work just right and the tenant would make the trade early, only to see the market turn less favorable thereby making the restructure look genius.
But achieving genius outcomes, while aspirational, is seldom how things actually work out. Hence it’s very important to consider a possible lease restructure in comparison to doing nothing at all. What would the current obligation + a future scenario (negotiated on the timeline of the existing expiration) look like? Is it likely to be more or less favorable than the early restructure? To be sure, the restructure negotiation necessarily plays out with lesser leverage than the tenant would otherwise enjoy if negotiating closer to its natural expiration. This is because of the remaining obligation. So why might an occupier consider attempting an early restructure? Several reasons:
Near term need to reduce obligation
(the benefits of negotiating now for reduced obligation outweigh the longer range benefits that might be achieved by being able to fully exercise leverage)
Near term need for capital to make improvements to the space
(especially relevant as companies think about redoing space to encourage RTO)
Belief the value of a restructured lease, notwithstanding the limits on leverage, will outperform the longer range cost of waiting and negotiating downstream
OK, so why would a landlord make this trade? For starters, there may be significant current vacancy and/or upcoming vacancy from now until the existing lease expiration causing the investors to seek stability. And despite what is often a “bullish” outward facing persona, in down markets (especially this current iteration) many investors are privately concerned. They may have limited confidence in future market performance and place greater value on stability, even if it comes at a cost. Their version of the math may tell them the future, when the tenant’s lease expires, could end up being worse than the present; and/or, even if it’s better, it may not be better enough to risk losing the tenant.
Surprisingly, occupiers often fail to contemplate restructure scenarios, let alone actually making the effort. This is due to a long held belief that the lease is largely fixed for the term and otherwise non-negotiable. Maybe. But maybe not. It may also be due to a lack of thoughtful analysis and/or quality advice. Tenants tend to think of real estate advisors when they think they have a definitive need for such services. They may also feel uncertain about engaging an advisor to underwrite different scenarios as they know tenant advisors are typically paid by the landlord upon completion of a transaction – hence the work necessary to underwrite a potential restructure may be speculative, lacking compensation. To be fair, not all tenant brokers have the resources (research, understanding of landlord motivations, experience) to undertake this exercise in a thoughtful manner.
Here are a few gating issues to consider before assessing a potential restructure:
Is the space suitable for some period of time beyond the existing expiration?
How long (i.e., 3 years, 5 years, etc.)?
Does it require improvements to achieve such suitability?
Is the current rent obligation above current market?
Does the landlord have exposure?
Equity/debt
Vacancy
Other
If the answer to these questions is “yes”, it’s likely worth underwriting possible restructure scenarios. The result of that analysis will inform whether it makes sense to make a bid. The ultimate decision, go or no go, should be made based on the extent to which the negotiated outcome performs positively in comparison to the alternative.